To trigger The Perfect Financial Storm, all that is needed is another shock to the financial system. It could be another LTCM or a monetary crisis like the European Monetary System in 1992. Today's derivative contracts link the world of equities, debt, interest rates, and currencies as never before. The market is dominated by a handful of players whose inter-dealer positions increase linkage between economies and financial markets that cross over multiple borders. The risk to the financial markets is a crisis in one market spilling over into another. The danger inherent in the interconnectedness of global markets is that a small, uncontrolled event can turn into a major accident that magnifies as it ripples throughout financial system.
Because derivatives multiply leverage, they increase the debt-based buying power of hedge funds and speculators. Because of this leverage, a single trader, or group of traders have the potential to bankrupt an institution. Recent examples proliferate in the case of Barings, Orange County, and LTCM. Today high-powered derivatives have become so complex that their danger is not fully understood. Even sophisticated users of these instruments have succumbed to their complexity. Hedge fund managers like David Askin, LTCM's traders, and companies like Gibson Greetings, Procter & Gamble and Metallgesellschaft have all fallen prey.
The Derivative Chain Reaction
What makes derivatives so prone to financial crisis is that not only do they amplify leverage, but they are also heavily dependent on a highly liquid money and capital market. Users of these instruments rely on broker/dealers in their role as market makers to keep these markets liquid. Those same dealers rely on the repurchase markets to finance their security positions. These dealers are in turn dependent on money-center banks for lines of credit that they can use when they experience difficulties in rolling over positions or meeting obligations. In addition organized futures and option markets make extensive use of credit lines for instantaneous delivery of cash to satisfy margin calls. All the players in this game are highly leveraged. In the case of securities dealers, they tend towards leverage and concentration. The same is becoming true of the large money-center banks. It is a tightly connected system where leverage makes all of the players vulnerable. Failure of one element in the chain can bring the whole system down. The whole system is dependent on the active support of central banks in the area of liquidity management.
This was the lesson of LTCM. Because of its loans from broker/dealers and money center banks and the position of its counterparties, LTCM's failure had to be contained. LTCM's demise could have put each one of its counterparties into a naked hedge position, holding on to only one side of the contract because the other side had disappeared. If each one of its counterparties sold out, they would have overwhelmed the system. Essentially, LTCM's failure would have been similar to a bank run in the 1930's.
Risk – The Essential Element in Derivatives
For regulators and investors the opaqueness of this highly complex market has made it more difficult to ferret out potential problems. Unlike the period prior to the breakdown of the Bretton Woods system, when currency and interest rate risk were nominal, risk was centered on the balance sheet. As a result of the breakdown of fixed exchange rates under Bretton Woods, participants had to deal with increased exchange rate and interest rate volatility. There was also an effort to circumvent discriminatory regulations and tax laws. The result was the growth of the derivatives market, which began to flourish after the introduction of the Black-Scholes model. The growth of derivatives made it possible to turn risk into a commodity that could be bought, sold, and restructured from the underlying asset.
Innovations in Risk Taking
Black-Scholes Option-Pricing Formula
The whole process that unfolded after the breakdown of fixed exchange rates led to disintermediation of the financial system from a floating rate system of currencies, the end of fixed commissions on Wall Street, the introduction of Government Sponsored Entities (GSE) in the credit markets to the growth of money markets. Both sides of the bank balance sheet were disintermediated. Commercial paper replaced bank loans. Certificates of deposit replaced deposit liabilities at banks. This evolution gave way to the birth of money markets, which became a further engine of credit. The mutual fund industry broadened and deepened participation in the financial markets and modern portfolio theory changed buy and hold investing into an active, trade-driven approach to portfolio management.
All of these innovations increased the need to manage risk. For institutions, corporations and investors, derivatives became the answer. Money center banks and Wall Street firms moved in to facilitate the move towards risk-based management. For banks the loss of relationship finance and corporate loans motivated banks to seek another source of revenue. Competition from the financial markets had depressed lending margins, so banks seized upon OTC derivative activity as a substitute for less profitable lending. Providing liquidity to the broker/dealer market, becoming a major underwriter of OTC derivatives, and trading for their own account soon became a major source of bank profits. The result is that the OTC derivatives market has grown from .5 trillion in 1990 to close to 0 trillion today. The growing need for custom-tailored products that met the specific needs of a user caused the OTC market to explode in size versus the growth of exchange-listed derivatives. This market is less liquid and prone to greater credit risk for the users.
