Extreme Events

For now, the global financial markets seem to have calmed down. But the "background noise" of bad news is still there. Since late 2006, 159 US mortgage lenders have already broken down in some way, and new ones are added to the list every week. Housing prices are still falling in the US, and the bubble seems to be about to pop in Europe too, where Spain and the UK seem to be first in line for a major housing bubble correction. Prices of oil and cereals are still rising sharply. The US dollar continues its fall. The interbank rate (e.g. LIBOR) is still well above 6 percent. Many businesses find it hard to get loans or to roll over their loans. Bloomberg reports:
"The U.S. commercial paper market shrank for a sixth week, extending the biggest slump in at least seven years"
"Commercial paper investments have declined $354.5 billion, or almost 16 percent, since the week ended Aug. 8"

I can't believe that everything is now well after a number of extreme events in August and September:

• At the beginning of August, some banks obviously had major problems, and central banks all over the world had to inject liquidity to keep the wheels going, on a scale not seen since September 2001, and in some cases never seen before.
• The US FED unexpectedly lowered the discount rate by ½ percent on 17 August.
• There was a "run on the bank" in British Northern Rock 14-18 September. When was the last time we saw a run on the bank in Britain? This was so serious that US Treasury Secretary Henry Paulson suddenly decided to fly over to London to meet the British Chancellor of the Exchequer Alistair Darling. On 18 September the British Government announced that they would guarantee all deposits at Northern Rock. Whew! Crisis averted for some time.
• Little more than a month after Ben Bernanke said that inflation was his main worry, he lowered the Fed Funds rate and discount rate by ½ percent on 18 September. This of course caused the US dollar to fall like lead.
• Saudi Arabia did not lower the interest rate this time. They have so far followed interest rate changes in the US, and their currency is pegged to the US dollar. This of course raises fears that they will now unpeg their currency from the US dollar, which would cause mass exits from the US dollar and possibly a dollar collapse.

So what are we in for next? Crude oil is now definitely above $80/barrel. The US$ has dropped about 3% in one month. Foreclosures in the US jumped up by 36% in August, which is up 115% from August 2006! And there are still loads of ARM mortgages awaiting interest rate resets over the next couple of months.

I guess there will be a few weeks of calm before we see the next extreme event. How many extreme events can the world financial markets handle before an avalanche is set off? Don't forget that everything is tied up by trillions of dollars in derivatives.

If we get bankrupts increasing because of the problems for companies to get loans, we will see a test of the credit default swaps (CDS). The amount of CDSs outstanding is equivalent in size to total world GDP. It's already doubtful whether many issuers of CDSs can live up to their promises. And who holds all these CDSs? Default by a big enough company somewhere in the world could thus cause a cascade of bankrupts and defaults, since both the issuer and the holder of a CDS might go down, in their turn bringing down other holders and issuers of CDSs.

There are even more interest rate swaps and currency swaps than CDSs. What happens to the issuers of these when interest rates and currencies start to move quickly and in unexpected ways? And don't forget that many hedge funds speculate in these kinds of financial instruments.

Like the Chinese curse says: "May you live in interesting times..."