Hope of Israel Ministries (Ecclesia of YEHOVAH):
The Danger of Derivatives -- A Warning for the Future!
"Come now, you rich, weep and howl for your miseries that are coming upon you! Your riches are corrupted, and your garments are moth-eaten. Your gold and silver are corroded, and their corrosion will be a witness against you and will eat your flesh like fire. You have heaped up treasure in the last days" -- James 5:1-3.
by Brooks Alden
The prophet Ezekiel wrote so much that we now see as prophecy but nowhere in his writing is the outlook so frightening as the one he describes in Chapter 7. Several times he echoes "the end is come." In Verse 7, he describes the same thing in slightly different terms, "....the time is come and the day of trouble is near." Then in verse 12 he warns, "The time is come, the day draweth near..." In his scenario, the Israel lands will all be under the rod. The lands will be full of bloody crimes, the cities full of violence, the worst of the heathen will possess our houses, our holy places will be defiled and destruction will come upon us.
This is a scary picture but could it be the reality in the years just before the fall of Babylon? Remember YEHOVAH God said through Ezekiel (Verse 3) "I will recompense upon thee all thine abominations." Are we in those years now, in fact, are we arriving at the pinnacle? Let's look at a few of the symptoms of a very sick world and as we do, think particularly of what has come upon us since 911.
Sadly, the world is like two super charged planes headed for one another at top speed and a crash is inevitable. Don't pay attention to the spin politicians place on events; they invariably interpret truth in the most convenient light. The fact is, the economic world is broke and like Humpty Dumpty, all the king's horses and all the king's men cannot put it together again.
In August 2001 I wrote an article (published in September that year just before 911) warning of the excesses of money supply and the dangers of derivatives. I had said we were in a no-win situation and that the day of reckoning was just round the corner. I also wrote, "As America, the world's greatest economy, goes, so goes the world." And America is clearly in trouble today. The painful cost of shipping millions of jobs and thousands of plants to third world countries, along with wars, illegal immigration, excessive money supply growth are only some of the ills coming home to roost. AMERICA HAS SPENT ITS WAY TO POVERTY. As an aside, one has to wonder why America became the spender of last resort. Yet, they did, particularly since the Asian meltdown of 1997 and now every American is paying the price. Don't think the other Israel nations are immune; they all played the same game but with fewer chips.
Who could have guessed that 2001 would have been such a disastrous crossroad for Israelites? It was the beginning of true sorrows for the Israel nations. We all lived through the years since so I will look at the cancerous results in just one area.
The World of No Reality
Space prevents a full analysis but let's at least look at the world of no reality, the little known dark cloud lurking over the entire world economy. It goes by a number of names, like hedge funds, off balance sheet products or derivatives. Perhaps the best way to describe the derivatives to which I am referring is to relate them to an insurance scheme where one party underwrites another party's risk. The great danger, of course, is that the party who assumed the risk will not be able to fulfill the obligation. Let me give you an example, "Why was Lehman Brothers sent to bankruptcy whereas other financial biggies were saved by taxpayers through rescue plans." Well, according to a local economist I talk to often, one reason is that Lehman held only 10 billion oz of silver but had issued 120 billion in derivatives and as the party who assumed the risk, they were unable to fulfill their obligations.
Derivatives played a major, major role in the recent Subprime Mortgage Crisis. The large Wall Street investment firms introduced derivatives to purposely CLOUD the value of the MBS (Mortgage Backed Securities), CDO (Collateralized Debt Obligations) and other packages that they were creating. As a result the buyers of these packages had NO WAY of knowing their true value. In this way the Wall Street firms could sell packages that were obscenely overpriced.
The people who worked in these firms collectively MADE OFF with billions and billions of dollars in salaries and bonuses while they left the buyers of their packages holding the bag. Alan Greenspan stated that this made the financial system stronger because it "off-loaded" risk. This is nothing but a blatant LIE! Off-loading risk does not make risk go away -- it just transfers the risk to another group or entity!
These same Wall Street firms DUPED large investors, made off with billions, and then went to the taxpayer to pay for the MESS that they created and profited from immensely.