The OTC market has created several problems that are generally avoided on supervised exchanges. There is a lack of transparency, liquidity, and competitive pricing. It has no centralized location. There are no rules and boundaries. OTC derivatives aren't openly traded, therefore price information is less transparent. Market information is lacking since only a few large institutions control it. Large money center banks dominate this market—concentrating power in the hands of a few key players. The large banks that dominate the market are also lenders to the end-users of derivatives. This makes the banks doubly exposed as writers and lenders to the same market. Because of this interconnectiveness, if one of these institutions failed, it would create a systemic risk that could bring the whole system down. The banks were both writers of derivatives and lenders to LTCM. In addition they were mimicking many of LTCM moves, which turned them into their own breed of hedge fund.
Another danger of this market is the off-balance sheet nature of OTC derivatives. This makes traditional regulatory and analytical analysis less effective. Traditional bank regulators have focused on bank balance sheets as a tool to assess whether banks have adequate capital to cushion them from potential losses. Capital requirements are based on ratios of equity to total assets. Because OTC derivatives are off-balance sheet in nature, they have made traditional capital requirements ineffective. This raises a serious issue when comparisons are made between the balance sheet assets of banks to their off-balance sheet derivative holdings. The notional value of derivative contracts are in many cases 40-50 times the value of balance sheet assets. This could create a future problem due to the exposure of contracts to a change in the underlying assets, which would necessitate a mark-to-market value of the derivative contract.
The Destabilizing Attributes of Derivatives
The plethora of crises throughout the 90's has provided ample evidence that the growth of derivatives has made financial crises more virulent and the widespread use of derivatives has increased the risk of financial storms. The sheer size of the market has increased their role in financial crises. They can accentuate booms on the upside and amplify busts on the downside. They can magnify the movement of prices and cause volatility to gyrate. The movement of price and volatility reinforce each other in times of difficulty in the financial markets. There are five attributes of this market that make any one of them the trip wire for financial disaster.
Dynamic Hedging
The use of dynamic hedging can be destabilizing in itself. This technique transfers risk from users to the market makers. When all market makers want to delta hedge in the same direction, at the same time, it becomes a one-way market with no takers on the other side. As a result, the markets break down and become illiquid.
Lack of Market Transparency
Because the OTC market for derivatives isn't transparent, it is difficult to judge equilibrium prices due to lack of knowledge of supply and demand. This can contribute to instability during periods of financial stress. The fact that this market remains opaque makes it harder for participants to gauge the underlying structure of financial positions as the price of the cash markets change. The balance between buy and sell orders triggered by dynamic hedging can remain obscured so the market dynamics remain hidden.
Dependence on Liquidity
Because OTC contracts don't trade on organized exchanges they are liquidity-dependent. During periods of market tension, where bid and ask spreads widen, market players may withdraw, thereby drying up liquidity. This lack of liquidity disrupts the risk management process so that actual hedging strategies result in involuntary risk exposure. This is what happened during the 1987 stock market crash. During periods of financial stress, margin and collateral calls increase forced selling and aggravate price declines. As prices decline, margin calls increase and trigger a need for credit. This can force interest rates to rise as money-center banks tap the interbank market. Unless central banks intervene, short-term costs would increase, further exacerbating liquidity.
Leverage Levels
Perhaps one of the most dangerous elements of the derivatives market is the amount of leverage they offer. This credit extension encourages speculation. The leverage offered by derivatives allows speculators to exaggerate prices on the upside in bull markets and on the downside in bear markets. Derivatives allow hedge funds and other speculators to take large positions, and in certain cases, mounting to trillions of dollars. LTCM had roughly .5 billion in equity, but controlled .25 trillion in notional value in derivative contracts. Because of the leverage and size of their bets, derivatives have the potential to destabilize markets.
Concentrated Control
The final risk is imposed by the concentration of a handful of global dealers in the risk management business. The top seven banks control 96% of all derivative holdings by American banks. One bank in particular, J.P. Morgan Chase, accounts for close to 60% of outstanding bank derivative holdings. 7 Because these banks hold large inter-dealer positions, a problem with any one of the players could spill over into others. Each of the major players is so large and the positions so concentrated that any one of them could become another LTCM.
The Domino Effect
Because this market has become so large, so concentrated and interconnected, it has the potential to implode into a worldwide financial contagion. A small, uncontrolled event could develop into a major financial crisis. It could begin with any one of the major players caught on the wrong side of a bet. The situation is amplified by the leverage of derivatives. It spreads like brush fire because the participants are interlinked. This creates a domino effect as the contagion crosses over financial markets and economic borders rippling through the world financial system. Volatility is magnified in the heat of forced selling. Price declines trigger margin calls, which causes more selling. Bid and ask spreads open up, credit spreads widen, and liquidity dries up, credit costs go up. It happened in 1987, in Mexico in 1994, in Asia in 1997, Russia and the US in 1998.
Could it happen again? Have the derivative markets become so large and so concentrated that another contagion much larger and involving even a bigger player could not be contained?
Yes.
