Keith Fitz-Gerald
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Derivatives: The $600 Trillion Time Bomb That's Set to Explode
Do you want to know the real reason banks aren't lending and the PIIGS have control of the barnyard in Europe?
It's because risk in the $600 trillion derivatives market isn't evening out. To the contrary, it's growing increasingly concentrated among a select few banks, especially here in the United States.
In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to a recent report from the Office of the Currency Comptroller.
The four banks in question: JPMorgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Goldman Sachs Group Inc. (NYSE: GS).
Derivatives played a crucial role in bringing down the global economy, so you would think that the world's top policymakers would have reined these things in by now – but they haven't.
Instead of attacking the problem, regulators have let it spiral out of control, and the result is a $600 trillion time bomb called the derivatives market.
Think I'm exaggerating?
The notional value of the world's derivatives actually is estimated at more than $600 trillion. Notional value, of course, is the total value of a leveraged position's assets. This distinction is necessary because when you're talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30, or, in extreme cases, 100 times greater than investments that could be funded only in cash instruments.
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world's gross domestic product (GDP) is only about $65 trillion, or roughly 10.83% of the worldwide value of the global derivatives market, according to The Economist. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble.
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One of These Banks is Europe's Lehman Bros. – And We're Going to Profit From Its Collapse
Back in July, I warned you that Europe probably had its own Lehman Bros. – an unstable financial institution on the brink of a collapse.
At the time, I didn't know exactly which institutions were most at risk.
Now I have a pretty good idea and want to share that with you.
One big firm, the Brussels-based Dexia SA, is already set to be dismantled.
And based on an analysis of 50 European banks with a combined $129 billion (92 billion euros) tied up in Greek sovereign debt, I've identified two other suspect institutions: BNP Paribas SA, and Societe Generale SA (PINK: SCGLY).
These banks have a high level of exposure to Greek sovereign debt and once they're forced to acknowledge the precariousness of their situation investors will stampede for the exits. That will have negative effects for both European and U.S. banks, as well as the overall markets. But there is a way to not only protect yourself, but turn a serious profit.
I will explain that to you shortly, but first, let me give you an idea of what it is we're dealing with.
Europe's Lehman Bros.
Basically, there are two ways to judge which banks are most at risk. You can look at how expensive the credit default swaps on these banks are compared to their peer group. And you can look at how quickly those credit default swaps have climbed.
Credit default swaps, in case you are not familiar with them, were originally created as "insurance" that protected the lender in case of a default. When they are purchased, the loan is turned into an "asset" and is then "swappable" for cash if the borrower defaults.
Generally speaking, the more expensive a credit default swap is and the faster its price has increased, the greater the risk there is associated with it.
As of Oct. 4 , the senior debt of the top 25 global banks with tradable CDS instruments was at 289 basis points. (A basis point is equal to 1/100 of a percentage point . They are commonly used to denote a rate change or, in this case, the difference or spread between two interest rates.)
However, the five-year senior credit default swaps for Societe Generale and BNP Paribas are considerably out of line with that figure – or at least they were as of Oct . 6. They've recovered since rumors of another rescue surfaced, but they're still dangerously high. Five-year senior credit default swaps were recently valued at about 386 points for Societe Generale and 287 basis points for BNP Paribas.
As for how fast the cost of insuring that debt has risen, the data is even more incriminating. Since 2009 Societe General's credit default swaps are up 294.17% and BNP Paribas credit default swaps have risen 199.60%.
This suggests two possibilities: 1) Traders are betting that the banks are substantially undercapitalized – meaning they may not have enough money to meet potential losses; or 2) They've got way too much exposure to Greek debt to withstand the country's failure.
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The Looming Bear Market: What You Can do That Washington Can't and Wall Street Won't
I just finished a battery of media appearances on Fox Business, Bloomberg, BNN and CNBC Asia, and without exception I was asked about two things: President Barack Obama's jobs bill and the U.S. Federal Reserve's "QE3."
The first thing investors and analysts alike want to know is whether or not the president's jobs bill will work. The answer to that question is "no" – not as it stands, anyway.
The second question is whether or not Fed Chairman Ben S. Bernanke will further extend the central bank to help the economy. Well, I do think the Fed will intervene, but I don't believe for a second that the central bank's intervention will help the U.S. economy.
As a result, we're likely to see stocks enter into a bear market and retest their March 2009 lows.
I know that's a terrifying thought. But to be perfectly honest, there's nothing President Obama or Bernanke can do at this point. If companies don't want to spend the $2 trillion worth of cash they're hoarding, there's very little the government can do to encourage them to loosen their purse-strings.
That said, I want to give you five specific steps to take to protect yourself from the looming bear market, preserve your sanity – and even profit.
But before I get to that, you need to understand the dangers that are fast approaching.
