Financial Reality Check

The Strong Dollar Policy - Jawboning isn't a Policy

2008-06-10T15:44:00.000-07:00

Over the last several years, as the chart of the U.S. dollar has looked more like the Enron chart just prior to its ultimate demise, high levels officials at the government and quasi-government organizations have been working hard on the "Strong Dollar" policy.

Their main strategy is to repeatedly put out the phrase "Strong Dollar Policy." Every time they say it the dollar goes up a notch and then starts its fall a little later when nothing is done. Now Bernanke in an unprecedented statement for the FED has joined chorus and this is providing more impact to the Strong Dollar Policy.

So now that the Fed is talking about a "Strong Dollar Policy," does that mean we are likely to start getting a series of rate hikes?

To answer that question you need ask another in my opinion and that question is "what happens if you increase the Discount Rate when business is accelerating its downturn?"

This is compounded by the problem of a housing market which just recently repeated the biggest drop in housing prices for a quarter since the Great Depression. What happens if the curve steepens?

So, in thinking through these two questions and the issues surrounding the OTC derivatives and CDO markets, I reach the conclusion that this is just a continuation of the "Strong Dollar Policy" which is the "we've painted ourselves into a corner" policy which is a continuation of an inflationary policy.

I honestly don't know why the market thinks that this policy is going to work but I'm waiting for action before I place any credence in the ever increasing cacophony of voices singing the "Strong Dollar Policy" mantra. Perhaps I am disillusioned.

In the meantime, I'm thinking I'll buy some more silver on this nice pullback.

The Destructive Potential of the OTC Derivatives Market - A General Discussion

2008-03-27T13:26:00.000-07:00

I think that someone whose business is buying and selling insurance companies and who happens to currently be the wealthiest person on Earth probably knows more about derivatives than myself or most others. Of course I'm referring to the wise and wealthy investor Warren Buffet. My concerns started years ago when I learned what Mr. Buffet was saying about derivatives. The beginnings of what he spoke of are beginning to finally show up on the radar as these often "off balance sheet" special investment vehicles, think Enron in some cases, otherwise known as Structured Investment Vehicles begin to implode. There is a WEB of interconnection between many of the counterparties that makes the potential for a major chaotic financial catastrophe to occur.

Mr. Buffet has described Derivatives as “financial weapons of mass destruction” see (http://news.bbc.co.uk/2/hi/business/2817995.stm) in which the article headlines reads “…Buffett warns on investment 'time bomb'

Warren Buffett

The rapidly growing trade in derivatives poses a "mega-catastrophic risk" for the economy and most shares are still "too expensive", legendary investor Warren Buffett has warned. …”

Further massive concentration of Derivatives in a single investment bank ($77 Trillion):

http://online.wsj.com/article/SB120587881717146583.html?mod=googlenews_wsj

"...

With J.P. Morgan Chase & Co.'s rescue of Bear Stearns Cos., a behemoth in the complex world of derivatives trading has become even bigger, and the business is now more concentrated.

J.P. Morgan has a derivatives portfolio that is the largest by far among U.S. commercial banks. At the end of last year, its portfolio hit $77 trillion in "notional value," which is the value of the assets underlying these contracts, according to its regulatory filings.

I would add that I don't believe anyone including the counterparties, the issuers of the derivatives or the investors knows with any certain what the value of those assets may be as they are not subject to the same scrutiny that most balance sheet items are. Isn't it strange how so much potentially chaotic paper is allowed to remain off balance sheet?

The concentration of more and more derivatives into the hands of fewer and fewer banks is a recipe for financial calamity in my opinion. With so many other convergent financial storms in the vicinity the chaos attractors grow more influential.

Here is a little more elucidation on derivatives and why they represent such a threat to markets and the entire financial system:

http://www.gata.org/node/5220

By Jim Sinclair
JSMineset.com
Thursday, July 5, 2007
http://www.jsmineset.com

Conde Nast's magazine, "Portfolio -- Business Intelligence," recently carried a story that is shocking even to me. I do not know where they got their numbers but I suspect that they fact-check their articles. The title is "$300 Trillion Time Bomb."

The article starts with an interesting question. "If Warren Buffett can't figure out derivatives, can anybody?" The answer requires an understanding of the question.

