Required reading on the current financial crisis and credit crunch

I've been wading through a lot of media reports on the international credit crisis. Most fail to comprehend the scope of the problem.

For me, there are three relatively short pieces that stand out in terms of putting this bizarre series of events into perspective.

The first is Carol Loomis's classic 1994 Fortune article on derivatives, called "The Risk That Won't Go Away". At the time it came out, it scared the daylights out of me.

Here's just a taste of what Loomis wrote in one of the most prescient business articles of all time: "if ten years from now - despite periodic booster shots from articles like this one - you still can't keep these things in focus, then cheer! That will mean derivatives have not been forcibly brought to your attention by bad, bad news, in which they make headlines as a villain, or even the villain, in some financial crisis that sweeps the world."

Well folks, derivatives are at the root of a financial crisis that's sweeping the world. For proof, you need go no further than Gretchen Morgenson's September 27 article about A.I.G, which appeared in the New York Times.  

The next piece worth reading is Robert Reich's blog entry called "The Meltdown: Part IV". Reich, former labor secretary in the Clinton administration,  points out that the off-balance sheet liabilities, including derivatives, have left the banks in dire financial straits. But the shareholders never knew this because there was no transparency in reporting this situation.

The third important article is by historian  Scott Reynolds Nelson, and it's called "The Real Great Depression". This piece, which appeared in the Chronicle of Higher Education, draws similarities between the current crisis and the depression of 1873.

(More information on the Panic of 1876 can be found on the Online Education website.)

The financial panic back then was triggered by overly generous lending, including mortgages, by a bunch of new financial institutions. Land values went through the roof in Europe.

But new competition from America  caused many European enterprises to become uncompetitive (just as current competition from China and India is demolishing U.S. businesses), triggering a crash of epic proportions.

Alan Greenspan, former chair of the U.S. Federal Reserve, wrote in his 2007 autobiography that one form of derivative--the credit default swap--is "a boon to the banks" because it transfers risk.

"The Bank for International Settlements tabulated a worldwide notional value of more than $20 trillion equivalent in credit default swaps in mid-2006, up from $6 trillion at the end of 2004," Greenspan cheerfully wrote in The Age of Turbulence: Adventures in a New World.

Yesterday, speaking before a U.S. Congressional committee, Greenspan acknowledged that he missed the mark in assuming that financial institutions would protect themselves from undue risks.

"Something which looked to be a very solid edifice and, indeed a critical pillar to market competition and free markets did break down," Greenspan said.

The articles by Loomis, Reich, and Nelson do not make for pleasant reading. But they offer insights and perspectives that you're not likely to see in your metropolitan  daily newspaper or in Greenspan's book. We live in scary times.