Introduction
There is a tremendous amount of material that I would like to write about in this particular segment of my series on "The Perfect Financial Storm? Financial Storms Heading Toward the U. S. Economy." However, due to the length of this article, I have chosen to release Rogue Wave - Rogue Trader in two parts. I ask for your indulgence and would like to commit to releasing the second part shortly. - Jim Puplava
It was late fall, a cold front was coming down off the Canadian Shield, a nor'easter was coming off the Great Lakes, and a hurricane was brewing off Bermuda. The Great Lakes and Canadian storms were headed towards the Grand Banks. Hurricane Grace, a late-season fluke, was headed toward the Carolina's. Inexplicably, Grace altered course. The jet stream, a river of cold upper-level air traveling above the earth at thirty to forty thousand feet, would drag Grace eastward. As Grace turned, it would collide with the two other storms fronts and become "The Perfect Storm".
The force of this killer-storm would create extreme conditions and great peril upon the seas. The biggest hazard was the sea itself. The harder the wind blows, the bigger the waves get and the more wind they catch. In effect, waves become a sail — able to harness the energy of the wind. Wave heights are determined by three factors: wind speed, its duration, and the distance (fetch) over which the wind blows. Scientists understand and can usually predict the general height of waves. But the big ones are unpredictable. They are known as "rogue waves." They are generally considered to be high, unexpected waves which in some instances come from a direction different from the predominant waves in the local area. They appear out of nowhere and can spell disaster.
Unfortunately for seafarers, the size of the wave increases exponentially as the force of the wind increases. In the Halloween Storm of 1991, meteorologists recorded wave heights over one hundred feet. These freak waves can come out of nowhere and catch sailors off-guard. When they hit a vessel, they can flip it, roll it, or cause it to founder. Breaking waves have been known to exert pressure of up to six tons per square foot. When they hit, they have the potential to sink ships instantaneously. Mariners fear and respect these rogue waves. Because of their steep crest, ships have a hard time getting their bows up fast enough before the wave breaks their spine as seen in the 180 meter-long vessel, Flare, [right] which broke in half and sunk after being hit by a rogue wave.
Rogue waves are the result of two wave trains coinciding at just the right moment for their energy to combine. In essence they become tall moving skyscrapers upon the water. Sometimes they can become so large that they can be picked up on radar. Most people don’t survive encounters with such waves. I recently had dinner with an experienced tugboat captain who recounted many tales of ships that simply disappeared. The prevalent theory behind their loss is the rogue wave.
Scientists have noticed an emerging trend of an increased occurrence of these freak waves. Unfortunately for those who make their living on the sea, rogue waves of eighty or ninety feet are becoming more common. They have, over the last thirty years, come to be recognized as uniquely challenging phenomena. No one knows the cause, but their increasing frequency has resulted in greater stress upon shipping, fishing, and the pleasure industries.
Rogue Waves & Rogue Traders on Our Financial Seas
We are experiencing similar phenomena in the world’s financial system. Severe storm fronts have been buffeting the financial system since the stock market crash of 1987. We've seen rogue waves hit in the peso crisis of 1994 and the Asian and Russian Debt crisis of 1997 and 1998. We have also seen the emergence of the rogue trader. First there was Orange County Treasurer, Robert L. Citron, who pushed Orange County to the brink of bankruptcy. Then we saw Nick Leeson bring down Barings, the British investment bank. Leeson put an end to 325 years of banking tradition in one weekend. More recently we saw Long Term Capital Management's disaster in 1998. In the case of Long Term Capital Management, it was a group of traders, including two Nobel Laureates.
Experts Agree on Our Vulnerability
It may be hard for one to imagine risk at a time of our current prosperity. Up until this year, the financial markets have gone up every single year for the last 17 years. At the same time, we are enjoying the longest running economic expansion in history. For precisely these reasons, policy makers in the U.S. gathered together last fall to discuss the vulnerability of the U.S. financial markets. They deemed the most dangerous near-term threat to U.S. leadership in the world would be a sharp drop in the U.S. securities market. A decline in our equity markets would hobble our economy, impair our financial health, create political instability, and damage U.S. security. A decline in U.S. prosperity would also impact financial security around the globe. A major crash in the U.S. stock market could ignite a chain of financial disturbances around the globe. It would impair our economy when it is needed most to strengthen the health of other nations, like Asia, who are just pulling themselves out of crisis conditions.
