CNN iReport

What makes anyone think that the financial crisis might be under control? Easing interbank interest rates? Have you ever wondered where exactly the money is flowing to? I will show my readers at the example of A.I.G. what the core of the credit crisis is and how to contain it.

In the first article of the series, I have established the root cause of the economic problem, the $1000/month income/cost gap of the average American, and in the second, I have set out proposals on how to address the gap boldly by governments because the market mechanisms fail at this point. I have also tried to make clear that, without radical steps, the economy looses a whooping 27% of activity as long as unemployment does not rise. If it does, the pain will be even bigger and longer.

I would like to know from A.I.G how big the potential for further losses is and what the risks to A.I.G.'s life insurance and pension activities are. There are no such questions and no answers. If there were, you would be scared. While A.I.G. has now access to $144 billion in government funds, the Fed might be looking at a gaping hole of half a trillion or even more by the time financial markets stabilize.

Nytimes, Oct 30, 2008, Walsh: "A.I.G.'s cash needs could grow even further. Much of the cash it needs is being used to meet collateral calls from its derivatives counterparties, and the precise collateral triggers and amounts are not public information. In general, the derivative contracts cost A.I.G. more as the real estate markets decline. The company's financial products division did a lot of business in that type of derivative, called credit-default swaps. By the same token, if real estate prices rebounded, A.I.G. has said, it could call some of the collateral back."

Read again, "if real estate prices rebound" they would be better off, and, in essence, it costs more if they don't. The trouble is that real estate prices will NOT rebound. After all that we have learned during the last several weeks and months, only gambling addicts can believe that their luck is coming back. So, they carry more money into the casino.

Even if the government takes the proper steps to fight a Depression, it will take a while for those programs to work, and America will still see a significant downturn. It will see housing prices further declining dramatically and stock markets starting to change their view from growth to decline, hence, further massive losses in valuations.

If I have not made myself clear enough: we will NOT see the lofty stock prices and real estate prices again for an entire generation (in real value), even if the government implements a successful anti-Depression cure.

For your comfort, the Nobel Laureate Paul Krugman said: "The long-feared capitulation of American consumers has arrived. According to Thursday's G.D.P. report, real consumer spending fell at an annual rate of 3.1 percent in the third quarter; real spending on durable goods (stuff like cars and TVs) fell at an annual rate of 14 percent." (Nytimes, Oct 31, 2008)

What that means is that A.I.G. carries immense risk in its derivative business that is threatening life insurance and retirement funds.

Moreover, A.I.G. is not alone. The entire financial system was and still is engaged in the unregulated casino style derivative market that is dependent on

1) no major player going belly up

2) markets going back up

If markets continue to go down, the derivative market will collapse as a series of major players will not be able to meet their obligations. The only reason why it has not fallen apart so far is because worldwide government bailouts in the total amount of trillions of dollars keeps the casino humming. For A.I.G. alone, the cost so far was $144 billion. How much is it going to be for the rest?

If this crisis is to be addressed properly, we have to KNOW what the risks are in order to figure out how to contain it. The derivative market size is a stunning $500 trillion (yes, that's a "T"). Even a small portion of that amount, if faltering, will unleash a tsunami that has the destructive potential to America's and the world's economies comparable to a major asteroid impact. It can throw society right back into the middle ages.

Two things need to be done:

b) launch an internal audit into all derivative activities of all players in the financial industry.

a) the derivative business of all players in the financial system needs to be broken off from its traditional business into a separate entity.

The window of opportunity is closing fast. Possibly within weeks, within a few months at the most we will see the water retreating out to sea, before the tsunami hits. If regulators do implement an economic stimulus plan that works (see "focus on income and equity"), the broken off derivative businesses may survive. If the plan does not work, the derivative business better be in quarantine.

This article is part of a series of articles focussing on what local, state and federal governments need to do now in order to address the upcoming economic Depression.

economic stimulus (1): the disabled consumer

at http://www.ireport.com/docs/DOC-132064

economic stimulus (2): focus on income and equity

at http://www.ireport.com/docs/DOC-132067

economic stimulus (3): quarantine risk

at http://www.ireport.com/docs/DOC-132200

economic stimulus (4): sweep up the unemployed

at http://www.ireport.com/docs/DOC-132202

economic stimulus (5): bailout state governments

at http://www.ireport.com/docs/DOC-132205

economic stimulus (6): protect food and energy supply

at http://www.ireport.com/docs/DOC-132795

economic stimulus (7): invest into the future

at http://www.ireport.com/docs/DOC-132856

economic stimulus (8): be globally the most competitive

at http://www.ireport.com/docs/DOC-133022 

economic stimulus (9): change politics

at http://www.ireport.com/docs/DOC-133026

economic stimulus (10): prepare for budget cuts

at http://www.ireport.com/docs/DOC-133113

Please comment. I will try to address questions, if I can.

H.R. Tschudi, economist and entrepreneur, Vancouver