As it has been proven in the first article of this blog, "The Largest Heist in History", the current financial and resulting economic crises are the effects of turning the financial system into a global pyramid scheme. The mechanism of this pyramid building was lending by financial institutions with loan to deposit ratios above 100%. This destroyed a long standing and proven practice of fractional reserve banking that was used to control credit supply. With loan to deposit ratio above 100%, a money multiplier was infinity (and the multiplication was happening with exponential pace). This resulted in a pyramid scheme that depleted the banking system from cash reserves and ballooned the banks balance sheets. These sheets represented bogus assets of ultimately very little, if any, market value, having been the product of pyramid scheme building process. Pyramids are bound to collapse as otherwise the banks' balance sheets would have grown unrestricted extremely quickly to massive numbers.
Credit Default Swaps are good examples of financial pyramid stabilisation system that lets it grow bigger than it would have otherwise and delays the collapse. In practical terms this risk management instrument, together with lending with loan to deposit ratio above 100%, is a lethal combination. A financial nuclear bomb. This comparison is particularly representative since similarly to chain reaction, a pyramid growth has exponential characteristics.
When a financial institution buys CDS' (from various other institutions) as an insurance against defaults on credits it granted, it spreads the risk of default on these credits amongst those institutions. When they resell them further in whole or in part, again to various other institutions, they propagate the risk further. At the limit, this way the entire system is covered by every single institution for a default on every single credit. It looks almost an ideal scenario: whenever any creditor, large or small, defaults everyone is coughing up a little bit to cover for it according to its committed resources and adopted risk profile. This way the financial pyramid grows being stabilised in the process. Whenever in multiple deposit creation cycle a default occurs on any credit, the entire system intervenes and absorbs it and the pyramid keeps on growing at exponential pace. Together with it, the value of CDS' sold keeps growing too. Even perversely, at times, over-supply of CDS’ onto the market was, in part, also driving supply of cheap, subprime, credit thereby accelerating a pyramid growth.
However since any financial pyramid is bound to collapse, at some point a default or a sequence of defaults becomes too big even for the entire system to absorb. One can say that a default size exceeds a critical mass which triggers a chain reaction of collapse. In the context of the current financial crisis, it appears that it was Lehman Brothers default that provided critical mass for chain reaction of the current liquidity crisis leading to the economic crisis as the banks stopped lending and the governments pumped enormous amounts of monies. Time will only show whether this huge money sarcophagus over the financial pyramid will stop the chain reaction inside or whether the chain reaction was simply slowed for the time being and will gather the pace again. In any event, not dissimilar to Chernobyl, the world will live with the consequences for many years ahead.