Saturday, September 15, 2007

When The Music Stops

Financial markets and real estate are connected by way of derivatives that involve perhaps $470 trillion in leverage globally. That's trillion...

The analogy of musical chairs fits both well. When the music stops, where will you be? No telling.
Many however will be looking at their hands wondering where the money went...
The money that never was. Artificially created money on paper and in the digital universe. In reality none of us can really know if our investments are solid or as insubstantial as smoke in a mirror. It may only be at the end of a panic that we find out for sure. That is the paradox of the modern derivatives market, the monster that ate the future.

Why do speculative markets always end in panic selling? Think of speculative market investors as players in a game of musical chairs. The chairs represent the safe positions where a nimble investor winds up with cash proceeds from the sale of their securities at a high price when there are still many buyers, before the music stops. The alternative position, standing, is the position occupied by everyone else after the music stops. These players are stuck holding their securities for lack of a buyer as values drop 20%, 30%, 40%, 60%, 80%... In a selling panic, there are few if any buyers.

When the game is on, the players circle the row of chairs while an orchestra comprised of financial services company employees -- brokers, press agents, market analysts, and others involved in marketing and selling equities-based financial products to investors such as investment trusts in the 1920s and mutual funds now [hedge funds in 2007] -- play in concert with popular press reporters and editors, financial planners and other groupies who play off the same sheet music. Those who don't play off the same sheet music are labeled "contrarian" and are sent off to remote web sites where they can play their odd sounding music in obscurity.

A speculative stock market is unlike musical chairs in one critical respect.An investor takes money out of his pocket to buy stock. He thinks he still has that much net worth, but all he has is equity paper instead. If the price of the stock goes up he thinks he has more net worth. He can even use the stock as collateral to borrow more money to buy more stock.

Meanwhile the original money he spent to buy the stock goes to the guy he bought the stock from. The stock seller might put the money in the bank where someone else will borrow it or he in turn might buy the same stock himself, helping to drive the price up some more. Now the guy that he bought the stock from has the money that he got from the first guy he sold the stock to. And so on.

Add up the money that everyone thinks they've got and it's far more than what is really circulating. But as long as the boom continues everything is fine and the apparent "wealth" grows.Some people after making a gain "hedge" their position. Some get involved with derivatives in other ways, producing even more apparent wealth along with apparent security.

What happens if a significant number of people all want to make a withdrawal?

That's when all the apparent wealth disappears.

It's a chain reaction. Collateral is gone so margin calls get generated. More withdrawals. More chain reaction.

Read the complete article at: itulip


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