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Gold and Energy Advisor's Real Wealth

Real Wealth #317  12/10/2012



The Derivative Financial Nuclear Winter Coming Soon

Why 2013 Could See the Total Collapse of the World's Financial Markets

For those who were paying attention, the 2008 economic system collapse and real estate market crash were both telling signs. While many pundits and media types hanging on a sound bite were more focused on the salacious headlines and greed that was involved, the more serious matter was how quickly the U.S. financial system seized up when the financial markets became unstable. What became evident over time was the fact that many of the major banking institutions, the companies that prop up the financial system with the government by managing currency, assets and liquidity, were all exposed badly to near-gambling levels of market positioning. And many of these positions involved shaky investments in derivatives.

The problem for the average American is that a derivative is a complex type of investment to understand. First off, unlike stocks or mutual funds, derivatives are not readily available as an investment option for the individual. These tools are primarily used by investment houses, large brokerages and banks to making millions of dollars of profit in a very short time.

Technically, the derivative represents a gamble that some other kind of asset or liability will behave in a certain way. The most common derivatives up until 2008 were those that included bundles of highly-risky mortgages. The mortgages themselves were loans that had an expected interest charge revenue stream if paid on time. When bundled together, that portfolio the represented a bond of sorts, producing profit on whoever owned the loans via the interest payments. Many investment houses bought these derivatives to make money off of bundled risky mortgages, betting the homeowners would continue to pay on time, even when they had adjustable rate mortgages.

The difference between the above type of derivative and a stock or mutual fund is essentially what is being bought. With the stock or fund, the buyer purchases ownership of a company and profits from the company doing well. The buyer can also lose ownership value if the company performance goes down, but the buyer still has the same amount of equity, unless more stock is issued which then dilutes existing ownership shares. With the derivative, there is no ownership per se. Instead, the investor is betting the derivative continues to pay profit based on the underlying asset still being valuable. If the underlying asset suddenly becomes worth nothing, the derivative itself is a total loss. There’s no equity to sell off. Thus the derivative on Wall Street is entirely a gamble on assumed outcome, i.e. a bet.

Now, in the above situation, many institutions aren’t entirely blind or stupid. They understand how risky derivatives are. However, they still wanted the potential profit from them. So many companies that invested billions into derivative positions also took insurance policies, anticipating the related derivative loss. This approach essentially cut into the profit margin a derivative position would pay, but many banks still felt the difference was worth the investment trouble. Given the size of the insurance policies involved, the larger insurance companies became the holders of the banks’ risk in the same market. As a result, large risk protection providers like AIG suddenly found themselves up a creek when all the mortgage derivatives collapsed and the investors came calling with their insurance claims for risk coverage.

Where AIG could have covered its policies issued, the risk would have been paid and the investor would have suffered some loss, but not a total wipeout. Instead, the amount of risk occurring so quickly overwhelmed AIG and others to the point they were facing bankruptcy in a day without even making a dent in the losses occurring in 2008. As a result, bank companies like Citibank, Bank of America, Deutsche Bank, Iceland’s national bank system, and MF Global among others were then looking at billions of dollars of losses without any safety net or recourse due to collapsed derivative values on the open market. The Federal Reserve had a major catastrophe on its hands because the banks involved were so exposed to losses they had no liquidity on their books when assets versus losses were added up. They were all technically insolvent.

As most are aware, the federal government had to step in and provide an infusion of cash flow through the TARP program to save many of the country’s big banks. A number of large names were not saved and instead carved up among those chosen to survive by the government. Washington Mutual was one such player thrown to the wolves for disassembly. The investment house of Lehman Brothers was another. Eventually, much of the government’s bailout funds were paid back by the various banks, but the same derivative lessons from 2008 weren’t apparently heeded by the industry. This was evident in JP Morgan Chase’s bad bet on more derivatives in 2011, resulting in a loss of more than $6 billion.

 

93% of the traded or held on U.S. markets are in the hands of four “too big to fail” banks. These four entities also represent 81 percent of the related market risk exposure.

The federal government through various pieces of omnibus legislation has tried to clamp down on the big banks and how much they can play their own company assets in risky bets on the financial markets. However, even though the laws have been passed, the regulations that actually spell out how the banks are supposed to behave have been stuck in industry negotiations with the Federal Reserve and the U.S. Treasury, even despite the obvious behavior of Chase and its losses after the 2008 debacle.

The above consistent behavior is why derivatives will continue to present a catastrophic risk and are the “financial weapons of mass destruction,” according to Warren Buffet. The fact is, an astronomical amount of derivative positions still exist on the financial markets, despite the credit freeze and near collapse of big markets after 2008. The value of these positions is estimated to be something in the neighborhood of $600 trillion to $1.5 quadrillion dollars in exposed institutional risk. In comparison, the global economy operates at a level of $70 trillion new dollars annually, far below the risk involved in terms of offsetting the potential loss.

Further, the big banks continue to be main players and investors betting on derivatives. Per the federal government statistics, 93 percent of the traded or held on U.S. markets are in the hands of four “too big to fail” banks. These four entities also represent 81 percent of the related market risk exposure.

Many think about this concept and shrug it off. The feeling tends to be that if the big banks want to throw themselves down the drain financially, it won’t really affect anybody on Main Street. Just the Wall Street brokers will be jumping off the roofs again. The reality is evident in what happened during the 1929 Stock Market crash. True, while the initial losses were felt by those directly tied to the financial markets, eventually every major business suffered as well.

