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The “Daisy Chain” Default Problem

The lack of transparency, in dark liquidity pools and dark books, lack of the ability to evaluate counterparty strength, conflicts of interest, and the ongoing credit bubble and housing bubble bursting certainly do not bode well for the financial system or for portfolios.

Counterparty failure is not the only cause of OTC derivatives failure in the dark transactions universe.

Real world (as opposed to the darkly liquid “paper world”) economic surprises can indeed be the cause of Dark Derivatives Systemic Failure.  That is, automated (or other) trading programs based on “dark algorithms” and trading “dark liquidity” will fail because of the flaws in their design.  In other words, economic circumstances change and these changes unexpected or unanticipated by the dark trading Model Makers can result in serious losses among one group of counterparties that render the entire daisy chain susceptible to failure.

The LTCM debacle is a classic example of this.  The Model Makers failed to anticipate a major financial market development - - Russia’s default on bonds and devaluation of the Ruble.  The resulting Daisy Chain of losses nearly brought down the whole financial system.

Since OTC derivatives are typically made between two institutional counterparties, and since they often employ leverage, the default of one institutional party can create an extraordinary loss/es for its counterparty (and consequences for the entire financial system) far in excess of the probable risk which was contemplated when the transaction was entered into.

And there is the rub.  The failure of one firm has a cascading effect on countless others because of the way the risks are offset to numerous other counterparties.  Think Enron.

Indeed, the entire financial structure is only as solid as the balance sheet of the weakest link in the Dark Derivatives parties and counterparties Daisy Chain. 

Derivatives Monsters’ Magnitude

According to the Bank for International Settlements (BIS – the Central Bankers Bank) the notional amount of derivatives outstanding was about $516 trillion in June, 2007.  The term “notional value” is a slippery one but effectively means the potential maximum value of the contract.  Strictly speaking, “notional value” is the total value of a leveraged position’s underlying assets.

On the other hand, the market value is often much less because the full potential (notional) value is thought to be improbable of being reached.  Indeed, the BIS reports that some $516 trillion notional value OTC derivatives had a market value of “only “ something in excess of $11 trillion.”  Nonetheless, significant numbers of defaults of parties to the $11 trillion ostensible market value in OTC derivatives could wreak havoc on the entire financial system.

Much more important from a systemic perspective is that if one party to a derivatives contract defaults, the magnitude of that default is typically the full notional value, not “merely” the market value.  And defaults of some parties to OTC derivatives contracts are inevitable.

The Amaranth Hedge Fund’s collapse of a few months ago and the LTCM collapse of a few years ago provide a graphic demonstration of the lethality of OTC derivatives.

No Sector Immune From Derivatives Risks

As we are learning, the massive risks associated with OTC derivatives are laced throughout the financial system.  Just a few weeks ago, who would have thought that a Big Pharma company Bristol Myers Squib would have to take a quarter of a billion dollar write down as a result of its derivatives transactions.  And who would have thought they would have to give “guidance” that more write-downs might have to be made?  Thus, it is not surprising that Warren Buffett called derivatives “toxicity…financial weapons of mass destruction.”

Indeed, consider the following data on OTC derivatives creation and the troubling acceleration of their creation.

Over The Counter (OTC) Derivatives – Accelerating Creation, Increasing Risk

Consider the import of the data from the BIS' own website - - Review Table 19 at www.bis.org.  Follow the path:  Statistics>Derivatives>Table19.  Note that as of December, 2006 there were:

• $6.475 trillion commodities contracts (excluding gold) outstanding
• $40.239 trillion foreign exchange contracts outstanding
• $291.115 trillion interest rate market contracts outstanding

But consider the stunning increases in OTC Derivatives in just the six months between December, 2006 and June, 2007.  As of June, 2007 there were outstanding:

• $7.141 trillion in commodities (excluding gold) contracts, an approx. $666 billion (approx. 10%) increase in only six months
• $48.620 trillion in foreign exchange contracts, an $8.381 trillion (approx. 20%) increase in only 6 months.
• $346.937 trillion in interest rate market contracts, a $55.822 trillion (approx. 19%) increase in only 6 months

(source:  www.bis.org.  Path:  statistics>derivatives>Table19)

What is also obvious from a comparison invited by Table 19 - - comparing June, 2005 figures with June, 2007 figures - - is the increasing Systemic Threat The Cartel’s* Interventional Regime imposes (see Deepcaster’s January, 2008 Letter “Market Intervention, Data Manipulation, Increasing Risks, The Cartel End Game and Latest Forecast”).  Note also on Table 19 the dramatic jump in most categories of derivatives from June, 2005 to June, 2007.