Schools in Trouble
Many school districts around the country have gotten into trouble due to derivative products sold by Wall Street investment firms. Massive fees are not made by merely issuing municipal bonds, but by adding derivatives into the mix. Let's take a look at a few examples which, unfortunately, are not isolated occurrences:
The Erie City School District in Pennsylvania was in dire need for cash. One of the schools, Roosevelt Middle School, wanted money to buy text books, fix a heating failure, leaking roof and ceiling tile that was falling down on students' heads. Since the school district taxpayers were maxed out and couldn't provide additional taxes, the school district turned to one of the most prominent investment banks on Wall Street -- which happened to be the districts financial advisor firm. This bank sold the school district the idea that the school board should engage in a complex derivative swaption contract by betting basically that short term interest rates would stay low and that the spread between the 1-year and 30-year rate will widen.
Of course, Wall Street took more than its share of the pie!
Now, there are two sides to every transaction, whether it's a real estate transaction, stock transaction or derivative transaction. As a result of entering into this transaction as the seller (which means that they were bearing the risk) Erie received $785,000 upfront cash, their advisory firm got $60,000, the bond insurer received $57,000, and lawyers and others received $106,000. This derivative -- according to Bloomberg data -- was WORTH $2 MILLION by selling it on the open derivatives market at that time, so the Wall Street investment firm REAPED $1 MILLION PROFIT without assuming any risk!
However, neither the Wall Street investment firm nor the financial advisory firm -- which was supposed to be working on Erie's behalf -- told the school board how much profit the Wall Street investment firm was making. Actually, it was up to the investment firm to decide HOW MUCH of the $2 million it would give to the school district.
Don't you think it was pretty generous of them to give Erie just under 40% of the proceeds since Erie was taking 100% of the risk?!! Talk about a scam!
As you have probably guessed by now, this derivative GAMBLE -- and they are gambles -- did not work out in Erie's favor. After three years the derivative had left Erie with a $2.9 million liability which the school district could no longer shoulder and they got out of the deal. They paid the investment firm $2.9 million to terminate the derivative contract.
Incidentally, this deal was an OTC (Over The Counter) derivative -- which means that it wasn't regulated by the SEC (Securities and Exchange Commission) and didn't go through the public bidding process. It was purely a private contract between the two parties.
This was not even the most outrageous deal! Another happened at Bethlehem's school district. The school board entered into a derivative deal with this same investment firm and another prominent Wall Street investment firm jointly -- again without competitive bidding. This time the school district received $900,000, the investment firm made a $630,000 fee, the two Wall Street investment firms each made $840,000 and $900,000 respectively. Each Wall Street firm made nearly as much from the deal as the school district received. And the advisory firm hired to consult on the district's behalf, received far more than half of what the district received.
Writes a Wall Street insider,
"During the past 4 years in Pennsylvania alone, Wall Street investment firms have pitched at least 500 deals like this [like the Erie and Bethlehem deals] totaling $12 billion, and most of them have been made without public bidding, by just taking the advice from their financial advisory firms. And since these deals are over the counter [OTC], and thus private, we DON'T KNOW how many and how bad the true situation with municipal derivatives really is. But as information leaks out, the evidence is that things are VERY BAD indeed" (Wall Street Loves Derivatives).
Unfortunately, these "over the counter" derivatives -- created, sold and serviced behind closed doors by consenting adults who don't tell anybody what they're doing -- are also a MAJOR SOURCE of the almost unlimited leverage that recently brought the world financial system to the brink of disaster. These instruments are creations of mathematics, and within its premises mathematics yields certainty. However, in real life, as Justice Oliver Wendell Holmes wrote, "certainty generally is an illusion." The derivatives dealers' demands for liquidity FAR EXCEED what the markets can provide on difficult days, and may exceed the abilities of the central banks to maintain orderly conditions. The more certain you are, the more risks you ignore; the bigger you are, the harder you will fall.
The Global Picture
Thomas Kostigen of MarketWatch writes the following assessment --
"There's a $700 trillion elephant in the room and it's time we found out how much it really weighs on the economy.
Derivative contracts total about three-quarters of a quadrillion dollars in "notional" amounts, according to the Bank for International Settlements. These contracts are tallied in notional values because no one really can say how much they are worth.
