Jamie Dimon, the man who put the turd in your turducken

"Wall Street’s biggest banks squeezed out a victory this week when the House narrowly approved a spending bill with provisions that would weaken a section of the Dodd-Frank financial regulations," says The Washington Post.

Then it tries to sweeten the bitter pill by saying, "But the win came at a high cost for the banks -- in spending down their political capital and inflaming public opinion."

As though the demigods playing carelessly with your money give a damn what you think. What bothers them is the possibility of having their train set taken away by the impact of falling oil prices on the unbelievably inflated derivatives market, as Ellen Brown explains.

Derivatives are the fourth horseman in Michael Panzner's apocalyptic vision of a destroyed world economy. Sat behind him, like the lethally oversized crowd in "Widecombe Fair", are the financial establishment and all those they have bought and bullied, and by George they want cushions and helmets for everybody who matters.

Democracy is a sick joke. On both sides of the Atlantic, a professional class of political gamesters have worked out how to get what they want for themselves while appearing to be answerable to you. In the case of last week's "CRomnibus", it was the blackmail of not approving the US Government's budget bill unless it had a deadly rider strapped into the saddle: banks that gamble with your deposits insisted on having the latter insured so that the bets could be bigger and more reckless. My bet wins, I win; my bet loses, you pay.

Matt Taibbi is close to despair at the complicity of the Democrats: "... they're not a real party. They're a marketing phenomenon, a big chunk of oligarchical Blob cleverly sold to voters as the more reasonable and less nakedly corrupt wing of a two-headed political establishment."

Are they wrong, these cynical psychopaths who are masters of our universe; or are we wrong, for expecting any other result?

There is an episode in Henry Miller's "Tropic of Cancer" where a foreign student in Paris is directed to the toilet but in his ignorance uses the bidet instead. Miller extrapolates this (p.158) into a vision of a heavenly feast in which you are brought a silver platter, which has on it only two stinking "number twos".

Do you imagine that the silver platter-owners can't guess your opinion? It's part of the treat for them.


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Derivatives players pocketing the chips?

"... total money and credit are contracting, [...] the world of derivatives and leverage is contracting despite our government’s best efforts to flood the system with money."

The Fourth Horseman

Michael Panzner's prescient book "Financial Armageddon" listed four major threats to the economy: debt, retirement and healthcare benefits for the elderly, government bailouts, and financial derivatives. So far, three have exploded into public consciousness; but the fourth is still to come.

Some say that the derivatives market is now worth over $1 quadrillion, as compared with gobal GDP of some $55 trillion. For most people, these numbers mean nothing, so here's a graphic representation:

Supposedly, this shouldn't matter, since every bet involves two parties and so the sum total is zero. This ignores counterparty risk, i.e. the chance that the other person will fail to deliver when the time comes. It's the sort of thing that busted the UK's oldest bank, Barings.

From what little I understand, the derivatives market suffers from much the same complexity and obscurity as the packaged mortgage mess - the dealers are making loads of bets with loads of other people - so the misery could get spread around rather than just take down one or two incautious players.

If just 1% of the derivatives market fails, this equates to some 18% of global GDP. We in the UK are dealing with an economic contraction of less than 6% year-on-year, and that's causing paroxysms.

An argument for holding some emergency cash, away from the banks?

Still not the truth

J. S. Kim (htp: Jesse) considers the $700 trillion derivatives market (worth maybe 23 times all the stockmarkets in the world), and notes that it's being used to disguise the true woeful state of the banking system. It is as though, when listing his personal assets, a compulsive big-time gambler could include all his current Lottery tickets and horse-racing betting slips:

"... when FASB suspended mark-to-market accounting rules recently, major international banks were allowed to re-value some of their derivative products closer to their notional value on their books to pad their balance sheets. Due to this change in accounting law, I can almost guarantee you that before market open Friday, Citigroup will announce better than expected financial results as they carried huge amounts of illiquid mortgages and financial derivatives on their balance sheets."

I fear that many major banks may be thoroughly ruined, and until the lying stops, effective action cannot be taken.

The seventh seal

Denninger's question:

With the $7 trillion dollars we have committed we could have literally given every homeowner with a mortgage a fifty percent reduction in the principal outstanding.

This would have instantaneously stopped all of the foreclosures by putting all (essentially) homes into positive equity - overnight!

So why wasn't this done?