As a result of those meetings, experts drew several conclusions from past crises. One lesson was that virtually every major financial crisis since the 1970’s has been a liquidity crisis. That is why you see the Fed rush in to liquefy the markets — whether it was 1987 stock market crash, the Asian tsunami in 1997 or the Russian debt and the LTCM derivative crisis in 1998. [1]
Crisis Accelerators
There were other lessons learned from these crises that can be applied to today’s unstable financial markets. These are known as "crisis accelerators". Accelerators are a mixture of technical and psychological factors that tend to accelerate the decline of asset prices. There are four major accelerators that can bring instantaneous destruction with any impending crisis.
Accelerator #1 Leverage
The first of these factors is leverage. The use of debt by investors to enhance their returns can quickly become a two-edged sword. In the case of Long Term Capital Management (LTCM), it proved to be lethal. Leverage also played a part in the accelerated selling in the stock market crash of 1987. Today, leverage has multiplied ten-fold since the stock market crisis of 1987. It can be seen everywhere but most conspicuously in consumer and corporate balance sheets. For consumers, it ranges from record margin debt, high credit card balances, to high mortgage debt. Corporations have leveraged their balance sheets while financial institutions have multiplied their investment in derivatives.
Accelerator #2 Forced Selling
A second accelerator that accompanies leverage is forced selling. When you are heavily leveraged and the market goes against you, investors are forced to sell in order to protect against heavy losses. Leveraged investors don’t have the luxury of holding on. In the case of LTCM, it ultimately led to their extinction.
Accelerator #3 Momentum Mood Swings
A third accelerator is a psychological factor. In today’s trend-following market, where day trading and momentum-based investment strategies prevail, trend followers pick up on forced selling, which begets more of the same action. Millions of computer systems are linked to today’s markets and are programmed to sell when markets fall. This action accelerates any downturn or crisis as investors have seen in good measure this year.
Accelerator #4 Loss of Confidence
The final accelerator is loss of faith or confidence. This is the most dangerous accelerator, because once confidence is lost, it is hard to regain. Loss of faith and confidence lead to sheer panic. It happened during the 1929 stock market crash and again in the '73-'74 bear market. This is why presidents and Fed officials are quick to calm investors that they have things well under control. Reagan gave investors confidence that the economy was sound after the October crash in 1987. Investors and the country believed him, and we went on. This need for reassurance is why, after the market swoons over the past month, Fed officials have been out in force reassuring the business and investor community that the economy is still sound.
These four accelerators mimic the "train" effect of waves, which build to create the rogue wave.
Today’s Complacency
The risk to today’s financial market is inherent in the varied institutions of our government. In my opinion, there is widespread complacency by investors and the investment community. I have also seen a basic moral hazard at work in the market place fostered by the supreme belief in the Fed and other major central banks. The belief is that the Fed is able and capable of bailing the U.S. and any other nation out of a crisis as demonstrated in 1987, 1994, 1997, and in 1998. The confidence in the efficacy of monetary policy is supreme. Most recently, they have been hailed as the chief engineers of the "soft landing." This is where the danger lies.
There will come a day unlike any other day,
an event unlike any other event and a crisis unlike any other crisis.
It will emerge out of nowhere at a time no one expects.
It will be an event that no one anticipates — a crisis that experts didn’t foresee.
It will be an exogenous event — a rogue wave.
It is this unpredictable exogenous event or series of events that could trigger a downturn in the financial markets substantial enough to impair our economy. There is already visible evidence of storm fronts on the horizon as I've discussed in early installments of this series. Policy makers and investors should be on the alert for these rogue waves and rogue traders. Two prominent areas to be looking for their emergence are in derivatives and the geo-political realm. It is these two areas that pose the greatest risk to our fragile markets.
The Danger of Derivatives
Derivatives Defined
The arcane world of derivatives is easy to understand once you break it down to its simple components. Derivatives are financial instruments whose value depends on the value of something else. In contrast to financial assets, derivatives are financial instruments whose "payoff" depends on another financial instrument or security. Those other instruments on which they derive their value can be a stock, stock index, a bond, interest rates, currencies or a commodity such as oil.
