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What will happen to derivatives- Explain Doomsday to me

Discussion in 'BBS Hangout: Debate & Discussion' started by rhester, Jan 7, 2009.

  1. rhester

    rhester Member

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    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.
     
  2. Invisible Fan

    Invisible Fan Member

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    I think the ideal situation is to bring all transparency to light so that the government can choose which banks are healthy and facillitate a gradual dissolution of the unhealthy ones. With the enforced transparency, corporations would no longer have the incentive to tightly hold these derivatives as their real market value is totally exposed. Several good economists have called for a derivatives clearing house in order for an orderly winddown instead of a violent bust like Lehman that left many creditors holding the bag of rotting and festering @#%$.

    The problem is that economists, like everyone else, don't have a great idea of what's inside these black boxes, so the real exposure can be far far worse than expected. Or maybe some institutions are highly respected and their insolvency would be yet another notch against American financial credibility.

    Whatever the reasons, Fed and Treasury are still acting like this is a liquidity problem, so their efforts have been to inject money like epinephrine shots to a heroin addict in order for the poison to run its course.
     
  3. rhester

    rhester Member

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    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?
     
  4. Baqui99

    Baqui99 Member

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    Nothing new here. The "parallel banking system" created by mortgage backed derivatives has had a global ripple effect that we've never seen before. Combine that with the ridiculous amount of leverage in the market (some funds are levered 40x to 1) and you have a perfect storm. The liquidation of good assets by hedge funds en masse in order to cover margin calls will continue for another year at least.
     
  5. rhester

    rhester Member

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    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
     
  6. rimrocker

    rimrocker Member

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    I think it all means we should go get one of those books that shows you how to can stuff and make your own soap.
     
  7. Baqui99

    Baqui99 Member

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    That's the million dollar (or should I say trillion dollar) question. Nobody knows the true impact of how far this could unwind. Not only that, but investors have been trying to put an old-fashioned "run" on the bank, as they try to pull their money out of the hedge funds. Problem is that most are contractually limited in terms of what % that they can pull out at a given point in time.

    Of course, the end result of all this is the frozen credit markets. With financial institutions continuing to write off bad debt, they are more reluctant to extend lines of credit. Consequently, global consumption, driven by capital spending is at a standstill.

    The good news is that by year's end you should start seeing a snap-back in end demand. I think we're in the middle of the trough right now. Meanwhile, if you're the CFO of a Fortune 500 company, you're in full cost-cutting mode. So conserve cash, slash expenses, and weather the storm until things get better.
     
  8. JuanValdez

    JuanValdez Member

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    The article lays it on a bit heavy with the demon rhetoric. Obviously, the derivative market has some significant structural problems; but I feel like derivatives themselves are too maligned. With better risk management, they are good tools.

    And, I think the article (and many others) misrepresent CDSs by calling it insurance. I think a better characterization is that it is (like all derivatives) a bet. You are betting that some entity will or will not default. You can use it to hedge yourself, but it can also be used to speculate. It is disingenuous to say it is not called "insurance" merely to avoid regulation, though it along with all other derivatives should probably be regulated.
     
  9. Invisible Fan

    Invisible Fan Member

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    The government at the very least would know. Then again, what happened during the initial phases of the 700b bailout was that even solid banks were receiving money in order to hide from the public which banks really needed the money. They did it with the reasoning that only needy banks getting bailout assistance would've amounted to a pariah status.

    So it could very well cause a panic if the amount of insolvent banks are greater than expected, and the fact that this is a housing bust driven recession gives the voices that want to protect banks a lot more standing. On the other hand, we're stressing the government's financial obligations through inefficient and slow subsidies rather than allowing pure market theory to correct itself.

    Those who want to open up transparency believe the gradual and controlled shocks in doing so now would far outweigh the consequences of propping up banks/other financial institutions and loading up default caliber national debt...
     
  10. rhester

    rhester Member

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    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.
     
  11. Invisible Fan

    Invisible Fan Member

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    Short answer: The risks are huge, and no one will know the full effects until the housing market bottoms. Historically, it'll take a while before stock markets recovers after a housing fueled bubble bursts.

    Because of globalization, we won't have a prolonged worldwide depression (if it gets to that point) where stuff that happens here affects a distant country 3 months later. Consequences there could be as quick as 3 days to 3 weeks. A manager in Florida cancels a large order in China and that Chinese manager shuts down his factory a day later. I'm sure Europe's schadenfreude will slowly morph into bitter rage.

    So instead of length, the severity of an economic downturn is magnified and more destructive.

    I don't know. When I started reading all this crap last March, I started to question whether I was either crazy or prone to doomsday theories. Fun sleepless times.

    Accepting that I'm powerless does help to some extent. Being able to work right now is another.
     
    #11 Invisible Fan, Jan 7, 2009
    Last edited: Jan 7, 2009
  12. B-Bob

    B-Bob "94-year-old self-described dreamer"

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    (1) I may be prone to over-simplify, and this may just be a dodge for my immense ignorance of matters financial, but I will maintain that nobody can really tell you they understand the risk very well. The system just has that many variables, with mass psychology being a significant one. It is a huge, non-linear system knocked out of balance. It's like pouring marbles onto your living room floor and wondering how many will end up on the rug in the middle of the room, versus how many will end up closer to the walls.

    (2) I trust that God, or my conception of God, gave us an amazing opportunity here on earth.
     

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