GEF @ 4:18 PM MST
July 1, 2008
“The economy resembles a financial tower of Babel. And it is starting to crumble. In an inflationary economy, big numbers quickly lose the shock factor.”
Over the course of just a few years, a single banana becomes 10 times more expensive than what a four-bedroom home used to cost. A simple two-ply square of toilet paper sells for $417, while a full roll is priced at more than $140,000. And don’t even torture yourself by guessing how much a gallon of gas can go for under these conditions. The numbers get so big, not only do people stop trying to understand them, they begin to ignore them.
So it is alarming that the latest report from the Bank of International Settlements (bis) went largely unnoticed.
According to the bis, the number of outstanding derivative contracts in the global marketplace soared by double-digit percentages last year. Anything going up by double digits should elicit interest in and of itself, but in this case it is the sheer magnitude of the numbers involved that raises red flags.
The bis reported the total amount of outstanding derivatives has reached a practically incomprehensible $1.28 quadrillion. Yes, you read that correctly—quadrillion! And as astounding as this astronomically huge number is, the actual totals are even bigger because this number does not include derivatives related to the commodity markets (which the bis says it can’t track because values aren’t available).
A quadrillion dollars is hard to wrap your mind around. It takes a thousand trillion to make a quadrillion. Start with 1 million and multiply by 1,000, then multiply by 1,000 again, then multiple by 1,000 yet a gain—and then finally you get to 1 quadrillion. You can think of it as more than 92 times the value of all goods and services produced in America during 2007, or almost 20 times global gross domestic product.
Don’t be surprised if you haven’t heard of derivatives. Outside of banking circles they are less known, but you can think of them as essentially unregulated, high-risk credit bets. Although a more traditional definition might be that they are financial contracts designed to enhance returns, reduce costs, or transfer risk on loans, investments and other assets from a protection buyer to a protection seller, without transferring the underlying asset.
When derivatives first came into vogue, they were largely used to help individuals and businesses reduce risk—kind of like an insurance package—pay a bit more now, and have coverage later.
The example Kevin DeMeritt, president of Lear Financial, uses is of a farmer utilizing a futures contract to “hedge” his crop of beans, so that when the time to sell comes, the farmer is assured of a set price. In this case he might buy a futures contract, which is a promise to deliver a portion of his crop at a set price regardless of the price of beans come harvest time. If the price of beans goes up, the farmer only receives the contract price on his hedged portion of his crop—losing the difference. But if the price of beans falls, the futures contract still pays out the agreed-upon price. Thus the farmer can plan on how much money he will receive at harvest time and can budget accordingly.
The danger now becoming evident is that the derivatives market isn’t just farmers and other business people trying to protect against risk. The market is increasingly dominated by industries of “investors” and hedge funds that only exist to make money through derivative speculation. And a big part of that speculating is done with borrowed money.
“Unlike the earnest farmer … many of today’s institutions use futures, forwards, options, swaps, swaptions, caps, collars and floors—any kind of leverage device they can cook up—to bet the h- – – out of virtually anything,” confirms DeMeritt (emphasis mine throughout).
But when you play with borrowed money, the risk of getting burned beyond recovery increases rapidly.
According to DeMeritt, the majority of the $1.28 quadrillion in derivatives is “owned” on somewhere near 95 percent margin!
That has got to be “one of the scariest phenomena in economic history,” he says.
In case you are wondering, 95 percent margin means that for every dollar speculators have spent betting on derivatives, approximately 95 cents of that money was borrowed. For $5,000, a hedge fund speculator can control $100,000 worth of credit derivatives.
All this leverage is great if you are on the winning side of the bet—but if you are not, your principal can be quickly destroyed. Borrowed money works both ways.
“The one lesson history teaches in the financial markets is that there will come a day unlike any other day,” says the Wall Street Journal. “At this point the participants would like to say all bets are off, but in fact the bets have been placed and cannot be changed. The leverage that once multiplied income will now devastate principal.”
But making this derivatives tower of Babel all the more dangerous is the fact that, instead of reducing risk, a growing number of analysts warn that derivatives traders are actually concentrating it—and concentrating it here in America.
Out of the top 10 commercial banks with derivatives (as of last September), nine are American. Of the top 25, all but five are U.S. corporations.
And a look at their massive exposure shows that even a small miscalculation or stumble in the capital markets could be a recipe for unprecedented disaster. For example, according to the U.S. Department of the Treasury, JP Morgan Chase bank has $1.244 trillion in assets. Yet, it has a mind-boggling $91.73 trillion in derivatives contracts on its books. A person could buy the whole bank for a comparatively paltry $129 billion.
That means that if JP Morgan was exposed to just 1.3 percent of its outstanding derivative contracts, and things went wrong, it would be completely insolvent. That doesn’t take into account any other liabilities JP Morgan already has on its books.
When Long-Term Capital Management went bust in the late 1990s, people thought that the ensuing financial crisis was bad—but that will be nothing if the current derivatives tower ever collapses.
Long-Term Capital Management leveraged $4 billion into $100 billion in assets. This $100 billion became collateral for $1.2 trillion in derivatives exposure! With all that leverage, it only took a minute market move to make them insolvent several times over.
The current derivatives tower absolutely dwarfs the Long-Term Capital Management failure.
It is a mountain of borrowing on top of borrowing, leveraged debt upon debt. And when it is all said and done, no one really is sure who owes how much to whom. It is utter confusion. That is why the Federal Reserve stepped in so quickly when investment bank Bear Stearns began to collapse.
“Fed’s Rescue Halted a Derivatives Chernobyl” is how Ambrose Evans-Pritchard characterized the situation in the Telegraph. Warren Buffet calls derivatives “Financial Weapons of Mass Destruction.”
“It’s going to get far worse than anyone wants to admit. Even respected newsletter writers hesitate to suggest the truth,” says economic analyst Bob Moriarty. “It’s the end of the financial system, as we know it. Central banks might be able to paper over a few trillion dollars but the fraud is 10 times what they can paper over.”
As Moriarty indicates, U.S. financial markets are nothing more than a huge Long-Term Capital. All it will take is a shock to the stock or bond markets, or maybe sharply rising interest rates due to a run on the dollar, and the major counter parties to the derivatives contracts will fail. And when that happens, living in America all of a sudden won’t be so easy after all.
Already, stresses are appearing in the system. The housing bubble is deflating, taking the financial integrity of America’s biggest banks with it. Margin calls are hitting and billions in bank reserves and debt-fueled speculation are being wiped out. And as the economy threatens to be sucked down the deflationary drain, the government is inflating like crazy to try and buoy the markets and keep consumers from cracking under record debt loads. But ultimately, the Federal Reserve’s response is probably doomed to failure; the stresses on the system are too large. The opposite forces of deflation and inflation will not balance each other out. Rather they will rip apart varying sectors of the economy, leaving a worst-case scenario for everyone to deal with: devaluing home equity for home owners, falling dollar, soaring costs for food, gasoline, energy, commodities, and a rising cost for mortgages and other credit. It won’t be pretty!
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