Derivative contracts consist of four basic types of contracts. They are forward contracts, futures contracts, option contracts, option on futures, swap contracts or a derivation of the five. Another feature of derivatives is that they are generally not reported on balance sheets… a very important revelation.
The key to understanding these complex instruments is to think of them as a premium much like an insurance product. When you buy insurance, you pay a premium in order to obtain protection against an event such as an accident, fire, or death. Derivatives are similar. They have a payoff contingent upon the occurrence of some event. The buyer of a derivative pays a premium in advance.
Most investors are familiar with options on stocks, which are a form of derivatives. For example, an investor could buy 100 shares of IBM trading at $92 for $9,200 or instead buy an option on IBM instead. A 1-month call option on IBM with a strike price of $100, would give the investor the right, but not the obligation, to buy IBM within one month's time. Instead of paying $9,200 and receiving the stock, the option would cost only $300. If IBM goes up to $125, the investor would make the same $25 a share as if the stock was owned, less the cost of the option.
However, for the option investor, the rate of return is much higher, since the investor did not have to put up the entire amount necessary to buy the stock outright. The cash investor made a return of 36% ($3,300 on $9,200) while the option investor made a return of 733% ($2,200 on $300). The buyer of the option was able to leverage his return by controlling the same amount of stock with less money. Derivatives can enable investors to leverage returns or hedge against risk, providing flexibility with a different risk/reward profile.
"The Players" in Derivatives
The main players in the derivative markets are institutions. They include investment banks, commercial banks, and end users such as mutual funds, corporations, and hedge funds. These institutions use computer systems to manage risk, account for positions, and track events such as the expiration of contracts, and measure the amount of capital at risk. Derivatives have become more complex over the years because of the convexity of these products.
Because these instruments are so complex, they require a risk manager to oversee a derivative portfolio. There are different levels of risk management. At the micro level, a risk manager may be a trader with the responsibility for derivatives in one asset class. At the macro level, the risk manager is in charge of determining the firm's derivative positions in regards to the longer-term trends of the market. Lastly, there is the middle office, which has the responsibility of enforcing the policies, risk and investment objectives of the firm. Middle office risk managers keep senior or upper management informed of the financial price risks to which the firm is exposed. The risk manager is similar to a portfolio manager in that they both want to maximize return on capital. However, the derivative risk manager must focus his attention more on risk than just the return on capital.
One of the biggest problems risk managers face is the rogue trader. A rogue trader is one whose behavior and risk-taking is intentionally inconsistent with the aims of management or its shareholders. The risk manager must constantly ferret out trading irregularities and be on the lookout for the rogue trader.
Three Kinds of Risk
Derivatives are subject to three kinds of risk. The first is leverage because derivatives expand the amount of assets that can be controlled as in the case with options or futures. A second form of risk is liquidity. A liquidity vacuum can occur when the bid/offer spreads widen to levels that make it prohibitively expensive to deal. Over-The-Counter (OTC) contracts make up 91 percent of derivatives while exchange-listed contracts are 9 percent. OTC contracts can be custom-tailored to meet firm-specific risk management needs. Since they are more specifically tailored, they tend to be less liquid than exchange listed contracts, which are standardized and fungible [those items of which any unit is, by nature or usage of trade, the equivalent of any other like unit]. The final risk in derivatives is counter-party risk. With derivatives, there are always two parties to a contract. The risk here is that the other party doesn’t perform or is unable for financial reasons to deliver on their obligations.
Derivative Dilemmas
There are many risk black holes when dealing with derivatives. They have become more complex over the years as investors have found the means to hedge against risks. The world of hedging exposes investors to a lexicon of terms known as "The Greeks". Essentially, they are techniques for hedging against the behavioral characteristics of an option, futures, forward or cash position. There is "Delta" [ D ] which tries to capture gains from volatility by hedging a portion of the option’s value. The idea behind "Delta" is to make money on volatility. The more times you can delta-hedge an option, the more profit can be realized to help pay for the option investment.
