They have become the primary underlying capital of our financial system. They are highly leveraged. When times were good, and housing prices were rising, we gained tens of trillions of dollars of "wealth" on the balance sheets of most banks and other financial institutions. This mostly all happened in the last five years.
Now that real estate prices have gone down, even when they were down just a modest amount, this leveraging started working in reverse. Most banks and financial institutions, as well as some companies (GE, GM, Ford, ...), the GSE's, and many municipalities, states and our federal government are profoundly bankrupt.
The risk to the value of the underlying assets, our real estate, does not change; you're right on that. But three other ruinous things happen.
The other essential problem of CDS's, since they are not openly marketed and thus transparently priced (no one knows what they are worth), and since they became the absolutely dominant form of nominal wealth, is that they made the very foundation of our "money" supply non-transparent and untrustworthy.
The sterling, and then the dollar were once based in gold. Then the dollar became based on U.S.Treasuries, and the reliable income stream (from our IRS tax collections) for paying the interest. Both those formed an adequately solid basis for a currency. The essential property of any currency is that people can trust it as a store for value.
The world's reserve currency, the dollar (as well as the Euro) is now based on CDS's, which are more systemically corrupt and less transparent than the promises of our politicians.
We are trying to finesse this by bailing out the failing companies, which means replacing their failing paper with U.S.Treasuries. But this requires printing Treasuries far in excess of what the income stream from the IRS tax collections can fund.
The result will be that the value of the failed CDS's do not rise to the value of Treasuries. Rather, the value of Treasuries (and hence the dollar) will fall to the value of the failed CDS's, junk bonds, failed stock, and defaulted mortgages.
Time to stock up on the guns, ammo and whiskey.
Very well done, Sir.
This is one of the more interesting threads I’ve read on FR, and I’ve been here a while.
Rather than directly inflate the currency that we were all tracking, we inflated these hidden financial instruments, and took advantage of the inherent lowering of prices for many goods thanks to newly industrialing nations (China) coming on line to hide this inflation.
We are now in a very volatile period, in which the money masters are trying to combat the enormous deflationary forces of this collapsing junk with an awe inspiring, but so far not yet adequate, increase in U.S.Treasuries.
We don't need to expand Treasuries one-for-one to match the collapsing CDS's -- thank heavens. That would mean somewhere between $50 and $100 Trillion, which is too big a number even for Paulson to dare ask for.
But we would need Treasuries of stable value in quantities of a few Trillion dollars, increasing our national debt from, very rough estimate, $10 Trillion to $15 Trillion. Holding the value of Treasuries anywhere close to par value, when this many new ones are printed, will be difficult. I am making my investments assuming a strong rise in U.S.Treasury interest rates over the next few years, as we saw in the inflationary periods of the 1970's.
If all the major counter parties (the other big nations which hold these Treasuries) decide to play nice, perhaps out of fear, then this might actually be sufficient to avoid collapse of the worlds reserve currency - our dollar.
Essentially the risk of systemic failure of the big banks has been elevated to the risk of systemic failure of the big nations.
In my personal behaviour, I am acting as if the odds favor this triage of the current monetary crisis happening successfully, after one to a few more years of pain and a recession, perhaps quite deep. But such a "successful" outcome is by no means certain. It could get a lot worse.
If, or when, the current international monetary scheme breaks down, it will likely devolve into a major war.
My top bet is that there will be one more big bubble first, in energy (oil, gas, coal, nuclear, solar, wind, geothermal, magic pixie dust, ...)