In my estimation, the disintegration of the derivative market is likely as this market mushrooms in size and becomes more concentrated. When markets are dominated by a small handful of institutions, market liquidity becomes less resilient to shocks to the system. With large, interconnected players, contagion risks increase and the market's ability to absorb price shocks is impaired. The derivative market is much larger today than it was in 1998 when LTCM got into difficulty. The players have become more concentrated. The models on which the markets trade still define risk in terms of volatility. Leverage is ignored. Liquidity is misunderstood. Regulators are asleep.
We must now gird ourselves for the next crises which may become even larger and uncontrollable. We know they currently exist in the world's financial system. They are appearing in the US credit and financial markets, in Argentina, in the emerging Euro, and in Asia. Because the markets have become so interlinked, a storm in one market can meet up with a storm front in another market. The stage is now set for the international jet stream or interbank market to bring these storm fronts together to form The Perfect Financial Storm.
Triggers and Chain Reactions
Like 1991's Perfect Storm, there now exists the possibility of a similar event in the financial markets. The financial radar screen shows three storm fronts gathering momentum: the stock market, the economy and the currency market. The international monetary system is the jet stream that could bring these storm fronts together. This huge inter-bank market that moves trillions of dollars of currencies around the globe on a daily basis could turn into a contagion that becomes unstoppable. The increased linkage between financial markets, in each economy and across borders, the large amount of inter-dealer positions in derivatives, the degree of leverage in the financial system, and the speed of technology to transmit market moving news events have created the possibility for all storm fronts to converge.
Systemic risk exists everywhere. It has been brought about by linkage and leverage. There now exists the possibility of a system failure that could precipitate a chain of events that spreads like brush fire. As we've seen in the past, turbulence in one market spills over into another as an unforeseen event triggers a chain reaction. Prices in markets implode, liquidity disappears, credit spreads widen, margin calls are made, forced selling accelerates, and the banking system breaks down and fails. The efficacy of central bank monetary policy is simply overwhelmed. The amount of leverage in the global financial system and the degree to which it is interconnected has become a force that becomes magnified as it ripples through the world's financial system.
The ability of governments and their central bankers to intervene and contain the crisis is limited. Today's system of derivative finance has moved beyond their control. This system is even more apparent as the OTC derivative market has moved beyond borders. It has become transnational falling under no one's jurisdiction. This has shifted the power between regulators and large financial institutions. In their efforts to provide liquidity to the financial system, central bankers have removed the liquidity risk out of derivative finance. In their role as lenders of last resort, they have encouraged the players such as broker/dealers and banks to take on even more risk through increasing leverage and thinly capitalized balance sheets. Their derivative book continues to mushroom in size as shown in the enormous growth since the demise of LTCM. The message in the LTCM bailout is that central bankers have provided a subsidy to the risk management business. "If you get too big, we won't let you fail." Unfortunately, this has served to encourage more speculation and risk taking.
Possible Trigger Mechanism
There are a number of trigger mechanisms that could force the jet stream off its course and bring about the convergence of these three storm fronts. The current crisis in Argentina and Brazil could spread throughout Latin America and jeopardize the Latin American version of the "carry trade," the use of dollars to buy high-yield debt issued by Latin American nations. The introduction of Euro-coinage next year could create monetary instability within the European Union similar to its introduction in 1992. America's growing trade deficits could bring pressure on the dollar and interest rates in the US thwarting Fed attempts to keep the economy out of recession and the stock markets from collapsing. Risk-adverse investors could cause credit spreads to widen as they did in 1997-98 during the Asian and Russian crisis. Rising gold and silver prices could squeeze the shorts in the precious metals markets, leading to the insolvency of a financial institution or hedge fund. Or an unforeseen military event could trigger a chain of events that leads to war. Keep your eye on Russia, China, the Balkans and the Middle East.
It is my belief that the origin of the crisis is most likely to come from America where a giant credit bubble is beginning to deflate. It has already begun in the stock market. It is now spreading to the credit markets and will soon hit the real estate markets. Just as the US is the largest center of concentration in the derivatives market, it is also home to the gold and silver carry trade.
No Safe Harbor for the US Dollar
Once this crisis hits, confidence in the dollar will evaporate. The dollar will no longer remain a safe refuge from the storm. If The Perfect Financial Storm becomes a reality, it will lead to a dollar crisis. With the dollar no longer a safe haven, gold and silver will once again resume their role as real money as the international monetary system breaks down. Ever since the dismantling of the Bretton Woods System in 1971, money has had no anchor. Instead of being tied to a measure of value such as gold, its value has been associated with debt. Since the demise of a gold-backed monetary system, debt has proliferated. There has been no constraining force on governments to contain it. Countries have lost the incentive to balance their books. Debt is now reduced through either default or currency depreciation. As the value of debt grows, it cannot be paid back and in the process, the real value of money ebbs.
