How the Smart Money Lost $1 Trillion, So Far

“It does not matter how sharp you sharpen a buzz saw that is set at the wrong angle. It will not cut straight.”

~ Cornelius Van Til.

When the best and the brightest investors in the world lose $500 billion in one year in one market segment — mortgages — this raises a question: What can the rest of us do to keep from losing our shirts?

Add to this another $500 billion in losses to non-bank firms as a result of the credit crunch. This total — a trillion dollars — is the estimate of the International Monetary Fund.

Are the losses winding down? Hardly.

“It just keeps spreading from one asset to another, so it’s hard to know when these writedowns will stop,” said Makeem Asif, an analyst at KBC Financial Products in London. “The U.S. economy needs to stabilize first. But even then, Europe could lag and recover later. There’s still a lot more downside.”

The extent of the losses in some of the largest banks and financial institutions is only now coming to light. When you think that Citicorp, America’s largest bank, has lost over $55 billion in the last year as a result of subprime mortgage losses, you begin to get a sense that all is not well. Merrill Lynch lost $52 billion. UBS, the Swiss bank, lost $44 billion. On and on the list goes. For a list of which organizations have lost how much money, click here.

Recently, I read a book by Charles R. Morris. It is titled, The Trillion Dollar Meltdown. It was published a few months ago. He had foreseen the breakdown of the capital markets in early 2007, and he had begun writing a book about this. The problem was, the credit crisis of August 2007 speeded up the timetable. He was trying to get the book out, and events were unfolding so fast that he was having trouble completing the manuscript. The book is a good summary of the basics of the capital markets crisis. It explains how the expansion of fiat money under Greenspan led to a series of extremely bad investment decisions. These highly leveraged investments now threaten to unwind erratically and unpredictably.

On pages 130 and 131, he provides a breakdown of the problem areas. He is way too conservative. For residential mortgages, he projects a loss of $450 billion. That loss is already at $500 billion, and from the looks of it, there is at least another $500 billion to go. I believe another trillion dollars of losses will be generated over the next three years. Then there is corporate debt. The estimated loss here he puts at $345 billion. For other forms of collateralized debt, which is heavily leveraged, he estimates $215 billion of losses.

His total of $1 trillion today now seems extremely conservative. We are already there, according to the IMF. I think that in any updated edition of the book, he is going to have to increase this estimate by at least 50%, and that is because he is a fairly conventional, fairly conservative fellow. I think he should increase the estimate by at least 100%. I may be too conservative.


The American stock market has taken the news of these losses and has shrugged it off. The market is down only about 20% or less since October 2007.

Investors seem to think that a trillion dollars of losses imposed on the economy by decisions made by the best and the brightest can be shrugged off.

The best and the brightest who still make the decisions on the allocation of American capital don’t think the errors of their intellectual and career peers amount to all that much. They are incorrect. The extent to which they are incorrect will be played out over the next three or four years.

The estimated loss in the mortgage market is $500 billion. The losses are not yet finished. The subprime losses seem to be slowing, but no one has suggested that all of the losses are behind us. They say the worst of the losses are behind us, but not all of them. So, month by month, we can be sure that the financial press will report that another bank or another financial institution has lost another billion dollars or $2 billion or $5 billion. We will be assured, once again, that the worst is behind us.

Next on the daisy chain of disaster are the Alt-A mortgage loans. These loans are the loans that are considered one notch above the subprime loans. There are at least $500 billion of Alt-A loans. The total is probably even larger.

Also beginning to disintegrate is what are known as pay-option ARMs. I have discussed this before. These are what used to be called backward-walking mortgages. The borrower is not required to make a monthly payment that covers the repayment of principal, interest, and insurance. It may cover only a third of the payment on the principal. Then, without warning, the borrower is notified by the lender that the loan has re-set, and his new monthly payment is three times higher than his previous monthly payment. At this point, he begins to fall behind on his monthly payments. At present, 48% of all those notified that their payments have increased are behind on their mortgage payments. But this is only the early stage of the re-sets. The re-sets will be going on for the next five years. They will escalate sharply through 2009 all the way through 2011. This market is in the range of $600 billion. About 60% of these loans were made in California. So, you think that California real estate is a disaster zone this year. Come back in three years and see what is going on.