Gold

Increases in the amounts of OTC derivatives outstanding for the Gold Market are perhaps the most stunning:

From the $359 billion outstanding at end-June 2004 they nearly tripled to $1,051 trillion at end-June 2007, an increase of approx. 290% (source:  BIS “Table A, OTC derivatives market, Triennial Central Bank Survey of Foreign Exchange and Derivatives market Activity”).

Note:  While BIS Table 19 shows a drop in OTC derivatives contracts for gold in the 6 months from the end-December 2006 figure of $640 billion to the end-June 2007 figure of $426 billion, it should be noted that the end-June 2007 number ($1.051 trillion) from the BIS Triennial Survey is a more comprehensive number, generically akin to the “upward revisions” which the U.S. BLS regularly makes.  Doubtless some substantial portion of the foregoing OTC derivatives contracts are for entirely commercial purposes, but with publicly visible Exchange-Traded derivatives also available for commercial purposes (and considering publicly traded companies take incur considerable risk by engaging in “dark liquidity” OTC transactions) it strains credulity to claim that most or all OTC contracts are for purely commercial, i.e. non-interventional, purposes.  It is clear to us that the near tripling of the derivatives contracts devoted to Gold, to over a trillion dollars in three years could have no other cause than the Fed-led Cartel* of Central Bankers need for them to suppress the Gold price.  Indeed, given the relatively small capitalization character of the Gold Market, what other cause could there be?

The Meltdowns Begin - - Quo Vadis?  Quo Vadimus?

We have already seen two negative consequences of the proliferation of OTC derivatives (Dark Liquidity) throughout the financial system.  One is the ongoing subprime default debacle and the other related one is the credit market freeze-up, which first became apparent in August, 2007.

It is not surprising that the proliferation of darkly liquid OTC derivatives should result in a credit market freeze-up.  After all, who knows, for example, whether a “package” of Collateralized Debt Obligations that a financial institution is considering buying contains some securities on which the counterparty/ies is/are about to default?

No to oversimplify too much, it is this characteristic of “darkness” that caused the credit market freeze-up of August, 2007.  No one wants to lend because they do not trust each other’s books or what is even worse, they do not understand what is on the books!  Very few understand these things since they are all based on computer models, dark algorithms and assumptions, but that is the very thing that works to kill confidence when no one can understand who has what.  The consequence:  lending institutions do not want to lend because they cannot get a clear handle on the strength of the balance sheet of the firm they might be lending to.

The response of the U.S. Federal Reserve (a privately owned for-profit entity) has been to increasingly liquefy the banking system by providing even more (borrowed) liquidity via a discount window and reducing rates.

But there are great systemic perils which arise from creating “borrowed liquidity” (the approach preferred by The Fed) versus the healthier “earned liquidity” (e.g. savings) on which Deepcaster has commented in his January, 2008 Letter “Market Intervention, Data Manipulation, Increasing Risks, The Cartel End Game, and Latest Forecast” and in “Profiting From Dark Liquidity and Other Systemic Risks (4/8/07 Alert at www.deepcaster.com).

The core of the systemic problem and increasing risk is that beginning after the Tech Wreck of 2000, the Fed-led Cartel* of Central Bankers created and allowed far too much borrowed liquidity (i.e. debt) to be created, creating the credit bubble and the mortgage bubble.  And this excess liquidity creation continues to this day - - M3 is increasing at more than 15% per year, about a 5 year doubling time, according to shadowstats.com!

The realities of the marketplace are causing these bubbles now to be in the process of being punctured, resulting in increasingly negative consequences and increasing systemic risk for the financial markets and the broader economy, as well.