 

It doesn’t take a rocket scientist to figure out
the above risk and calamity it brings.


A catastrophic bank loss on derivatives playing out will first damage every major bank in the country. It will also collapse the currency structure, causing significant inflation to occur as the dollar value falls tremendously. With both credit freezing up or becoming quickly unavailable, no loans or lines of credit can be issued. Since many companies rely on lines of credit to cash flow production cycles until sales occur 30 to 45 days later, significant damage will occur to such industries, shutting them down due to a lack of cash flow. If they can’t buy supplies and pay workers, they can’t produce, which means they can’t sell to make profit and keep functioning. Period. When big companies freeze up, they lay off workers. Suddenly, Main Street becomes filled with lines of people unemployed and losing their homes due to unpaid bills. The 1929 films play themselves out all over again on modern TV. This is how fragile the U.S. economy really is.

It doesn’t take a rocket scientist to figure out the above risk and calamity it brings. The terrorist Osama Bin Laden put the math together. It was the main reason why he attacked New York twice, thinking if he could cause a financial collapse it would cause a cascading meltdown of the U.S. economy. Instead of planes and bombs, he should have started a derivative investment company.

One posited solution tries to argue that banks should then just be reduced in size to eliminate the risk to the U.S. economy. By taking some kind of a pseudo anti-trust breakup approach, the banks can be broken down to less riskier entities. It was a topic seriously discussed in 2009 as the country dealt with the aftermath of the 2008 market drop. However, elections and stalemates in Congress make that idea pretty much impossible to get the necessary laws passed for increased regulatory limitations.

As a result, the same “too big to fail” bank continues to embed themselves in every critical element of the U.S. economy. They have become a necessary parasitic entity to the financial health of the U.S. markets and dollar. Killing the parasite or directly reducing its size would in turn serious damage the weak U.S. economy as well.

One would think that given the last four years, the banks themselves would be playing a lot smarter, but they aren’t. Chase proved that fact by its further gambling on derivatives. While Chase was exposed due its bad market investment decisions, the other players are just as involved. They just haven’t gotten burned yet. However, if one were to look at the U.S. Treasury reports, the four big banks have serious continued exposure to derivatives:

*JPMorgan Chase*

Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars)

Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)

*Citibank*

Total Assets: $1,347,841,000,000 (a bit more than 1.3 trillion dollars)

Total Exposure To Derivatives: $52,150,970,000,000 (more than 52 trillion dollars)

*Bank Of America*

Total Assets: $1,445,093,000,000 (a bit more than 1.4 trillion dollars)

Total Exposure To Derivatives: $44,405,372,000,000 (more than 44 trillion dollars)

*Goldman Sachs*

Total Assets: $114,693,000,000 (a bit more than 114 billion dollars - yes, you read that correctly)

Total Exposure To Derivatives: $41,580,395,000,000 (more than 41 trillion dollars)

That means that the total exposure that Goldman Sachs has to derivatives contracts is *more than 362 times greater* than their total assets.

The size of the money involved is astronomical. So how did the problem and vast risk occur again? Further, what sort of world would we be facing if another crash in derivatives occurs again?

Based on statistics from Nasdaq, one of the two major public market managers, traders will have to provide stronger and increased collateral to continue playing trillions of dollars’ worth of derivatives on the market. This margin requirement likely represents $1.7 trillion to play $10.2 trillion on the market in 2013. That said, the margin is just the amount of funds needed to initiate trades on the first day, not what is needed to back the investment over the life of the position. In market-speak that means the banks involved are playing with bets they can’t pay in cash if they lose.

Today, the U.S. gross domestic product combined is under $15 trillion. This figure is lower than 2008 due to the losses to business in the last few years and current recovery. A sudden loss in derivatives would potentially represent a near-fatal body blow to the economy. Yet the banks don’t seem to get the picture. Instead, according Reuters news sources, many big banks are advising clients to play trades through offshore derivative brokerages to avoid new U.S. regulations and margin requirements. By moving trades through foreign banks, the U.S. laws don’t apply, but the money still plays in the same financial global markets.

Just like Greece, eventually the remaining liquidity to bet and support derivatives has to dry up. When that occurs, the big bank players will have to face the fact that they are entirely exposed to market risk again. Customers who thought their money and assets were safe will likely find their money was put to risk as well as banks frequently co-mingle institutional assets with customer assets. When the bank goes down, so does the customer. Only a paltry $250,000 per account is protected by federal depositor insurance.

To make matters worse, the banks seem to have their own star chamber discussing how to continue playing derivatives. According to a New York Times article, nine representatives meet regularly to discuss how to preserve the profit and gain the involved banks make off of derivatives. The meetings are confidential as well as the players. In a basic sense, this sort of activity might reek of a cartel, but the banks aren’t selling anything in their meetings; they are strategizing how to invest in risk. The above said, the nine players include Citigroup, Bank of America, Morgan Stanley, Goldman Sachs, and JP Morgan Chase. These five institutions hold more than 90 percent of the U.S. economy’s cash flow and liquidity.

The U.S. already bailed out the financial system once with a serious cash “blood” transfusion. When the derivative market collapses again with the five above banks involved, the economy’s heart attack may actually kill off the system permanently.

Please see risk disclosure link below.