His answer: the government is trying to cover the staggering bets of the derivatives market. With borrowed money. The Treasury has swallowed the grenade and put its fingers in its ears.

This is the fourth horseman of the financial apocalypse that Michael Panzner predicted, as summarized here on Bearwatch on May 10, 2007.

UPDATE: Jesse comments on another fresh sum - tens of billions - needed to cover AIG's losses. As he says, there is an air of expectancy; but also of unreality, like the announcement of a major war.

Derivatives blowup may hit insurance and car makers

This blog looks at the implications of failed investment bank Lehman's call on their "insurance" in the form of derivatives contracts. If everyone can handle the the cash call when it comes, good; if not, maybe a domino effect - one failure unbalancing another in a chain reaction. In particular, will hedge funds , who tend to play with borrowed money, be able to honour their contracts, or will they be the weak link in the chain?

Next up, says "George Washington", are the insurance and auto companies. It seems Standard & Poor's fear these could be the last days for GM and Ford.

I'm given to understand that players in derivatives usually balance their position with bets both ways; but they tend to be big bets. It's like a seesaw with an elephant at each end: if one elephant steps off, or turns out to be a baby compared to the other... What's the chances of $55 trillion of derivatives being well-balanced at all points?

So there are good reasons to think that next week is going to be more exciting than most of us would wish. Friday's Dow volatility may be repeated.

Derivatives: the "pub with no beer"

You could be forgiven for thinking that financial bloggers are hysterical and fantasy-ridden, far more so than the middlebrow newspapers that have only just caught on to the crisis.

Until you learn the facts.

The money system is so enormous and complex that nobody knows all the details, but it is estimated that in 2007, the entire world's GDP was equivalent to $54.35 trillion.

Derivatives - mutual insurance without the requirement on anybody to hold any assets - have recently been estimated by the Bank for International Settlements at over $1,000 trillion.

To put it visually (figures are in trillions of dollars):

And now a quotation on default rates - the percentage of bonds (promises to repay) that fail:

NEW YORK, Aug 1 (Reuters) - The U.S. junk bond default rate rose to 2.25 percent in July from 1.92 percent in June, as a credit crisis and sluggish economy pushed more companies into bankruptcy protection, according to data from Standard & Poor's released on Friday.

The default rate is likely to rise to 4.9 percent over the next year and could reach 8.5 percent if economic conditions are worse than expected, S&P said in its report.

Note that in the case of derivatives contracts, a default rate of less than 5.5% would equate to a wipeout of a whole year of the entire world's earnings.

No wonder that governments are absolutely determined that confidence in the system must be maintained, at whatever cost. It may take a long time to blow up a balloon, but it doesn't burst slowly.

And how do we get out of this threatening situation? How on earth, to use a different analogy, will the cat ever climb back down from so high a tree?

Unbelievable, unimaginable

The problem with looming economic disaster is that you look out the window and since what you see is normal, you wonder what that mad Cassandra is wailing about.

Michael Panzner reproduces an article by Paul Farrell in MarketWatch about the absolutely enormous international derivative market, currently estimated at $516 trillion. Those numbers are beyond imagining, but if 2% goes bad, that's equivalent to 20% of the world's annual GDP up the chimney.

Gambling with more than you've got

The world's economy is now like a huge gambling table, and the players collectively are betting several times the value of their assets.

FT Alphaville (thanks to Michael Panzner for the alert) gives the above graphs to show how much is at stake in the business of mutual guarantees known as "over the counter" (OTC) derivatives: over $500 trillion. That's not all: Wikipedia's article (last link shown) explains that there is also a separate class of Exchange-Traded derivatives.

These sums are quite unimaginable. But we can compare them with other figures: according to FT.com, the total value of the US and European stockmarkets in March this year was a mere $31 trillion. Wikipedia estimates that the total value of all stocks and bonds in the world is less than $100 trillion.

Our daily lives stand on a thin crust over this boiling financial melange. We'd sure better hope that the experts haven't bitten off more than they can chew.

(Picture source)

Warren Buffett and derivatives

John Carney, in DealBreaker.com today, discusses Warren Buffett's recent involvement in derivatives, notwithstanding his previous publicly-announced disenchantment with the product. Does he understand the risks better this time around, or has he simply worded the contracts more carefully?

Why gold?

The Market Oracle yesterday and Gold Seek today both feature an article by Michael Kosares from his own site (USA Gold) on why he thinks you should own gold.

