Saturday, September 20, 2008

Systemic Risk

Over the past year the Federal Reserve and the Treasury have bailed out Bear Stearns, Fannie Mae, Freddie Mac, and AIG. This weekend they are in another huddle up preparing themselves to have a large bail out plan ready for every company that starts to stumble.

The most common term you hear when they tell the country why they are bailing out these firms is that they pose systemic risk to the financial system. This is correct. If AIG was allowed to fail last week, the stock market would have collapsed in a fashion similar to the Great Depression. The reason for this collapse is not based on their subprime exposure, which I have been saying for months is just the first step of this credit crisis. It is because of their exposure to a type of derivative known as a Credit Default Swap. Back in January, I started talking about this being the next major term you would start hearing on the news. Well, it has finally hit the front page so let's talk a little bit about what it is and the risks involved.

The derivatives market is an "off balance sheet" market that has no rules and no regulations. Credit Default Swaps are one form of derivatives and probably the most popular. The CDS market is roughly $63 Trillion in size. Click on the chart below which shows the size of this market in comparison to the ENTIRE global economy and the subprime problem.



So what is a Credit Default Swap? As with everything on the Daily Tuna we're going to talk about it in very simple terms.

CDS are a form of insurance against a company defaulting. Defaulting may mean they go bankrupt or something causes them not to make their payments.

Let's say Mike wants to buy bonds in a company we'll call Bear Stearns. This means that Mike would give Bear Stearns a set amount of money and Bear Stearns pays him a fixed amount of interest on the money being lent. During the period Mike collects interest every month and at the end of the period he is paid back the total amount he lent Bear Stearns.

This works out well for Mike as long as Bear Stearns is capable of paying the interest every month and the total amount due at the end of the term. If they happen to go bankrupt, he would be wiped out. This makes him nervous so he wants to find a way to insure himself against those losses if that happens. This is just like getting insurance on your house in case it happens to get hit by a hurricane.

So he calls David and David tells him that he will insure the money that Mike lent to Bear Stearns. To insure the money he requires David to pay him 3% interest on the total amount. Again, this is just like any insurance works; car, home, ect.

The credit default swap market started fairly small in the early 2000's and has absolutely exploded in size through this year. The insurance at first was issued by a few select major banks, and then started being issued by investment banks, hedge funds, and even regular insurance companies. One of those insurance companies became a major player in the past few years. You may recognize their name as AIG.

I'll try to use another simple example to show how David would evaluate how much money he wants to insure and how much interest he needs to charge to protect himself. Let's say David insures $1,000,000,000 ($1 Billion) worth of bonds for 1,000,000,000 (1 Billion) different companies. He runs careful numbers to figure out how many of those companies will go bankrupt and how much he'd have to pay out based on that number. He assumes that in the worst case scenario .5% of the banks will fail. This means he would have to pay out $5 Million in this scenario. He then charges Mike and all the other people buying bonds 3% to insure the bonds. This means on "paper" he is making $25 Million per year. $30 Million he charges minus $5 Million against what will default and he'll have to pay out.

This scenario works fabulous as long as some event does not cause a larger than normal amount of banks to fail. An event like a subprime crisis. Every year the insurers were calculating less and less risk into their analysis. On top of this with more people entering the market there were competition for lower rates. Bank A was charging 3%, but Bank B was willing to do it for 2% so people would go with the lower rates. On top of that the people insuring the debt were paid on both the amount of bonds they insured, AND the lower they estimated the risk. Looking at the example above, if David assumed that only .25% of the banks would fail, "on paper" that year he was now making $30 Million instead of $25 Million. This meant higher and higher bonuses for these risk analysts that they collected up front.

Of course, just like with the subprime CDO's the numbers were based on home prices going up forever and there never being a recession. I don't want to make it any more confusing than what I've already talked about, but what "David" would do is look at the amount he was currently insuring and then have ANOTHER company insure his position if something should go wrong. This now creates a domino effect. If a bank fails, one insurance company cannot cover the losses and the person behind them cannot cover the losses. Remember, this market is $63 Trillion in size. It makes the subprime crisis look like a drop in the bucket.