A Roadblock to Recovery
President Obama and Chairman Bernanke can toss all the money they want at the economy. But no amount of spending can change the fact that we need the following three things to get our market moving again. They are:
- Sustained demand.
- A solution to the European sovereign debt crisis.
- And a bottom in housing prices.
As it currently stands, the U.S. economy will be lucky to log 1% growth this year, which is even lower than the anemic 1.5% I predicted in my annual forecast in January.
That's pathetic for a nation that spent more than $1.4 trillion of borrowed money on "stimulus." This lackluster growth is also evidence that the Obama administration's $800 billion stimulus plan – and the Fed's two rounds of quantitative easing – did absolutely nothing to salvage our economy.
Citizens are scared silly. Businesses are uncertain. They're uncertain of regulatory changes, uncertain of taxes, and uncertain about their overall economic environment. So they're doing what rational people do when confronted with the unknown: They're hunkering down.
And with good reason.
The typical U.S. family got poorer during the past 10 years due to a decade-long income decline. Median household income fell to $49,995 last year, and is now 7% below where it was in 2000. The number of people living in poverty has risen to 15.1%, the highest level since the U.S. Census began tracking this information in 1959.
It should also be noted that a large portion of that decline is directly attributable to inflation, which the Fed continues to assert is "transitory."
Out of the Fire…
You may be holding out hope that the president's jobs plan will help turn things around – but it won't.
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Why Gold Will Replace U.S. Treasuries as the World's Last Risk-Free Investment
It wasn't long ago that U.S. Treasuries were considered a "risk-free" investment. But the financial crisis, hulking budget deficits, political gridlock, and the Standard & Poor's debt downgrade have changed that perception – forever .
Now there's only one safe -haven investment: gold.
Since surging to a record high $1,917.90 an ounce earlier this month, the price of gold has slipped on profit taking. But don't let that minor correction fool you into thinking gold's bull run is over. The yellow metal's best days are still ahead.
How do I know? Because, unlike U.S. debt, gold can't be downgraded. It has inherent value that's more reliable than the word of even the most powerful country on earth.
Gold was used as currency for centuries. In fact, it's still being used for transactions in places such as China, India, and much of the Middle East – regions that are eager to diversify away from the beleaguered U.S. dollar.
But now gold's also usurping the role U.S. Treasuries have played for the better part of a century – that of the ultimate investment safe haven.
Just take a look.
The World's Real Risk-Free Investment
From July 21, 2009 to mid-July of this year, the correlation between Treasuries (as represented by the iShares 20-Year Treasury Bond ETF (NYSE: TLT)) and gold (as represented by the SPDR Gold Trust ETF (NYSE: GLD)) was 0.5 – meaning that only half the movement of one coincided with the other.
However, in the period ranging from July 21, 2011 to Aug. 16, 2011, the correlation jumped by 78% to 0.89. That means gold and 20-year Treasuries are moving in near- perfect lock step.
Could Goldman Sachs Group Inc. (NYSE: GS) CEO Lloyd Blankfein Do the First "Perp Walk" of the Financial Crisis?
Lloyd Blankfein, chief executive officer of Goldman Sachs Group Inc. (NYSE: GS), has hired high-profile criminal defense lawyer Reid Weingarten.
This is a game changer even if we don't yet know where the fire is.
Blankfein has led the firm for six years and spent the past two dealing with allegations of conflicts of interest and fraud. A Senate report released in April said Goldman dumped subprime loan exposure onto unsuspecting clients during the mortgage meltdown and then in 2010 gave Congress misleading testimonials about the firm's actions.
So far, Blankfein has not been accused of any crime or crimes. That means, and I cannot stress this strongly enough, that he is innocent in the court of law – even if he is held slightly above pond scum in the court of public opinion for his and Goldman's role in causing the financial crisis.
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The European Banking System is Finally on the Verge of Collapse
I hate to sound alarmist, but it looks as though the European banking system – and consequently the global banking system – is edging its way towards another epic collapse.
That means in just a few short months, stocks could be back at their 2009 lows while gold prices travel north of $2,500 an ounce.
This is the worst-case scenario that's been bandied about ever since Europe's debt problems first came to light.
How do we know that this is what's happening?
Because somebody is having trouble obtaining the money they need — and they just borrowed it from the lender of last resort.
The European Central Bank (ECB) last week lent $500 million dollars to an undisclosed Eurozone bank through a credit mechanism that had been dormant for the past 12 months, with the exception of one $70 million draw in February.
This comes as no surprise – the warning signs have always been there.
In fact, I warned Money Morning readers just a few weeks ago that the Eurozone could have its own American International Group Inc. (NYSE: AIG) – or worse, its own Lehman Bros. Holdings Inc. (PINK: LEHMQ) – lurking somewhere in the shadows.