The unraveling of all of these mortgage loans caught the lenders by surprise. Despite numerous warnings in the contrarian newsletter field, the best and the brightest in the richest and most successful financial institutions and banks in the United States encouraged these loans in 2004 and 2005. Alan Greenspan publicly encouraged these loans.

The smart money was unbelievably stupid money. They stuck their own investors into disasters. They sucked large European banks into disasters.

The man who saw this most clearly and wrote about it constantly for seven years was Dr. Kurt Richebächer. He wrote from 2001 to 2007 that Greenspan’s easy money policies would produce the worst recession since the Great Depression. He was convinced that fiat money was leading the best and the brightest of American financial experts into making loans that would inevitably blow up in their faces. Of course, that means that the loans will blow up in our faces. Every month, his newsletter warned that this mania for debt could not be sustained for much longer. The problem is, he kept saying this, but nothing happened. People dismissed him as someone who was old-fashioned. He died in August of 2007, the month that his predictions began to come true. That was the month that the credit markets of the West froze up.


I do not call these people the best and the brightest out of a sense of skepticism. I am not skeptical about their intelligence. I am skeptical about the monetary policies of the Federal Reserve System, which led the best and the brightest into a series of investments that have collapsed.

The reason why these people made such catastrophic errors is because they were lured into believing that fiat money issued by the Federal Reserve System, which produced below-market rates of interest, in fact pointed to a new era. This new era would bring endless capital appreciation and endless economic growth without a major recession and without major financial losses to the institutions that invested in terms of the false economic signals that the Federal Reserve System was issuing.

The problem was not the lack of intelligence of these renowned experts in finance. Their problem was that they had never heard of Austrian School economics. They did not believe, as Austrian School economists have believed for 90 years, that central bank policies of monetary inflation produce a boom, and that this boom will always be followed by a bust. They believed, as textbook writers in the field of economics and finance have universally preached, that the decision-makers at the Federal Reserve System are the best and the brightest people in the history of finance.

The textbooks are completely favorable to the Federal Reserve System. So, Maestro Greenspan had no critics in Congress other than Ron Paul, a physician, and Jim Bunning, a former baseball pitcher. They were right. Greenspan was wrong.

So far, the economy has lost a trillion dollars in capital just from the subprime loan fallout. The media have begun to speak about the losses that are going to take place on the other mortgage instruments collapse. They are not yet talking about the economic setback from the recession which is also a product of Greenspan’s policies of monetary expansion.

The best and the brightest are like very sharp buzz saws. It doesn’t matter how sharp they are; they cut crooked.


One of the most important insights of Austrian School economics is the fact that the free market is extraordinarily complex. It is so complex that no single individual, no committee, and no computer program can account for more than a tiny fraction of the factors that drive a modern economy.

The Nobel Prize-winning economist, Friedrich Hayek, made this the central point of his writings from 1948 until 1985. He died in 1992. In his Nobel Prize speech, he focused on this aspect of the market. The market has enormous quantities of relevant knowledge, but it is only through the private property social order and the free interplay of pricing that society can become the beneficiary of the knowledge of the masses of individuals.

Hayek’s outlook, like Austrian School economics generally, was hostile to the concept of central economic planning. There is no possible way that a committee of salaried bureaucrats can plan an entire economy. The best and the brightest, no matter how good and no matter how bright, cannot possibly match the knowledge that is produced by all participants in the society who are deciding day by day what to buy, what to hold, and what to sell.

Think of the famous lyric of the great country western song, “The Gambler.”

You’ve got to know when to hold ’em; know when to fold ’em; know when to walk away; know when to run.

This is exactly what we’ve got to know. This is exactly what the central planning agency has to know. But it cannot possibly know this. There are too many decision-makers, who own too much property, who face too many different local situations, for any central planner to come close to understanding what drives the economy, moment by moment, let alone far into the future.

The best and the brightest in the investment world do their best to figure out when to buy, hold, and sell. If they are deliberately misinformed by the rate of interest, because the Federal Reserve is tampering with the rate of interest, the best and the brightest will drive the economy off the road. This is what has happened.

What about the rest of us? We are not graduates of the best business schools. We did not get recruited by large New York banks at the age of 25. We have not spent 30 years monitoring specific markets. We do not share information with other people who are equally well-trained, and equally experienced, who work in the same large multinational bank. How are we expected to allocate our capital when the best and the brightest lose $500 billion by investing in subprime loans that no one in his right mind should have invested a dollar in?

