Derivatives the new 'ticking bomb'

Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen

By Paul B. Farrell, MarketWatch

Last update: 7:31 p.m. EDT March 10, 2008

ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe Berkshire should be a fortress of financial strength" wrote Warren Buffett. That was five years before the subprime-credit meltdown.

"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.

Also fresh on Buffett's mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared with the hundreds of billions of dollars of subprime-credit write-offs now making Wall Street's big shots look like amateurs.

Buffett tried to sell off Gen Re's derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a "financial weapon of mass destruction." That was 2002.

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:

1. Sarbanes-Oxley increased corporate disclosures and government oversight
2. Federal Reserve's cheap money policies created the subprime-housing boom
3. War budgets burdened the U.S. Treasury and future entitlements programs
4. Trade deficits with China and others destroyed the value of the U.S. dollar
5. Oil and commodity rich nations demanding equity payments rather than debt

In short, despite Buffett's clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.

Data on the five-fold growth of derivatives to $516 trillion in five years comes from the most recent survey by the Bank of International Settlements, the world's clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier's window at a racetrack or casino, where you'd place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:

• U.S. annual gross domestic product is about $15 trillion
• U.S. money supply is also about $15 trillion
• Current proposed U.S. federal budget is $3 trillion
• U.S. government's maximum legal debt is $9 trillion
• U.S. mutual fund companies manage about $12 trillion
• World's GDPs for all nations is approximately $50 trillion
• Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
• Total value of the world's real estate is estimated at about $75 trillion
• Total value of world's stock and bond markets is more than $100 trillion
• BIS valuation of world's derivatives back in 2002 was about $100 trillion
• BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes "transactions in which a major private dealer (bank) is involved on at least one side of the transaction," but doesn't include private deals between two "non-reporting entities." They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion "notional" value (maximum in case of a meltdown) of the deals is a good measure of the market's size, the 2007 BIS study notes that the $11 trillion "gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets."

Bubbles, domino effects and the 'bad 2%'

However, while that may be true as far as the parties to an individual deal, there are broader risks to the world's economies. Remember back in 1998 when LTCM's little $5 billion loss nearly brought down the world's banking system. That "domino effect" is now repeating many times over, straining the world's monetary, economic and political system as the subprime housing mess metastasizes, taking the U.S. stock market and the world economy down with it.

This cascading "domino effect" was brilliantly described in "The $300 Trillion Time Bomb: If Buffett can't figure out derivatives, can anybody?" published early last year in Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger's $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded:

"There's nothing intrinsically scary about derivatives, except when the bad 2% blow up."

Unfortunately, that "bad 2%" did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was "contained."

Bottom line: Little things leverage a heck of a big wallop. It only takes a little spark from a "bad 2% deal" to ignite this $516 trillion weapon of mass destruction. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile. It's only a matter of time.

World's newest and biggest 'black market'

The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.

Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.

BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic "shadow banking system" that has become the world's biggest "black market."

That's crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don't. They're not "real money." They're paper promises closer to "Monopoly" money than real U.S. dollars.

And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.

Comments? Yes, we want to hear your thoughts. Tell us what you think about derivatives: as "financial weapons of mass destruction;" as a "shadow banking system;" as a "black market;" as the next big bubble dangerously exposing us to that unpredictable "bad 2%."

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Good article. It was about 10 years ago that Nick Guarino of the Wall Street Underground was issuing similar warnings about derivatives. For that reason I'm putting as much of my assets into gold as possible. Derivatives, of course, can work out w...

- TraderTerry

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Very interesting comments, they are too. But BEWARE! If you never traded precious metals before, NOW is not the time to start. And never believe Warren Buffet, he ain't looking out for YOUR interests .. that said, have a read.

GEAB N°22 is available! Global systemic crisis / September 2008 - Phase of collapse of US real economy

- Public announcement GEAB N°22 (February 16, 2008) -

According to LEAP/E2020, the end of the third quarter of 2008 will be marked by a new tipping point in the unfolding of the global systemic crisis. At that time indeed, the cumulated impact of the various sequences of the crisis (see table below) will reach its maximum strength and affect decisively the very heart of the systems concerned, on the frontline of which the United States, epicentre of the current crisis. In the United States, this new tipping point will translate into a collapse of the real economy, final socio-economic stage of the serial bursting of the housing and financial bubbles (1) and of the pursuance of the US dollar fall. The collapse of US real economy means the virtual freeze of the American economic machinery: private and public bankruptcies in large numbers, companies and public services closing down massively (2),...

A revealing harbinger: from March 2008 onward, the US government will cease to publish its economic indicators due to budget restrictions (3). Those who read the GEAB N°2 (02/2006) and included Alert certainly keep in mind our anticipation which connected the upcoming fall of the US dollar with the US Fed's decision to cease publishing the M3 indicator. This new decision is another clear sign that US leaders are now anticipating a very bleak economic outlook for their country.

