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Panic In The Streets

This morning I read an interesting article by Steven Pearlstein of the Washington Post. In “Caught in a Downdraft and Starting to Panic,” Pearlstein noted how Main Street and Wall Street have come to terms with a troubled economy:

The country and Wall Street have already made great progress in moving through the stages of economic grief:

• Willful blindness. (“Bubble, what bubble?”)
• Denial. (“House prices never fall. It’s only those speculators in Las Vegas and the Gulf Coast.”)
• Rationalization. (“Maybe subprime did get out of hand, but it’s really a small part of the market.”)
• Fantasy. (“Things should be pretty much back to normal by the second half of ‘08.”)
• Anger. (“If it weren’t for those yahoos up in structured finance…”)
• Capitulation. (“We might as well take these write-downs now and get it over with.”)
• Depression. (“This is going to get worse before it gets better.”)

Now we’re entering a new stage: Panic.

Pearlstein pointed to the following as evidence of this next stage of grief:

Hedge funds scrambling to actually hedge their positions. Central banks throwing money at money-center banks. Huge financial institutions desperately raising capital from foreign investors on concessionary terms. Day after day of triple-digit declines on the Dow. Gold prices heading toward $1,000 an ounce, with record lows on the dollar. Policymakers and politicians tripping over one another to offer economic-stimulus plans.

Not even the cheerleaders can turn the tide:

Despite the brave exhortations from the CNBC Squawk Box, we are nowhere near the end of the financial unraveling that is necessary for an economic bottom to be reached.

Pearlstein predicts that the final stage will involve the unraveling of credit-default swaps:

Looking ahead, the final phase of this unraveling is likely to implicate the giant market in credit-default swaps. Those swaps are essentially contracts that allow sophisticated investors to bet on whether a company, a government entity, or even a securitized package of loans will default on its debt obligations. And they can place these bets whether they own the underlying security or not.

Because these contracts trade on unregulated derivatives markets, nobody knows who holds the losing side of the bets. But it’s a good guess that if defaults rise even to historically normal levels, a big hit will be taken by highly leveraged hedge funds, some of which may be unable to pay off on their bets and simply collapse. That, in turn, would trigger even further losses by banks and other investors that, unlike pure speculators, rely on those instruments to insure against default.

The credit-default swap has become so central to modern global finance that its size — the amount insured, in effect — is estimated at $43 trillion. If the losing side is unable to make good on even a fraction of a percent of those contracts, it could set in motion a financial chain reaction that could easily rival the subprime debacle.