What will happen to derivatives- Explain Doomsday to me

I don't have a link for this it came in an email, but I don't really understand the size and amount of leverage at risk in derivatives, so

Could the financial experts please read this and bring either some balance or explanation to this Doomsday scenario...

I have researched alot on derivatives and I have found they are not transparent and regulated well and it is hard to find the size of these debt instruments in the global economy...

I really would appreciate someone shedding some light on this article: (It's a long read, sorry)



By John Pugsley
Chairman,
The Sovereign Society

The nightmare scenario has begun.

We’ve been warning people about it for over 4 years now. And while the powers at be would love you to think that they’ve got everything under control, you’ll soon see that once the next wave of the global derivatives disaster hits, no amount of Fed fiddling will be able to contain the crisis this time.

While we originally warned that JP Morgan might be ground zero for the global derivatives disaster, Jamie Dimon (who’s been called the world’s greatest banker) was soon employed to unwind their giant derivatives portfolio and reduce their exposure and risk.

Although he managed to do this with some success, other players took up the slack and the derivatives bubble continued to grow unchecked and unregulated.

We later sent out warnings of a new demon derivative that had begun to proliferate like wildfire…which threatened to take down banks like Wachovia, Merrill Lynch, Morgan Stanley, Deustche Bank, and hundreds of other hedge funds and financial institutions.

“There are about 700 banks in critical condition…100-150 of them, with $1 trillion in assets, will essentially go bankrupt in the next year.”


Bill Gross, the legendary bond investor, called this particular type of derivative one of the banks’ most “egregious concoctions” to date! It’s the now infamous investment, which goes by the name of the Subprime CDO (Collateralized Debt Obligation). The investment derives its value from the subprime mortgage markets.

These investments were basically bets on whether or not the average American homeowner with a poor credit rating could make his monthly mortgage payment on his inflated home.

For bankers and mortgage brokers, loan applicants who previously would have been considered bad risks suddenly became great clients. That’s because the higher risk these borrowers represented, meant ultimately the lender could charge higher rates and fees…and then quickly sell the loan off to unsuspecting institutions.

And in a world of low interest rates, low inflation and easy credit they were a gloriously effortless way for banks and hedge funds to reach for yield. The risk was low and the reward high…at least until everything started to go wrong…and these miracle bets began to rapidly unwind…


Pop Goes the Largest Leveraged Asset and
Credit Bubble in History


You see, as we mentioned before, these derivative bets are bought on an enormous amount of leverage.

For example, any wealthy individual can go to a broker these days and put down $1 million, and then leverage this amount 3 times. The resulting $4 million ($1 million equity, $3 million debt) can be invested in a fund of funds that will in turn leverage this $4 million another 3 or 4 times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them another 3 or 4 times and buy derivatives like subprime CDOs, which are often themselves leveraged 9 or 10 times!

At the end of this long credit chain, the initial $1 million of equity can become a $100 million investment, out of which $99 million is debt (leverage) and only $1 million is equity. So we get an overall leverage ratio of 100 to 1.

It was this kind of new Super-Leverage which helped create the largest asset and credit bubbles in the history of humanity, including a global real estate bubble, a mortgage bubble, a bond bubble, a credit bubble, a commodity bubble, a private equity bubble, a hedge fund bubble and the mother of all economic bubbles: the global derivatives bubble.

It’s how global stock markets grew from $25 trillion to $50 trillion in just 5 years, and how the global derivatives market leapt from $100 trillion to almost $600 trillion. In economic terms, these bubbles grew in the blink of an eye.

And now they’ve all begun to bust at the same time—plunging us into the deepest de-leveraging since the Great Depression.

“…total global losses from the coming financial meltdown could easily reach $25,000 billion to $30,000 billion.”


You see, when you have this kind of monstrous amount of leverage built into the system, a mere 1% fall in the price of the final investment (the CDO) can wipe out the initial equity, and create a chain of margin calls.

And here’s where the real problem lies: The one we’ve been warning investors about for over four years now…the one at the very core of the credit crisis.

The amount all these traders have to put down in order to place their derivative bets is based upon their credit rating. The stronger their credit rating, the less they have to put down.

