Understanding the financial market meltdown: the rise and fall of the shadow economy... by gimleteye

Risky subprime mortgages are held out as the cause of the world-wide financial crisis. Untrue.

What equity markets reflect, today, is the "de-leveraging" of a shadow economy, inflated by risky financial derivatives. Hard to understand? Picture it this way: deregulation of financial markets and instruments, especially through the rise of hedge funds, allowed a shadow economy to become larger (much larger) than the real economy. Many people knew how dangerous it was, but they were not in positions of power. (click on "read more")

The real economy is driven by real companies building equity and profits through products and services that consumers need. Certainly, debt is part of their equation-- but only to the extent that it services growth. The shadow economy uses debt to engineer additional leverage; not as a means to an end as much as an end itself, driven by fees calculated as a percentage of debt and not tied to any real value beyond that debt.

Hedge funds-- unregulated by and large-- are driving down equity markets across the world, as managers respond to redemption calls by investors to retrieve what money is left from the shadow economy. Because hedge funds only allow withdrawals once or twice a year, the selling going on now-- and market volatility-- is to meet redemption calls by year's end.

It used to be called a Nantucket Sleigh Ride, when whalers in rowboats used for spearing, were towed wildly across open seas until their quarry tired and died. Sometimes those fishermen were never retrieved. What we are experiencing now is the financial equivalent of a Nantucket Sleigh Ride: the whale is the shadow economy.

Not many citizens or taxpayers asked to be on this ride, but we are here-- in the boat-- because we allowed debt to substitute for real economic growth.

The masters of the universe, throwing the spear into the whale, are the financial engineers who understood how leverage works, especially when it is unregulated.

It is not clear to anyone how many hedge funds are now cashing out of the stock markets, but this catastrophic unwinding is driving equity levels far below reasonable norms.

The people we elect to Congress and the White House have proven themselves ignorant of the forces at work. They were persuaded to ignore to the need for regulation by the massive campaign contributions from Wall Street, insurance companies, and related interests. In 2005, Alan Greenspan, then chairman of the Federal Reserve, said, "By far the most significant event in finance during the past decade has been the extraordinary development and expansion of financial derivatives. These instruments enhance the ability to differentiate risk and allocate it to those investors most able and willing to take it - a process that has undoubtedly improved national productivity growth and standards of living." Greenspan was right about the importance of derivatives; he was wrong about the consequence of allowing the shadow economy to grow so wildly.

Investing, as Warren Buffett understands, is not like going to Las Vegas; unfortunately, we are paying a very sharp price for the abandonment of fiduciary responsibility in the management of the economy by individuals in high places (in both political parties)-- represented by the revolving door between federal agencies and industry-- who should have known better.