A dollar default is unthinkable in these affluent modern times. Or is it?

Last week a “flight to safety” of investors in America’s $3.5 trillion Treasury money market was only halted by Secretary Henry Paulson’s swift action in nationalising the banking sector’s bad debts.

Read The Great Harvard Sausage Scandal 2008 over at Syntagma.

Of course, most of the movers and shakers have already salted away their massive bonuses and are probably even now relaxing with a cocktail or two on their yachts in Monte Carlo harbour.

They have left us with a colossal mountain to climb. In the UK, house prices have a further 25-30 percent to fall, according to Roger Bootle, and already Britain’s largest mortgage lender, HBOS, has failed. How many other banks will go before we hit bottom?

Read the rest of the article.

Can we really have witnessed the demise of three top investment banks in so short a time? Bears Stearns, Lehman Brothers and Merrill Lynch have all disappeared off the radar in quick succession.

What is happening to the world’s — and especially the American’s — financial system?

It started with the slicing, dicing and splicing of U.S. mortgages of sub-prime customers. The structured financial instruments that were sold off around the world became known as CDOs (Collateralized Debt Obligations).

They have poisoned the world’s financial system, like seeping toxic waste. Now a new danger is forming on the horizon.

CDSs (Credit Default Swaps — insurance policies for bonded commercial IOUs), which are out there in their trillions and trillions, are beginning to crumble in the face of massive defaults.

The world’s biggest insurer AIG is already in Lehman territory — its shares plummeted by 70 percent in early trading yesterday. The long-foretold CDS crisis is with us at last.

So what precisely are CDSs and how will their demise affect most of us in coming days, weeks, months and years?

George Soros estimates that the value of CDSs now equals half of U.S. household wealth, an almost unimaginable number — let’s call it $23 trillion.

CDSs are hedges made by investors in case a company defaults on its debts. In effect you bet on a company failing to protect your investment in the event it does just that. The problem arises when large numbers of companies go bust and the CDSs themselves become worthless since no-one can pay them out.

A CDS seller undertakes to compensate a buyer if a corporate bond defaults. Since there is no limit to the size of cover taken out, the value of CDSs often exceeds a company’s debts. Moreover, many CDSs are bought with borrowed money so the infection of the system drives deep into the financial heartland like veins in a blue cheese.

The danger now is debt deflation: a rapid reversal of debt issuance, or deleveraging as it is called.

Tim Congdon of the London School of Economics says, “Banking system capital is being wiped out. The risk is that this could lead to a contraction of credit and set off a self-reinforcing downward spiral, leading to the sort of debt-deflation we saw in the 1930s.

“It is already clear that money growth has ground to a halt over the past three months. We must prevent it from actually contracting. If the Fed and European Central Bank don’t cut interest rates soon, it is going to be a problem.”

The Bank of England’s rigid inflation target, set by Gordon Brown when inflation was low, is now a millstone round Mervyn King’s neck at a time when energy, food and commodity price rises are being imported from global markets.

The Eurozone is similarly caught in a time warp relating to Germany’s neurotic fear of hyperinflation. Add the growing divergence between euro economies and a far deeper than necessary downturn is guaranteed for Western European countries.

America is already suffering a double blow: the fading of the effect from the summer tax stimulus and a loss of export competitiveness as the dollar rises.

What began as bad government, worse regulation, grasping banks, financial structures that lacked resilience because they were built on sand, have left us with a perfect storm that is about to come ashore and swallow large parts of the economy.

George Soros, the hedge fund operator who famously “broke the Bank of England” in 1992 after short selling sterling to force the pound out of the ERM, has given an interesting interview to a British newspaper.

“This is a period of wealth destruction. The people who make money will be few and far between. There will be a lot more money lost than made.

“I think this is probably more serious than anything in our lifetime. I think the dislocations will be greater because you also have the implications of the house price decline, which you didn’t have in the 1970s, so you had stagflation and transfer of purchasing power to the oil producing countries, but here you also have the housing crisis in addition to that.”

In other words he believes that the United States and Britain are facing a recession of a scale greater than both the early-1990s and the 1970s.

In the UK will be hard hit, he says. “House prices have risen over the years and are further away from sustainable than in practically any other country, in terms of household indebtedness and the relationship of house prices to incomes.

“This is going to be compounded by the fact that the financial industry weighs more heavily on the economy than in other countries, because London is the centre of the global financial system, and you have the unfortunate condition that the Bank of England is bound into inflation targeting, and is not in a position to lower interest rates until you have an economic slowdown.”

However, “It’s much better than the straitjacket sterling was in when I broke the Bank of England. The ERM would have been abandoned even if I had never been born.

“As a hedge fund manager, I do not claim to be serving the public interest. I am in the business to make money,” he says. “It’s a difficult point for people to understand and there’s a general attitude when they see people profiting to say that markets are immoral, or making money by speculating is immoral.

“It’s really the job of the authorities to set the rules, and there are times when some people break the rules or engage in improper activities, like the sub-prime mortgages. The impact fell particularly heavily on black and Hispanic minorities.

“It is a scandal, and I think you can blame Greenspan for not regulating the mortgage industry. But that’s very different from speculating in government bonds or financial instruments, and that’s a difficult point to get across, but I feel very strongly. Markets play a very useful role and they are amoral, not immoral.”

A version of this article appeared in Syntagma recently.

As we predicted here, this credit crunch cum downturn cum recession cum slump cum … was always going to happen in slow motion. That’s because of the normal lags involved in the transfer of economic conditions between countries and continents. Britain is said to be around nine months to a year behind America.

While the U.S. downturn started at the back end of last summer, it’s only now starting to decimate the British economy and parts of the eurozone. If we want to know how bad it’s going to get, we only need to peer across the Pond.

Gold rushes come and go in the world’s innovation capital, California. But when they go … they really go.

The City of Vallejo in California has filed for Chapter 9 bankruptcy, making history it seems. Half Moon Bay, home to some internet digerati, may well be next. According to John Moorlach, Orange County board chief, “This is the tip of the iceberg: everybody is going to line up for Chapter 9 in California.”

What can it mean to people on the ground when their city goes belly up? What of their assets, houses etcetera? It will be interesting to watch this pan out.

According to Goldman Sachs and Lehman Brothers American house prices are likely to fall 25pc from peak to trough. With between 10m and 12m households in negative equity already, there’s still a way to go.

Shares across the developed world are set for big falls too. Albert Edward Société Générale’s global strategist says, “Nowhere and nothing will be immune. We are on the cusp of an equity meltdown that will slash and shred portfolios. We see a global recession unfolding. Liquidity will drain away and crush the twin emerging market and commodity bubbles. The recent hope that ‘the worst might be over’ is truly staggering. Profits are disintegrating.”

Ambrose Evans Pritchard of the Telegraph (UK) — ever the Cassandra (rightly so, in my view) — says pointedly, “Britain, Europe, Japan, and China will go down before America comes back up. This is turning into a synchronised bust, after all. The Global Slump of 2008-09 is under way.”

The Bank of England and the European Central Bank are still stubbornly refusing to cut rates because of inflation fears, which will be the least of our miseries in the next two years and should abate soon as global demand falls off the much-imagined cliff.

It’s probably true that Ben Bernanke’s Federal Reserve has saved the U.S. and other countries from another Great Depression. But nothing can stop a slump now because it’s already happening.