Now if their credit rating is downgraded, they have to put up more money to cover the bet. In order to do that, the bank, hedge fund, money market fund, private equity fund, etc. must sell its investments. Problem is, it’s unable to sell many of its investments (like CDOs) - because nobody wants them, so it has to sell its good investments (like its stocks). And naturally when things sell, prices drop, which causes further selling, and further downgrades and so on…

And that’s what we are seeing in global markets right now. It’s why stocks, investments and markets that seem far removed from the subprime mortgage meltdown are being affected by it.

But the worst is yet to come.


The Catalog of Crises


It’s not only that we have a financial crisis, we also have a banking crisis, a credit crisis, a food crisis, an energy crisis and a commodity crisis.

We’ve already seen $10 trillion wiped off global stock exchanges in just a month. And that was after trillions of dollars had been injected into the system from central banks the globe over…

And now the next demon derivative is about to whip down Wall Street and wipe a further $20 trillion off global exchanges, spinning the world into what might end up being a global deflationary collapse.



Wall Street’s Next Demon Derivative Delivers Final Blow


You’ve heard of the subprime CDO (the derivative at the core of the current crisis). Now another kind of demon derivative is about to take the spotlight. It’s called the CDS (Credit Default Swap). And you’ll soon understand why, no matter what central banks do, it will deal the final blow to the global financial system.

At its very simplest a CDS is an insurance contract. And it’s made between two parties, one of whom is giving insurance to the other in hopes that he will be paid in the event that a financial institution or corporation, fails. However, Wall Street big-wigs have been very careful not to call this investment an insurance contract because if it were insurance, it would be regulated. So instead they use a magic substitute word called a 'swap,' which by virtue of federal law is deregulated.

And this is where we run into trouble. Because what was originally intended as insurance has now often become once again a highly leveraged speculative bet. Now in a typical CDS deal, a hedge fund will sell protection to a bank, which will then resell the same protection to another bank, and such dealing will continue, sometimes in a circle. And this practice has the potential to put investors into webs of relationships which are not transparent.

Since the U.S. Treasury has not classified these derivatives as “insurance,” they trade free of any government regulations. Because of that, the firm selling the CDS is not required to set aside any reserves from the premiums received to insure against possible future loss claims.

“…the kind of wrenching financial crisis that comes along only once
in a century.”

Alan Greenspan, New York Times, October 9, 2008

This obviously makes the sale of the Credit Default Swaps potentially very profitable. But if the bet goes sour, and the company defaults or goes bankrupt, then that small bet can get very expensive.

So what was essentially supposed to be a safe insurance contract is now a series of highly leveraged dangerous bets. And in the past seven years trading in this market has leapt a mind-boggling hundred-fold.

This new CDS market now stands at a size larger than the entire capitalization of all the world’s stock markets combined.

And since these bets are all based on the future credit worthiness of a country, company or consumer (basically a bet on the ability of a party to repay his debts), they’re all about to go horribly wrong.

In a global economy made up of thousands of corporations and institutions, many of which borrowed 10-100 times their capital in the past few years, most will be un able to repay their future debts – meaning these new demon derivates are going to unwind at a rapid rate…with fall-out so large it will dwarf the current damage caused by the crisis so far.


Why Bailout Band-Aids Won’t Save the System


Central banks around the globe have already injected trillions of dollars into the system. And while these bailout band-aids have helped, the problem is too big now. A band-aid might be good to cover a blemish or an abrasion, but we now have a gaping hole in the financial system: One that is growing larger every day.

Plus the government’s ability to deal with a crisis of this magnitude is unfortunately limited. Over 700 banks are already in critical condition…150 of them (with a trillion dollars in assets alone) have Texas Ratios of 1:1. (A Texas ratio is a measure of the banks’ credit troubles. And historically when banks have reached 1:1, they fail.)

While the Fed does have the ability to bail out banks, how many more will they have to bail out before investors start to lose faith in the whole American financial system. But even if they were to take the unlikely action of bailing out every bank, it still wouldn’t be enough.

They’d need to bail out the hundreds of non-banking institutions too, including all the hedge funds, money market funds and private equity funds that are also on the brink. And they’d need to bail out the thousands of crashing corporations and the millions of already bankrupt mortgage holders. That’s what is needed to save the system…to prevent a tsunami of foreclosures, an implosion of the corporate sector, not to mention the coming torrent of defaults on credit cards, auto loans and student loans.

