Derivatives Beast Eats Wealth Faster Than Fed Can Create It

March 13, 2008

Elaine Meinel Supkis

I wish to share some emails with everyone. It seems bankers misunderstand derivatives. They understand the classical concept of derivatives but misunderstand how this was grossly warped over the last ten years into a constant money-creating machine. This machine has now broken down but the submerged derivatives have yet to entirely surface. As all systems unwind or collapse, this triggers more and more derivatives to 'appear' suddenly on ledgers. These are supposed to be protections in downturns but since people wanted them to make money all the time, this triggering of $500 trillion in derivatives is now becoming a destructive tornado of hedging that is actually sucking down money rather than creating it. Indeed, there are so many elements of 'The Outer Darkness' here is it quite astonishing to me to see it in full operation. Humans thought they could evade risk via derivatives. Instead, as is usual in the reverse-magic plutonic world where wealth is created, these end up being destroyers of wealth.

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On Mar 12, 2008, at 6:41 AM, X wrote:

Hey Elaine…FYI here are some opinions by some writers who think deflation is happening here and now, and that there is little cash available except for the new transient cash/credit the central banks create, such as the sage poster mannfm1 at the PrudentBear forum who just wrote:

RE: Fed Saying: :Cash is Trash
mannfm11
NEW 3/11/2008 11:47:24 PM

NO, they are saying there is no cash. You might go read Citi's financial report that came out about August. They were $400 billion in the hole in liabilities to other banks. I don't think but a few people here understand the system is insolvent. The $200 billion, which $60 billion was already out there is in exchange for collateral that will see a margin call if there is any doubt to its value. Cash is king. Ask Carlyle who seems to think that just their name should produce a 300% profit. Leverage is over and deleverage is a loud sucking sound that will suck cash out of all the pockets in the world.

Another person I follow on this topic is Rick Ackerman who just wrote in his newsletter Rick’s Picks:

So Why Did Gold
Barely Budge?

published March 12

A tediously dull gold market appeared yesterday to shrug off the extremely inflationary implications of the Fed’s latest rescue plan for the banking system. The central bank sent shares soaring on Wall Street with the announcement that it will set aside $200 billion of Treasurys to lend to banks and securities dealers. The unsubtle subtext was that the central bank would accept as collateral for such loans any worthless or nearly worthless scraps of paper the borrowers might have lying around. That would represent a radical and unprecedented augmentation of the Fed’s role as lender of last resort, especially since no one believes that the initial, $200 billion will prove to be much more than the ante in this global-stakes game.

Considering the news, gold’s yawning reaction was most puzzling. Is it possible that bullion finally agrees with the theory, broached here with increasing urgency in recent months, that deflationary forces emerging in the financial sector have grown too powerful to be countered by loose monetary policy, no matter how profligate? … That is what we expect, and it implies there will ultimately be no hyperinflation. However, as long as the threat of one seems real, gold and silver quotes are likely to remain firm….

I guess these views mostly agree with you…
Best wishes, X
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Gold markets are international. The biggest buyers were, up until November, India and China. By far. The mere fact that both countries have a billion plus people makes them a huge market for anything. Slight changes in their purchases have big effects in markets. So far, they have taken a huge amount of US dollars pouring into both nations due to offshoring and outsourcing activities by US and European corporations. At the beginning of the New Year, they went on a spending spree for gold. Now they will collect more dollars and try to do the same again. Only, thanks to global inflation of all things humans need to stay alive, the ability to pour more money into buying gold is actually diminishing, not growing. Inflation has finally caught up with incomes across the globe.

This means the 'positive flow' period in all inflationary cycles is now done. All inflation is 'good' at the beginning. People feel richer, businesses make greater profits. Money from the government flows across the land and everyone rejoices for prices are always well behind the dropping value of the currency. So easy money buys things produced by harder money. The benefits are great. Money isn't merely devalued by printing paper or clipping and debasing the metals in coins. It is created via loan generation. So if interest rates are kept lower but even just .5% compared to the rate of rise of prices, everyone can make money without the slightest effort. Stocks, property, art works, status symbols, prostitutes all rise in 'value' while the money made from buying and selling these things increases as the supply of money via loan creation, increases.

