A Complex Array Of Paper Currencies

"The con game is impressive. They call debt money. The entire foundation of the current monetary system is a complex array of paper currencies backed by sovereign debt. The problem for its managers is that the sovereign debt is crumbling."Jim Willie

Entire article:
http://www.financialsense.com/contributors/jim-willie/handicapping-the-collapse

Derivatives & The Blob

I was flipping channels over the Thanksgiving holiday and stumbled upon the movie classic, "The Blob".  I had forgotten that this 1958 horror classic starred Steve McQueen.  I remember as a kid that this was the ultimate scary movie.  "The blob eats you alive!".

Reading an article on Bloomberg last night regarding financial derivatives reminded me of The Blob.  It just oozes along devouring everything in its path.  In the end, they froze The Blob and sent it to the Arctic for a permanent freeze.  How are we going to "freeze" these instruments that Buffet described as "weapons of mass destruction"?

"Global derivatives trading in over- the-counter and exchange-traded futures and options will represent a $700 trillion market with $3.7 quadrillion in annual turnover by the end of this year, research company TABB Group said.  Rules to have central clearing for over-the-counter trading would require additional collateral of as much as $2.2 trillion, Westborough, Massachusetts-based TABB said in a statement on its website, citing a report it completed at the request of the World Federation of Exchanges."
Source: Bloomberg

"The 'derivative monster' still lurks in these financial waters. Every contraction cycle needs a culprit. Derivatives will be the blame for this one."
Random Roving, July 3, 2010
 
"Puplava's risk comments are targeted at the significant amount of derivatives in the world.  His argument is that the risk can NOT be taken out. Many on Wall Street believe that great mathematical models can remove the risk. For a more thorough understanding of the crisis evolving...."             http://www.financialsense.com/series2/rogue.htm

Random Roving, March 27, 2003 (email era)

The Delusional Benefactors

"Mass delusion is always encouraged by those who benefit most from the mass delusion. David Lereah has admitted that he lied about the housing bubble because he was employed by realtors. Realtors made millions in commissions. Appraisers made millions in fees by inflating appraisals. Mortgage brokers made millions by encouraging people to lie on mortgage applications. Wall Street whores made billions by creating toxic packages of mortgages and selling them to Irish nuns, old ladies and clueless municipal administrators. The ratings agencies made hundreds of millions in fees for slapping AAA ratings on toxic derivatives. Politicians got rich from political “contributions” from Fannie Mae, Freddie Mac, Wall Street, and the NAR. Any reasonable human being could look at the chart above and see that this would end badly, but Americans wanted to be deluded. They choose to believe. The housing market has now been falling for five years, with another five years to go. Ben Bernanke has reduced interest rates to zero. I wonder how that will work out."
James Quinn, TheBurningPlatform.com

The Derivative Dice

"Some government-run investment funds are recklessly rolling the dice by participating heavily in mania-era investment ploys. In Illinois, for instance, the state pension fund is using derivatives to 'recoup returns' and try and 'fix' a 60.9% underfunding."
Steve Hochberg, Elliott Wave International

"Every contraction cycle needs a culprit. Derivatives will be the blame for this one."
Random Roving, July 3, 2010

The Great Maestro On Derivatives

This one will be a "keeper" for a long time:

“The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions …. Derivatives have permitted the unbundling of financial risks.”
Alan Greenspan, May 2005

The Derivative Monster

The "derivative monster" still lurks in these financial waters.  I just finished Michael Lewis' latest bestseller, "The Big Short", which chronicles the details behind the mortgage meltdown.  At the core of the crisis were collateralized debt obligations (CDOs) a form of derivatives.  I still think that derivatives will be the core of the major meltdown that still lies ahead.  The reason is that a small "bet" can control a significant amount of dollars.  It has been reported that $700 TRILLION of derivatives exist worldwide. These options have way too much leverage.

I'm confident on the "what", but the "when" is very unknown.  This financial casino can only keep the gamblers at the table for so much longer.

Weiss Research's team just released this in a report:
-Fact: The U.S. derivatives that helped cause the last debt crisis are merely being shifted around like deck chairs on the Titanic.
-Fact: Nothing whatsoever is being done about the derivatives monster overseas, which is more than TWICE as big.
-Fact: Most important, despite months of debate and thousands of pages of legislation, the two biggest risk-mongers of all — the Treasury and the Fed — didn't even get a slap on the wrist. They got more power.

Every contraction cycle needs a culprit.  Derivatives will be the blame for this one.

"Jim Puplava posted a great article on the banks last year...especially focused on those with large derivative positions. JPM Chase has an incredible derivative position."
Random Roving, August 18, 2002 (pre-blog email days)

The wild ride continues!!
"In February this year he ranted every week on his radio show about 'naked short selling', 'credit default swaps', and 'derivatives'. I was originally unfamiliar with these terms and was amazed last week when they became front page news."
Random Roving, September 30, 2008

"We've just seen the beginning of the derivative implosion. Remember, Warren called them 'weapons of mass destruction'."
Random Roving, January 1, 2010

Aristotle & The Story of Thales

"Aristotle described the story of Thales, a poor philosopher from Miletus who developed a 'financial device, which involves a principle of universal application.' Thales used his skill in forecasting and predicted that the olive harvest would be exceptionally good the next autumn. Confident in his prediction, he made agreements with local olive-press owners to deposit his money with them to guarantee him exclusive use of their olive presses when the harvest was ready. Thales successfully negotiated low prices because the harvest was in the future and no one knew whether the harvest would be plentiful or poor and because the olive-press owners were willing to hedge against the possibility of a poor yield. When the harvest-time came, and many presses were wanted all at once and of a sudden, he let them out at any rate he pleased, and made a large quantity of money."
Source: Wikipedia

Now you understand today's financial markets.

