Now that we heard that Citi had a good quarter, which is laughable(after how much public bailout?), I bet this latest financial rally doesn’t last more than two weeks. Here is why…
The US Treasury/Fed has put up $11 Trillion of bailouts and guarantees to the US and world financial system. But we don’t hear virtually any specifics as to who got what. Why is that?
Derivatives Secrecy problem
That is because the world has well over $1000 trillion of derivatives out which are unregulated and deeply underwater. That is why we are not told who gets what, because if it were known how much loss is out there, we definitely would have had a world bank holiday, which has been narrowly averted two times in the last year and a half since Aug 2007.
Unregulated means unknown
Since the derivatives markets are unregulated and so huge, even the US Treasury and Fed (and anyone else interested) cannot find out who owes what, and who has lost what. If you follow the derivatives story, you see that this market grows over 15% a year…so, last year we had say $1000 Trillion of derivatives, and now this year over $1200 Trillion…
Now, the reason this market is growing like this is that most of these contracts are rolled over with new ones, and the losses are rolled over. Ok. And one reason the total grows 15% a year is that losses are carried forward if possible…among other reasons. So follow the math here…
I want to show you something. In case you don’t quite understand what unregulated means: You and I can make a derivative agreement right now for $1 billion. We merely take a napkin and scribble a note which we both sign to say bet on a currency between us, and the total amount we ‘wager’ is $1 billion. One or both of us put up a minute amount of capital behind our bet, say $1000. And depending on how things go, we agree that if the gain/loss exceeds that, we roll it forward, but eventually will have to settle at the end. At first, all that is risked is $1000 each. But there is upside and down side of up to $1 billion total exposure (this is the notional value or amount leveraged).
In case you buy the story from derivatives makers that the notional value is not that bad, well it is that bad as it is the actual amount being leveraged, so that is a red herring excuse to say the notional value is not really that much, it IS that much.
That’s all there is to it. There is no law no regulation that can stop you and me from making a $1 billion derivative contract on a napkin over a martini lunch…. See it’s not regulated, these are essentially private agreements. This action (non regulated exchange) is called over the counter OTC– a private sale/agreement between just you and me and no oversight exchange involved….And as you can see, the leverage can be astronomical.
Derivatives subsumes entire financial universe since 1990
Now, take this idea in 1990 when the total derivatives market worldwide was about $20 trillion. Then, take sophisticated investors and banks institutions of all types, like GE, GMAC, Morgan, BoA, Citi, etc, AIG. And even mid sized financial companies and insurance companies and even money market funds and every type of bond market (government, corporate and muni) and add in all the world real estate market… and start securitizing everything and then… follow me here, then start the OTC derivatives between whoever wanted in the game, starting at size of $20 Trillion in 1990…
The majority of the derivatives markets are OTC (unregulated). It has grown from $20 trillion in 1990 to now $1200 trillion in notional value. That is the total amount of leverage exposure. And that is not the entire derivatives market, since commodity derivatives and such are not included in this.
Now, understand that since these are OTC, who owns what is impossible to know. The immense losses are not being revealed because of the panic the Central banks know will ensue, hence even the US Congress can’t get the Fed or Treasury to reveal who got what. The only way we have averted a world bank holiday on two occasions was for the US Treasury/Fed to basically sweep all the trillions of losses so far under the rug – at a cost so far for the US alone of $11 trillion.
The point here is, with $1200 trillion of derivatives exposure out, and it being OTC mostly and thus secret, the only way for the world financial system to hold together is for the public sector to sweep the entire mess under the public domain….and as the losses continue to accumulate, more and more has to be done, yet nothing appears to improve in the overall credit markets.
Now, can you tell me how $11 trillion, which is admittedly a lot of money, will be enough to cover the mounting losses on $1200 trillion of leverage???
Clearly they cannot stay ahead of this. Can they? I don’t think so.
