Synthetic Instruments: the Opiate of Hypercapitalism


The past 20 years have seen explosive growth in the US economy.  Everyone is now well aware that the party has ended and "subprime" has been added to the general lexicon.  Unfortunately, very few people will come to understand the real underpinnings of the current disaster, appreciate how widespread the effects may be, and realize just what kind of changes are needed to right the course.
 
To put it succinctly, the record bull market ride we have had has been entirely artificial.  Brilliant economic minds like Warren Buffet and George Soros have written on, and warned about, this reality for some time now, but  the momentum of a trend (especially a wildly profitable one), is difficult to slow.  No one wants to hear a few isolated voices of dissent; even if it is the voices of the most successful investors of their generation.
 
The current collapse is not so much a result of subprime as it is an inevitable outcome of the increasing distance between financial instruments and the value of real assets.  As the value of the instrument is increasingly abstracted from the value of the underlying asset, risk becomes more difficult to accurately measure and the wealth that is created becomes increasingly artificial.
 
It can be argued that the entire derivatives market is out of control.  Some measure of speculation is a healthy part of a free market system as it can help generate wealth which can lead to the creation of real value, but a reliance on speculation, is a poison pill.  Nearly all of our economic growth over the past two decades has been based on speculative instruments.  As a result, the valuation of the derivatives market is greater than the value of all real capital in circulation.
 
That regulators have continued to distance themselves from this, essentially looking the other way as it reached critical mass, and that central banks have rushed to fill voids with more currency, amounts to almost criminal collusion.  When asked why he hadn’t bought into the mortgage backed securities business, Warren Buffet essentially answered (to paraphrase), that it is almost impossible to measure the real risk of the underlying assets once they have been rolled and re-rolled into the special investment vehicles used to securitize them.  Hence, they become a suckers bet whose only real purpose is to generate massive commissions for hedge fund managers and short term returns for investors.  Not exactly "value investing", the premise upon which Buffet built one of the greatest fortunes in the history of the human race.
 
If the foundation upon which your economy is built is a fiction, it stands to reason then so is your economy.  The US economy isnt so much melting down as it is returning to its real, and sane, valuation.  The question is will regulators have the intelligence, and wearwithal, to steer the ship forward and will an amazingly ignorant populace resist the lure of "boogeyman and bandaid" politics that will surely be dangled before their eyes by enterprising politicians eager to secure their own positions.
 
Politicians, like Wall St up and comers, tend to tell people what they want to hear and give people what they want in exchange for personal gain and short term glory.  When the people are as clueless as a herd of sheep, the way forward cant look anything but grim.
 
I expect to see "too little too late" regulation that is miss targeted, short term protectionist moves that do more harm than good down the road, massive government spending on programs and entitlements that amount to little more than bandaids for a spoiled populace, and "business as usual" on Wall St and the Beltway.
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