Then there is "Gamma" [ G ]. Gamma is the second derivative of the option price, which deals with the sensitivity of the delta (rate of change of the delta) with respect to the cash price of the underlying asset. Because of the convexity of the option price curve, there is a greater opportunity for the change of the option price if the cash or spot price moves. In other words, the greater convexity delivers more bang for the buck if you’re long, and more pain if you are short.
Options become more expensive when volatility in the market is high, and less expensive when volatility is low. The sensitivity of an option’s price to changes in its implied volatility, all other things being equal, is called the "Vega". There are other Greeks such as "Rho " [ R ] which deals with an option’s sensitivity to changes in the domestic interest rate.
Formula for Disaster?
If you are getting the impression that this is a risky and quite complex business, you are beginning to get the picture. Derivatives are a difficult concept to grasp. Their explosion in size and use go back to a formula that was developed back in the 1970’s. In 1973 three economists — Fisher Black, Myron Scholes, and Robert Merton — developed the "Holy Grail" that revolutionized modern finance. The elegant formula they unleashed upon the world led to the creation of a multi-trillion dollar industry known as derivatives. Both Merton and Scholes would receive the Nobel Prize for their work in 1997. A year later, they would take part in one of the greatest financial disasters in modern history due to their reliance on their formula to predict risk. See link to actual formula
The formula is known in the financial world as the Black-Scholes Option-Pricing Formula. It's usefulness was that it enabled investors to determine how much a call-option is worth at any given time. The combination of the Black-Scholes model with probability theory caused the world of derivatives to explode. Complex computer models have been developed to take advantage of every permutation and possibility of every financial instrument and market. Today the notional value of derivatives worldwide is estimated to approach $100 trillion.
Derivatives take leverage to the tenth degree. The opportunities for disaster are manifold. In the derivatives market, when you make a mistake, it can be deadly. When derivatives implode, they aren’t just bombs — they are more like a nuclear explosion. Because they are highly leveraged and risky, they can produce high returns when they go right and catastrophe when they go wrong.
The “Tail” of Long Term Capital Management
The headlines of the 90’s are filled with stories of tragedies from Orange County, Barings, to more recently Long Term Capital Management. LTCM was a hedge fund started back in 1993 by John Meriweather, a legendary bond trader from Salomon Brothers. Meriweather recruited professors from academia as part of his trading team. Two prominent partners of his firm would be the famed economists Myron Scholes and Robert Merton, originators of the options formula.
LTCM bedazzled the financial world with spectacular returns, which were accompanied by low risk. Right from the start, the firm made huge amounts of money for its investors through the leverage of investments made in derivatives. One of their first trades was betting the ranch on a $2 billion trade in the bond market without using a dime of their own cash. In its first year of business, which was the volatile year of 1994, after their fees, LTCM made 28% for its investors. That was an incredible feat considering most investors lost money that year.
In its second year of operation, LTCM made returns of 59%. In actuality, LTCM made less than 1% on its assets. The 59% return came from the amount of leverage it used. At the end of 1995, LTCM was leveraged 28 to 1. By the spring of 1996, Long Term had $140 billion in assets or thirty times its capital. They went on to earn a profit of $2.1 billion or 41%. This small band of traders made more money than most major corporations that year. In fact, not even Lucent, McDonalds, Disney, Sears or Nike made as much as LTCM.
By the end of the year, the firm had close to billion in equity, nearly 0 billion in debt, and had a derivative book that totaled .25 trillion. The partners would go on making even bigger bets confident that their black box formulas would insulate them from risk. Professors Scholes and Merton were confident of the key assumption of their model that the volatility of a security would remain constant. They were counting on the probability of risk would be contained in a normal bell-shaped curve. What they did not count on was the tail of the curve, which is where unlikely events occur.
