Yertle the Turtle and the financial collapse

Two articles in the Boston Globe stand in stark contrast to one another. James M. Stone, "former Chairman of the Commodity Futures Trading Commission and prior to that commissioner of insurance for MA, [now] CEO of the Plymouth Rock Group" insurance companies, wrote an OpEd in the Globe on 2/5/09, in which he outlines six criteria for effective new financial regulations. The article is remarkably lucid and clear, a call to "think of financial regulation as mainly a set of prohibitions on harmful practices, more a rulebook than a bureaucracy".
In contrast, I was appalled to read in the 2/6/09 Globe that Timothy Geithner is considering changes to the 'mark to market' accounting regulations. The argument is that since the market has lost so much value, marking to market reduces banks' assets, limiting their ability to lend. This is the worse possible reaction to this crisis.

I would argue that the only thing that can salvage financial markets is TRANSPARENCY. We are in the depressed economic state we are in now because of a failure of TRUST. Let us stop pretending the financial markets collapsed because homeowners started defaulting on their mortgages. True, homeowners' default rates went up, but the markets collapsed because of the flimsy financial structure that was built on these mortgages and other consumer debt.According to Stone "By 2008, banks and brokers were leveraged [on their derivative instruments] as much as 30-to-one." The true weakness of the markets stems from the huge shadow projected by the leverage on derivative products. Warren Buffett has compared derivatives to a neutron bomb with the potential to destroy the entire world economy: a "disaster waiting to happen."

An article by DK Matai, Chairman of ATCA Open, quoted by former FT journalist Tome Forenski, gives a sense of the size of the derivatives threat. According to the article, the total global dollar value of derivatives, as of December 2007, was 1.144 Quadrillion dollars (or 1,144 Trillion US dollars).
To give a sense of the size of $1.144 quadrillion dollars, DK Matai specifies:

"1. The entire GDP of the US is about USD 14 trillion.

2. The entire US money supply is also about USD 15 trillion.

3. The GDP of the entire world is USD 50 trillion. USD 1,144 trillion is 22 times the GDP of the whole world.

4. The real estate of the entire world is valued at about USD 75 trillion.

5. The world stock and bond markets are valued at about USD 100 trillion.

6. The big banks alone own about USD 140 trillion in derivatives.

7. Bear Stearns had USD 13+ trillion in derivatives and went bankrupt in March. Freddie Mac, Fannie Mae, Lehman Brothers and AIG have all 'collapsed' because of complex securities and derivatives exposures in September.

8. The population of the whole planet is about 6 billion people. So the derivatives market alone represents about USD 190,000 per person on the planet."

Clearly, this type of exposure is large enough to terrify anyone who is worried about financial risk.
I believe that as long as we do not face up to the risk in leverage and derivatives carried by financial institutions worldwide, it does not matter how much money the government invests in financial institutions, it will never be enough. If big banks own 10 times more derivatives than the entire US GDP, our government will never be able to stabilize banks by cash infusions alone. We must remove the veil and deal with the real risk. It will no doubt be painful and staggering amounts of value will be lost, but I just don't see how we can avoid losing that value. The only tangible assets are the homes, cars, and even diplomas those consumer loans were buying. Let us salvage the true assets and burst the financial bubbles, instead of throwing money at bubbles and letting the assets go under.

In contrast, we have Timothy Geithner proposing to veil the risk of even the fraction of assets that must be disclosed at fair market value. Everything I learned in a Wharton MBA hammered in that transparency and information comfort markets, while opaqueness destabilizes them. How can less disclosure help us out of this crisis? Banks will not lend because they know they need the cash to cover their own mistakes, their leveraged derivatives etc. Until we take care of the flimsy foundation and bring all our financial institutions to a firm footing, credit will not flow.

'Yertle the Turtle' is the Dr. Seuss story of a turtle king that built his throne by climbing on other turtles' backs, believing he ruled all that he could see. Little turtle Mack brought down the whole edifice of 281 turtles perched on his back, by burping. In my opinion, homeowners defaulting on their mortgages are akin to Mack's little burp, while the highly lucrative derivative products that enriched the financial establishment for years, are akin to the throne built by layer upon layer over Mack's back. We are all free-falling into the mud as a result of this collapse.