Financial House of Cards -- But Insured!

Financial House of Cards -- But Insured!

Question: What do you call a financial house of cards that's insured?
Answer: an even bigger financial house of cards.

Just as portfolio insurance was fingered as a prime culprit in the 1987 stock market crash, another kind of insurance -- against credit defaults -- is rapidly emerging at the center of today's unfolding stock market crash and spreading global financial crisis.

But first, the house of cards.

It's no secret that Wall Street leverage reached unprecedented heights the last few years. Unlike regulated banks, which are allowed maximum leverage of about 10:1, investment banks like Bear Stearns, Lehman Bros. and others staked out positions levered at 30:1, 40:1, or more.

To illustrate what extreme leverage does to investment returns, imagine the consequences of buying a $1 asset with leverage approaching 50:1.

To translate, 50:1 leverage means that you are buying a $1 asset with two cents of your own money and 98 cents debt. If the asset even goes up a modest amount, to say, $1.05, you've done enormously well: your two cents has turned into seven cents -- a return of 350%!

However, consider what happens if the $1 asset drops to 95 cents: you're wiped out.

As long as housing kept rising, the former scenario held and Wall Street made fabulous amounts of money. However, housing nationally peaked more than two years ago, and has been falling ever since. Wall Street is now very much on the wrong side of that double-edged sword.

"Honey, I blew up the financial system"

Exacerbating matters exponentially is what Wall Street firms did to reduce the risk of a downturn.

Mindful that it was building a financial house of cards, Wall Street wizards, in their infinite wisdom (and cupidity), decided not to design a more stable financial structure, but, incredibly, to conceive yet another financial instrument, this one designed to protect against collapse -- or at least the horrific fallout from a collapse.

Called "credit default swaps," these insurance instruments were supposed to make the firms lending 98 cents on the dollar whole should the borrowers ever default.

In fact, credit default swaps became so popular that they became a way to speculate on almost any outcome, financial or otherwise: some economists estimate that, in a $50 trillion world economy, the amount of outstanding credit insurance instruments totaled as much as ten times that. Even better, the premiums on credit default swaps represented an important revenue stream for insurers like . . AIG.

So no more house of cards, right? Wrong.

It turns out that the companies writing the insurance had a small fraction of the reserves needed to make good on all their commitments. Voila! The financial kings suddenly have no clothes. Or capital. So they need ours -- a lot of it, and very quickly, please.

What does that ultimately mean?

Instead of acting as a bulwark against market collapse, that potentially $500 trillion of credit default swaps became the biggest financial card of all in Wall Street's now very much collapsed deck.

As Warren Buffet might put it, it appears that Wall Street's "financial weapons of mass destruction" are now detonating. The punctured housing market simply lit the fuse.

Next post: redesigning the system.