Then the Day of Doom arrives: loans have to be made easier and easier in order to be passed on. 0% loans on hyper-expensive cars are offered. Real estate dealers offer 'teaser rates' and 'free gifts.' The more we see 'free gifts' the more likely we are about to see the inevitable reversal of easy money. Now, relentless inflation appears. No longer to the 'fun' things go up in value, they begin to collapse in value. The 'hard' things such as food, fuel and taxes, all begin to climb. If a country refuses to pay taxes in the teeth of this inflation, they go bankrupt within a few years. If a country allows food and fuel to continue their relentless inflationary climb, we see riots, insurrections and revolutions. Eventually, inflation will outstrip incomes and starvation sets in. This is a big motivator towards revolution.

So we just passed through about 7 years of the Fatted Cow's reign and are now entering the Thin Cow's realm. This is why gold hasn't shot up. People NEED fuel. So oil continues it climb. But gold is optional. The more food and fuel eat into discretionary income, the less money there will be for all other things. This is the relentless logic of all inflationary systems. The dead last thing to stop inflating is always food. This is when either brutal starvation enters and culls 1/3 of the population or there is a violent revolution. Any government that refuses to track the pain of food and fuel escalation while pretending there is no inflation, FALLS. To revolutionaries or a coup. The US is insisting on following a bizarre and I would suggest, CRIMINAL concept that food and fuel do not signal inflation. So they refuse to take this into account.

Here is another good email exchange from another anonymous reader:

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On Mar 11, 2008, at 11:12 PM, XYZ wrote:

Remember the banker that I told you about earlier? This is what he has to say about the 500+ $ Trillion derivative mountain. I don't understand all this ugh, but I am trying to get a handle on it. What do you make of it?
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(the banker):

That number [500+ $trillion] is highly inflated and works off of "notional" not real exposure.

For example, if I were to be in a transaction where I had fixed rate assets and a floating rate securitization tranche, I need to hedge the risk of rates going way up and me not having enough cash to pay for the deal, thus I would do a fixed for floating swap.

If my deal were $100MM, then the "notional" would be that amount. My fixed interest rate would be 3.5%, where the floating could be +/- between that amount. Every month the payment is netted, if floating rates are lower than 3.5%, I would have to pay the swap counterparty. If rates are higher, then they would pay me.

For example, if we used 3.5% for the fixed payment and floating rates were at 3.4%, then I would technically pay the fixed rate to the counterparty. (100*3.5%*31/360). They would pay me (100*3.4%*31/360). I would use their 3.4% to pay the bondholders.

Thus, the "netted" amount I would pay the swap counterparty would be 100*.1%*31/360 or $861.11.

Now, suddenly, instead of this massive $100MM number, you suddenly get down to an exposure of $861.

This is how much of the derivatives world works, whereby the "notional" amount is some huge indexed number, but the actual exposure is far less than that.

Take for example oil futures. You can take out $100bn in oil futures, yet your maximum exposure would be a very small amount of this number, whatever the delta is between the contract and spot prices at settlement. Suddenly, the $100bn number is now $200MM.

THat is why it's impossible to encapsulate derivatives into the worldwide wealth, because it has more or less nothing to do with worldwide wealth, nor will it ever be settled by worldwide wealth.

--------------------------

I wanted to understand the impossible 500 trillion sum so I asked: :

But why is there this hugely inflated "notional" value, $500+ trillion, to begin with if that sum isn't real? Do people inflate the values of their transactions? The inflation in that "notional" sum must come from somewhere.

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The banker answered:

It isn't inflation.

If you read my explanation, you'd realize where it comes from.

For example, lets say I need to sell $100MM in wheat in 6 months, I want to lock in the price today, so I enter into a contract to sell that wheat for $100MM in 6 months. Somebody, who may or may not be looking to buy wheat in 6 months, will take the opposite side of the contract.

Lets say that that person doesn't want the wheat in 6 months, but instead used the wheat contract to hedge against agriculture inflation. At 6 months the price of wheat on the open market is $106, but since the person doesn't want wheat, they settle in cash. Thus, the person who wants to sell the wheat sells it in the open market for $106MM, then pays the person who doesn't want the wheat $6MM.

Thus, what exchanged hands was far smaller than the amount of the "notional" value. Somebody still wanted to hedge exposure to $100MM in wheat and they did, that's why they used it for that amount.

Now, if somebody really wants to hedge against wheat prices *and* wants to take delivery, then they use the contract for that amount.

The notional amount is only an relative value for what you want to hedge or speculate against. Keep in mind that this is a zero-sum game, somebody wins and somebody loses, but the base of the cash transacted will always be $0 in total.