Object Lessons - - A Harbinger for the Future

“But for systemic intervention and manipulation by the Federal Reserve, it appears we might be contemplating a collapsed U.S. banking system and a looming deflationary great depression that could have dwarfed the bad times of the 1930s.  Such is the good news.  The bad news is that with those same systemic interventions, the Fed is locking in a hyperinflationary great depression in the decade ahead, with the turmoil possibly breaking by 2010 or earlier.”  (emphasis added)

shadowstats.com, Issue Number 39, January 2008

“The mounting evidence is that the Fed-led Cartel is knowingly creating conditions designed to force the U.S. to eventually have to choose between a hyperinflationary great depression and The Cartel’s ominous “End Game” which Deepcaster has described in its January, 2008 Letter.

Deepcaster, February 14, 2008

Let us conclude by examining some examples which threaten the financial system as a whole.

The Bond Sector

Consider one Sector - - The Bond Sector.  This Sector reveals that the damage to institutions built on “collapsing paper” has only just begun. If not contained, this damage could spread throughout the entire Financial System.

There are about $10.4 trillion of dollar-denominated bonds of which $7 trillion are prime AAA and $1.4 trillion are subprime BBB.  Of these, the prime bonds are projected to lose 30% of their market value or about $2.1 trillion, the subprime to lose 80% of their value or about $1.1 trillion and the ALT-As to lose another $1 trillion, according to Jim Willie.  From the beginning of the subprime crisis, the total value of bond losses is expected to be about $4.2 trillion!

One of the many negative consequences of these losses is that financial institutions (holding these bonds in their portfolios) are forced to make asset write-downs, which reduce reserves.  In addition, when reserves are already being destroyed by loan defaults, and when the reserve defaults are magnified by the fractional reserve system, the problems are compounded.

Two methods for maintaining reserves are going to the Fed’s discount window and/or calling in loans.  But employing these methods creates some negative consequences for consumers and for the entire financial system.  Depleted reserves are one reason we already hear that some bankers intend not to allow additional draws from Home Equity Lines of Credit, and why some credit card companies are talking about increasing rates or calling in their loans.  And further bank borrowing exacerbates the “borrowed liquidity” problem which Deepcaster has demonstrated is “A Cure Worse Than the Disease” (see Deepcaster’s January 2008 Letter at www.deepcaster.com).

Thus, for financial institutions holding large chunks of what is now considered “junk paper” institutional failure is a real possibility.  And many of these institutions can forget about a Warren Buffett riding to the rescue.  (Buffet’s offer to provide reinsurance to certain monoline bond insurers, thereby guaranteeing the ratings of some of their insureds, extended only to their municipal bond portfolios, not to corporate bonds.)

Worse yet, the list of municipal bond auction failures is growing.  Increasing numbers of municipalities cannot get funding   for schools, hospitals, and roads, etc.  The Fed’s favored Primary Dealers claim they cannot lend any more due to heightened risks which were generated by, and reflected in, the famous August, 2007 credit freeze-up.  But these are the same Dealers who have gotten rich gouging the municipalities in better days.  Clearly, it is likely there will be more problems coming in this financial sector.

Following the aforementioned causal thread reveals only one road to a seriously impaired market sector.  Unfortunately, there are several others.

The Entire Financial System

Now in light of the above consider overall health of the financial system.  Recent Bank for International Settlements (BIS - the Central Bankers Bank) data releases reveal some $516 trillion (notional value - - see above) in OTC (Over-the-Counter) Derivatives outstanding as of June, 2007.  Consider also that OTC Derivatives constitute highly risky “Dark Liquidity” for the several reasons set out in Deepcaster’s April 8, 2007 Alert entitled “Profiting From Dark Liquidity and Other Systemic Risks.”  Exchange-Traded Derivatives by contrast are relatively transparent and are typically less risky because a clearinghouse often guarantees their performance.  Not so with OTC derivatives.

Deepcaster has laid out the evidence, on several occasions, that a substantial chunk of the multi-trillion in OTC derivatives outstanding are available for, and used for, market manipulation by The Fed-led Cartel* in various multi-trillion-dollar tranches.