But valuing them correctly is exactly what we should be doing because these comprise the viral disease that has infected the financial markets and the economies of the world.
Try as we might to salvage the residential real estate market, it's at best worth $23 trillion in the U.S. We're struggling to save the stock market, but that's valued at less than $15 trillion. And we hope to keep the entire U.S. economy from collapsing, yet gross domestic product stands at $14.2 trillion.
Compare any of these to the derivatives market and you can easily see that we are just closing the windows as a tsunami crashes to shore. The total value of all the stock markets in the world amounts to less than $50 trillion, according to the World Federation of Exchanges.
To be sure, the derivatives market is international. But much of the trouble we're in began with contracts "derived" from the values associated with the U.S. residential real estate market. These contracts were engineered based on the various assumptions tied to those values.
Few know what derivatives are worth. I spoke with one derivatives trader who manages billions of dollars and she said she couldn't even value her own portfolio because "no one knows anymore who is on the other side of the trade."
Derivatives pricing, simply put, is determined by what someone else is willing to pay for the contract. The value is based on an artificial scenario that "X" will be worth "Y" if "Z" happens. Strip away the fantasy, however, and the reality of the situation is akin to a game of musical chairs -- without any chairs.
So now the music has finally stopped.
That's why stabilizing the housing market will do little to take the sting out of the snapback we are going through on Wall Street. Once people's mortgages were sold off to secondary buyers, and then all sorts of crazy types of derivative securities were devised based on those, and those securities were in turn traded on down the line, there is now little if any relevance to the real estate values on which they were pegged.
We need to identify and determine the real value of derivatives before we give banks and institutions a pass-go with more tax dollars. Otherwise, homeowners will suffer as banks patch up the holes left in their balance sheets by the derivatives gone poof; new credit won't be extended until the raft of the old credit is put behind.
It isn't the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to sway attention away from the place where greed truly flourished -- trading phony instruments [derivatives] to the tune of $700 trillion....Right now, this elephant isn't just in the room, it's sitting on us."
Weapons of Financial Mass Destruction
Warren Buffett, the billionaire investor and long-time chairman of Berkshire Hathaway, Inc. is a man who speaks his mind. He cuts through Wall Street B.S. like a hot knife and exposes the bloody truth about the foibles of modern finance. His comments on derivatives, in particular, have always been especially enlightening because they EXPOSE this supposed risk-sharing panacea for the HOUSE OF CARDS it has become.
Mr. Buffett called derivatives "Weapons of financial mass destruction." "The introduction of derivatives has totally made any regulation of margin requirements a joke," he recently stated, referring to the U.S. government's rules limiting the amount of borrowed money an investor can apply to each trade. "I believe WE MAY NOT KNOW where exactly the danger begins and at what point it becomes a super danger. We don't know when it will end precisely, but...at some point some VERY UNPLEASANT THINGS will happen in markets."
Mr. Buffett noted that existing accounting conventions allow parties involved in derivative transactions to value the same contract differently, leading to an inadequate or incomplete picture of the contract's risk. "I will guarantee you, if you add up the marks on both side, they don't add up to zero," Mr. Buffett said, referring to the accounting of a single derivative contract.
The "credit derivative" is the most dangerous instrument yet, and neither the risk controllers at the big banks nor the bank examiners themselves seem to have any good ideas about how to handle it. A vehicle by which banks can swap loans with each other apparently gives everybody a win -- banks can diversify their portfolios geographically and by category with the click of a mouse. Worse yet: As this business has grown, it has moved far from its early days as a way to swap risks. Most "credit derivatives" now are simply a way for a market participant (a bank or a hedge fund) to acquire a portfolio of loans or securities WITH NO UP-FRONT COST and VERY LOW interest charges.
Banks and supervisors have a lot of trouble accounting for these instruments. If the bank owns the loans and securities it is swapping, it will own them again when the swap expires, which argues that capital should continue to be allocated against the principal. If it doesn't own them, then the transaction is simply a bet on price movements that does not acquire or dispose of an asset -- and can be carried OFF THE BALANCE SHEET at a much lower capital charge. In June of 1997 the Fed ruled that banks could take all such transactions off the balance sheet, making them VIRTUALLY COST-FREE to banks -- especially if the swap partner is another bank and qualifies for the 80% reduction in capital requirements given to interbank loans by the rules of the Bank for International Settlements.
