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Today's Market WrapUp 06.25.2003 Mon Tue Wed Thu Fri Puplava Archive Up
To Our Eyeballs
A good example of what can go wrong with this approach was the S&L crisis during the late 70’s and late 80’s. Financial institutions borrowed short (deposits) and went long on their investments. When markets cratered or when rates went up as they did in the late 70s, the resulting losses almost bankrupted the industry. We have the same thing going on today but on a much larger scale. The degree of leverage and the mismatch between short-term loans and long-term investments has never been greater. The spec community made up mainly of leveraged hedge funds is counting on the Fed to maintain or peg interest rates to keep the carry trade in business. There is only one problem with this proposition, which is that the Fed is no longer master of all it controls. With so much of our debt now in the hands of foreigners, it is the foreign investor who now controls indirectly the interest rates in the U.S. As long as foreign central banks continue to buy our Treasury debt, funding our massive trade and current account deficit, the debt pyramid can continue to function. If they lose confidence or decide not to fund our trade deficits, then “Houston we have a problem.” Interest rates could rise through either lack of foreign buying or even worse, foreign selling of all or part of their Treasury holdings. At the moment the Fed is able to export inflation by forcing foreign central banks, mainly in China and Japan, to intervene in their domestic markets by selling their local currency and buying dollars in order to keep their currencies from appreciating against the dollar. The biggest buyers of U.S. debt have been China and Japan who are both running large trade surpluses with the United States. Their buying of our Treasury securities is helping to prop up the dollar and keep it from falling off a cliff. However, with the U.S. now running an annualized trade and current account deficit of $600 billion and a budget deficit of $400 billion, this cannot be kept up indefinitely. Coming someday soon is a day of reckoning. Some unexpected event, such as a major terrorist attack on U.S. soil or another derivative mishap, could transpire and evaporate all remaining confidence in the safety of assets held in the U.S. If this type of event were to transpire there would be a simultaneous rush for the exit gates resulting in the dumping of U.S held securities. This possibility grows greater by the day as budget and trade deficits explode to the upside and go parabolic. In addition to the twin U.S. deficits there is the expansion of credit in all sectors of our economy, both at the consumer, business, and governmental levels. This is the result of the Fed’s desire to inject liquidity and credit into the economy and the financial markets. The annual credit borrowings of over $2.5 trillion annually are leading to a corresponding growth in the derivatives market. This can be viewed in the graphs below of M3 and the notional value in the growth of derivatives at U.S. banks, which account for close to 50 percent of the world market for derivatives.
As the supply of credit has expanded in the U.S. economy and financial system, so has the use of derivatives. According to the latest OCC 1st Quarter 2003 report on bank derivatives, the notional value of derivatives at U.S. banks (mainly 3 banks: J.P. Morgan Chase, Bank of America, and Citigroup) increased by $5.3 trillion during the first quarter of this year to $61.4 trillion. Another way of looking at the derivative position of these banks is that those derivatives represent a 61-megaton nuclear financial device awaiting a detonator to set it off. If that event ever happens the fallout from such an explosion will bring the present financial system to its knees. In fact, it may be what brings the present fiat system of credit to its end. As Warren Buffett said months ago, derivatives are financial weapons of mass destruction. They have been used to create artificial profits, hide losses, and create an unrealistic profit stream by many corporations, both financial and non-financial. This morning we just learned that Freddie Mac, the second largest source of mortgage financing in the U.S., may have underreported its profits by $4.5 billion. The restatement resulted from the misreporting of several hundred thousand derivative contracts. Freddie had derivative contracts with a notional value of $1 trillion last year. Apparently management was using derivatives to pad profits for future years or when it had losses or a drop in earnings. Freddie Mac is not a transparent company. With such a large derivative portfolio it would be hard to imagine what their true profit and risk exposure is because the world of derivatives is so opaque. The same holds true for the large money center banks, which can carry an asset on its balance sheet at cost without having to mark it down. In the case of derivatives the value of most contracts are artificially priced. This is because most derivatives are of the OTC variety, complex and without a tradable market. Their price is derived from complex mathematical formulas that may not reflect the true value of a contract. To quote Buffett again, their value reflects more mark to myth than it does reality. In the case of mishap no one knows what their value would be until a willing buyer steps up to the plate. Suffice to say, in a period of a crisis it can be assumed that their value would be worth a lot less than what is carried on the books. In addition, given the size of the notional value of these contracts and the enormous amount of leverage that goes with them, any sizable loss in the value of these