Certainly Mr. Buffett can dissect the transaction and understand the specific performance required and the lack of financing to guarantee the financial capability of the item. What Mr. Buffet was saying with this question is: How can so many people be that stupid and reckless?

If, as Conde Nast's magazine claims, the derivatives figures are at or above $300 trillion, then gold will go much higher than even I suspect. The authority on the size of the derivative pile is the Bank for International Settlements and the International Monetary Fund.

The article takes the standard tack of saying, "There is nothing intrinsically scary about derivatives, except when the bad 2 percent blow up." I disagree with the first part of that statement but wholeheartedly agree with the second.

Nothing intrinsically scary about derivatives? Then what would you call the following about over-the-counter derivatives?

1) They have no regulation.

2) They have no standards.

3) Without standards there can be no viable market.

4) They are unlisted.

5) They are traded by private treaty negotiation.

6) They are valued by "mark to model," which is a total cartoon.

7) They have no financial guarantee such as a clearing house.

8) They are unfunded special performance contracts floating in cyberspace. All funds in OTC derivatives are taken out as spreads and commissions.

9) More than 50 percent of the earnings of major international investment banks come from granting in the private treaty negotiation of these instruments of mass financial destruction.

10) Financial performance of OTC derivatives depends on the financial capacity of the loser in the transaction.

11) Control has been loose in interest-sensitive OTC derivatives because of multiple dealings outside of the initiating two parties until no one knows who has what.

12) The replacement value of these instruments is in the multi-trillions of dollars.

13) The massive expansion of these instruments has come in interest-sensitive and debt-guarantee instruments. Those are the most vulnerable.

From this point the character of over-the-counter derivatives only gets worse. If that does not scare you, you can see "Poltergeist" and "The Exorcist" and consider them musical comedies.

This situation guarantees an expansion of international liquidity, making one wonder if this is not what the equity markets lately have been taking their lead from. This tells me that "three strikes and you are out" is the rule for the U.S. dollar, and we now have two strikes at the .8050 to .8150 mark on the USDX.

This also tells me that funds operating against gold shares will have to cover once momentum and regression fail to support further moves on the downside. That is, IF the shorts can MAKE cover, since in most cases now the only stockholders left are those without margin and true believers in their situations.

The way to beat the shorts in anything is to do nothing. Shorts can push price but they must trust that by pushing the price lower they will panic the remaining holders to help them make their cover on a high-volume down day. If the shorts fail to get this to occur, then the covering will happen in a panic by the shorts themselves and therefore be of a different order.

As almost always, gold today mirrored trading in the dollar but multiplied the dimension of the move. Remember that in the United States this is the week of the July 4 holiday, even as it is summer in Europe, where no true European works. Asia never makes price but only takes advantage of it by buying breaks and selling strength.

Crude oil, which was never supposed to go over $70, reached up to $72 but reacted when the inventory reports came out. The downward pressure in energy pressured gold down. This is all noise and fury with no meaning. Gold is headed for $761, $887.50, and over $1,000. The dollar is headed to .7200 after the three strikes and then will be out of the game. …"

To me its clear why the Fed is backing the buyout of Bear. Bear has one of the largest OTC holdings of the big investment banks. One can guess at who some of the counterparties may be.

The Credit Crisis is Just Beginning Part II

2008-03-27T10:40:00.000-07:00

This post refers to my original Post "The Credit Crisis is just beginning"

While this article goes back several months, it is by one of the leading experts on derivatives and his insights are is germane today as they were when this article was done. For those really trying to understand what is happening with the credit crisis, this article is extremely informative and from an authoritative source. Clearly this speaks to the impact of OTC Derivatives on the massive credit crisis which is unfolding.

http://www.thestreet.com/newsanalysis/investing/10380613.html

"The Credit Crisis Could Be Just Beginning"

"...

One of the world's leading experts on credit derivatives (financial instruments that transfer credit risk from one party to another), Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years, he seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch -- and I expected him to defend and explain the practice.

I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the "third inning." This was pretty amusing, it seemed, judging from the laughter. So I tried again. "Second inning?" More laughter. "First?" Still too optimistic.

Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we're actually still in the middle of the national anthem before a game destined to go into extra innings. And it won't end well for the global economy.

Ursa Major

Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions. ..."