I use interest rated hedges all of the time. I also use currency hedges, which together make up a huge part of the market.

Farmers use derivatives all of the time. Hell, some even use weather derivatives these days to hedge against drought.

The Shiller index has derivatives for people who have taken risks in houses, they use derivatives to hedge against losing money.

Credit Default Swaps are derivatives that can be used to hedge against default events. For example, if I have $100MM at risk against GE that I might lose if they go bankrupt, I could buy a CDS to hedge that risk. If they default I would get paid say $5MM, but the $100MM is only used to index my total exposure, not to transact in the amount.

It's all about what you need to index against, what exposure you need to offset, but the risk inside of that exposure is much smaller than the whole exposure.

---------------------------

XYZ
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Elaine Supkis wrote:
HAHAHA. In normal times, yes.

When things go very wrong, NO. Again and again, I have watched safe derivatives suddenly turn totally toxic. Things out of whack can whack great banks. Remember Barings Bank and how it fell? Or Lloyd's of London?

No, the amount can suddenly emerge in a very nasty way which is why I showed it as a whale under a ship. All it has to do is hump upwards a bit and the ship tips and sinks. See? People also are much riskier if they feel their are protected by hedges. Farmers, for example.

Elaine
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From XYZ:

On Mar 12, 2008, at 12:19 AM, XYZ wrote:

Heh, yes. Some modern cars you have no idea you drive at 60 miles an hour unless you look at the speed meter. They are so smooth. Kids kill themselves all the time driving their parent's luxury cars. Well the banker says that the actual exposure is far less than 500 trillion. But even 1 % exposure is 5 trillions and if that implodes it is enough to kill the financial system many times over. And most likely the exposure is far more than 1 % easily enough to take out the world economy and then some.

Even without technical knowledge I have long felt things are too out of whack. I trust my intuition if nothing else and when the US is behaving like the Soviet Union did in the 1980's with all the lies and absurdities I know it cannot last for ever. It was so extremely obvious that Bush was insane when the 2000 election came about, yet I watched the media and the political spin machine build up a political persona that was the exact antithesis to what he really is all about.

I have a favourite saying, an old mariner wisdom: "When your sea chart and reality do not match - go with reality." You'd better believe there's a reef ahead. Or giant whale tipping your ship over LOL.

XYZ
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The following news stories show that this banker who wrote his analysis just this week, hopelessly misunderstands how derivatives now work and how frightful our dangers now are since the bankers and investors have foolishly tried to make derivatives bigger than the value of all things on earth. This inflation of the value of their hedges are a hazard, to say the least. And I am not alone in suggesting this. To me, there is natural logic to all systems. Mother Nature has harsh restrictions and rules concerning reality and these operate within the darker realms of money making. Anything to do with death is Her world. And I would suggest the upper limit to hedgings would be the total value of all things on earth. Once the hedgers reach this magic point, the system reverses!

This is because it CANNOT go forwards anymore. Once it passes this point, it reinforces the inflationary dynamics eating up the value of money. The more the hedgers try to outrun this force by increasing their hedgings, the faster the money is devoured by inflation. If all hedge derivatives were to reach infinity and be more valuable than everything in the universe, the Laws of the Universe will instantly turn them into NOTHING. It vanishes! This is simple: if a dollar is worth a loaf of bread and a hedge is set into motion that is a trillion times more valuable than a loaf of bread, a trillion loaves of bread won't be created.

The denomination of the dollar will be one trillionth of a loaf of bread! IE: one atom or even, just one electron. We can reduce the value of a dollar to that degree if dollars are created by electronic units produced by computers. The upper limit for paper money was reached in Germany in 1924 when 12 billion RM equalled a loaf of bread. The value of paper was greater than the sums the paper represented. Ergo: burning the paper for heat was more valuable than holding it and buying bread.

Central banks' 'Band-Aid' buys time, experts say

Most analysts said the euphoria would be short lived, since the liquidity measures don't deal directly with the complicated loans linked to U.S. mortgages that are at the root of the global troubles.

“It's more than a Band-Aid, but at the end of the day, it is treating the symptoms as opposed to the underlying problem,” said Ted Carmichael, chief economist at J.P. Morgan Securities Canada Inc. “It's not clear the central banks can fix the underlying problem.”
*snip*
While the Bank of Canada's role is minor in the co-ordinated worldwide effort, it's proportionate to Canada's money- market problems, and is an appropriate show of solidarity with the Federal Reserve, economists said.

