Under The Surface

The current selling on Wall Street is not so much about subprime home loans going bad, but about the sudden realization that bad loans are everywhere and that they are linked through derivative networks.
According to Tod Harrison, founder of Mynyanville and who writes a nifty column for Marketwatch.com, the subprime problem "only scratches the surface of the structural risks in the system," as there may be as much as "$370 trillion in outstanding derivative contracts," out there waiting to do something.
But Harrison notes that although there is that estimated figure floating about "nobody knows" how much of a derivative web there really is, thus rendering the extent of its potential as another unknown.
Harrison further adds: "derivatives aren't evil products. They're fantastic risk management tools when managed correctly. Unfortunately, given the proliferation of hedge funds and the massive amounts of leverage in the system, the odds of a "tail event" (an outlier move that isn't factored into financial models) increase in kind. "
Admitting that he's not sure if the subprime issues are that "tail event" or not, Harrison wisely notes that "it is that possibility -- the percentage probability -- that is currently being priced into the system."
His discussion gets more interesting, though, when he writes: "You see, in a finance based economy, such as the one we currently have, the dependence on financial operations has never been more acute. General Motors, General Electric, Ford, to name a few, all feed their bottom line and buffer earnings through financing operations. We like to call these "financials in drag" because most folks don't view them through the same lens as traditional banks. But let's be honest, do you think GM makes money selling cars? No. They make money selling loans. And those loans are packaged and repackaged numerous times and passed amongst financial intermediaries."
Harrison's astute analysis notes that the passing off of loans to others is a good thing in a liquidity driven, stable market. And it's rarely questioned when companies beat their bottom line earnings estimates." But, he cautions that "The other side to that trade will come to bear, however, if a pebble falls into this" intricate global machination. The perception of that risk has diminished through the years as it failed to materialize."
In effect, "The unfortunate truth is that the risk, rather than dissipating, has actually increased on a cumulative basis."