Time perspective of the seven sequences of the impact phase of the global systemic crisis as anticipated since mid-2007 - Source LEAP/E2020, GEAB N°18 (10/2007)

In this 22nd issue of the GEAB, LEAP/E2020's experts try in particular to anticipate very specifically what will come out of the collapse of the US real economy for the United States themselves and for the other regions of the world. Meanwhile our team presents five sets of strategic and operational recommendations helping to protect oneself from the upcoming deterioration of the global systemic crisis.

On the occasion of the second anniversary of the publication of our famous “Global systemic crisis Alert” which toured the world in February 2006 (4), LEAP/E2020 wishes to remind that we are now resolutely stepping into an era with no historical precedent. Our researchers insisted on that many times in the last two years: any comparison with the previous crises of our modern economy would be fallacious. It is neither a “remake” of the 1929 crisis nor a repetition of the 1970s oil crises or 1987 stock market crisis. It is truly a global systemic crisis, that is to say a crisis affecting the entire planet and questioning the very foundations of the international system upon which the world was organised in the last decades.

According to LEAP/E2020, it is also instructive to observe that, two years after the release of this « Alert » which at the time generated both the interest of millions of readers worldwide and the condescending irony of most « experts » and « managers » of the economic and financial spheres, everyone is now convinced that a crisis is truly happening, that it is really global, and for most people already that it could indeed be systemic. However, it is always a repeated astonishment for our team to see the degree of incapacity of these same experts and managers in understanding the specific nature of the phenomenon currently unfolding. According to them, this crisis would only be a usual crisis but bigger. As a matter of fact that's how the financial media reflect the dominant interpretations of the ongoing crisis. According to our team, this approach is not only intellectually lazy (5), it is also morally guilty, because it has for a main consequence to prevent their readers (whether they are simple citizens, private investors or public or private organisation managers) from preparing for the upcoming shocks (6).

For this reason, in opposition to all what can be read in the mainstream media always eager to conceal the truth and serve the interests of those who rule them, LEAP/E2020 wishes to remind that it is first and foremost in the United States that the systemic crisis is taking an unprecedented shape (the « Very Great US Depression » as our team decided to call it in January 2007 (7)) because it is around this country, and this country alone, that the world got progressively organised after the second World War. The various issues of the GEAB extensively described this situation. In short, it appears to be useful to make clear that neither Europe nor Asia have a negative saving rate, a full-scale housing crisis throwing millions of citizens out of their homes, a free-falling currency, abysmal public and trade deficits, an economic recession and, on top of all this, a number of costly wars to finance.

Neither Asia nor Europe (or more precisely ‘nor the Eurozone') will suffer the roughest, the most sustainable and the most negative impact of the ongoing crisis; but the United States will, as well as all the countries/economies strongly linked to the US (what our experts have decided to call “the American risk”) (8). A “decoupling” is indeed taking place between the US economy and the other large regions of the world. But “decoupling” does not mean “independence” and it is clear that, as anticipated by LEAP/E2020 for many months, Asia and Europe will be affected by the crisis. But « decoupling » entails that the evolution of the US economy and of the other large regions of the world are no longer synchronised, that Asia and Europe are now moving along courses no longer determined by the US economy.

The global systemic crisis is in fact the beginning of an economic « decoupling » between the US and the rest of the world, knowing that the non « decoupled » economies will be dragged down the US negative spiral.

US Self-Employment in a Steep Downturn - Source Bureau of Labor Statistics / Merril Lynch (shaded region represents period of US recession)

The cases of the housing (2006) and financial (2007) bubble-bursting are eloquent. Indeed, the large majority of operators (non-specialised in the concerned sector) discovered that « the party was over » a long time after the trend had reversed. During the entire reversal period (which usually lasts between 6 to 12 months at most), dominant stances kept repeating them that nothing was changing and that emerging worries had no reason to be; and later, that the problems would remain confined to the sector concerned and to the US only. All those who, in the US and elsewhere, listened to these arguments are bitterly regretful now that they are stuck with unmarketable houses (or about to be foreclosed) or now that they see the value of their assets crumble day after day (9).

Concerning stock markets, our team has anticipated since October 2007 that international stocks would plummet by 20 to 60 percent according to the region in the course of the year 2008. Today, we must re-evaluate our anticipations as we estimate that losses will be even greater than that. Indeed, on the one hand, stock markets have already lost between 10 and 20 percent since the beginning of the year (10), and, on the other hand, the collapse of the real economy in the US by the end of Summer 2008 will drag down all stock markets. According to LEAP/E2020, international stock markets will probably drop by 50 percent in average compared to 2007 (including in the emerging countries) (11).

