BEST OF CHRIS LAIRD

March 16, 2009

Central Banks in a "Pickle"

Now that we heard that Citi had a good quarter, which is laughable (after how much public bailout?), I bet this latest financial rally doesn't last more than two weeks. Here is why…

The US Treasury/Fed has put up $11 Trillion of bailouts and guarantees to the US and world financial system. But we don't hear virtually any specifics as to who got what. Why is that?

Derivatives Secrecy problem

That is because the world has well over $1000 trillion of derivatives out which are unregulated and deeply underwater. That is why we are not told who gets what, because if it were known how much loss is out there, we definitely would have had a world bank holiday, which has been narrowly averted two times in the last year and a half since Aug 2007.

Unregulated means unknown

Since the derivatives markets are unregulated and so huge, even the US Treasury and Fed (and anyone else interested) cannot find out who owes what, and who has lost what. If you follow the derivatives story, you see that this market grows over 15% a year…so, last year we had say $1000 Trillion of derivatives, and now this year over $1200 Trillion…

Now, the reason this market is growing like this is that most of these contracts are rolled over with new ones, and the losses are rolled over. Ok. And one reason the total grows 15% a year is that losses are carried forward if possible…among other reasons. So follow the math here…

I want to show you something. In case you don't quite understand what unregulated means: You and I can make a derivative agreement right now for $1 billion. We merely take a napkin and scribble a note which we both sign to say bet on a currency between us, and the total amount we 'wager' is $1 billion. One or both of us put up a minute amount of capital behind our bet, say $1000. And depending on how things go, we agree that if the gain/loss exceeds that, we roll it forward, but eventually will have to settle at the end. At first, all that is risked is $1000 each. But there is upside and down side of up to $1 billion total exposure (this is the notional value or amount leveraged).

In case you buy the story from derivatives makers that the notional value is not that bad, well it is that bad as it is the actual amount being leveraged, so that is a red herring excuse to say the notional value is not really that much, it IS that much.

That's all there is to it. There is no law no regulation that can stop you and me from making a $1 billion derivative contract on a napkin over a martini lunch…. See it's not regulated, these are essentially private agreements. This action (non regulated exchange) is called over the counter OTC- a private sale/agreement between just you and me and no oversight exchange involved….And as you can see, the leverage can be astronomical.

Derivatives subsumes entire financial universe since 1990

Now, take this idea in 1990 when the total derivatives market worldwide was about $20 trillion. Then, take sophisticated investors and banks institutions of all types, like GE, GMAC, Morgan, BoA, Citi, etc, AIG. And even mid sized financial companies and insurance companies and even money market funds and every type of bond market (government, corporate and muni) and add in all the world real estate market… and start securitizing everything and then… follow me here, then start the OTC derivatives between whoever wanted in the game, starting at size of $20 Trillion in 1990…

The majority of the derivatives markets are OTC (unregulated). It has grown from $20 trillion in 1990 to now $1200 trillion in notional value. That is the total amount of leverage exposure. And that is not the entire derivatives market, since commodity derivatives and such are not included in this.

Now, understand that since these are OTC, who owns what is impossible to know. The immense losses are not being revealed because of the panic the Central banks know will ensue, hence even the US Congress can't get the Fed or Treasury to reveal who got what. The only way we have averted a world bank holiday on two occasions was for the US Treasury/Fed to basically sweep all the trillions of losses so far under the rug - at a cost so far for the US alone of $11 trillion.

The point here is, with $1200 trillion of derivatives exposure out, and it being OTC mostly and thus secret, the only way for the world financial system to hold together is for the public sector to sweep the entire mess under the public domain….and as the losses continue to accumulate, more and more has to be done, yet nothing appears to improve in the overall credit markets.

Now, can you tell me how $11 trillion, which is admittedly a lot of money, will be enough to cover the mounting losses on $1200 trillion of leverage???

Clearly they cannot stay ahead of this. Can they? I don't think so.