It's the second time since December that financial markets struggling to cover their positions have forced powerful central banks to act together. Then, the banks said they were making extra short-term credit readily available to help financial institutions get through the end of the year, traditionally a time of high demand for cash.

But now, there is no year-end crunch to explain away the sudden seizing up of credit markets. Rather, growing fears about the U.S. economy and concerns about the ability of investors and financial institutions to withstand the deterioration of their balance sheets have prompted a renewed round of reluctance to lend.

Whenever an irresponsible government and banking system puts more inflationary money into the system, all the financiers and speculators rejoice. The most irresponsible thing for any government to do is to lend money at a super-low rate when inflation is raging. There is this awful drawback to this sort of dynamic: to do this, governments must punish savers. So savings fall and inflation rages. Savers, instead of holding a currency, get rid of it as fast as possible. At first, they can do this by buying gold, silver, art works and other things of 'value.' But inflation begins its cruel rule and eventually, $12 billion ends up buying a loaf of bread. Always, farmers rejoice when food becomes the main focus of inflation. All the money in a country ends up pouring into the farms.

But eventually, the farmers get hammered, too. Again, the landowners of farms charge higher and higher 'rents' so the farmers lose all the wealth they accumulate. If farmers are free and can keep the money, they are hammered by inflation in TAXES. They are taxed until the government retrieves all the money. If they are not and the government allows this to continue, we get riots, insurrections and revolutions as the city attacks the heart of the government and overthrows it. I think history is very, very clear about all this by now.

Here is yet another article about the Derivatives Beast:

Derivatives the new 'ticking bomb'
Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen

"We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

That warning was in Buffett's 2002 letter to Berkshire shareholders. He saw a future that many others chose to ignore. The Iraq war build-up was at a fever-pitch. The imagery of WMDs and a mushroom cloud fresh in his mind.

Derivatives bubble explodes five times bigger in five years

Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

****Sarbanes-Oxley increased corporate disclosures and government oversight

****Federal Reserve's cheap money policies created the subprime-housing boom

****War budgets burdened the U.S. Treasury and future entitlements programs

****Trade deficits with China and others destroyed the value of the U.S. dollar

****Oil and commodity rich nations demanding equity payments rather than debt

The derivative bubble was NOT caused by government oversight. The government sat idle while the banks inflated this thing to monstrous size. Suddenly, it began to emerge into view! The government then had to figure out how big this monster is and then, how to slay it. The bankers don't like this. This thing comes from the Outer Darkness where wealth is created magically. If it appears into view, the magic vanishes and its appearance causes it to vanish, too, along with all the money. But if the government prints money while this thing is growing and it sucks up all the money the government wants to circulate in the cities so there will not be food riots, the government MUST see how big this is!

Then there is the obvious problem that government writ can't stop food riots if the value of money drops. This is how inflation leads to depressions: to stop the hyper-inflation, the government and the banks have to stop LENDING MONEY! AAAARRRGH. And this is the whole problem: if they stop lending money, commerce collapses. Money suddenly becomes much more valuable [NOTE: banks are holding CASH now, not lending!] and a loaf of bread goes for 10¢ instead of $10 billion. The hazards of inflation should be obvious which is why all the G7 central bankers make mopey faces and talk ever-so-solemnly about the need to prevent inflation and pat themselves on the back when they prevent inflation.

Only since 1984, they did this by LYING about inflation. We just went through a long, long cycle of dropping interest rates that was TOTALLY FAKE. All things are connected and this is very connected to not only rising inflation today but also all the hidden bubbles, the biggest being the trade bubble and the derivatives bubble.

Seeking Alpha worries about deflation:

For one - long-term interest rates were already rising in the 50s and the 60s before commodities or price inflation really got going in the 70s. Contrast that with today, where interest rates have been falling precipitously for two decades.

Another thing that worries us about a comparison with the 1970s is wages. Wage inflation increased sharply in the mid- to late-1960s, from around three percent per year to seven percent and then finally 9% in 1980. Wage inflation is completely absent today, which is surely attributable to cheap labor in emerging countries and the internet.

I amended their chart, adding important information.