Sierpinski's Triangle and The U.S. States

In February 2009, I made a post referencing Sierpinski's Triangle for a theory on the fractal nature of this calamity. The New York Times reports today about "the state of the States":

"California, New York and other states are showing many of the same signs of debt overload that recently took Greece to the brink — budgets that will not balance, accounting that masks debt, the use of derivatives to plug holes, and armies of retired public workers who are counting on benefits that are proving harder and harder to pay. And states are responding in sometimes desperate ways, raising concerns that they, too, could face a debt crisis. New Hampshire was recently ordered by its State Supreme Court to put back $110 million that it took from a medical malpractice insurance pool to balance its budget. Colorado tried, so far unsuccessfully, to grab a $500 million surplus from Pinnacol Assurance, a state workers’ compensation insurer that was privatized in 2002. It wanted the money for its university system and seems likely to get a lesser amount, perhaps $200 million. Connecticut has tried to issue its own accounting rules. Hawaii has inaugurated a four-day school week. California accelerated its corporate income tax this year, making companies pay 70 percent of their 2010 taxes by June 15. And many states have balanced their budgets with federal health care dollars that Congress has not yet appropriated."

The entire article:
http://www.nytimes.com/2010/03/30/business/economy/30states.html

The Storm Series

I stumbled upon http://www.financialsense.com/ back in 1999 and was extremely impressed with Jim Puplava’s diverse content and his weekly radio show. I’ve listened to it since then on a weekly basis. His forecasts of the future have been amazingly accurate. In 2000-01, he wrote a series of papers entitled “The Storm Series”. I found that he had significant data supporting his forecasts and most of all, it made sense. I’ll recommend reading it again: http://www.financialsense.com/series2/perspectives2.html

Puplava called $140/barrel oil and $1000/ounce gold. In February this year he ranted every week on his radio show about “naked short selling”, “credit default swaps”, and “derivatives”. I was originally unfamiliar with these terms and was amazed last week when they became front page news.

Puplava's View on Derivatives

Puplava's risk comments are targeted at the significant amount of derivatives in the world.
His argument is that the risk can NOT be taken out. Many on Wall Street believe that great mathematical models can remove the risk. For a more thorough understanding of the crisis evolving....
http://www.financialsense.com/series2/rogue.htm

What Worries Warren

WHAT WORRIES WARREN
Buffett on Investing in Stocks Today
'Unfortunately, the hangover from [the market bubble] may prove to be proportional to the binge.'
FORTUNE
Monday, March 3, 2003
By Warren Buffett

In a section of his upcoming annual letter to shareholders separate from the
derivatives discussion, Buffett talks about stocks, cash, and the lure of junk bonds. A list of Berkshire's major common stock investments (those with a market value of more than $500 million at the end of 2002) will be posted on March 8, on www.berkshirehathaway.com.

We continue to do little in equities. Charlie and I are increasingly comfortable with our holdings in Berkshire's major investees because most of them have increased their earnings while their valuations have decreased. But we are not inclined to add to them. Though these enterprises have good prospects, we don't yet believe their shares are undervalued.

In our view, the same conclusion fits stocks generally. Despite three years of falling prices, which have significantly improved the attractiveness of common stocks, we still find very few that even mildly interest us. That dismal fact is testimony to the insanity of valuations reached during The Great Bubble. Unfortunately, the hangover may prove to be proportional to the binge.

The aversion to equities that Charlie and I exhibit today is far from congenital. We love owning common stocks--if they can be purchased at attractive prices. In my 61 years of investing, 50 or so years have offered that kind of opportunity. There will be years like that again. Unless,however, we see a very high probability of at least 10% pretax returns (which translate to 6% to 7% after corporate tax), we will sit on the sidelines. With short-term money returning less than 1% after-tax, sitting it out is no fun. But occasionally successful investing requires inactivity.

Derivatives are financial weapons of mass destruction. The dangers are now latent--but they could be lethal. Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we've been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

In banking, the recognition of a "linkage" problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a "chain reaction" threat exists within an industry, it pays to minimize links of any kind. That's how we conduct our reinsurance business, and it's one reason we are exiting derivatives.

Many people argue that derivatives reduce systemic problems, in that participants who can't bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants. And, on a micro level, what they say is often true. Indeed, at Berkshire, I sometimes engage in large-scale derivatives transactions in order to facilitate certain investment strategies.

Charlie and I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by nondealer counterparties. Some of these counterparties, as I've mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

Indeed, in 1998, the leveraged and derivatives-heavy activities of a single hedge fund, Long-Term Capital Management, caused the Federal Reserve anxieties so severe that it hastily orchestrated a rescue effort. In later congressional testimony, Fed officials acknowledged that, had they not intervened, the outstanding trades of LTCM--a firm unknown to the general public and employing only a few hundred people--could well have posed a serious threat to the stability of American markets. In other words, the Fed acted because its leaders were fearful of what might have happened to other financial institutions had the LTCM domino toppled. And this affair,though it paralyzed many parts of the fixed-income market for weeks, was far from a worst-case scenario.

One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock, while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.

Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers, and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don't understand how much risk the institution is running.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Knowledge of how dangerous they are has already permeated the electricity and gas businesses, in which the eruption of major troubles caused the use of derivatives to diminish dramatically. Elsewhere, however, the derivatives business continues to expand unchecked. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.

Charlie and I believe Berkshire should be a fortress of financial strength--for the sake of our owners, creditors, policyholders, and employees. We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly apprehensive about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Derivatives and JPM Chase

Jim Puplava posted a great article on the banks last year...especially focused
on those with large derivative positions. JPM Chase has an incredible derivative position.
The wild ride continues!!