This sort of re-evaluation is typical of the work of anticipation carried by LEAP/E2020. Month after month we try to distinguish which trends are growing and which are relenting in order to improve the accuracy of our evaluations. We do not strive to “be right” (12), not to “sell” or “promote” anything. We seek simply and without prejudice to describe in advance the consequences of the heavy trends at play in this 21st-century world, and to share with our readers what we think are the proper means to protect oneself from the most negative effects.

In this 22nd issue of the Global Europe Anticipation Bulletin, with the alert we sound about a collapse of US real economy from September 2008 onward, we are trying again to warn those concerned that this major event will generate many very severe socio-political troubles in the United States (13) whose economy is truly on a tumbling course (14), a situation extremely likely to entail very heavy consequences for the financial and monetary markets, and for the world's economy. We have not yet reached the heart of the crisis. According to LEAP/E2020, we will be there in the second semester of 2008.

----------
Notes:

(1) A very instructive film was recently nominated at the Sundance Film Festival: I.O.U.S.A., directed by Patrick Creadon. As it follows the journey of David Walker, US Comptroller General (and therefore responsible for controlling federal public spending), during a series of conferences on the state of public expenditures throughout the country, this film shows the very direct impact of the current crisis on American citizens and the United States. The release of this film illustrates the fact that, in just a few months time, this crisis left the mere circles of experts and boardrooms of financial institutions to enter into the daily life of the US citizens.

(2) In the past few days, the complete collapse of Municipal bonds (or « Munis ») illustrates the fact that the crisis is spreading to all the sectors of the US society. This collapse will freeze all public investment projects scheduled by local authorities in the US. It is one of the first big victims of the implosion of « bonds insurers » announced by LEAP/E2020 in the GEAB N°19. It also demonstrates the fact that large banks are now incapable of playing their role of financers of the country's economic activity. Sources: Financial Times, 02/13/2008 & Bloomberg, 02/14/2008

(3) Source: EconomicIndicators.Gov, Economics & Statistics Administration, US Department of Commerce

(4) See GEAB N°2, 02/15/2006

(5) The first reason that may prevent those « experts » to conceive the « unconceivable », is not a matter of intelligence but a « commercial » problem. Indeed it would compel them to review most of their intellectual principles (their work hypotheses) and their business base (their « clients » would not appreciate to learn that they were on the wrong track all these years).

(6) On this subject, it is worth noticing the very straightforward speech made by the head of the Bank of England, Mervyn King, who recently warned his fellow citizens that the current crisis would downgrade significantly their living standards. Unfortunately, no US leader, including among the Democrats, is able to produce such a speech, knowing that their fellow citizens are hit even harder than the British. Source: The Telegraph, 02/14/2008.

(7) See GEAB N°11, 01/15/2007.

(8) In this 22nd issue of the GEAB, the LEAP/E2020 team gives a set of recommendations helping investors to assess themselves the « American risk » of a country, sector or investment.

(9) The same goes for all those who chose to listen to similar arguments telling them, along the years 2006 and 2007, that it was impossible for the EURUSD exchange rate to go above 1.30, then 1.40, and now 1.50… while waiting 1.70 at the end of the year 2008.

(10) Only « dream merchants » can still imagine that stock markets could improve by the end of the year, while the crisis is speeding up.

(11) It is worth reminding that in January 2008, in just a month, global stock markets saw USD 5,200 billion-worth go up in smoke. Source: China Daily News, 02/10/2008

(12) Even if our anticipations undeniably proved to be right in the past two years concerning the global systemic crisis.

(13) See ‘Sequence 6 : 2nd quarter 2007 – 4th quarter 2009 : « Very Great Depression » in the US, social unrest and growing influence of the army on public management, GEAB N°18, 10/15/2007

(14) Predictions about the failure of dozens of US banks in the coming two years illustrate the scope of upcoming difficulties. Source: Reuters, 02/01/2008

Samedi 16 Février 2008

In the same category:

Global economy in stagflation: Recessflation in the US, soft growth in Europe, recession (3rd quarter 2007 – 2nd quarter 2009) - 05/02/2008

Value of international academic degrees: How to choose today an international degree that will still be worth something in ten to twenty years? - 28/01/2008

Main characteristics and consequences of this US economic recession - 08/01/2008

Special offer! Each new subscriber gets Special Edition 'GEAB/SUBPRIME CRISIS: Causes, development, consequences and strategic advice'... because an in-depth understanding is required to secure oneself - 12/08/2007

GEAB Archives Offer (1) - Six archive issues of your choice for 50 euros - 22/01/2007

Dollar crisis / Euro above 1.30 USD: A message from Franck Biancheri, Director of research at LEAP/E2020 - 27/11/2006

French prospectivist, Pierre Gonod, analyses LEAP's work of anticipation - 30/08/2006

Sibelgate: Just a bit of digging today

http://www.usenet.com/newsgroups/sci.med.diseases.lyme/msg02226.html

This is how US intelligence gets compromised.

