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Will Derivatives Wipe Out Some Currencies?

By Chris Laird      Printer Friendly Version
Sep 6 2007 10:26AM

www.prudentsquirrel.com

Over the last several years, there has been a lot of discussion about the size of the derivatives market, and how much it has grown since 1990. That market was around $20 trillion in size in ‘90, and now is estimated by the BIS to exceed $600 trillion world wide.

Given that amount is 10 or 12 times the entire world GDP of roughly $50 trillion a year, this amount of derivatives is just astounding. The fact is that world currencies are threatened if these go sour. We will get into this in a moment. First, let us discuss some derivative basics.

Derivatives proponents (brokers and bankers) have previously stated that the actual value of derivatives is a fraction of the actual total size, and that all the worry is overblown. The total size is called the ‘notional amount’. For example, if we decided to make a contract on the price of gold for 100 ounces, (a private futures contract between us) the notional amount would be 100 times the price of gold. If the price of gold rose $1, the value of that contract would be $100, but the notional amount is $68,000 (680*100). Derivatives proponents state the cry about the incredible notional amounts is over done, and try to get us to focus on the smaller ‘value’ amounts and not to worry.

Oh yes, we should worry!

Well, the fact is, when we hear of derivatives in $600 trillion amounts, the TRUTH is that this is the actual leverage out, and when values change, the value of the contract varies greatly - according to all that leverage. Notional amount is the actual amount being bet on, pure and simple. The de emphasis of gigantic notional amounts is mere smoke screen.

We have already seen what happened with the US mortgage derivatives, and how trouble in the subprime CDOs, SIVs, etc, spilled into other credit markets and caused panic and threatened systemic banking crises in the EU, US, and Canada. Right now, those central banks are vigorously trying to stem a meltdown in the money markets, as corporate paper (short term money for banks and companies) has pretty much stopped rolling over. The lenders in that market are afraid if they roll the paper over, they will be stuck with loans to companies banks and institutions who are hiding huge derivatives losses. If they roll over the paper (extend) then, if these borrowers go bankrupt, their CP becomes endangered.

This is why the Central banks are having a hard time convincing the CP markets to take advantage of their short term stop gap loans (via the discount window for example), and the central banks efforts to stem the credit meltdown is not working. In the EU for example, Libor (London interbank rates - short term money) rates have hit 9 year highs Tuesday - and bankers are saying that indicates the central bank efforts to revive the CP markets is not working. Bankers set rates among themselves - central banks can only offer their own money at CB rates, but they cannot force banks to loan it out. This is why the CP markets are still in severe trouble.

Bail outs?

We have heard the justified cries that central banks should not bail out all those reckless investors in derivatives, and their bankers and brokers. The trouble is, central banks may not have a choice, right or wrong. If derivative losses spread enough to paralyze the credit markets, then economies will grind to a halt. So, right or wrong, central banks probably have no choice but to try and stem the ongoing losses and credit crisis with bailouts.

Central banks will have to take on the huge losses

Now, we get to the heart of the matter. One of the ways the Fed was able to initially stem the most threatening problems from the mortgage derivatives mess was to buy the troubled stuff that no one wanted at book value. Eventually, central banks may find that is the only way they can stem the credit freeze. Just offering to loan central bank money to the system does not take the losses off peoples book’s.

Even if some short term action pushes some central bank money into the system, the losses stay and will have to be recognized at some point. So, this strategy by central banks of just loaning money will not work, and is only a very temporary stop gap measure. The existence of losses in people’s portfolios is what is stopping lenders from participating in the essential CP markets. If they even suspect someone has mortgage derivatives losses - they will not roll over the CP. The only solution? Central banks have to buy the bad assets (losing derivatives) at book value and take them off people’s hands outright. The Fed has been doing this, offering to take MBS and other non standard collateral for their money. Then, the troubled assets become the Central Bank’s problem.

Now,  that amounts to monetization of losses. (Monetization is central banks buying out losses by printing the money for it.) This leads to serious trouble. A central bank can monetize some things, but it surely cannot monetize trillions and trillions of them over and over. If they do that, then the value of their own bonds collapses, and the currency devalues.

Now we get to some numbers. So far, the Fed, ECB, BOJ, and other central banks are all madly trying to flood money into the credit markets so CP will roll over. The trouble is, the CP markets are not normalizing, and eventually, these central banks will realize the only solution will be outright bail outs in gigantic amounts.

So far, CBs have already put out well over half a $trillion so far. We are probably going to see over a $trillion soon. With the notional amounts of derivatives in general exceeding $600 trillion world wide, we see a serious problem arising. You know, I would not expect the entire $600 trillion universe of derivatives to go bad, but, if even a fraction do, (they already are) then CBs end up being on the hook for trillions.

