Saturday, October 24, 2009

Understanding Everything

I'd like to welcome aboard my foreign/non-US viewership that has grown significantly over the past six months. Also, before getting started I would like to thank Jim Puplava of the PFS Group for a lot of the information presented in this segment.

My goal with this web page, which I hope I have accomplished, is to take somewhat complex topics and discuss them in a way that is easy to understand.

One of my main focus points has been the next major shift in the global financial markets, which is the fall of the United States currency.

However, there are many, many, aspects to the financial system other than currency trends and how they effect the markets.

I would like to take a step back now and try to bring some of the market cross currents full circle by looking at where we've come from, where we are today, and where we are headed. I will be taking new aspects into view such as market cycles and derivatives. To help you understand some of the topics here, I would advise starting with the documentary above titled "The Warning." It was developed by Frontline, and presents a fantastic behind the scenes look at the origins of the derivatives monster.

If this gets a little complicated, I apologize, but I think the information is important as we move forward. With that said, lets begin.......

In 1985 there was an event held called the Paris Accord, and a few weeks later at the G7 (a gathering of global leaders) it was determined that the dollar's value was too high and hurting global markets. Actions were taken to change this course, and in the Summer of 1987 this caused a mini run on the dollar and it began to plunge. To counter this, the Federal Reserve raised interest rates to 10%.

This rate raise caused some turmoil in the markets, and many believe it was one of the determining factors that led to the October, 1987 stock market crash. Forever known as Black Monday, the stock market crashed 22% in a single day. To help you visualize that type of decline, it would be the equivalent of the market falling 2,200 points today, in one day.

Two weeks before the 1987 stock market crash, a new Federal Reserve Chairman had been crowned. His name was Alan Greenspan, and he would take the markets in a brand new direction that the world had never seen before.

To counter the market crash in 1987, Greenspan dropped interest rates and unleashed an ocean of liquidity into the market. Throughout the 1990's, every time there was a set back, mini-crisis, or recession, Greenspan did the same thing; lowered interest rates, and flooded the market with money. There are consequences for these actions.

In the 1990's we saw the greatest stock market run in world history, as Greenspan brought the market to unimaginable heights. In the mid-90's an instrument known as derivatives began to grow off banks' balance sheets. It started very small and began to grown exponentially. The Frontline documentary above discusses this period in detail. They end the program around the 2000 period and that is where I want to pick up from there.

After Long Term Capital Management collapsed, our regulators had a chance to reign in the derivatives growth and protect the financial markets from "systemic failure." As seen in the film, they did everything in their power to prevent regulation.

In 1999 they repealed the Glass Steagall Act. This act originated during the great depression creating a wall between the banking and investment banking portion of these large banks. This meant that banks in charge of protecting the public's money could now take endless risk with that money.

In 2001 they created the Commodities Futures Modernization Act. This completely removed derivative securities and credit default swaps (a form of derivatives) from Federal oversight. The market had officially become the Wild West.

In 2004, regulators removed the leverage ceiling that banks had to maintain. Up to that point, banks could only leverage at 12 to 1, meaning if they had $1 in assets they could borrow $12 more. Once this was removed leverage exploded and in some cases reached 40 to 1. (As seen in Bear Stearns before their collapse.)

These three acts opened the door to a derivatives explosion, but while this dark market began to grow, Alan Greenspan continued dumping gasoline on the fire with his free money policy.

In 2001, in response to the stock market crash, he lowered interest rates down to 1% to try and get overleveraged Americans out the door to borrow and spend.

This is where things become very important. Greenspan had created a period of boom and bust cycles with his reckless free money policy. What is important to understand is that each time we experience a boom bust cycle it takes a different form than the last.

When the stock market exploded in 2000 the cheap money that Greenspan brought into the system found its way into the real estate market. Everyone knows the story from here.....the cheap money allowed loans to be sold, packaged, securitized, and sold all around this world. This created the real estate bubble that blew into 2006.

