Now, because the valuation of assets on investment bank balance sheets depends on this insurance being worth something, I’m worried Paulson wants the government to backstop it.

Problem 1: the losses on this stuff could run as high as $1 trillion, because quite a bit of it is tied to second tier securitizations that may go to zero.

Problem 2: Since these are CDS contracts, there is a sense in which they are gambling debts. What does it say about the state of finance in the US, if the US Treasury decides to “save” investment banks by taking over the gambling debts of bankrupt counterparties?

The financial press needs to stop playing into the Orwellian doublespeak of investment bankers by calling super senior CDOs (which sound like investment products) what they are: super senior insurance liabilities that were marketed by the insurance buyers as assets. The whole market was built on the assumption that the government would bail it out if (or should that be when) the insurance issuers collapsed.

I can’t begin to grasp the potential implications either.

It is the sheer pace of change which seems to me make everything so unpredictable. As I understand it, it was only in mid-September that the Fed’s balance sheet started ballooning out of control. This was not so much of an immediate problem, because the panic meant that the Treasury could sell a vast quantity of very short term paper. But this kind of panic funding will not be available for ever — may not indeed be available for very long.

In an interesting paper reproduced on the FT Alphaville site, John Kemp suggested that it was only China who had the resources to provide the requisite funding. He want on to suggest that ‘while China probably does not want to add to its holdings of dollar assets and its exposure to the United States, the size of its existing holdings, and its need to protect their value, may leave it no choice.’

(See http://ftalphaville.ft.com/blog/2008/10/09/16850/follow-the-money-v/.)

It seems to me that the Chinese would very much want to avoid risking the rapid disintegration of their export-led growth strategy, and possible major political turmoil, by pulling out from dollars while the U.S. financial system is on the life-support machine. But if they once conclude either that the patient is going to expire anyway, or that their holdings are in danger of catastrophic fall in value whatever they do, then they might be deeply reluctant to add to their holdings: which could be enough to precipitate chaotic collapse.

I agree that it is likely that the Chinese and other Treasury holders will want to play for time — until after the election, nobody can take any realistic bets as to the direction of U.S. policy. And they will also want if they can to think through the implications of alternative courses of action before doing anything with irreversible consequences. But — as with so many processes in tightly-coupled systems — if once an initial stability is seriously disrupted, change can follow rapidly and chaotically, and people have to make policy on the hoof.

As to what forms chaotic change might then take, I also have difficulty thinking things through — and in any case chaotic processes are inherently unpredictable. Would Bernanke then make the resort to printing press which he mentioned as the ultimate backstop in 2002? Very likely, I would have thought. A competition in currency trashing would then appear quite likely, with even the Germans being drawn reluctantly in, and inflationary pressures emerging at some point. Would we have an orderly sequence — deflation followed by inflation? Or might the whole sequence unfold much more quickly and chaotically then generally anticipated?

What I would imagine is that the dollar rapidly ceases to be the global reserve currency. But as to what would replace it, I cannot begin to envisage. Is there any reason why one should have a global reserve currency? (On a more detailed point, I am curious as to what oil producers would do. Would they continue pumping heavily at depressed prices, or might they conclude that oil in the ground is a better reserve than any currency? If so, can they afford to run down reserves?)

As regards your other question: my late father was indeed Hrothgar. Not long before he died, back in 2002, he said that this was such an interesting period of economic history, he was sorry he would not live to see how it turned out. But then he was 14 in 1929, and the possibility that apparent stability could suddenly disintegrate was always with him.

It would be more accurate to say that the failed institution will be the Federal government. The only way out of this mess likely will be scrapping the Federal Reserve Note, instituting a commodity based currency, switching the financial center of the country to Chicago (go Obama). It is certainly not too soon to begin thinking about currency reform. However, the initiative for this will probably end up having to come from the heartland, probably Texas. The progressive coasts are exhausted as the Zeitgeist is dead.

Why is there talk of saving them now? The subtext is important. US muncipalities are creaking under the stress of higher interest rates. Is this a flawed plan to somehow put confidence back into bond insurance – to save hundreds of bond-issuers from direct federal bailout?

If so – this is like telling a house-owner, after a fire, that the burnt-out shell would be quite habitable with a lick of white paint.