Derivatives, the One Market the Fed Hopes You Won’t Find Out About
Interest-Rates / Credit Crisis 2010 Apr 13, 2010 - 12:18 PM GMTBy: Graham_Summers
As we celebrate year three of the Great Financial Crisis with the first official bailout of an entire country (Greece), I’m still astounded and the complete and utter lack of coverage the underlying cause of this Crisis has received.
We’ve had tens of thousands, if not hundreds of thousands of articles and research reports have been written about the Crisis, and yet I would wager less than 1% of them actually bother talking about what caused it, let alone how the various efforts to stop it have in fact FAILED to address the key issues.
Remember back in 2007? At that time we were told it was all about Subprime mortgages. Then in 2008, we were told it was the investment banks, specifically Lehman Brothers’ failure and AIG’s credit default swaps. In 2009, we were told it was poor accounting standards and bad bets made by Wall Street. And here we are in 2010, and we’re still being told it was simply bad bets made by Wall Street.
All of these answers are partially right, but none of them are totally 100% accurate. Why? Because they fail to address the one underlying issue that links ALL of these items. I’m talking about the Black Hole of Finance: a bottomless pit that no official or regulator bothers mentioning in public because acknowledging it would mean acknowledging that all of the efforts to stop the Crisis are truly paltry.
What caused the Crisis?
Derivatives.
You’ve probably heard this term before, or have some vague understanding of what it means. But the actual reality of derivatives and what they mean for the financial markets remains a topic no one in the mainstream media (or the regulators for that matter) wants to touch.
Why?
Let’s do some quick math.
If you add up the value of every stock on the planet, the entire market capitalization would be about $36 trillion. If you do the same process for bonds, you’d get a market capitalization of roughly $72 trillion.
The notional value of the derivative market is roughly $1+ QUADRILLION.
I realize that number sounds like something out of Looney tunes, so I’ll try to put it into perspective.
$1+ Quadrillion is roughly:
- 40 TIMES THE WORLD’S STOCK MARKET.
- 10 TIMES the value of EVERY STOCK AND EVERY BOND ON THE PLANET.
- 23 TIMES WORLD GDP.
What’s a derivative?
As their name implies, derivatives are “derived” from underlying assets (homes, debt, etc). A lot of smart people have tried to explain what these things are, but miss the forest for the trees. A derivative is NOT an asset. It’s, in reality, nothing, just an imaginary security of no value that banks trade as a kind of “gentleman’s bet” on the value of future risk or securities.
Let’s say you and I want to bet on whether our neighbor Joe will default on his mortgage. Is the bet an asset? Does it have any real value? Both counts register a definite “no.”
That’s the equivalent of a derivative.
It is total and complete lunacy to claim these items are anything more than fiction (perpetuated by another fiction: that Wall Street is able to value these things or price them accurately). But thanks to Wall Street’s lobbying power, they’ve become the centerpiece of the financial markets.
If these numbers scare you, you’re not alone. As early as 1998, soon to be chairperson of the Commodity Futures Trading Commission (CFTC), Brooksley Born, approached Alan Greenspan, Bob Rubin, and Larry Summers (the three heads of economic policy) about derivatives. She said she thought derivatives should be reined in and regulated because they were getting too out of control. The response from Greenspan and company was that if she pushed for regulation that the market would implode.
Remember, this was back in 1998: a full DECADE before the Crisis occurred. And already, the guys in charge of the markets knew that derivatives were such a big problem that trying to regulate them or increase transparency would destroy the market.
So why are these items so accepted? Well, for one thing Wall Street makes roughly $35 billion+ per year from trading them, so it has a powerful incentive to keep them untouched.
Also, it’s kind of difficult for Ben Bernanke and the world’s central bankers to claim they saved the financial world from destruction when you realize that even the most liberal estimate of the bailout costs ($24 trillion) is equal to less than 2% of the derivatives market.
Indeed, even saying the number ($1+ QUADRILLION) sounds ridiculous. Every time I’ve mentioned it at a dinner party I get nothing but blank stares or snickers. Can you imagine if someone in a position of power actually bothered explaining this on TV? The entire financial media would respond with, “well, that’s great, now we…. wait a minute… what did you just say?”