Inflation certainly fell after 1982. But it didn't vanish. Proof of this is how swiftly debts began to rise afterwards. From 1982 until today, the US government rang up over $8 trillion in debts. Our trade deficit went from $10 billion a year to $800 billion a year. Over $12 trillion in trade deficits. This overhang of money is a monster that feeds on its own energy systems. Just this last year, we were told, the dying dollar, namely, inflating prices here at home would lead to the US running better trade numbers. The trade deficit was supposed to vanish.

Instead, it is growing! Indeed, even though we sell food to the world and reap the benefits of farmers charging higher and higher prices for food, we import energy. And so instead of gaining ground, we are still losing ground. If other nations were in financial trouble like in the early 1970's when Russia had to run to the US farmers for food, the ruble was worthless and the dollar was protected from inflation caused by the Vietnam War. If the US didn't sell food, we would have had worse inflation but it balanced our trade somewhat. But starting back then, we began to import oil. Now, inflation is here and won't go away except if oil prices fall.

Which they did thanks to Russia again: Russia suddenly began selling energy to the world and this drove down world oil prices again. This rescued us from inflation but only temporarily.

Here is yet another chart that shows us clearly how 'off the charts' things have gotten. Stability is very important with all financial systems. Instability is dangerous.

US rate cuts will push oil up to $120

I’m still a buyer of oil at today’s price of $108 plus… In fact, I’m sticking my neck out and telling you I think that WTI contracts are going to hit $120 – and it’s going to happen soon…

It’s all down to the dollar.

The era of cheap oil is well and truly over; it is never going to return. Even Alistair Darling knows this… That’s why he postponed the scheduled fuel-duty rise in today’s budget statement as fuel inflation bites.

We NEED a fuel duty. Our government is insane to just let this pour into the US! It will NOT protect us from inflation at all. Letting in more and more oil makes inflation WORSE. For, in order to pay for this oil, we are destroying the value of the dollar. The outside world has too many dollars already and they can't 'clean' this money by giving us more loans anymore, we are too deep in debt. So this money fuels inflation. And since we have no control over our oil consumption, it continues to feed inflation and the cycle gets worse and worse as food inflation in the oil pumping nations gets worse. Eventually, this inflation within our trade partners and our oil producers will outstrip our ability to pour more dollars into these nations.

We could try to go to infinity. This is when $12 billion buys one gallon of oil. Or a trillion dollars buys one atom of oil. But instead of doing this foolish thing, we have to stop and figure out reality. There is no Santa Claus and giving ourselves billions of dollars in 'free' money in the form of government grants and central banking hand outs for useless paper CDOs, we have to reform our finances from scratch.

Often, nations and empires do this via wars, revolutions and coups.

Bernanke Playbook Gives Hints on Fed's Next Moves: Mark Gilbert

In November 2002, when Bernanke was merely a Fed governor, he gave a speech about ``Deflation: Making Sure `It' Doesn't Happen Here.'' More than five years on, the text provides a step- by-step guide to the Fed's reaction to the current credit crisis, and hints at the tricks left up the central bank's sleeve.

The speech is relevant even though two of its premises -- a general decline in consumer prices and a benchmark central-bank rate that's close to zero -- don't currently apply to the U.S. experience. Bernanke detailed the Fed's likely response once the blunt instrument of cutting borrowing costs had lost its potency to revive the economy -- which is exactly the situation the central bank finds itself in now.

``When inflation is already low and the fundamentals of the economy suddenly deteriorate, the central bank should act more preemptively and more aggressively than usual in cutting rates,'' Bernanke said. ``By moving decisively and early, the Fed may be able to prevent the economy slipping into deflation.''

I am a huge believer in the magic of money. The ruling elites feared an inflationary/depressionary cycle hammering them and possibly causing revolutions. So they deliberately chose Bernanke because he said to them, 'I am a wizard who knows the magic of preventing this from happening. I will save all of you using the powers of the Federal Reserve and the tools given to us by our ancestors who figured out fractional banking. I will save everyone by creating infinite money at 0% forever.'

Now, if I were in those meetings, I would have shouted, 'Like HELL. You are a menace to us all!' But then, I would also arrest everyone in the room for being pirates using tax havens to evade their duties to their nation. Among other things. In other words, I would be a revolutionary and they would all be tossed in the Bastille.

So we will watch this epic battle as our rulers try to inflate themselves out of the hideous deflationary cycle they, themselves, set into motion. A cycle they created because they wanted to hedge themselves from all risks while at the same time, being very risky. And Miz Risky is really the Whore of Babylon. Where our soldiers are being blown up every day. More than 12 in the last 3 days.

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