Give us all a break - it ain't the Valerie Plames and Sibel Edmonds that create the problems!!

Berkshire makes play for troubled firms' muni risk

Buffett says plan would make bond debt AAA again; CDOs aren't included

NEW YORK (MarketWatch) -- Warren Buffett's Berkshire Hathaway on Tuesday came off the sidelines in the mortgage-market crisis, unveiling a plan to take on $800 billion of liability in municipal bonds currently insured by three troubled firms.

The undertaking would represent Buffett's biggest, and boldest, foray into the bond insurance business to date, and it stands to earn billions of dollars if successful.

Shares of some bond insurers initially gained ground on the news, lifting the broader market on hopes the plan will relieve one of the main pressure points in the current credit crisis. MBIA and Ambac shares, however, lost ground at last check, with MBIA down $1.61, or 12%, at $11.97 and Ambac off $1.38, or 13% , at $9.10.

In recent weeks, state insurance regulators in New York intensified talks with large financial firms in hopes of cobbling together a lifeline to assist the struggling bond-insurance industry. Berkshire Hathaway has begun to insure muni bonds in New York after getting a license quickly from the state Insurance Department.

And in January, the National Association of Insurance Commissioners said that it's working with Berkshire to help it expand quickly and operate in multiple states.

Buffett, the chairman of Berkshire, said that last week his firm offered to take on $800 billion worth of municipal bond risks currently covered by three of the world's largest bond insurers.

Speaking on CNBC, Buffett said the firm made the offer to Ambac Financial
(ABK:

Buffett said that under the proposal, Berkshire would assume the liability for the bonds in exchange for a payment from the current insurers of 1.5 times the premium they're currently receiving.

He said one firm has rejected the offer, and the other two have not yet responded.

Buffett's offer would cover municipal bonds but not the billions of dollars worth of complex securities known as collateralized debt obligations that Ambac, MBIA and FGIC have also guaranteed.

"We're doing this to make money," Buffett told CNBC, adding, "The world would know $800 billion in tax exempt bonds are AAA again."

Some observers questioned whether Buffett's plan will be enough to help the bond insurers because it excludes CDOs.

"Buffett's muni-reinsurance offer will provide some cash, but not address the core problem which is structured finance exposures," Egan Jones Ratings, a rating agency, wrote in a note to investors.

Bond insurers have been hit hard by the mortgage crisis. There's now concern that they'll have to pay big claims on guarantees they sold on mortgage-backed securities and CDOs.

Several bond insurers have already begun to lose AAA ratings, imperiling their business models. A more worrying consideration is that, when a bond insurer is downgraded, all the securities it has guaranteed are, in theory, downgraded as well. These companies have guaranteed more than $1 trillion of muni bonds, which could also lose AAA ratings.

Bailout possibilities

Concerns about the wider impact of trouble in the $2.4 trillion bond insurance business have encouraged some regulators to begin working on possible bailouts of specific companies. The New York Insurance Department, headed by Eric Dinallo, is urging big banks that are counterparties to the bond insurers to inject fresh capital into the companies and has hired boutique investment bank Perella Weinberg to advise on the plans. See full story.

Some bond insurers, such as MBIA, have been trying to keep their top ratings by raising new capital.

Buffett said that if bond insurers accepted his offer, which would likely pay off handsomely for Berkshire, the companies would free up capital and relieve pressure on their credit ratings.

The plan could help stabilize the muni bond market, an important source of financing for local governments and school districts that has begun to creak in recent months.

Buffett, whose firm earlier this year began reinsuring some municipal bonds, also said Berkshire is currently being paid a 2% premium for reinsurance, while the standard premiums are about half that. He said that difference reflects how nervous the market is about the bond insurers.

"We're getting double the premium at the moment to be the second payer," Buffett said.

Berkshire has a successfully swooped into different parts of the insurance business during times of stress, avoiding the underwriting cycle that's plagued the industry from its birth. Insurers usually vie for new business when times are good, eventually bringing down prices and threatening future profitability. When earnings drop, companies underwrite fewer risks, bringing prices back up again.

Buffett tries to do the opposite: taking on little or no risk when prices are low and piling in when rates surge.

In the wake of Hurricane Katrina, Berkshire generated huge profits by reinsuring catastrophe risks that few other companies wanted to take on at the time. As other reinsurers returned to the market and prices fell, Buffett stepped back.

Greg Morcroft is MarketWatch's financial editor in New York.

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Buffett says Berkshire Hathaway offered to reinsure $800 billion in muni bonds