Death by Debt

Here are extracts from Chapter 3 of my book, physician The Doom Loop in the Financial Sector, and Other Black Holes of Risk (University of Ottawa Press, 2010), pp. 101-2:

Thus, by the middle of 2010 six of the seven largest economies in the world looked to be in no shape … to spend their way out of another serious financial meltdown for a very long time to come [due to accumulated debt levels]….  Recent events have seriously eroded the margin of safety in the discretionary public resources available to most of the world’s wealthiest economies; that is, the capacity of their governments to incur additional debt responding to a further financial crisis,…”

Read the full article: Death by Debt [PDF]

Financial Risk: The World turned Upside Down

Image courtesy PIAZZA del POPOLO / Flickr

Here’s the latest from the Greek debt crisis:

“Europe is seeking to avoid a default at all cost because it could also initiate payment of credit-default swaps, there with unpredictable results. There is little public information on which financial institutions have sold credit-default swaps and might have to absorb losses if Greece defaulted, there but it is likely that American banks and insurance companies have taken on the largest share. The shock to the global economy might compare to the collapse of Lehman Brothers in 2008, illness the European Central Bank has warned.” (Jack Ewing & Landon Thomas Jr., “Europe faces tough road on effort to ease Greek debt,” The New York Times, 4 July 2011)

Wait a minute! In credit default swaps the first party pays a premium to a second party in order to “insure” the value of an amount invested in corporate or government bonds made by the first, and the second party guarantees to make up the shortfall if that investment loses value, for example where the issuers of the bonds default on their debt.* Derivatives such as credit default swaps are a risk management strategy for investors, protecting them (for a price) against large losses. So how does this very sensible risk mitigation strategy, used by individual investors, end up causing or exacerbating another broad financial crisis?

The World turned Upside Down