When Big Is Bad

On July 27th, CNBC screened one of their biggest ever TV interviews, with the economic Big Four: Henry Paulson (Treasury Secretary); Carlos Guttierrez (Commerce Secretary); Rob Portman (director, Office of Management and Budget); and Edward Lazear (chairman, Council of Economic advisors).

Indeed, we can not remember when such an august body was last assembled for such a TV interview. To us, it showed just how big and very serious is the situation before us and that our government is deeply concerned, as they should be.

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Clearly, the interview was staged to calm both national and international nerves at a time of very big risk.

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For example today, Bloomberg reported, "HSBC Holdings Plc, the world?s third largest bank, may pay the price for lending $47 billion to Americans as the U.S. housing market fell into recession."

That is a big number for any bank. To put it into perspective, the $47 billion should be compared with net income of HSBC?s $15.8 billion. Another crucially important factor will be how much of these loans were off-loaded into the securities markets as collateralized debt obligations (CDO?s).

Talking about CDO?s raises another big, perhaps the biggest ever, financial number in history. It is the gigantic size of the derivative market, as a whole. Some sources report this to be a staggering $493 trillion. Yes, trillion!

Let us remind you of the true magnitude of a trillion.

If you had one trillion dollars, it would take you some 31,000 years to count them, a dollar at a time, at one every second, 24/7!

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The crucial problem with the massive size of the derivative markets is not its absolute size, but its relative size. Relatively, it is some seven times the total value of world residential housing and many times the size of the pooled reserves of all the world?s central banks!

This is not the only major concern. Remember that much of the "action" in the derivatives markets is based upon a high degree of leverage.

Furthermore, the complexities of the many derivatives themselves means that it is extremely hard to see exactly who ends up holding the "baby".

So, if anything caused a serious problem, a world-wide financial and economic disaster could follow. In other words, the potential problem could be too big to handle, short of collapse.

It is like someone who has a baby gorilla as a pet. It can be controlled. But when fully grown, the owner is no longer capable of controlling the pet.

In this respect, the Bloomberg report that yet another hedge fund has stopped investor withdrawals is of concern of a spreading problem.

In yesterday?s CNBC interview, we saw a lot political evasion of questions. For example, when Mr. Gutierrez was asked for his personal judgment on a trade position, he diverted the question away from himself by replying, "Well, I think the figures would suggest?"

There were also lashings of calming words.

Paulson mentioned several times, his great confidence in the world economy and of that of the United States. This was echoed several times by the other panelists.

Admittedly, the announcement that the U.S. economy grew last quarter at the fastest pace for over a year (an annual rate of 3.4%) was good news.

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But it is not quite so cheerful when one sees that it was propelled by: exports (due mainly to a vastly depreciated dollar); government spending (Iraq, etc); and temporary inventory rebuilding. There was little to show enthusiasm on the part of the most vital component, the U.S. consumer!

The American consumer is still the major single item in the world economy. Should the American consumer stall, as we fear may happen increasingly from now into 2008, then the rate of world economic growth will falter, and that could present a big problem.

We feel that the recent market corrections are a dawning of reality, not merely the "wake-up" call that Paulson professed.

Even then, as Bloomberg reports, "Asian stocks fell the most in four months, extending a rout that wiped out $1.3 trillion of global market value yesterday, as investors shun riskier assets because of a deepening U.S. housing recession." We believe this is an indication of how a downturn in the U.S. economy could easily affect world wide growth adversely.

The Bloomberg report goes on to quote Schroeder strategist, Simon Doyle, as saying, "If the U.S. is under question, there might be a broader contagion."

Amongst the most audacious of Paulson?s assertions was, "What we are seeing is risk being re-priced. That?s healthy. It?s a market adjustment."

Well, we believe that an earthquake could be considered an "adjustment" or even the dropping of the two atomic bombs in World War II!

The problem comes when an adjustment is so large that it risks bringing down many structures with it. This, we think, is what we now face.

The irresponsible leverage, aided heavily by the hedge fund industry, lax banking practices and politicized central bank money supply increases, is now in danger of coming unwound.

The recent fall in corporate bond prices and the rise in price of Treasuries indicate a major flight to quality. We feel it will increase and even draw into question some of the ratings assigned to certain corporate debt.

One bright light is that seeing the horrific potential of a financial melt-down, the Fed must be reassessing its professed stand against inflation and even start to think of lowering rates.

If that happens, it will store up great problems for the future, in terms of stagflation.

However, even we would argue that there are times when continued unhealthy laxity is better than the imposition of a discipline that could kill the patient.

It is all a question of priorities. Today, the overriding priority must be the preservation of capitalist free markets and world trade.

We did not believe many of the soothing words of the Big Four, but we feel, in the circumstances, they were right to offer them.

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