As illustrated by this graph, the shrinking power of the dollar and the concomitant increase in inflation is directly linked to the dollar and gold. The dollar has lost 95% of its purchasing power over the last century. As the result of the abandonment of the semi-gold standard under the Bretton Woods System, the dollar continues to lose purchasing power, interest rates and currencies gyrate, giving rise to the the risk management business powered by derivatives. Central banks were supposed to create stability in the financial system. Instead they have left a monetary wake in its place.
Financial Instability Marks the 20th Century
The history of the twentieth century has been one of financial instability. Brief periods of stability took place when the power of government was constrained by the gold standard. The ability to create money out of thin air, the power to inject liquidity into the banking system, and then act as lender of last resort, has made our system of money unpredictable. Essentially, it has made the financial system more chaotic. By decoupling money from gold, central banks hijacked gold from the people in order to create a credit pyramid. Their ability to increase credit has been responsible for creating the boom and bust cycles that have punctuated our economic landscape over the last century. Their ability to expand and contract credit has created excess demand for goods and services beyond our economy's ability to produce. The result has been inflation. Voluntary restraint on consumption is the ultimate factor which constrains price increases.
Ignorance and Deception Perpetuated
The utility of money is proportional to its quantity. People are willing to except money in discharge of debts because they understand the only way to minimize losses in any exchange is to execute it through the agency of money. Essential knowledge of this fact has been clouded by government efforts to manipulate this standard of value. Ignorance is replicated through our education system. The deception that governments can create wealth through the monetization of their own credit is an article of faith at almost all universities. Public ignorance allows governments, through their central bank minions, to tamper with the value of money on a weekly, daily, or hourly basis. They not only get away with it, but are in fact applauded for doing it. The attention accorded to Fed Open Market meetings is an example of this adulation. Investors wait with bated breath for the oracles to speak. These meetings are shrouded with an aura and reverence similar to a conclave of cardinals electing a pope.
Spin and Psychobabble Predominate
This ability to expand and contract credit, and the boom and bust cycles that accompany it, are never fully explained as to their cause and effect. Instead they are explained away by Washington and Wall Street spin that amounts to nothing more than economic psychobabble. Instead the public is fed a daily dose of new era paradigms that range from technology-led productivity gains to government and corporate fiscal discipline. Today, many Americans still believe the Clinton tax increases created the prosperity of the 1990's. They just don't perceive that our "prosperity" was actually the result of the creation of the largest credit bubble in history. The fact that credit manipulation can ultimately lead to a credit collapse that vaporizes capital, as it did during the Great Depression, is quickly glossed over. Mark these words. When the system implodes, they'll look for a scapegoat to distract the public's attention from the real culprit – the unmitigated creation of credit.
This system of credit creation continues unabated to this day as evidenced by our mounting trade deficits, rising consumer debt levels, a negative savings rate, and the deterioration of corporate balance sheets. In the process, the credit worthiness of the United States has also fallen. The demonetization of gold has led the United States from a position of strength to one of weakness. We have gone from the world's largest creditor nation to the world's largest debtor nation in less than three decades. Under this system of irredeemable currency, inflation has been the result. Despite this debasement of our currency, the producers of goods and services around the globe are still willing to put their faith in paper.
There Will Be a Day of Reckoning
Ignorance is bliss. But the rise in the cost of goods and services cannot remain hidden for long. Sooner or later people will wake up to the fact that they have been fooled. Right now confidence in paper is supreme. During a crisis like The Perfect Financial Storm, that confidence and faith in paper will evaporate. The public will eventually realize that the emperor has no clothes. When that happens, gold and silver will once again resume their traditional role of marginal utility. The system of unequal weights and measures is about to be reversed. Unwittingly, central bankers are bringing about the demonetization of their irredeemable currencies and in the process, returning real money back to the people.
In a free market economy, the laws of supply and demand determine the price of a commodity. When demand is greater than supply, the price rises until equilibrium between the forces of demand and supply is restored. This has not been the case in the gold and silver markets. The price for gold and silver has remained stagnant or has in fact declined. Declining prices have occurred against a backdrop of constant deficits. Precious metals have lost their role as real money and have been replaced by a system of fiat currencies. In the process, gold and silver have been relegated to the status of an industrial commodity.
However, during the monetary turmoil that would accompany The Perfect Financial Storm, their role as money would be restored. Under the Storm Scenario, they become the ultimate hedge or investment for survival. In fact, should it occur, their return as a monetary asset would give rise to the greatest transference of wealth in history. This rise would be birthed by a vesuvian eruption in the monetary system that triggers investment demand. To understand how this would take place, it is necessary to look at each of these markets.
References
[8] "World Gold Output May Plunge 35% in 8 Years," Bloomberg, April 11, 2001
