There is, of course, a difference between Bernard Madoff and the Wall Street structuring machine. The structuring machine levered up thin returns into fat ones, and Madoff invented fat returns that weren’t there at all. Madoff’s investors didn’t do the obvious sums: the options strategies he advertise theoretically might work for a small portfolio but couldn’t possibly have worked for a portfolio of a few billion dollars (let alone tens of billions) because the trading requirements would have been an order of magnitude larger than the entire options markets.

Investors in structured product didn’t do their sums, either, with the result that write-downs in the global financial system to date have reached $993.9 billion, against $919 billion in capital — which is to say that the entire global financial system is insolvent, except for Fed bailouts. Bloomberg (the professional service, not the publicly available news) has done the numbers, and they are impressive. Freddie Mac had $56 billion of writedowns against $15.6 billion of capital, Freddie Mac had $58.4 billion of losses against $20.8 billion of capital, Washington Mutual had $45.6 billion of writedowns vs $12.1 billion of capital, and so forth.

The government has killed some of these institutions and recapitalized others. But recapitalizing doesn’t help unless they can earn income on something. Given that housing starts and permits are the lowest in history, home prices will continue to collapse, joblessness will explode, delinquencies will rise, etc., how is it possible to avoid a complete and total breakdown of the global financial system?

A common estimate is that yet another $1 trillion of write-downs is yet to come (and pessimists have bigger numbers). The first $1 trillion was roughly equal to the capital of the financial system; against what capital (or better, whose capital) will the next $1 trillion be written down? Think of Soylent Green: it’s made of people, specifically, hedge fund investors.

A partial but important answer, as I suggested in a post yesterday, is the equity of hedge funds.

1) The Fed borrows at 0% from the world ($286 billion in short term inflows during October alone)

2) The Fed lends at 0.5% (or whatever the funds rate is after today’s announcement)

3) Hedge funds are liquidated and sell structured product at pennies on the dollar to banks

4) Banks finance structured product taken from hedge funds at 0.5% and earn double digits

5) Very high earnings from very high-yielding assets compensate the banks for continued losses in the rest of their portfolios

6) The Fed through its commercial paper program and perhaps other direct lending programs to make sure that large-capitalization investment-grade debtors continue to pay interest.

That is why financial stocks are up today, despite the terrible Goldman Sachs data, and despite the catastrophic housing data. I wouldn’t buy the financials’ common stock here, to be sure. They are zombie stocks, kept alive by the evil magic of the Wizard of Constitution Avenue.

This entry was posted on Tuesday, December 16th, 2008 at 9:55 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.