In spite of all the talk of spending hundreds of billions of dollars, our leaders are not talking about the mammoth in the room--the Derivatives market. This will be the next shoe to drop and it will flatten all our efforts so far and make them look like playschool practice. Some economists will tell you this market is no big deal because the bets are counterbalanced--that is, if one goes up, the other goes down.
First of all, you must ask yourself: if you were holding a ton of bricks in one hand and a ton of rocks in the other, would you be balanced, or would you simply be crushed? The amounts are so enormous that they effectively cannot be collected, even in a significant portion, because the financial institutions don't have anything like the required amount of resources. Second, and even more importantly, even a slight loss in relative terms would be unrecoverable by the financial institutions that made the bets. As we've seen, the financial players don't have anywhere near the kind of precision in their modeling to protect themselves from currency fluctuations (where most of these bets reside) or, for that matter, much of anything else. The issue of how reliance on quantitative models actually causes the failures that its promoters seek to avoid is the subject for another article, but I will say, their managers should study more of human nature and less of non-real world mathematical models.
Getting back to the derivative crisis; to resolve it, and to save the worldwide economy, Obama must assume FDR-like powers, something he has seemed reluctant to do so far, despite his mandate to do so. The first thing he should do is to declare all derivatives placed outside of legally regulated markets (90% of them are unverified contracts) null and void. These "bets"--worth $180 trillion according the U.S. Office of the Comptroller of the Currency in America alone, and over half a quadrillion dollars worldwide--could not have been made in traditionally regulated markets, because the players had insufficient collateral, i.e. they flouted the law and their fiscal responsibility.
Because for every buyer there is a seller, the amounts lost would zero out and no one would gain an advantage. We would just get to reset the clock. This is as fair as things can be made given where we are. Right now, this enormous sum is only good for driving companies into bankruptcy and tying up the courts for years while the "winners" of these bets squabble over the crumbs of the bankrupt companies. This is already happening with creditors fighting over the last crumbs of Lehman Brothers. This is a pointless and destructive squabble and the administration must act to prevent years more of these.
If the parties object to the elimination of their derivative bets, they should be reminded of the penalty for fraud.
What's causing the panic in the markets right now is the realization that the losers have insufficient money to pay the winners. The domino effect of multiple collapses cannot be stemmed by any government, even by running the printing press overtime. The only solution is to wipe them off the books and ensure these bets are never made again by sending those who make them in the future to jail.
This won't solve everything, but it will allow us to put the big insolvent banks into receivership without worrying about what other institution's bets will be uncovered. THAT, and not the inability of subprime borrowers to pay, as bad as that is, is what is really keeping the Administration acting like deer caught in the headlights, paralyzed and unable to react effectively. Of course, they do not want this to get out, so when it does, it must be dealt with finally and thoroughly.
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