In chaos theory, the "butterfly effect" is the idea that a tiny flap of wings in one country will contribute to a reaction in another that can wildly alter the weather of, possibly, both.
The current global credit typhoon has its own butterflies. Among them: a modest 2002 home purchase in, say, Stockton, California—financed with a nonprime, or otherwise faulty, mortgage loan.
By the time that home in Stockton was supporting two or three ill-advised loans in 2005, those loans had disappeared into packages called asset-backed securities (ABS), then were to global banks, insurance companies, and pension funds—particularly in Europe. Like their US counterparts, the European financiers bought boatloads with borrowed money. Then they, too, shoved them off books into Structured Investment Vehicles that required no capital charge and little reporting.
With US investment banks making huge profits from packaging churning loans, volume in mortgage securities exploded. US investment banks then added another link to the chain, repackaging ABS securities into CDOs, or collateralized debt obligations. In that way, the Belgian-Dutch bank Fortis (and others) came to own a piece of Stockton. If one Stockton home defaults, the global effect is miniscule. But if lots of home loans go under, the damage reverberates globally—just as it is now.
The current global fallout might have been manageable, if banks hadn't entered a massively interconnected circle of $55 trillion worth of privately negotiated credit default swaps.
But that wasn't the case.
While European institutions are getting hit mostly by exposure to toxic US assets, mortgage markets in the UK and Spain also are coming under increasing pressure. The bigger problem is the global borrowing still going on. With an average leverage of 10 times, we could be looking at an eventual $14 trillion systemwide loss. That's a dark scenario, which is why it's imperative that the US government help homeowners in Stockton keep their homes by backing renegotiated lower mortgages with lenders.
John McCain explicitly mentioned this in the last presidential debate. Barack Obama noted that Treasury Secretary Hank Paulson's $700 billion purchase plan, vague as it was, contained the ability to do this.
Meanwhile, as the leaders of central banks throughout the world realize they are all in this together, they will be forced to keep injecting capital into the banking system. And, hopefully, to do some thinking.
Three weeks ago, the Federal Reserve decided that saving Merrill Lynch could be accomplished by giving it to Bank of America. Since everyone calling the shots in Washington has been spectacularly ineffective in preventing the downward spiral of the financial system so far, one wonders why other bank mergers are now going through without examination. Moreover, why are European banks heading in the same direction? Merging murky books with deteriorating ones is not a recipe for strength and stability.
In the absence of a controllable framework, central banks around the world are paying for the excess of an unregulated financial system. What we need is a Glass-Steagall Act for our times. Can we regulate the $55 trillion credit derivatives industry unleashed by the US Commodity Futures Modernization Act of 2000? Can we have higher global capital requirements going forward, or put a structure in place that will both contain the current fallout and avoid future credit typhoons? It's time to find out.