Still, while this may not surprise you, it certainly surprised the heck out of the rose-colored glasses crowd that can't seem to understand the European sovereign debt crisis is finally about to wash up on our shores.
That's why stocks in the United States and around the world have taken such a brutal beating recently. Officially the story is about the renewed worries over Europe's debt crisis and U.S. data that suggests we're once again sliding into a recession.
But what's really happening is that global traders are moving quickly to liquidate holdings and raise cash while they can.
That's why so-called risk assets like stocks, corporate bonds, industrial metals, oil and higher-yielding junk instruments are tanking, as gold, the dollar and the yen are bucking up.
The U.S. Federal Reserve already is engaging in damage control. President of the Federal Reserve Bank of New York William Dudley has said the risks of a double-dip recession are "quite low," despite anemic growth. And it's been rumored that U.S. Federal Reserve Chairman Ben S. Bernanke will telegraph new monetary stimulus measures Friday during his speech in Jackson Hole, WY.
But really, who are they kidding?
This crisis has nothing to do with liquidity (which is how the central bankers are trying to fight it) and everything to do with solvency (which is how they should be fighting it).
Not only are the risks of a global recession mounting by the minute, but I believe the concentration of risks is approaching critical mass.
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How You Can Beat 'The Street'
I can't tell you how many times during the ugly trading days we've seen in recent weeks that I've heard someone say that the little guy can no longer compete – that he or she can't beat "The Street' – in today's stock market.
In fact, I hear it all the time: Wall Street has rigged the game, has turned Washington into its lapdog, and only wants to separate the retail investor from his or her money.
I guess such defeatist sentiments are understandable – especially on days like Thursday when the Dow Jones Industrial Average plunges more than 419 points. But they're also misguided.
You see, while most retail investors believe that they can't beat The Street because the "little guy" is disadvantaged, I hold just the opposite view. I know you can beat The Street, and beat the Big Boys at their own game, precisely because you are the "little guy."
How do I know this? Simple. I've helped tens of thousands of investors around the world do just that.
So let's deep-six the defeatist attitude and get down to business: The person who can most help your bid to outfox Wall Street is the one who's looking back at you from the mirror every morning. Just remember:
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1) The playing field is level – even if you think it's not.
2) Small investors can be more nimble.
3) Professionals face risks that you don't have.
4) A proven portfolio approach can make you steadier than the markets.
5) You need to have the courage to participate to get started.
It's a Better Playing Field Than You Think
Yes, the B ig B oys have "dark pools," exclusive trading platforms and more computing power than at any point in recorded history. But so what?
The typical personal computer available to retail investors has more power than the entire NASA Apollo Mission profile and the data you can pull off the Internet is truly stunning.
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Four Ways to Play the Bond Market Bubble
By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning
To hear the "bond bubbleistas" tell it, the bond market is poised to collapse the second interest rates start to rise.
But if you're thinking about dumping all of your bonds, you should think again.
Yes, rates will rise – but not as fast as many analysts are forecasting. What's more, even if rates do increase, the price risk is not as bad as you might think.
That's why the more appropriate strategy is to simply reorient your bond portfolio, rather than pull out all together.
Don't get me wrong. I'm not trying to make light of the global financial crisis or our current situation, but people have been calling for an "end" to bond markets, in one form or another, for quite a long time.
Failed Forecasts
PIMCO cofounder and fund manager Bill Gross has actually done so twice, most recently dumping all government bonds in early 2011. He's since admitted he was wrong and piled back in. Granted, his business is bonds so he had to, but the point is moot.
PIMCO investors paid through the nose in lost performance, though. The PIMCO Total Return Fund was up just 3.2% as of August, trailing more than 70% of its peers and lagging the 5.6% return of its benchmark index, according to Bloomberg.
Meredith Whitney famously called for the $3 trillion muni-market Armageddon in November 2010. Her clock is about up and she's mentioning nothing about her prediction in recent appearances despite turning the bond markets upside down for months.
Even economist Nouriel Roubini has eaten crow when it comes to bonds. He called for the complete meltdown of everything we knew to be true in 2004, 2005, 2006, and 2007. And while he's since become a media darling, his predictive record is less than stunning. Journalist Charles Gasparino, who investigated Roubini's track record, noted that he couldn't find a "single investor who regularly uses his research."
My point is not that any of these incredibly smart people were wrong – everybody is wrong from time to time – just that investors risk a lot by not "risking" anything.
Let me explain.
No Substitute for Stability
Fueled by banking blunders and the European banking crisis, U.S. Treasuries have not only risen this year, they've rocketed so high that in August the benchmark 10-year yield dropped below 2% for the first time since 1950 and traded at around 1.96% yesterday (Thursday).
That means investors who hung in there despite the risks and the hype have enjoyed a nice return from bond appreciation even as they continued to reap the benefits of the yield those bonds kicked off. Those who bailed out did so prematurely and got left behind.
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