It is only the best and the brightest who can be suckered by the Federal Reserve so completely as to invest in anything as stupid as subprime loans. It took extremely smart people, using extremely detailed computer programs, designed by brilliant experts in mathematics, to make investment decisions as utterly wrongheaded as these people made in the mortgage industry. We have barely begun to see the extent of the stupidity of these loans.

Decisions made by the salaried bureaucrats employed by the Federal Reserve System, because these decisions affect the decisions made by the best and the brightest, have a leverage effect. I don’t just mean leverage in terms of debt, although that is extremely significant. I mean leverage in terms of concentrating bad information in one location: the federal funds rate. Then the misinformation spreads rapidly through the financial sector, which is a good old boys network, run by people who graduated from the same expensive graduate schools, who spend time talking with people just like themselves. This is true leverage. It compounds ignorance. It spreads ignorance rapidly through the entire financial section because nobody stands at the information gateway and says: “Stop!”

There is not much leverage of this kind in a free market. Decision-making is decentralized. It is also highly competitive. People with different views put their money where their mouths are. Also, in a society without fractional reserve banking and central banking, there is no pyramiding of money on top of a small base of government debt. In a society in which everyone is allowed to buy and sell with gold coins, and everyone can go down to his bank and trade his passbook savings account entries for gold coins, there is not much financial leverage. Debt is limited, and the sources of money are decentralized. So, a mistake made by one lender will not be made by competing lenders. There are always mistakes, but the mistakes are offset by profits generated by lenders who accurately forecasted the state of the market.

We do not live in such a world. That world has been systematically taken away from us since the creation of the Bank of England in 1694. A steady movement of politics and education away from decentralization and personal responsibility has destroyed the levers of power that used to be held by consumers and depositors in banks. Everything has moved in the direction of the centralization of power, the centralization of decision-making, the centralization of credit. The great winners have been the best and the brightest in the largest financial institutions. But these winners are now being publicly exposed as incomparable losers. The trouble is, we lose with them.


Everyone is looking for a way out of the unraveling of the mortgage market. This unraveling is now spreading to other segments of the credit markets. There is a crisis in municipal bonds. Banks are tightening credit requirements for business loans, consumer loans, and even credit card loans. This is much needed, but it is like locking the barn door after the horses have escaped. Bernanke drones on endlessly in his testimony before Congress about how the Federal Reserve is now overseeing new systems to monitor credit. Too late. His predecessor, Mr. Greenspan, should have imposed these new, supposedly stringent controls in 1987. He didn’t. Instead, he inflated. The economy recovered, and the world cheered for the Maestro.

Now the economy is going over a cliff. The Maestro is retired. Bernanke is in charge. He will take the blame. There is going to be plenty of blame.

The general public knows nothing of this. The general public simply trusts the people who are in charge. The general public thinks that The best and the brightest really are running the show.The best and the brightest are running the show. That is the problem.

A tiny handful of investors have figured out that something is radically wrong with the capital markets of the United States, and maybe the entire world. This was what Dr. Richebächer said for at least seven years. These little people, who read the obscure e-mail letters, and who visit obscure blog sites, have a better sense of the nature of the looming crisis than the best than the brightest have. The best and the brightest keep telling us that the worst is behind us. People who read the newsletters snicker. Month after month, the people who read the newsletters turn out to be correct.


We are told by the best and the brightest economists that deficits don’t matter. We have been told by the best and the brightest political scientists who write the textbooks that, with respect to national debt, “we owe it to ourselves.” I loan you $500, but we owe it to ourselves. Americans are taxed 15% of their wages to fund Social Security’s so-called trust fund, which is filled with non-marketable IOUs from the U.S. Treasury. Voters shrug it off. “Who cares? We owe it to ourselves.”

On Thursday, August 21, 400 theaters in the United States are going to show a movie produced by Bill Bonner’s Agora organization. It is called “I.O.U.S.A.” After the showing of the movie, there is going to be a live discussion with Warren Buffett and other experts in finances.

What this movie shows is that deficits do matter. Deficits across the board matter. We live in an economy that is entirely founded on debt, and we now face a national debt is growing so rapidly that there is going to be a default.

For a list of theaters nationally that will be showing this movie, click here.

August 16, 2008

Gary North [send him mail] is the author of Mises on Money. Visit He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

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