One reason is the fecklessness of the US Government:

"...the national debt stands at $8.9 trillion - nearly $30,000 for every man, woman and child in the United States. And there appears to be no end in sight to the fiscal madness. The debt clock ticks non-stop at the rate of about $1.3 billion per day.

I should point out that there is a difference between the "deficit" and "additions to the national debt." The deficit often quoted by politicians and the mainstream press is discounted by borrowings from the social security fund - a machination meant to dilute the real budget deficit which is the actual addition to the national debt."

I only knew recently about this business of putting their hands in the social security till and leaving an IOU. That is disturbing, because of the desperation it implies. Wasn't it the financial cost of the First World War that led to the raid on British social security funds and the switch to a rob-Peter-to-pay-Paul system?

Kosares starts his article with two quotes (I've added the sources):

"[U]nder the placid surface there are disturbing trends: huge imbalances, disequilibria, risks -- call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot. What really concerns me is that there seems to be so little willingness or capacity to do much about it. . . We are skating on thin ice." - Paul Volcker, Former Chairman of the Federal Reserve (Washington Post, 10 April 2005)

"[W]e live in a globalized environment and in a country which has enormous fiscal and external deficits. So you have to figure out some way -- which I have not done I might add -- to protect yourself if we should have a real currency problem here." - Robert Rubin, Former Treasury Secretary (interview with Kim Schoenholtz, Citigroup New York, 10 October 2006)

He discusses 6 trends: the US National Debt, the trade deficit, dropping real rates of investment return, derivatives, debt to foreigners, the US dollar's decline.

The conclusion, obviously, is that in times of doubt and distrust, gold will act as a haven for real wealth, as it has done in the past. "Price appreciation... is a sidebar to gold ownership. The main story is gold's asset preservation qualities."

Jim Puplava's interview with Richard Bookstaber

Richard Bookstaber's interview on Financial Sense (21 July - audio file) was interesting. He discussed the derivatives market (which is the subject of his book, "A demon of our own design"), in which he has been intimately involved. It's a long interview and I'll just pick out one or two points.

Derivatives are financial bets. Portfolio managers use them as a kind of insurance, which then means that they can safely (they think!) increase their exposure to equities.

But derivatives are complex, and can have unexpected effects. For example, in October 1987 there was a sizeable drop in the stockmarket, and as the prices went down, automated trading programs noted the crossing of pre-set thresholds and this triggered more selling, which took the market below other programmed thresholds, and so on.

Also, to work properly, the derivatives market needs to be "liquid and efficient". Well, when the major turmoil was happening as just described, people held off buying back in - the scale had scared them. So they weren't doing what the system expected them to do, and this change in behaviour meant that there was less support at certain price levels than the system assumed.

Another way in which the system became inefficient at greatest need, was that certain classes of asset behaved in an untypical fashion. For example, normally bonds move together, and in the opposite direction to equities; but in 1987, when it looked like major disaster, poorer-quality bonds fell as though they were equities (because of fear of their defaulting), whereas Treasury bonds (backed by the government) rose.

I have heard that in times of stress, people make unusual mistakes, such as confusing left and right, and it seems that the derivatives market has similar potential in extreme situations. You can't tell how people will react under great pressure.

Then there's "black swan" events that haven't been factored-in, but can still happen, such as Russia's decision to default on its loans, which very nearly did for Long Term Credit Management and much more besides.

On top of that, there's the question of leverage, i.e. borrowing that greatly increases the risk and returns of an investment. The current debacle re mortgages packaged as interest-yielding investments stems from the fact that not only are the packages leveraged by a factor of 10 or 20 to 1, but the hedge funds that bought them might themselves be leveraged by a factor of 5, so magnifying the basic risk of sub-prime lending by a multiple of 50 or 100. So when things go wrong, they really go wrong. As we now see.

There is also the question of inadequate information about derivatives. The method of accounting was originally developed to track rolling stock for railways, not for super-fast, computer-based trading. The data available may not be what you need to assess the situation properly, and will almost certainly be out of date in the moment-to-moment market changes. Bookstaber thinks we need to use modern technologies to get the right data out of the system fast enough to make sensible decisions.

And in assessing risk, people's memories are too short. Fund managers may be too young to remember really bad times like 1989-91, so run the risk of complacency.