And the tragic reality is it can’t be done. These kind of non-banking bailouts lie beyond the abilities of the Fed.

Ten of the biggest Private Equity outfits (Ex-president’s clubs, as we called them), were busily buying up hundreds of companies on extravagant amounts of leverage. And they weren’t just buying up small firms, they were buying up some of America’s most iconic brands, including: Hertz, Dunkin’ Donuts, Baskin-Robbins, Metro-Goldwyn-Mayer, Warner Music, Neiman Marcus, J Crew and Toys “R” Us.

They de-listed these companies from the public exchanges, stripped them down, cut their costs and their workforces, loaded them up with debt, charged them questionable fees and rushed them back to public markets at warp speed.

To quote industry insiders, they “bought them, stripped them and flipped them.”

But the success of this buyout binge hinged on one very important factor: a booming economy.

You see Private Equity firms use the rising sales of the companies they acquire to pay back their enormous debt loads. But in a recession when sales tumble, they will be unable to make the crippling repayments. They will default. This is what we’re starting to see happen. Since they bought up trillions of dollars worth of companies (a significant swath of the global economy) the impact will be enormous. Corporate bankruptcies will soar. Private Equity firms will be unable to launch them back onto public exchanges. They’ll be stuck owning ailing assets. And many will get crushed under the burden of their huge debt loads.



Corporate default rates were a mere 0.6% in 2006 and 2007. But in a typical U.S. recession these rates surge above 10%. In a severe recession they’ll soar even higher.

And once the tsunami of corporate bankruptcies start to flood the market, it is then that we will bear witness once again to the devastating power that these demon derivatives carry. For the intricate web of relationships, including all the banks, hedge funds, money market funds and investors that bought insurance on these faltering companies, will want to be paid. Problem is, many won’t have the funds to pay up. They’ll go bankrupt.

It’s why AIG – the world’s biggest insurance company— fell and had to be bailed out by the banks.

And it’s why Lehman Brothers also went bankrupt. And even if the Fed had saved them it would’ve only slowed down the meltdown. It wouldn’t have stopped it. Because this time, the bets have been too big, and they’ve burrowed too deep into the global financial system…

Nothing will be able to stop the coming catastrophic implosion of the Credit Default Swap market. Even if the Fed could inject funds into every hedge fund, money-market fund and corporation (which they can’t), the sums would need to be so large that it would destroy the very fabric of the American financial system anyway.

Once the CDS marker starts to implode, there will be a run on the banks…and a run on stocks. And expect the coming CDS—driven global stock market crash to dwarf the last crash, which saw $10 trillion wiped off global exchanges in a matter of weeks, as investors priced in a global recession. This time they’ll be pricing in a severe recession and maybe a depression. Expect a further $20 trillion to get wiped off. And because of the lack of transparency in the CDS market, everyone will hoard cash, making the credit crunch even worse…leading to a complete systemic financial collapse. The curtain will have finally fallen on the Wall Street era.

 

So if it were transparent, do you mean it would be known which banks or financials are holding the most risk and the amount of risk in the CDS market?

Would that cause panic?

 

How much liquidation of good assets are you talking about (trillions?)? And if it continues another year what does that mean for financials that are in trouble?

I am trying to get ahold of the impact of the huge numbers used in the article.

Thanks

 

Part of my reason for really wanting to understand these big numbers is that in the Brazosport area where I live the recession is really hitting very hard... many people losing their jobs, big stores closing at the Brazos Mall...

The area is dependent on Dow Chemical, BASF Chemical, Shintech Chemical etc.

Dow Chemical layed off every single contract employee right before Christmas, including 3 that attend our church, they are still without work.

Now I am told Dow Chemical is going to layoff Dow employees for the first time.

The ripple effect is starting to pile.

I don't know the effect in Houston but our Company here is discussing a wage increase freeze at this time... I was in the meeting this morning.

So I'm trying to gage the magnitude (how many trillions) of the continued restriction in the economy.

A friend of mine in West Virginia just called me and told me they are really suffering.

While I have a good job and my trust is in God... I was wondering if it is really known in the talking head media what the actual risk out there is.

All those trillions of derivatives makes my head swim and wonder if the old

'it will never happen here' is in play.