Although the public has yet to be let in on the dirtiest little secret of this unfolding debacle, they will soon understand that what they do understand is but a small fraction of the ugly truths that fester just beneath the surface of the markets.
The problem up until now has been viewed as a residential SUB-PRIME real estate problem and although the tax payers seem pretty bitter about a bailout, the government—both sides—are trying to sell us on the idea that this was simply a good idea gone bad.
According to them, they were trying—out of the kindness of their hearts—to help every single person in the United States realize the dream of home ownership but unfortunately for US—and in compassion for THEM—they simply went a bit too far in their zeal to assist the less fortunate.
Do we have a sub prime mortgage problem? YES! Is that problem causing pain in the mortgage backed securities market? YES! Should that problem bring down the entire world’s financial systems? NO…uh, unless of course those sub prime mortgage backed securities are just the tip of a larger iceberg involving Alt-A loans as well as other types of consumer debt. (think credit cards) all of which were insured against default by what Warren Buffett referred to as “financial weapons of mass destruction.”
I hate to constantly bring up all of the negatives I see out there but I want to deal with a bit of market psychology here. Soon enough, people will most likely start digging around and as they do, the newspapers should finally help then understand this debacle in greater detail. It’s bad enough that they think they have an idea of the core problem (real estate) but once they discover the much more dangerous and unpredictable boogieman, I’d guess it will really hit the fan.
The “Dirtiest” Little Secret is DERIVATIVES!
It’s very easy to get caught up in all the chatter about “franchise value” “earning power” “asset value” etc. so let’s take a major step back and try to put all of this financial system chaos in perspective. I haven’t talked much about this one in a while but way back in March when JPM took over Bear Sterns I told you all that the model was telling me JPM was in trouble. I also guessed that JP Morgan had a very strategic purpose in taking over Bear Sterns—their very survival.
It’s becoming increasingly obvious to me that companies are being strategically “rolled-up” like a snowball into larger and larger institutions in order to hide derivatives exposure and to backstop derivatives defaults. If I’m correct, the largest institution—the FED, US GOV, Central banks—will eventually own both sides of all the worthless insurance policies created over the past 15 years as they play a game of financial Russian roulette in hopes that the gun never fires a bullet into the temple of the fragile confidence that props up fiat currencies around the world.
The Bear Sterns “Bargain”
Back when JPM announced their agreement with Bear Sterns many in the press—and many analysts as well—called the deal “a bargain.” The BAM model, on the other hand, called it “a boat anchor” and I said it looked to me as if the deal were forced by the GOV out of necessity in order to hide/control the truth behind the derivatives time-bomb. One other publication was also willing to at least entertain that unpopular view and they even revealed Bear’s $10 Trillion notional value worth of derivatives.
(JGS NOTE: If swings in BUSINESS CYCLE EUPHORIA are not pre-ordained and predictable, how was the BAM model able to forecast all of these events—from housing to banks to brokers—way back in the summer of 2005?)
Commercial Banks or Casinos?
Commercial banks must report quarterly derivatives exposure to the government and those numbers can be found at http://www.occ.treas.gov/ftp/release/2008-115a.pdfwww.
In the OCC’s Q2 2008 report, they showed—
–“The notional value of derivatives held by US commercial banks increased 1.8 trillion in the second quarter, or 1%, to 182.1 trillion.”
–“The notional value of credit derivatives was listed at 15.5 trillion of which 99% were “credit default swaps.”
Now Let’s Look at the REAL BIG Numbers…I Wonder if AIG is Involved?
Of the 596 TRILLION in derivatives (that’s an old number from 2007) 66% are interest rate contracts. Incredible that we allowed ourselves to get into this mess but it’s pretty easy to understand the model’s forecast for 15-21% rates in a few years—
(This from Wikipedia)
Broadly speaking there are two distinct groups of derivative contracts, which are distinguished by the way they are traded in market:
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way.
The OTC derivative market is the largest market for derivatives, and is unregulated. According to the Bank for International Settlements, the total outstanding notional amount is $596 trillion (as of December 2007). Of this total notional amount, 66% are interest rate contracts, 10% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. OTC derivatives are largely subject to counterparty risk, as the validity of a contract depends on the counterparty’s solvency and ability to honor its obligations.
Bottom-Line, and it’s NOT GOOD
Way back in my August 27 report of 2007 with the headline “They Don’t Know What They Don’t Know” I was attempting to make a point about the unknowable world of derivates risk and the “daisy-chain” that links them but as I see the looks on the faces of Bernanke and Paulson I’m now afraid that they know enough to be absolutely terrified. Just think back to the relentless nature of the interventions over the past year and you’ll begin to worry, just as I do, that the government’s models look more like the BAM model than they want anyone to know. The fact that the government has stepped in during each and every crash zone I’ve published over the past 15 months is NOT a coincidence. They must be seeing some of what I’m seeing behind the scenes. It’s interesting that the current wrangling over the huge bailout package is taking place just prior to another forecasted crash zone. This 45-50% “air-pocket” under the market dictates that the authorities act decisively and although the BAM model tells us that this action will merely postpone the inevitable depression era crash decline into 2012-2016, we should be thankful for small favors.
Full report coming soon