The problem is not made any easier by the fact that over 70% of all derivatives are OTC (over the counter - private one on one contracts). This is why the MBS and mortgage derivatives mess collapsed so fast, because there was no market for them. As losses spiraled out of control, no one wanted to touch them even at something like 5 cents on the dollar. The only solution? Central banks having to be buyers of last resort. The holders of these bad derivatives were forced to keep them on book - and then lost their own credit worthiness.

Another problem is that trouble in one sector of derivatives is like a loose cannon crashing around on the deck of ship in a storm. It spreads damage to other parts of the ship. Hopefully, the loose cannon crashes through the thwarts and falls into the sea….The sea in this case is all the nations’ central banks.

The derivatives ship

The derivatives ship is a multi deck aircraft carrier. Each deck is a sector of derivatives. Now, lets say, one sector of trillions of derivatives goes bad, and no one wants them. The holders (counterparties) then cannot offload them. Soon, the weight of mounting losses causes them to be unable to cover other derivatives they hold, and all of a sudden, the entire web of derivatives becomes in danger because the counterparties cannot now count on each other to cover their bets…The damage spreads from sector to sector, or to different decks.

All of a sudden, a systemic collapse emerges, and even if one institution has counterparties covering their losses (hedges) they find their hedges fail as the other party falls into insolvency.

Thus, the illiquid nature of OTC derivatives causes a gigantic systemic collapse. Right now, central banks are really afraid of this possibility. So far, central banks have NOT stemmed the crisis in CP markets. Libor rates prove that. Now, the CP market is the most vulnerable sector because it is money that has to roll over every 270 days or less. Considering that that market is 2.2 trillion in the US alone, and that it affects all aspects of commerce, we see we have a major problem on our hands. As of last week, about $250 billion of CP in the US has not rolled over (put another way, outstanding CP in the US has dropped by $250 billion, or over 10% of all of it!) in only 3 weeks!

Gold and the USD here

A couple of weeks ago, there was a stamped into US treasuries, and 3 month Treasury yields dropped up to 2% in one day. Eventually, those rates stabilized, but it showed flight into safety and into the USD. Another factor in play is that, as credit markets become illiquid, banks, institutions and companies hoard cash to operate. If they cannot roll over short term paper, they need cash. So, they hoard cash. This is happening right now in the European financial sector right now.

Gold is also benefiting from flight to safety. The advantage gold has in this situation is that, once people realize that Central banks will have to become buyers of last resort for $trillions of bad derivatives, they will prefer gold to actual currencies.

Gold is being whipsawed in two ways. One is flight into gold ultimately. The other is selling of gold during stock sell offs. Every time gold rallies right now, it is subject to panicky selling when investors need cash. And right now, everybody seems to need a lot of cash.

This story is only beginning, and I heard one good comment about this present derivatives / credit crisis that ‘the unwinding of credit and leverage will not be denied’. That means that all the leverage out there right now is subject to waves of unwinding. Considering all the leverage in the stock world, that does not bode well at all.

Will derivatives ultimately kill some currencies?

Now, given the fact that I don’t think Central banks can escape having to monetize more and more trillions worth of derivatives, the question arises ‘what will be the fate of major currencies?’

Central banks have a serious dilemma. If they let the financial system ‘take’ the losses, the credit markets freeze. That will just hammer world economic activity. If central banks do monetize all these growing losses (likely to snowball) then they threaten their own currencies. Both choices are quite bad. Can they work out of this mess? I don’t know. One thing for certain is they will have to act very soon. I think a consensus is building, that, as people begin to understand what is happening, they are going to start dumping some of the major currencies where the derivative losses are centered.

Ultimately, gold should benefit greatly in this situation, although it is subject to some panic selling when institutions need cash during equity crashes.

Also, considering the weakening US, Japanese, and EU economy due to credit contraction, we have one hell of a financial storm building on the horizon. It is a huge black cloud looming on the horizon in front of us. I can see no good reason to be staying in equity markets right now. Cash is definitely king at this time. (gold and precious metals are likely the best cash).

One final note, there has been some talk going around that commodities in general should benefit significantly as these currencies start to have trouble. One major reservation I have about that is that commodities are so sensitive to economic activity. If things really get out of hand in the financial world, I expect some significant economic slowing and falling demand for all the major commodities, and even possibly oil. The world equity bubbles are the only thing still keeping people spending. If those tank, the last standing source of profits for people is likely to start to evaporate. This is not going to be good for commodities.

We at PrudentSquirrel have been discussing getting liquid for months. We have anticipated the last 3 major world stock drops this year by up to 2 days in email alerts to subscribers. Subscribers have told me they would stay with Prudent Squirrel just for the alerts alone.

The Prudent Squirrel newsletter is a financial and gold commentary published 44 times a year. Subscribers also get mid week email alerts as needed.

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Christopher Laird
Editor-in-Chief
www.PrudentSquirrel.com

 

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Chris Laird is not an investment advisor/professional. This article, and the PrudentSquirrel newsletter, is general market commentary only. It is not intended as specific advice. You should talk to your own investment professionals for specific advice.

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