Deleveraging is taking down the public treasuries
Now to our pickle analogy. I assume that people know what that is in baseball. A runner is trying to get from second base to third base, but the third baseman and second baseman have him in a ‘pickle’ ie he is caught between the two. Ok so if they tag him he is out right? So they narrow in on him and cut off his path to either base, and it looks funny, he runs back and forth, and they just keep moving in till one tags him out….
Now, you might wonder why all the panic last fall and the drama right, with Paulson and the Bernanke and telling Congress we were about to have a total world financial collapse (We almost did too, and averted it by a few hours but that is another story).
Our players: The base runner is the US Treasury and Fed. Third baseman is deflation. Second baseman is inflation. The game is the entire world financial market. Then, whoever tags the base runner, the Fed out, is the endgame…either inflation or deflation wins…ok so let’s continue. But basically, the Fed is caught in a pickle between inflation and deflation and not enough money to get safe.
Now, clearly, either there will be inflation or deflation as the final outcome. If the Fed just monetizes everything, the USD will definitely collapse. We will have what might be a terminal inflation in the US at that point, where the value of the USD collapses totally in 2 years after the Fed is tagged out. Then the only solution is terminal inflation of the USD – called hyperinflation.
If the Fed chooses not to monetize, then, well all the derivatives continue unwinding relentlessly, in this secrecy, where no one knows who is next. Unless the Fed uses the public purse to sweep more and more unwinding derivatives under the rug, the entire world financial system collapses. I am serious….I am not exaggerating. We almost had this happen on two or more occasions that I recall since Aug 2007…
Now, the question arises, is it possible to avoid uncontrolled inflation and the destruction of the USD, or uncontrolled deflation and a total implosion of the $1200 Trillion of world derivatives that has subsumed the entire world of money. I think the answer is negative.
Why? Simply because if the basic issue here is that the world financial system is deleveraging, and it’s $1200 Trillion in size affecting every financial institution you can name, how can $11 trillion stop it? That is less than 1% of the amount out there!
Now, who else other than the US Fed even can raise another $11 trillion for the next year or two or more? No other central banks can, except possibly the ECB or China can raise this money, or maybe they all throw in with Japan and anyone else who wants to jump into this emergency….
Which is why Bernanke said he needs more authority to deal with ‘systemic risk’ and why Obama just stated the G20 needs a world stimulus….
If you have followed along with who has been throwing tons of money out there to stop the world financial panic, the US Fed is by far the leader. Then the ECB, and then China and others in smaller degrees. But I have estimated that the entire world effort so far to stop the deleveraging at not more than $20 trillion so far. That is not even 2% of what’s out there.
Public Running out of money
And the Central banks are running out of money. The bond markets are showing increasing interest rates on the 10Y UST for example which has risen from around 2% to now 3% roughly. Once the bond markets blink, the Fed has no alternative but to buy the US Treasury issues itself, which is printing USD to finance the US budget. So far the Fed has blinked on that step. That step is verboten in the bond markets.
Gold and USD in this ‘pickle’
Now, we have been talking about how flight to safety has been moving both to the USD and to gold and is why gold has held up some when practically everything else has not. What happens when/if the Fed actually starts to buy US Treasuries? We hope that does not happen for a while, and so does everyone else…because that is when the USD will face a day of reckoning.
How long the world bond markets and currency markets tolerate that activity is a question. Basically, if they do not tolerate it, then the USD will fall drastically, probably by 50% over a year at least. If they tolerate the Fed monetizing the US Ts, then maybe we have more time.
What should happen at this point if/when it happens (Fed buying US Ts directly) is that gold and the USD should separate. Recently, they have rallied and fallen together based on what the flight to safety situation is that week. We at PrudentSquirrel are very closely tracking this issue.
There is more to this on the inflationary outcome vs the deflationary. But we can’t cover everything in this paper. Our PrudentSquirrel newsletter has been discussing this situation for several months now.
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