The Credit Crisis is Just Beginning

2008-03-21T10:18:00.000-07:00

Some of the spin on the front page today regards the question (suddenly raised) of “Is the Credit Crisis Over” (see: http://www.cnbc.com/id/23725629 ). For an article posing this question to appear on a week like the one we’ve just had is to me ludicrous.

In my opinion this new round of spin is some of the most blatant propaganda and it is being spun because this has been a week when we saw some of the worst news yet in credit markets from the Bear Stearns bailout to and what in the opinion of many was an orchestrated take down of commodities while a 3/4th point cut in interest rates resulted in dollar gain. This isn’t the normal trend. Additionally it is a week in which smaller but no less indicative events of the continuing unknowns in the OTC Derivatives and CDO markets such as Merrill’s law suite against Security Capital Assurance (see http://dealbook.blogs.nytimes.com/2008/03/19/market-fears-that-merrills-lawsuit-signals-more-write-downs/ ) where the headline states “Market Fears That Merrill’s Lawsuit Signals More Write-Downs” and lots of other news showing problems in credit markets.

No one knows how much of the $500 + Trillion dollar OTC Derivatives markets will actually be worth in market value by the time this is all over and if even if by some miracle its 90 percent of it nominal value, the increase in money supply to bail out the larger counter parties will continue to apply currency devaluation on a global scale as the derivatives problems are not just dollar centric.

This doesn’t even take into account the likely massive increases in budget deficits as the economy slows and correspondingly tax revenues decrease while government expenditures continues to increase for bailouts, unemployment, the continuing wars and unfunded mandates. Bonds will become increasingly un-attractive to foreign buyers as the debt cycle continues to feed back with economy. This is already happening as was reported in the headline “Foreign investors veto Fed rescue “(see: http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/03/17/ccview117.xml ) in which the article states “...Asian, Mid East and European investors stood aside at last week's auction of 10-year US Treasury notes. "It was a disaster," said Ray Attrill from 4castweb. "We may be close to the point where the uglier consequences of benign neglect towards the currency are revealed." …”

That in a single week in which the FED in an unprecedented move to lend money to non-bank entities and announces it will inject $200 Billion in loans into the system and in which two entities , Freddie and Fannie, which some believe are near needing a bailout already, are given permission to take on hundreds of billions in new mortgage paper and not only that take on some mortgage paper previously considered “Jumbo,” and all while having capital requirements loosened in the same week should give one pause to consider what may become of these credit behemoths and how seriously the FED now believes the “Credit Crisis” is becoming. Is this a week in which a headline such as, “Is the Financial Crisis Over? The Debate Is Already On,” seems germane or appropriate. To me, I can only answer “absolutely not.”

In my opinion the changes at Freddie and Fannie won’t help most distressed home buyers or new home buyers unless they have plenty of cash and super credit (as lending standards and credit continue to get tougher) and in particular it will cause an acceleration to the “credit crisis” if housing prices continue to fall and if the S&P and Moody’s stop “deferring” as was implied in the following Bloomberg Article Headline (http://www.bloomberg.com/apps/news?pid=20601109&sid=aU9CQgvfHRzI&refer=home ) where the headline reads “Moody's, S&P Defer Cuts on AAA Subprime, Hiding Loss (Update3)”. I do believe these moves may lend short term support to some financial entities with lots of bad CDO paper on their books by allowing quasi-government entities to buy it and thus transfer the liability to the tax payers, but I don’t believe it will help home owners. Ultimately if these entities need to bailed out the amounts are catastrophically large and will only boost the inputs to hyperinflation.

What happens to the investment banks when the AAA paper gets cut again, does the FED step in. Why are bankers being told to remain quite about Lehman (see http://www.thisislondon.co.uk/standard/article-23457808-details/NY+Fed+tells+banks+to+keep+quiet+to+protect+Lehman/article.do ) where the headline reads “NY Fed tells banks to keep quiet to protect Lehman” or CIT Group having to draw on a $7.3 Billion bank line to conduct daily operations (see: http://news.moneycentral.msn.com/ticker/article.aspx?Feed=OBR&Date=20080320&ID=8369598&Symbol=BSC ) .