If the government were to let a large company fail that has significant Credit Default Swap exposure, (think AIG who had $500 billion in mortgage swaps) the entire financial system would melt down. To insure this does not happen they are now putting together a plan to move all the bad debt onto the treasury's balance sheet to try to postpone this from happening. They will then print trillions of dollars to cover these losses.

The Federal Reserve knew this was coming over the summer which was why they orchestrated a major sell off in the gold and silver paper market with two of the major investment banks. These banks took short positions in July on the metals that were 5 to 10 times greater than anything ever seen before. This had the short term effect of taking down their values sharply and allowed the Fed time to orchestrate the past two weeks of bailouts. However, this short position has the effect of taking a beach ball and pushing it further and further under water.

The very rich moved into the physical metal market over the past 6 weeks and have taken enormous positions during this opportunity. In interviews with dealers around the world they will tell you they have had record buying over the past two months, but it has come in the form of multi-million dollar purchases. If you call a silver dealer today you most likely will have to wait 6-8 weeks to take physical delivery because of the current shortages. The smart money is now moving in with tremendous force because they can see what is unfolding before them.

Friday, September 19, 2008

TitanicAmerica

What a week. I've spoken to many people over the past few days about my thoughts on everything that's been happening and what it all means. It's hard to explain the ramifications of the past two weeks in a single conversation, but let me try with a simple story.

An enormous cruise ship was created a few years ago that was going to be the gold standard of luxury. The ship, named TitanicAmerica, was filled with happy people looking forward to the amazing lifestyle the ship would offer.

Instead of building an engine, the captains decided to hire other ships to pull TitanicAmerica. There were many ships hired to pull, some of the bigger ones were The Japania, The Chinia, and The OPEC Nationia. These ships filled their boat with working crews not only to power the ships, but also to work to feed the TitanicAmerica during its travels.

And so the TitanicAmerica set sail one lovely afternoon. It was business as usual for the cruise line for many years. The other boats would fish all day long and bring the food over to the TitanicAmerica to serve them a royal feast. During the day the other boats had crews in their lower ships shoveling coal and working hard to keep the great cruise ship at it's desired pace. In return for all their hard work every day the workers received a paper IOU that they called a "dollar." These dollars were backed by nothing but redeemable for something tangible in the future.

Then one afternoon there was a fire in the lower deck of TitanicAmerica. In order not to alarm the guests aboard, Commander Bernanke and Commander Paulson did the only rational thing they could think of. They took a sledgehammer to the side of the boat to let in water and put out the fire. This worked quite well until more fires started to spring up. Using their intelligence they quickly smashed more holes into the side of the ship to put out the fires. Then there was an enormous fire one afternoon that they called the fire of Fannie Mae. In order to put this one out they tied some explosives to the ship and blew a huge hole letting in an enormous amount of water.

The people on the top deck continued with their lives as if nothing had changed. However, something had changed for The Japania, The Chinia, and The OPEC Nationia. As the water started to pour into the TitanicAmerica it was becoming much more difficult to pull them at their same speed. They started to slow down due to amount of effort it took to drag along the sinking ship with its work crews.

Looking at this situation, what would be the best option for the other ships pulling the luxury boat? If they stop towing the American ship they would stop receiving their IOU's. However, some of crew members were starting to get nervous that the people on TitanicAmerica actually did not have something to pay back. They realized that the other ship had no fishing poles and it had no engine. It only had people on board that ate the food they worked hard to fish for every day.

Obviously, the best option for the other ships is to cut their tows and leave the TitanicAmerica. If they do not, eventually even their ships will get pulled down into the water. After a few days of being confused at not having to feed the Americans, the people on board will find out that they can just fish for an hour a day to feed themselves and spend the rest of the day sunbathing and relaxing.

The TitanicAmerica at this point will realize that it wasn't the fire in their ship that they had to be most concerned about, it was keeping the lifeline from the other ships that was keeping them from drowning.

