The One Market The Fed Doesn't Want You To Know About Graham Summers

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The One Market The Fed Doesn't Want You To Know About
Graham Summers
April 12, 2010
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 $1.4 QUADRILLION.

I realize that number sounds like something out of Looney tunes, so I'll try to put it into perspective.

$1.4 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. If you think I'm exaggerating, you can read the actual Washington Post story here.

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:

Let's put these percentages into perspective. With the total value of derivatives at $1 QUADRILLION, even equity based derivative contracts (a mere 1.1% of the total market) are roughly $10 TRILLION in notional value. Commodities, the smallest slice of the derivative pie at 0.6% of the total derivative market still represent about $600 BILLION in notional value.

However, the largest segment is the Interest Rate Contracts, which comprise 84% (some $800 TRILLION) of the derivatives market. 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.

First off, you need to examine the derivative exposure of the bank where you store your savings. All told, there are 1,065 insured US commercial banks that trade/ use derivatives. However, the vast majority of derivative exposure involves only a small handful of institutions.

They are: JP Morgan, Goldman Sachs, Bank of America, Citibank, and HSBC. I'm sure you'll notice that four of these received the BULK of all bailout money. When you see the below chart, you'll know why (BTW the chart is denominated in TRILLIONS).

Derivative Exposure

All told, these five banks account for 97% of the $203 trillion in derivatives sitting on US commercial bank balance sheets (that we know of). Let's put this into perspective:

Total equity at these five banks is about $737 billion. So if you assume that only 1% of derivatives are "at risk" (odds are it's more) and 10% of that "at risk" money is lost, you've wiped out nearly 1/3 of the banks' equity.

If 2% of these derivatives are "at risk" and 10% of those bets go bad, you've wiped out $400 billion or nearly HALF of the banks' equity.

If 4% of derivatives are "at risk" and 10% of those bets go bad, you've wiped out ALL OF THESE BANKS' EQUITY and they go to ZERO.

Remember, I'm only accounting for derivatives here… I'm not even including ON BALANCE sheet risks, mortgage backed securities, and all the other junk floating around.

If you're wondering why Bailout Ben is keeping interest rates at 0% despite claiming we're in recovery, here's your answer.

Good Investing!

Graham Summers

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