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Cliff-Risk Nation

In the credit derivatives market, certain instruments are exposed to what is known as "cliff risk." This ominous sounding phrase describes a situation where the last in a series of adverse developments obliterates the value of what was only recently viewed as a triple-A-rated security. Up until that point, however, rating agencies, investors, and bankers assume that circumstances will eventually right themselves and that the principal will be paid in full, in spite of whatever bad news might have come along beforehand.

This latter way of thinking is not confined to the nether world of complex securities with tongue-twisting names like CDOs-squared. In many respects, it describes a point-of-view that permeates many aspects of modern financial life. Increasingly, Americans have taken it for granted that good times beget more of the same and they have acted accordingly. If bad news comes along, the damage is absorbed. Unlike with some toxic derivatives, however, many believe that if circumstances do manage to take a turn for the worse, something can always be done about it.

The massive build-up of public and private debts, unfunded pension promises, and other obligations underscores this perspective. Rather than coming to terms with untenable liabilities taken on because of past miscalculations, the mindset has been "don't worry about it now." If financial problems don't disappear of their own accord, they can be restructured, rolled over, refinanced, or even renamed. One way or another, the thinking goes, the situation will be resolved, because there are any number of options that are readily available.

This mindset probably explains why we haven't seen the type of response to a growing list of negatives that wizened old-timers would have expected. In the past, significant trade deficits and other unstable imbalances, myriad signs of a looming recession, talk of a subprime meltdown-inspired credit crunch, and the inevitability of down cycles following periods of historically high profit-margins and overextended uptrends would have had money managers scrambling to batten down the hatches by now.

Instead, mutual fund cash levels are near record lows, margin debt and leverage-based speculation are at euphoric extremes, and risk spreads reflect an extraordinary degree of complacency. Every data point, whether good or bad, is seen as another reason for heads-I-win, tails-you-lose optimism.

Nowadays, many would probably argue that it makes little sense to worry or even plan ahead for disaster, because there are numerous escape routes available if things do actually come to a head. Liquid markets, electronic trading and other modern technology, innovative financial products, hedging and stop-losses, and an unfailingly supportive Federal Reserve are seemingly permanent fixtures of today's financial landscape that will no doubt counteract any unwelcome adversity.

At the same time, the belief exists that there is still big money to be made from taking out-sized risks, and incentives remain heavily skewed to the upside. Practically speaking, current performance is all that matters, with nary a thought given to longer-term returns -- or concerns. What might be lost through aggressively geared-up bets on repeated rolls of the dice seems to pale in comparison to what can be realized if everything goes exactly according to plan

Many Americans have adopted a somewhat similar perspective in their day-to-day financial lives. Don't make enough to keep up with the Joneses? Just charge the credit card. Don't have enough to buy a home? Borrow 100% of what you need -- higher property prices in future will make the extravagance worthwhile. Interest rates are too high? Sign up for adjustable-rate financing with ultra-low up-front teaser rates. Can't afford to make all your monthly payments, or even survive on your paycheck? Refinance what you owe or simply borrow what you need.

In fact, the mantra seems to be: "Why be defensive at all?" With a support system supposedly in place that can theoretically postpone the day of reckoning more-or-less indefinitely, the rational response is to push the envelope to its extremes. Combine that with the constant bullish squawking and tom-tom thumping by banks and other financial institutions, retailers, policymakers, politicians, and the media, and it adds up a siren song of short-sightedness and self-indulgence that is hard to resist.

Governments at all levels are in the same thrall. How else can you explain politicians who talk, talk, talk about fiscal responsibility, but who continue to advocate ever-escalating spending and borrowing nonetheless? Or who insist on using almost Dickensian pay-as-you-go accounting systems that ignore mind-boggling financial obligations that our children -- and our children's children -- will ultimately be responsible for? One problem, of course, is that many have drunk the Kool-Aid that says we can grow our way out of each and every mess. In that delusory state, they carry on as before.

Corporate America is also mired in the here and now, with little apparent trepidation about any challenges that lie ahead. Managers seem mainly focused on slashing costs and paring back investment, instead of longer-term planning, when they are not feathering their nests, of course. Corporate policies, including executive compensation plans, are strongly aligned with short-term performance goals. Even in economically sensitive industries, borrowing levels are going up while reserves are kept to a minimum. You would have thought the best and the brightest would know better.

Yet everywhere you look, people are unwilling or unable to stop what they've been doing, especially in recent years, because it seems to have worked so far and for so long and everyone else is playing along, too. Many economic and financial squalls have passed without causing serious disruptions, at least in the aggregate, and it's hard to refute the optimists when they argue that the times are as good as they've every been.

And yet, one day, as is likely to happen ever more frequently with CDOs-Squared and other toxic new age monstrosities, the "event" that really matters will come along. A paradigm-killer that sets in motion a chain reaction that completely undermines the apparently never-ending stability that everyone has gotten used to. By then, people will realize very quickly that America, once viewed as the world's foremost economic superpower, is nothing more than a cliff-risk nation.

 

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