To me this doesn’t sound like the end of the credit crisis. This sounds like we are heading again into another week, month and year in which we are seeing the real beginnings of the destructive manifestation of the Derivatives markets which Warren Buffet has described as “financial weapons of mass destruction” see (http://news.bbc.co.uk/2/hi/business/2817995.stm) in which the article headlines reads “…Buffett warns on investment 'time bomb'

Warren Buffett

The rapidly growing trade in derivatives poses a "mega-catastrophic risk" for the economy and most shares are still "too expensive", legendary investor Warren Buffett has warned. …”

In the same article Buffet is quoted as saying

"...
Derivatives generate reported earnings that are often wildly overstated and based on estimates whose inaccuracy may not be exposed for many years. """

Now look at this headline regarding to the massive concentration of Derivatives into the hands of a single company. Does anyone really know how much $77 Trillion represents relative to the U.S. economy?

http://online.wsj.com/article/SB120587881717146583.html?mod=googlenews_wsj

"Morgan Adds To Derivatives Muscle"

"...
With J.P. Morgan Chase & Co.'s rescue of Bear Stearns Cos., a behemoth in the complex world of derivatives trading has become even bigger, and the business is now more concentrated.

J.P. Morgan has a derivatives portfolio that is the largest by far among U.S. commercial banks. At the end of last year, its portfolio hit $77 trillion in "notional value," which is the value of the assets underlying these contracts, according to its regulatory filings. ..."

As fewer and fewer banks control the massive risky, unregulated market for OTC derivatives, it only takes a few exogenous events with major counter parties and the whole thing could create a world wide financial melt down. Why are OTC derivatives not regulated, required to be on the balance sheet, and why do they have no real world means of market value computation? Follow the dots.

For me, the debate never even started. If anything, the credit crisis is just beginning. Its time to take cover.

S&P Defer Cuts on AAA Subprime, Hiding Loss

2008-03-13T12:59:00.000-07:00

In a two day period we see two headlines.

1. Moody's, S&P Defer Cuts on AAA Subprime, Hiding Loss (Update3)

http://www.bloomberg.com/apps/news?pid=20601109&sid=aU9CQgvfHRzI&refer=home

and then

S&P Sees End to Subprime Mortgage Writedowns

http://www.cnbc.com/id/23611885

The first barely gets noticed and the second is up on the front page all day. I just wonder how long it will be to the flood of law suites begins role towards the ratings agencies.

Bloomberg quotes Cuomo as saying “…``Both S&P and Moody's are attempting to make piece-meal changes that seem more like public relations window dressing than systemic reform,'' Cuomo said in a statement today, calling the reforms ``too little, too late.'' …”

http://www.bloomberg.com/apps/news?pid=20601087&sid=aEDF36p42n5Q&refer=home

Then I dig a little further and find this from www.thestreet.com

“…"The changes imposed by S&P and Moody's fail to address the root cause of the problem, which is skewed incentives," Egan commented. "S&P and Moody's are paid by issuers that desire the highest possible ratings and in turn the lowest possible issuance costs. Given the fact that investors' interests and issuer interests are at odds, continued reliance on issuer-supported ratings is misguided."

Fixing the ratings mess, similar to the challenges of addressing the solvency issues of troubled monoline bond insurer companies such as Ambac Financial ABK and MBIAMBI, is a difficult but necessary chore. Egan suggests that the ratings firms move from an issuer model to an investor model, in which the investor pays to get a rating on a particular security.

Ratings are used by big pensions and health and life insurance companies, which are required to make investments on the basis of the due diligence already performed by ratings agencies. Those industries may face troubles if ratings on monoline bond insurers are further lowered and the scores of the underlying securities comprising high-grade CDOs are slashed as well. At that point, institutional investors may be forced to liquidate or put back those securities at discounted prices and incur losses.

Then, ratings agencies may be facing more than just grousing. They may face a wave of class-action litigation, speculates Tempus Advisors' Grebeck. …”

I haven’t seen any announcements of class action law suites against the ratings as of yet against the ratings agencies but I will be surprised if we don’t see a “wave of class-action litigation” coming fairly soon. Apparently the AAA paper is in a whole lot of trouble. The idea that the problem in the financial industry is solely caused by a bunch of “bad home buyers” is some of the most egregious act of con and pure dishonest spin I’ve ever heard.