Speaking of age, there's a demographic risk, too: the baby-boomers are coming to the point where they'll want money out for retirement, and maybe the market hasn't fully realised this change in the financial climate. It could be a "slow burn" crisis like the one that hit Japan, lasting maybe 15 or 20 years.

Now, many of these periods of turbulence probably don't impact on the individual investor, says Bookstaber; the private investor should buy and hold, not panic.

However, a systemic risk that could have really serious consequences is the possibility of a major failure in the mortgage and credit markets, which could then roll on to the banking sector.
Yet again, we're back to the banks, credit and the money supply. How ever did we come to think of bankers as responsible people!

Anyhow, listen to the audio file and see if I've represented it fairly. And buy the book if you think it's relevant to your line of work or investment.

Is the credit system cracking up?

Bob Hoye, in Prudent Bear (yesterday), discusses "the Unholy Trinity of central banking, derivatives and artificial rating of credit". He sees these as systemic risks - I'll say more about that when I come to Richard Bookstaber's interview on Financial Sense last Saturday.

Making money out of disaster?

The Contrarian Investors' Journal concludes its series on exploiting the possibility of a crash, by suggesting a series of short-term bets on the drop. It's a gamble, of course, but appeals to the Black Swan types who look for an "asymmetric outcome" - a disproportionately large payoff if the unlikely event happens. In other words, if the event has 100-1 odds against occurring, but the bet is offering 500-1, it seems worth taking - if you're a gambler.

But there's another risk involved: the "bookie" may not be willing, or able, to pay out. A prudent investor should consider counterparty risk.

Nassim Taleb on "Black Swans"

A very interesting article today in The Daily Reckoning Australia by Nassim Taleb, on asymmetric outcomes.

As the Daily Reckoning put it on May 14th, "...the importance of any event is equal to the likelihood TIMES the consequences." Most people underestimate the impact of rare events and so their risk calculations are skewed.

They may also miscalculate the probability of such an event occurring. I believe this was a factor in the 1986 Space Shuttle disaster. As Wikipedia puts it:

...NASA's organizational culture and decision-making processes had been a key contributing factor to the accident. NASA managers had known that [the] design of the [booster rockets] contained a potentially catastrophic flaw, but they failed to address it properly. They also ignored warnings from engineers about the dangers of launching on such a cold day and had failed to adequately report these technical concerns to their superiors.

We could use this a metaphor for the economic system and its technical risks, of which some of our bears continue to warn.

Further concern re derivatives

The Contrarian Investor's Journal continues its series on crash preparation. Part 1 showed how you could lose your shirt on shorts; now part 2 sounds a warning on derivatives - like Peter Schiff, Michael Panzner and Richard Bookstaber.

Panzner reviews Bookstaber on derivatives

Michael Panzner's view on the dangers of derivatives is confirmed in a new book by Richard Bookstaber, a senior insider in that world. "A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation " is available from Amazon here, where you will also find a review and further information about the author.

Panzner's Financial Armageddon site reviews it (under 18 May) here, quoting and commenting on a previous Wall Street Journal piece. He calls the whole system "Ponzi finance" and Bookstaber himself is calling for a reduction in the complexity of these financial instruments. See also my review of Panzner's Financial Armageddon, which considers these and other risks to America's economy.

Michael Panzner warns again of systemic risk

Michael Panzner continues to warn of a possible financial earthquake. His 17 May article in Seeking Alpha (see my link list) quotes the NY Fed Reserve President as saying "consolidation of global financial firms, increased leverage and increased complacency all have raised the risk of a systemic shock" - what I'd call the BBC syndrome (big, borrowed heavily and complacent about system risk).

Bigness is no guarantee of security, rather the reverse - think of hedge fund Long Term Capital Management, or indeed the Titanic; on borrowing, the bears have warned until they are hoarse; and complacency has been fostered by increases in the money supply.

Perhaps the complacency is the most dangerous part. People like Michael Panzner and Peter Schiff are like the architect in the 1974 movie "Towering Inferno", worried about a potential disaster because of bad wiring; but the warnings are ignored because there's extra profit in trimming security.

It's noteworthy that the Fed Reserve President, Timothy Geithner, was addressing his remarks to a conference on derivatives, which according to Mr Panzner are another source of instability in the world economy. Derivatives use highly complex mathematical tools, but as far as I can make out their purpose is simple: to see how near to disaster you can go without crossing the line. In other words, trimming security.