This is what's happening right now in the global economy. The Fed and the government are trying to put out every fire so people will not start to smell the smoke and understand what is going on down below. The past two weeks were the equivalent of setting off dynamite in the side of our ship.

A few people understand what is happening and are jumping into lifeboats and swimming over to the foreign boats. (Foreign Markets) The people on board the TitanicAmerica laugh at them as they paddle away telling them that the foreign markets are starting to slow down as well. They do not understand that it is because they are hooked onto the sinking ship that they are slowing down. Once they let go, the TitanicAmerica will begin to sink and there will be a panic to get into a lifeboat.

Wednesday, September 17, 2008

The Bigger Picture

Well, I'm sure you've heard the headlines:

-Fannie and Freddie Nationalized ($6 Trillion in obligations)
-Merrill Lynch buys Bank of America
-Lehman Brothers Bankrupt
-AIG Nationalized ($1 Trillion balance sheet)

You've heard the panic on the streets about major bank failings. You saw that the Dow dropped 500 points on Monday, which was its biggest one day drop since 9/11. You hear that all these bank employees are losing their jobs, and the stockholders are getting wiped out. And you hear that things are very, very, bad right now.

I've been talking about these things happening for about a year now, so it's important that you understand that as bad as things are being portrayed in the news, they are much, much worse.

Let's start with Bank of America. I think this was a brilliant move over the weekend by BofA. What the bankers have realized is that the Fed will step in and bail you out only if you will bring systemic risk to the market. So what should the goal of every bank be right now? That's right, put as much horrible risk on your balance sheet as possible.

They started this with the acquisition of Countrywide months ago, and they sealed the deal this weekend with the ridiculous purchase of Merrill Lynch at $29 a share. Merrill most likely would either be bankrupt right now or bailed out as we speak if they had not stepped in. So what did Bank of America do? They took all of Merrill's toxic balance sheet and combined it with their own horrible balance sheet. This now makes them too big to fail and will force the Fed to bail them out if they get in trouble. Of course, you won't hear this on the news, but that's what happened.

Letting Lehman go bankrupt was a great move by the Fed. This allowed the public to perceive they were taking a "strong" stand by not allowing everyone to fail. Then Monday morning to start the day, they dumped 70 BILLION DOLLARS into the market! In combination with this, they opened up their discount window not only to take toxic mortgage securities, but just about any kind of toxic debt banks want to get off their books! Unbelievable. For people that understand, this is actually worse than letting them fail and bailing them out.

24 hours later, the Fed had a chance to show its muscle and its new "no bailout" stance with the AIG troubles. What did they decide to do? Bail them out to the tune of $85 Billion. Helicopter Ben has finally lived up to his name and we are now at the point where he is literally dumping money from helicopters.

What would have happened if these companies were allowed to fail? We would be in a worldwide financial meltdown. It would be absolutely horrible right now. The Dow most likely would be down 4-5000 points, the dollar would be plummeting, and the yields on bonds would be surging as people around the world dumped American assets. With these bailouts the government has postponed that outcome to a future date and made the problem much, much worse. If they would just allow the inevitable collapse to run its course in the free market, they could tell the world that there will be a very tough period, but that they stand behind the value of our currency.

If we continue on the course we are on now the value of the dollar is not going to fall drastically, it's going to fall to zero. We are full steam ahead on the course to hyperinflation. Anyone holding dollar denominated assets such as stocks, bonds, or cash is going to get destroyed. Annihilated. This is not some sky is falling scenario. I've been talking about these bank failures for a long time and when I started a year ago they seemed absurd. So please listen to me while you have the opportunity: IF YOU ARE HOLDING DOLLAR DENOMINATED ASSETS, YOU ARE GOING TO BE WIPED OUT.

I can't tell you when it's going to happen or how long the government can continue to pull their smoke and mirrors game; but when the world wakes up to the con that's being played and they realize that they do not need to send 2.5 Billion dollars every day to a bankrupt country that will never pay them back, it's going to be a blood bath. It'll be a game of musical chairs and a rush to the exits. The last person with dollars in their hands is going to be holding monopoly money and unfortunately that's going to be the American public who have no idea what's being done to them right now.