But it is important to reiterate that there are at least three major problems flowing from this mountain of toxic OTC derivatives weapons of financial mass destruction.

First, as indicated above, they constitute “Dark Liquidity” transactions in which the “outside world” (and indeed, sometimes one party to the derivatives contract) may not fully know the strength or weakness of their counterparty/ies.  And, typically, entities other than the parties and counterparties know little or nothing of those derivatives and their risks, other than, perhaps, that they exist.

The key implication is that these derivatives’ darkly liquid character often makes attributing a “market value” to them an exercise in mythmaking.

It also makes putatively “safe” investments in “Safe Haven” sectors, for example, in a “Big Pharma” company, not so safe after all.  Who could have known that Bristol Myers Squibb had derivatives losses until they announced a quarter billion dollar write down recently?  And Bristol indicated there might be more such losses to come.  So much for Big Pharma as a “safe haven.”   Indeed, so much for other traditional “safe havens” which the OTC derivatives disease has infected.

Second, OTC Derivatives creation has been accelerating at an increasing rate.  To accommodate increasing financial sector imbalances (created largely by their own flawed policies) The Fed-led Cartel* has had to accelerate derivatives creation at increasing rates (see Deepcaster’s January, 2008 Letter “Market Intervention, Data Manipulation, Increasing Risks, The Cartel End Game, and Latest Forecast” at www.deepcaster.com).  This manifests an increasing reliance on (and thus increasing risk from) OTC derivatives as a means of market stabilization, as well as Intervention.

The third problem has to do with the slippery term “Notional Value” discussed above.  The apologists as it were, for massive derivatives creation (i.e. typically, those who understate the risks) claim that Notional Value is not Market Value.  And since market values are so much less than notional values, they claim the overall risk is correspondingly less.  That is true to a point.

But the “market value” of the $346 trillion plus in Notional Value Interest Rate Contracts reported by the BIS (06/07), for example, is nonetheless some $6 trillion.  A pretty hefty “real” market value, with potentially great impact if a significant portion default.

The Achilles Heel of OTC Derivatives

But there is an even more significant consideration we reiterate for emphasis; typically, upon default of one counterparty to an OTC derivative contract the notional value becomes the full value of the loss!

And when that Notional Value becomes full value due to one counterparty default (and of course we are seeing an increasing number of counterparty defaults - - even the Big Media occasionally covers them) the negative “ripple effect” on the primary party and his other counterparties, increases the likelihood of massive losses and dislocations system wide.  And the first recent realization of that phenomenon was in the subprime default-generated-credit-market-freeze-up of August, 2007.

The practical consequence of the foregoing is that The Systemic Meltdown Threat becomes ever greater, as OTC Derivatives Creation accelerates.

No Salvation from the U.S. Economy

One important consideration:  if the Threat were “only” one of such companies (whose businesses are built on, or involve, derivatives - paper) collapsing, perhaps the strength of the underlying “Tangible Sectors” (i.e. manufacturing, agricultural and related) of the U.S. economy could serve as a buttress against broad-based damage suffered as a result of “paper” based companies collapsing.

However, the U.S. economy has been dramatically weakened in recent years by outsourcing, globalization, gutting of the manufacturing base and particularly by The Fed’s profligate increases in money supply and credit availability beginning in 2001.  Thus, as a consequence, the role of the U.S. as the driver of the World Economy and the U.S. Dollar as the World’s Reserve Currency is likely coming to an end as is the prosperity and, indeed, the very existence of the U.S. middle class.

Consider Paul Craig Roberts’ (former Under Secretary of the Treasury under President Reagan) view of the health of the U.S. Economy:

“It is difficult to know where Bush has accomplished the most destruction, the Iraqi economy or the U.S. economy.

In the current issue of Manufacturing & Technology News, Washington economist Charles McMillion observes that seven years of Bush has seen the federal debt increase by two-thirds while U.S. household debt doubled.