Unfortunately for Long Term, those unlikely events came in 1998 when the markets shuddered from a swelling list of negatives from Russia, Asia, and China to the White House intern Monica Lewinsky. LTCM started out the year with .6 billion in capital. By September of 1998, LTCM would have days of half a billion dollars in losses. The hemorrhaging was so huge and came so quickly, that it would take the Fed orchestrating a bailout by 14 banks and investment firms. [2]
Reckless Disregard for Lessons
The lessons of Orange County, Barings and LTCM have not been learned well. After being taken over in 1998, one of the main principals was back in business in 2000. The widening of credit spreads, the lack of liquidity, Russia’s debt defaults were uncertainties that the computer models had missed. Yet despite these blowups, the derivative markets continue to mushroom in size. The notional value of derivatives in insured commercial bank portfolios increased by .69 trillion in the second quarter of this year, to .3 trillion. The bulk of this amount, or 95%, is concentrated in our seven largest banks. With the merger of J.P. Morgan and Chase over half will be concentrated in just one bank. [3]
Rogue Roulette
The investment portfolios of our nation's largest banks have turned into casinos. Credit exposure, as a percent of risk-based capital, has increased; while trading profits, as a percent of gross revenue, have also gone up. Derivatives allow institutions to leverage up their investments by enabling them to control a larger amount of an investment product. Going back to my example of IBM, an option contract can control the same amount of shares of IBM versus owning the shares outright with less money. Add leverage to these contracts and you can control vast amounts of investments or markets. Consider LTCM, which had under billion in equity, 0 billion in debt and controlled .25 trillion in notional value derivative contracts. That is leverage carried to infinity!
Rogues at the Wheel
Originally, the derivative business began as a way of insuring against risk. In the 90’s the world of derivatives turned into a business of speculation used by institutions, hedge funds and well-heeled investors to leverage their returns. The hedge funds, in particular, remain almost exclusively the domain of the wealthy. They are unregulated investment pools that aren’t registered with the SEC. They can concentrate their portfolios, use leverage, and bet the ranch without prudent concerns for diversification. When they blow-up, as in the case of LTCM, they create nuclear shock waves throughout the financial system.
Some day, this new form of leverage which has permeated the tony-world of Wall Street will be regretted. With an almost religious faith, bank and brokerage trading rooms have adopted the mathematical certainties of the academics' models. As if the world and the mindset of investors can be contained by the certitude of the professors' "black box." Most investment bank trading floors are staffed by PhDs who have studied and believe in the "Holy Grail" of the Black-Scholes model. The conceit and hubris of Wall Street is unfathomable. It is the ultimate deception that their mathematical models could eliminate wars, pestilence, stupidity, and being struck by lightning in the real world.
Derivative Positions - A Telling Story
Credit Equivalent Exposure of the 25 Commercial Bank and Trust Companies
With The Most Off Balance Sheet Derivative Contracts
June 30, 2000 in $ millions
Source: Office of the Comptroller of the Currency
Just look at these tables. They depict the derivative position of our nation's leading banks. Even more disconcerting is the fact that most of these derivatives (95%) are concentrated in just seven banks. The two graphs below depict an alarming picture of risk being undertaken by our chief financial institutions in the pursuit of profits. Another aspect of this picture is the degree of credit exposure these banks have in relation to their capital ratio. For Chase Manhattan Bank and J.P. Morgan it is over 400% and 800% respectively. Also, consider the fact that these two banks represent more than 50% of the banking systems' derivative holdings — and now the two banks are merging. In other words, over half of the banking systems' derivatives will be in the hands of just one financial institution. Could this be another Long Term Capital Management in the making? [4]
Financial institutions have lobbied against regulating this market. But in my estimation, it is one area that regulators should be monitoring very closely. These institutions are betting that most of what they are doing can be hedged against. They are betting that much of what they do will fall within the bell shape of the risk curve. Once again, the risk is in the tail of both ends of the curve where the rogue wave lies. In his book “Against the Gods: The Remarkable Story of Risk,” Peter Bernstein writes that nature’s patterns only emerge from the chaotic disorder of random events. When it comes to probabilities or coin tosses, the flip of each coin doesn’t remember the flip of the previous coin. But the markets never give us a complete sample with an error rate plus or minus 3-4%. The markets are in a continuous state of flux — changing from one paradigm to the next. In the real world, investors are more apt to encounter discontinuities and the occasional rogue wave.[5]
The professors' black box doesn’t know when a rogue wave will hit. It can only estimate its probability. In the financial markets, when storms fronts are everywhere, heading into the eye of the storm with a ship heavily laden with cargo is a risky proposition. The problem with black boxes is that they are built on certainty, while the real world is not.