What was not seen, however, was the off balance sheet derivatives growth centered around the housing bubble. As these loans were being created and insured by lenders such as AIG, there was another market that was taking "side bets" on whether these loans would default. These side bets were known as credit default swaps. At the peak, the credit default swap market approached $60 trillion in size, three times larger than the entire housing market.

During last fall, you repeatedly heard that banks were being bailed out to avoid systemic risk. The systemic risk did not come from the actual loan defaults, but from the off balance sheet bets made on the mortgages. AIG was not only insuring the actual mortgages, but they were insuring the gambling off balance sheet arena in the dark derivatives world. If one institution could not pay out on its derivatives position, every institution would simultaneously fail down the line.

So this brings us to the present. Last fall, just as we did in the year 2000, we had a major crash. Just as we did in 2000, the Federal Reserve has rushed in and dropped interest rates to zero and flooded the market with liquidity. The size and scope of the bailouts today are far, far, greater than the previous two times:

In 1990: Bailout was in Millions $$
In 2000: Bailout was in Billions $$
In 2008: Bailout was in Trillion $$

Before I discuss where we go from here, it important to understand that during this entire process one thing has remained constant: The derivatives market has continued to grow in size.

In 2001 the entire United States derivatives market was $60 trillion.

Today this market now stands at $204 trillion.

The entire global derivatives market has just crossed over $600 trillion in size.

During the crisis last fall you would have expected this market to shrink considerably right? No chance, it has not missed a beat. The market grew 1% last year during the crisis, and it grew over 1.5% last quarter in size.

Looking at the major banks today:

J.P. Morgan has $1.7 trillion in total assets.
Their derivatives position: $80 trillion.

Goldman Sacs has $120 billion in total assets.
Their derivatives position: $41 trillion.

Bank of America has $1.5 trillion in assets.
Their derivatives position: $39 trillion.

Citi has $1.1 trillion in assets.
Their derivatives position: $32 trillion.

These four banks account for 95% of all derivatives trading. It is also clear to see that just a small loss in their derivatives positions wipes away their entire net worth completely.

Alright, quick recap:

1990 recession Greenspan floods liquidity creating boom in stock market.
2000 stock market bust, Greenspan floods liquidity creating boom in real estate.
2008 real estate bust, Bernanke flooding liquidity as we speak.

Today we are living the reflationary boom as the stock market is now reflecting that reflation. As I've said, each boom/bust cycle takes a different form, so the important question is, what happens from here? Here is how I see it playing out:

The boom from the most recent liquidity injection is going to move toward the emerging markets and commodities creating the next bubble in these two markets. The bulk of the liquidity will not go back into US stocks and real estate. (This process has already started as foreign markets and commodities have far outpaced US stock and real estate gains this year)

The next crisis or bust, which may be two or three years away, is going to come from the dollar.

(For reasons why we are approaching a dollar crisis you can read essentially every other post on this website. It is dedicated to making that point crystal clear.)

Now here is how it all ties together:

As the dollar begins to fall, interest rates are going to rise across the board as investors demand a higher return to offset the currency risk. Even the Federal Reserve will have to raise rates to try and stem the inflation.

In the $600 trillion derivatives off balance sheet black hole, 95% of the financial instruments are tied to interest rates, they are known as Interest Rate Swaps.

As the interest rates begin to move violently upward, it will cause chaos in this swap market, similar to what was seen on the insurance purchased on subprime real estate.

It is only a matter of time before this market detonates.

This is the reason Bernanke is doing everything in his power to keep interest rates low. He is buying treasuries, buying mortgage securities, and he has the Fed Funds rate set at 0%. This strategy, however, has a perverse effect on the value of our currency and combined with Obama's mission to bankrupt the nation, foreign investors are heading for the exits.

The bailout for the next bust will be in the quadrillions, not trillions. The question is, can you save dollars faster than Bernanke can print them? I don't know anyone on this earth who can.

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