This massive Keynesian stimulus produced pitiful economic results.  Median real income has declined.  The labor force participation rate has declined.  Job growth has been pathetic, with 28% of the new jobs being in the government sector.  All the new private sector jobs are accounted for by private education and health care bureaucracies, bars and restaurants.  Three and a quarter million manufacturing jobs and half a million supervisory jobs were lost.  The number of manufacturing jobs has fallen to the level of 65 years ago.

          This is the profile of a third world economy.”

      “The Dollar’s Reserve Currency Role is Drawing to an End,” vdare.com, January 25, 2008

Of course, the United States has been brought to this sad pass primarily by the policies of The Federal Reserve coupled with globalists who have pushed the United States into NAFTA, CAFTA, and other U.S.-economy-destroying and middle-class-destroying agreements.

Deepcaster asks:  how can so-called “free” trade agreements be fair to the American workers (or to U.S domestic businesses) if it means they have to compete with the wages (and production costs) of workers (and businesses) in countries in which wage rates (and production costs) are a tenth or less than those in the United States?  In sum, our view is that “fair trade” is more conducive to economic health than ostensibly “free” trade.

A far healthier U.S. economy existed in the 1950s when the United States was more self-reliant, less globally entangled, much less indebted, and had its own domestic market as its largest market, by far.

Again, consider Paul Craig Roberts’ view:

“Economists have romanticized globalism, taking delight in the myriad of foreign components in U.S. brand name products.  This is fine for a country whose trade is in balance or whose currency has the reserve currency role.  It is a terrible dependency for a country such as the U.S. that has been busy at work off shoring its economy while destroying the exchange value of its currency.”

The Future -  - Darkly Liquid Derivatives Destructive Ripple Effects

Indeed, the Markets have already begun to experience, and will continue to experience, what Deepcaster calls The ‘Darkly Liquid (i.e. OTC) Derivatives Destructive Ripple Effect.’

A Prime Example

To oversimplify only a bit:  In the Summer 2007 upward interest rate resets of not just subprime mortgages, but also other home mortgage categories such as Prime (AAA), and Alt.-A began to cause an increase in the mortgage default rate.

But the problem then was (and still is) that many of those loans had been bundled together in ‘packages’ to institutional investors.  In turn, these packages may or may not have been resold to other investors, in what becomes a ‘Daisy Chain.’

Many of these packages were ‘constructed’ in the legal form of derivatives known as Mortgage Bonds.

But the key point is that most of these packages had, and still have, ‘darkly liquid’ characteristics (see above).  These characteristics raise perfectly legitimate questions such as:  who knows what is in the packages?  Who knows how many more defaults are ABOUT to occur in these packages, but have not yet?

Zero Market Value Derivatives (ZMVs)

Thus, the credit markets experienced their August, 2007 freeze-up, predictably.  Who wants to buy or sell these darkly liquid instruments when no one knows what is in them?  And since in principle there is no public market for such dark liquidity instruments, the “market value” fell to, well, zero, in many cases.  And, in fact, many of those instruments which can not be marketed today have, de facto, zero market value.  Deepcaster names those “ZMV” derivatives.

Result:  Prime, Alt-A, and Subprime Mortgage Bonds are looking at multi-trillion dollar losses.  Worse, the industry does not acknowledge the magnitude of these losses, nor does the complicit Big Media report them.

But the Bad News Does Not Stop There!

Banks and other institutions holding these bonds have had to, and will continue to have to, write down the value of their portfolios which, in the Banks’ for example has, and will continue to, cause them to have difficulty (if not the impossibility) in meeting their reserve requirements.

[The Fed acted to temporarily ease this problem by opening the Discount Window via a Term Auction Facility (TAF) whereby Banks can borrow reserves, as it were.  But this creates even more borrowed liquidity (as opposed to earned liquidity) which Deepcaster has characterized as ‘The Cure Worse Than the Disease’ - - a phenomenon fully explained in Deepcaster’s January 2008 Letter.]

Many of these Bonds had their AAA ratings insured (guaranteed) by the so-called Monoline Insurers.  But now these Bond Insurers are facing liabilities of billions, and possible bankruptcy resulting from the losses in ‘market value’ of the Bonds.

And of the consequent several bad results is that with the aforementioned ratings, and thus ratings insurers, failures, the Municipal Bond Market (and other Bond Market Sectors) are becoming increasingly frozen.