Exacerbating the problem of derivatives and leverage is the short-term trading mentality and high turnover in the stock and bond markets, Mr. Buffett added. "There is an electronic herd of people around the world managing an AMAZING AMOUNT of money who make decisions based on minute-by-minute stimuli," said Buffett, adding, "I THINK IT'S A FOOL'S Game."
Why are such derivatives dangerous? The one lesson history teaches in the financial markets is that there will come a day unlike any other day. At this point the participants would like to say all bets are off, but in fact the bets have been placed and CANNOT BE CHANGED. The leverage that once multiplied income will now DEVASTATE principal.
The banking supervisors have not begun to control the buildup of leverage on the derivatives chassis. Indeed, as we have seen, the former Federal Reserve Chairman Alan Greenspan argued that the mathematicians are improving their formulas to make the business less risky. But the more security the math seems to give, the GREATER THE RISK on the day the highly improbable happens. Some eighty years ago Frank Knight, arguably the greatest American economist ever, wrote that economists did not always make clear "the approximate character of their conclusions, as descriptions of tendency only." In theoretical mechanics, perpetual motion was possible; in real life it was not. "Policies must fail, and FAIL DISASTROUSLY, which are based on perpetual motion reasoning without the recognition that it is such," wrote Knight.
It's real, it's happening -- and the world financial system is CRUMBLING as a result.
A Lot of "Based On Nothing"
Relating derivatives globally, think on this! The world economy is somewhere around 60 trillion dollars whereas the issued derivatives are somewhere in the neighborhood of 900 trillion. Scary isn't it when you think of the potential risk? But something even scarier, there is approximately 10 billion oz of silver produced annually, 9 billion is used for commercial purposes so 1 billion is available.
But, some suggest that in the past six months or so, 100 billion of derivatives have been issued. That's a lot of "based on nothing." My economist acquaintance mentioned that another major bank with 1.5 trillion in assets and 1.2 trillion in debt has 97 trillion in derivatives outstanding. It reminds me of what I wrote in 2001, "As the majority of derivatives pass as off-balance sheet products, the risk factor cannot be spotted through financial statement analysis. There is simply no central clearing system to measure the overall risk. One analyst put it this way, "If all the houses in New York burnt down, the insurance companies wouldn't have the money to cover the insurance. Yet, every financial house in America is potentially burning because of the risk of derivatives, yet no one is keeping track of the risk factor." We do know that 136 banks in the United States went broke so far in 2010, worse than the depression days of 1929.
I wish I could go into a myriad of other ills, like the fragility of pension plans the world over, why at least one state is either issuing or considering issuing I.O.U.'s for tax refunds, why England is in even worse condition that America, what's in store for real estate and on and on. Still, what has been written, particularly on derivatives, may help us understand the staggering equity market correction of 2008, the recent 1,000 drop written off as a trader error and why MORE OF THE SAME is on the horizon.
What to Expect in the Immediate Future
The response so far to the derivative problem has been for central banks around the world to try to paper over the problem. This will continue. More and more paper money will be created to try and fix the problem. Since the exorbitant creation of money is the root of inflation, we can expect rising prices due to the watering down of the value of money. By diluting the value of money, it takes more and more of it to buy the same item. While this looks like rising prices, in reality it is the falling value of the currency.
This will continue and even accelerate. Expect and plan for prices of the goods you buy to rise. The exception to this, of course, is the prices of homes. Because the secondary mortgage market is in its terminal phase (due to Wall Street mixing in derivatives), financing to buy a home is fast drying up -- including first time home buyer loans. Reduced funds available for financing -- coupled with the fact that there will be hundreds of thousands of foreclosures -- make it easy to predict that the prices of homes will continue to fall. But the price of everyday items will continue to go up as the value of money is diluted by the government printing presses. There is a HUGE worldwide financial storm brewing.
Remember, the system is broke and there is not enough fingers to plug every hole in the dam. It must ultimately COLLAPSE. As Revelation tells us, "Alas, alas, the great city Babylon, that mighty city! For in one hour is thy judgment come."
-- Edited By John D. Keyser.
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