The Oil-Drenched Black Swan, Part 3: Multiple Risks, Multiple Unknowns

It is these unforeseeable and uncontrollable consequences that are poised to wreak havoc on the global financial system.

Here’s the thing about risk: it bursts out of whatever is deemed “safe.” It wasn’t accidental that the Global Financial Meltdown originated in home mortgages; it was the perceived safety of the mortgage market that attracted all the speculative debt and leverage.

The authorities (those few who weren’t bribed to look the other way) were caught off-guard by this explosion of risk in a presumably “safe” market, but this was entirely predictable: this is the nature of systemic risk.Since 2009, central state/bank authorities have backstopped the private banking sector and the sovereign debt market with everything they’ve got. The Federal Reserve alone threw something on the order of $23 trillion in guarantees, loans and backstops at the private banking sector, and the other central banks have thrown trillions of yuan, yen and euros to shore up the banking sector and sovereign debt.

They did this because they identified the banking sector and sovereign debt as the sources of systemic risk. Now that they’ve effectively shored up these two risk-laden sectors with the full weight of the central state and bank, they presume the systemic risk has been eradicated.

They could not be more wrong. As I often note, risk cannot be disappeared, it can only be masked or transferred. The systemic risk will not manifest in the heavily protected banking sector or the sovereign debt market–risk will break out of sectors that are considered ‘safe”–like oil.

Yesterday, I described how The Financialization of Oil has followed much the same path as the financialization of home mortgages in the 2000s: a “safe” sector has been piled high with highly profitable and highly risky debt and leverage.

Once the narrow base of collateral shrinks (as it has in oil), the inverted pyramid of debt and leverage collapses, distributing losses that then trigger defaults as the dominoes fall.