The New York Port Authority, for example, could not get sufficient purchasers of their Bond Offering recently, and thus the Offering failed!

Indeed, the number of failed Municipal Bond Auctions has risen dramatically in recent weeks!

In sum, one brilliant commentator summarizes The (Private, For-Profit) Fed’s role at the center of this Derivatives Disaster:

“It seems as if, more and more, the banks are dumping those worthless CDO’s, SIV’s, and the rest of the alphabet soup trash they have right into the lap of the Fed which is in essence, monetizing them.  It is beyond obscene what is taking place when we stop to consider what has happened.  The greedy ******** that infest Wall Street have created mountains of this worthless junk which served to initially enrich themselves by inflating their profits on paper and allowing stock prices to rise along with fat-cat corporate bonuses and other perks.  Then the bottom fell out and they had no one to sell them to so they turn around and get to dump this **** on the Fed which creates more money out of air to pay for them.  What an amazing corrupt scam….”

          Anonymous, February 18, 2008

A Systemic Solution

Please note first that Derivatives Per Se Are Not Inherently Toxic.

Indeed, Exchange-Traded, Clearinghouse guaranteed, Publicly Marketed, Transparently Visible (as opposed to darkly liquid OTC) derivatives play a very valuable role in our financial and commodities markets!

But if the system is to be saved from collapse, the elimination of some kinds of OTC Derivatives, and the strict and publicly visible regulation of others, is essential.

Also essential to prevent eventual systemic collapse, whether through an eventual hyperinflationary depression, or otherwise, is the re-linking of fiat currencies to Gold and Silver, i.e. to Real Money, and not just to some other Fiat Paper.

Such re-linking could prevent the “Collapsing Paper Derivatives Problem,” which if allowed to continue could be both the catalyst and partial cause of a Climacteric Systemic Collapse.

An Approach to Protecting and Profiting for Individual Investors

It certainly seems that the lack of transparency in dark pools and dark books, lack of ability to evaluate counterparty strength, conflicts of interest, and the continuing stagflation and impending credit bubble bursts certainly do not bode well for the future or for portfolios, unless one implements an approach such as the following which addresses these issues.

So how does one protect from and profit in spite of these risks?  This poses a considerable challenge.  A significant focus of Deepcaster’s Letters and Alerts is aimed at answering these questions.  But the following observations may provide some partial answers:

1)     Keep a significant portion of your wealth in tangible assets including Precious Monetary Metals (in amounts subject to timing considerations) and Strategic (e.g. Crude Oil) and select agricultural commodities which the public needs and regularly uses.  Deepcaster has identified certain of these assets and addresses the timing considerations in his recent Letters and Alerts.

Even though The Cartel may manipulate the prices of these tangible assets down from time to time, in the long run one will be rewarded for owning them, if they are in great demand and that demand is relatively inelastic.

2)     Attempt to make, although it may be very difficult, an evaluation of counterparty strength.  Regarding options, for example, are they clearinghouse guaranteed?  And how strong is the clearinghouse?

3)     “Go local” in banking, and commercial, and essential goods supply relationships.  “Self reliance” and “local reliance” are key goals. 

4)     Develop an investing and trading regime for certain key tangible assets markets to minimize or avoid the impact of Cartel-initiated takedowns.  In this connection, Deepcaster has developed an approach for investing and trading in the Precious Metals Markets described in its April, 2007 Letter at www.deepcaster.com.

5)     Stay informed about the currently ongoing implementation of “The Cartel End Game” as described in Deepcaster’s August 11, 2006 Alert and June, 2007 Letter at www.deepcaster.com.

6)     Push for transparency.

7)     Insist regulators provide oversight.

8)     Stay informed.  Given the rapidity, magnitude, and increasing significance of “dark liquidity” transactions, failure to stay informed can be lethal.  But, since the transactions are “dark” staying informed is difficult, to say the least.  And that is a primary challenge.

Deepcaster

February 29, 2008

DEEPCASTER LLC

www.deepcaster.com

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-- Posted Friday, 29 February 2008 | Digg This Article