contracts would be sufficient to bankrupt their holder. Given the substantial danger they pose to the financial system, it is absolutely astounding that the Fed has joined ranks with the speculators in opposing any meaningful supervision of the industry. In fact the Fed has extolled their virtues and encouraged their growth through the reckless expansion of credit. It believes if a problem erupts as it did with LTCM it is big enough to bail anyone out. But LTCM is small potatoes when it comes to the big three money center banks. Meanwhile, these nuclear financial devices continue to proliferate while the time clock leading to detonation keeps growing shorter and shorter. It wouldn’t take much to trigger a detonating device to set things into motion. A horrific terrorist attack, a sudden military defeat, a leveraged one-way financial bet by a major hedge fund or money center bank, and we would have financial Armageddon. The fact that the Fed has engineered these financial bubbles, encouraged them, and at the same time has allowed and opposed any supervision of the derivative markets is an abrogation of financial responsibility. The reckless way in which credit inflation has been injected into the financial and economic system has no parallels other than the credit schemes of John Law in 17th century France. Meanwhile the hedge fund community should take no comfort that the Fed is there to bail them out. This market is getting bigger than the Fed’s ability to manage it. You do not need to look beyond the 13 rate cuts over the last two years to see that the efficacy of Fed monetary policy is starting to wane. Short-term rates have been cut to 1 percent; long-term rates are at half-century lows. What’s next? Does the Fed start buying stocks, bonds, and mortgages next as it has been suggested? What happens when that doesn’t work? When you are operating on a credit based fiat system eventually the average Joe figures out he has been taken to the cleaners. When that happens there is flight out of fiat paper into tangible goods as citizens lose confidence in the system. As the dollar loses more of its value, as interest rates remain negative in real terms and head to zero in nominal terms, as the economy fails to recover on a sustainable basis, confidence in the present system will evaporate. It has started to happen already with foreign investors who net short out of dollars during the first half of the year. It is only the Asian central banks that are keeping the dollar from going into a freefall. Yet how long before their confidence evaporates as the credit spiral goes out of control? For safety reasons and for protection of your own assets I would strongly urge you to buy silver and gold now before it gets too late, or simply becomes too expensive and unavailable. This is especially true when it comes to silver. Today's Market Major markets fell today as result of disappointment of the Fed’s decision to cut interest rates only a quarter of a point. The markets became unsettled by Fed comments that the economic outlook remains uncertain and the Fed may be unwilling to ease rates even more. However, the tone of the markets still remains bullish. Advancing issues still outnumbered declining issues by 18-15 on the Big Board and by 17-15 on the Nasdaq. John Q. is back in the market with fresh new money flowing into mutual funds. Bullishness by individual investors and by the public is at a record. Bond prices took it on the chin falling along with the dollar. The 10-year note lost 22/32 with the yield advancing to 3.33 percent. The big losers today were in the pharmaceuticals, insurance, and financial shares. Tech stocks still remain strong along with Internet issues, which are sporting bubble-like valuations again. The economy still manages to weaken with durable goods orders falling for the second consecutive month. Outside the housing and mortgage bubbles there doesn’t seem to be anything else holding up the economy besides the debt-ridden consumer and government. Volume came in at 1.4 billion on the NYSE and 1.6 billion on the Nasdaq. The VIX rose .43 to 23.19 and the VXN fell .68 to close at 31.75. Copyright
© 2003 Jim Puplava Graphic Source: CBSMarketWatch, Bloomberg, OCC
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In order to keep asset bubbles inflated the Fed once again
cut interest rates today by a quarter of a point, reducing the
discount rate to 1 percent, a 45-year low. The markets were
disappointed with both stock and bond prices falling sharply along
with the US dollar. The spec community was hoping for a half point
cut. By cutting rates a half point, short-term rates would fall to
.75%, widening the spread between short and long-term rates, the
profit margin that drives the “carry trade.” As shown in this graph of the yield curve, the
carry trade functions on the ability of speculators to borrow on the
short-end of the curve, and invest at a higher rate at the long-end of
the curve. The difference is profit, and when this trade is leveraged
that profit can be huge. The carry trade is one reason that long-term
rates have fallen precipitously since the last Fed meeting in May. At
that meeting the Fed said it was worried about deflation; in this case
the Fed was referring to asset deflation and not goods deflation. The
message was heard all around the globe. The green light was given for
speculators to go ahead and speculate by borrowing short-term and
investing on the long side. This is a basic violation of prudent
financial principles. You don’t borrow short and invest long. If
rates suddenly change and rise, your investments and your source of
funding would be mismatched resulting in heavy losses. These losses
would be magnified by the degree of leverage employed.