The Gold Carry Trade - A Harbinger of Trouble
There is another risk to this derivative strategy which is even more ominous — the gold carry trade conducted by our financial institutions. As shown in the table below, the gold derivative position of our banks is a small fraction of their total derivative position. However, the position is much larger when compared to the actual gold physical market. Gold miners around the globe only produce about 2,500 metric tonnes of gold per year.
NY Bullion Banks Playing With Fire
The real story behind this explosion in gold derivatives is the gold carry trade The central banks have deposited or loaned gold to the bullion banks at a very low interest rate. The rate at which banks borrow from the central banks is called the gold lease rate which is currently 1.46% (1 yr.). The gold that banks borrow is immediately sold into the market at the prevailing rate for gold. The banks then invest the proceeds into investments paying a higher rate of return. This has become a very cheap source of capital for New York bullion banks like Chase, Morgan, and Goldman Sachs.
Source: Bloomberg
Paying the Piper Poses Problems
However, a problem develops when the gold deposit is called or the gold loan comes due. When the bullion banks sold the gold short, that gold entered the physical market of gold. Today that gold is probably resting on the necks, ears and arms of women around the world as bracelets, earrings or necklaces. If those loans are ever called or the price of gold moves up, the bullion banks have a big problem on their hands. It is unlikely to be resolved by appealing to the good nature of women around the world to relinquish their jewelry for paper certificates of deposit.
Veneroso Associates estimates that official-sector gold loans stood at 9,000 to 10,000 tonnes at the end of 1999. Most of this gold has been converted into jewelry so it can’t be retrieved. These figures could be even higher this year since the gold derivative book at bullion banks has increased. With demand for gold far exceeding supply, inflation on the rise, oil prices exploding, tensions rising in the Middle East, the price of gold should be exploding. It hasn’t. Why not? The only plausible explanation is that "someone" wants to keep the price of gold artificially suppressed. The culprit can be found in the gold derivatives market. [6]
It is beyond the scope of this Perspectives series to cover all of the reasons why the price of gold is being suppressed. For readers wishing to know more about this situation, an excellent source of information and detail can be found at gata.org under the “Gold Derivatives Banking Crisis." It is a long document, 118 pages, but well worth the read for the curious.
Currently, annual demand for gold is estimated to be running around 4,000 tonnes per year. World gold demand exceeds supply by roughly 1,500 tonnes per year. The selling of gold by central banks and the leasing of gold from central banks by New York bullion banks such as J.P. Morgan, Chase, and Citibank, are alleviating the supply deficit. Another major player in this market is Goldman Sachs, which doesn’t report its position to the OCC (Office of the Comptroller of the Currency) because it is an investment bank. The total gold derivative position is .1 billion as of the end of the second quarter of this year. The top seven commercial banks make up .5 billion (83%) of that amount. The total above-ground supply of gold is only 120,000 tonnes, of which 33,000 is held as official central bank reserves. The total market value of gold in this world was worth .1 trillion as of the end of 1999 when the price of gold was 0. Since then, the price of gold has fallen to its recent price of 8.20.
Notional Amount of Off Balance Sheet Derivatives Contracts by Contract Type and Maturity
for the 7 Commercial Banks and Trust Companies With the Most Off Balance Derivative Contracts
June 30, 2000 in millions (Note data are preliminary)
Source: Office of The Comptroller of the Currency
Don't get lost in the numbers. The important point is that the total value of gold derivatives at the end of the year amounted to 26,000 tonnes. This represents ten times the annual production coming from the world’s gold mines! Even more important is the fact that the gold derivative position is only 6-7,000 tonnes short of the entire gold holdings of the world’s central banks. The remaining portion of the 120,000 tonnes is made up of scrap and jewelry.
The problem with the gold derivative holdings in bullion banks is that they far exceed the physical market for gold. If the price of gold were to move up, as in the case of a financial crisis or geo-political event such as presently occurring in the Middle East, this large short position could act as a NASA space launch for the price of gold. A financial crisis or war could breed a panic exit out of paper assets into real assets.