The most common derivatives are based on common financial entities/ issues: commodities, stocks, bonds, interest rates, etc. However, the vast bulk of them (84%) are based on interest rates. If you’ve been confused as to why Bernanke claims the US is in recovery but promises to keep interest rates at 0% for a long time, there’s your answer.
After all, in 2008 the Credit Default Swap (CDS) market (which incidentally is only
1/10th the size of the interest rate-based derivative market) nearly destroyed the entire financial system. One can only imagine what would happen if the interest rate-based derivative market (which is ten times as large) suffered a similar Crisis.
At some point, and I cannot tell you when, the ticking time bomb that is the derivatives market will implode again. We’ve already had a warning shot with China telling its state owned enterprises to simply default on their existing commodity based derivative contracts with US investment banks.
We are also discovering that Greece and Italy (and likely other) countries have used derivatives to hide their true debt levels. This realization has sparked an investigation into derivatives in Europe, which could of course spark off a chain reaction if things get too ugly.
Suffice to say, the “derivative issue” is nowhere near over. It’s only a matter of time before we have another glitch in the system which will kick off Round Two of the Financial Crisis. In the meantime, there are a few steps you can take to protect your savings.
- Move some money to a bank with little if any derivative exposure
- Have some physical cash on hand
- Own some physical bullion/ silver
I personally am doing all of the above. You should do the same.
Regarding #3, how much bullion you purchase is up to you. But you should have several months’ worth of expenses in gold and silver bullion.
Why Gold AND Silver?
Because if the banks are closed or if paper money is worthless, you don’t want to be walking around with an ounce of gold (worth $1k+) to buy groceries. No, you will want some precious metals of smaller denomination to purchase/ barter with, hence the need for some silver.
Buy some of both now. I am doing so. And I will be doing so regularly going forward. I cannot tell you which broker to use, but whoever you work with, make sure that YOU store the gold/silver yourself (more on this in a moment) and that you buy bullion that is liquid enough that you can buy or sell it quickly.
In terms of actual gold coins, there are three coins that comprise the bulk of the bullion market. They are Kruggerands, Canadian Maple Leafs, and American Gold Eagles. I’ve been told to avoid Maple Leafs by both a trader and a bullion dealer as they can easily be scratched which damages the gold and reduces the coin’s value.
In terms of silver, the easiest way to get it is in pre-1965 coins (often termed “junk” silver). The bullion dealer I spoke to prices them at 50 cents over spot. However, you can also get silver one-ounce rounds (coin-like medallions) and 10 ounce bars both of which can be bought at 95 cents over spot. Finally, you can buy Silver Eagles at $2.50 over spot.
Again, I cannot tell you which dealer to go with, but look for someone who’s been dealing for years (not a newbie). You should also ALWAYS ask for references from the dealer (former clients you can talk to about their purchases/ experiences).
Some warning signs to avoid are dealers who try to store your bullion. NEVER, I repeat, NEVER store your bullion with someone else. ALWAYS store it yourself. Also, be sure to talk to the dealer for some time and ask him or her numerous questions about the industry, the coins, etc. If they can answer everything you ask in a knowledgeable fashion, their references check out, and you verify everything they say with a 3rd party, you should be OK.
Good Investing!
Graham Summers
PS. I’ve put together a FREE Special Report detailing THREE investments that will explode when stocks start to collapse again. I call it Financial Crisis “Round Two” Survival Kit. These investments will not only help to protect your portfolio from the coming carnage, they’ll can also show you enormous profits.
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Graham Summers: Graham is Senior Market Strategist at OmniSans Research. He is co-editor of Gain, Pains, and Capital, OmniSans Research’s FREE daily e-letter covering the equity, commodity, currency, and real estate markets.
Graham also writes Private Wealth Advisory, a monthly investment advisory focusing on the most lucrative investment opportunities the financial markets have to offer. Graham understands the big picture from both a macro-economic and capital in/outflow perspective. He translates his understanding into finding trends and undervalued investment opportunities months before the markets catch on: the Private Wealth Advisory portfolio has outperformed the S&P 500 three of the last five years, including a 7% return in 2008 vs. a 37% loss for the S&P 500.
Previously, Graham worked as a Senior Financial Analyst covering global markets for several investment firms in the Mid-Atlantic region. He’s lived and performed research in Europe, Asia, the Middle East, and the United States.
© 2010 Copyright Graham Summers - All Rights Reserved
Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.
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