The Problem With Golden Paper
In the potential meltdown of LTCM, whose derivative book consisted mainly of interest rate, foreign exchange, equity, and credit derivatives, there was a ready supply of the paper assets such as bonds, equities, and currencies in relation to their derivative book. In the case of the bullion banks, the world of physical gold is far smaller than the world of gold derivatives. The annual production of the world's gold mines is roughly 2,500 tonnes. The total supply of gold in the vaults of the world's central banks is only 33,000 tonnes.[7] The problem becomes apparent when a financial or geo-political crisis erupts as to where the gold exists in the vaults of central banks or in the form of jewelry. This problem of paper gold and physical gold could become the central banker's worst nightmare.
As if anticipating that problems are afoot, Treasury Secretary, Lawrence Summers and Federal Reserve Chairman, Alan Greenspan, have been lobbying Congress to approve legislation dealing with a potential derivatives crisis before they adjourn. As a result of those efforts, the House passed HR4541. The bill is designed to reduce risk to the nation's banking system should a major financial institution experience a derivative explosion. This piece of legislation being promoted by the Clinton Administration would allow a bank or investment firm that becomes insolvent due to derivatives to use the net value of its losses rather than the gross value. The purpose of which would be to avoid tying up trading contracts in bankruptcy proceedings.
The New York Mercantile Exchange found the bill's passage appalling. In effect, HR4541 removes the energy and metals markets from public scrutiny and regulatory oversight. Could the Administration know something that the financial markets don't yet know? Usually, where there is smoke, there is fire. With tensions in the Middle East rising, oil prices escalating, inflation on the move and the stock market in turmoil, the price of gold is going down as a result of the bullion banks and their derivative book. Maybe Washington and Wall Street are preparing for the next bailout.
The price of gold is declining along with silver, at a time when they are both in short supply. World crises abound every which way you look. Our financial markets remain shaky, and John Q. Public is waking up to the fact that inflation is becoming real as he pays his bills the first of every month. Washington is intervening in the oil markets, the stock market, the bond market and the currency markets. The moral hazard argument is now at work. We know about bank deposit guarantees. Now it looks like we'll have financial market guarantees. Hold on to your wallets — this is going to get interesting.
If you don't want to be struck by lightning, you don't stand under a tall tree in an open field during a lightning storm. The same wisdom can be applied to the world of derivatives. Our financial markets hang on a thin thread of probability and belief in a bell-shaped curve that such an event will never occur. Yet history reveals otherwise. The lesson of this last decade tell us that rogue waves and rogue traders do hit the financial markets. So far we've managed to survive them. The academics will tell us that their models will help us to avoid them. They have endeavored to convince the financial world of their mathematical certainty. But the real world isn't full of certainty.
There will come a day without warning, at a time when nobody expects, when that rogue wave will appear. It will be a day when events overwhelm the financial markets... when the house of paper will fall... when our financial institutions will be put to the supreme test... when the mettle of a man is tested... when faith in our institutions will be called into question. It will only be on that day and in that hour, that we will know if the Holy Grail of Finance truly exists.
References:
[1] Council on Foreign Relations, Financial Vulnerabilities Project.
[2] Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long Term Capital Management, Random House, New York, 2000.
[3] Comptroller of the Currency, OCC Bank Derivatives Report, Second Quarter 2000
[4] Comptroller of the Currency, OCC Bank Derivatives Report, Second Quarter 2000
[5] Bernstein, Peter, Against the Gods, John Wiley, New York, 1996
[6] gata.org, The Gold Derivatives Banking Crisis, p.4
[7] gata.org, The Gold Derivatives Banking Crisis, p.16
Reading Recommendations:
Ship-sinking monster waves revealed by ESA satellites 21 July 2004
Once dismissed as a nautical myth, freakish ocean waves that rise as tall as ten-storey apartment blocks have been accepted as a leading cause of large ship sinkings. Results from ESA's ERS satellites helped establish the widespread existence of these 'rogue' waves and are now being used to study their origins. See Story
Freak waves spotted from space, BBC, 22 July 2004
The shady phenomenon of freak waves as tall as 10 storey buildings had finally been proved, the European Space Agency (Esa) said on Wednesday. See Story
Oops... How Did I miss that 100-Foot Freak Wave? by Robert Folsom, Elliott Wave Int'l.
