June, 2009

Derivatives Tsunami #2 Is On Its Way!

Background

In my March, 2009 Commentary, I addressed the issue of derivatives as being the root cause of the financial crisis engulfing the United States. I urge you to reread the entire March, 2009 Commentary as it provides a basic primer for this June, 2009 Commentary.

Here is what you should be aware of:

1. the greatest area of concern in the derivatives arena is the over-the-counter derivatives which are not regulated by any government agency (domestic or foreign) and which simply represent private contracts between two or more parties;
   
   
2. the Obama Administration is attempting to pass legislation which would regulate the over-the-counter derivatives described in (1). Their efforts will be "too little, too late;"
   
   
3. over-the-counter derivatives represent over 50% of the total derivatives market and, as of 12/31/08, amounted to approximately $592 trillion;
   
   
4. in my March, 2009 Commentary, I noted that "credit default swaps" (a type of derivative) were a major contributing factor to the financial crisis which erupted in September/October, 2008 and led to the bankruptcy or solvency problems for many financial firms;
   
   
5. "credit default swaps" are actually a relatively small part (about $42 trillion or 7% of the 12/31/08 $592 trillion) of over-the counter derivatives;
   
   
6. the major potential problem area in over-the-counter derivatives is a category called "interest rate swaps." At 12/31/08, "interest rate swaps" amounted to about $328 trillion or 55% of the total $592 trillion of over-the counter derivatives;
   
   
7. said another way, "interest rate swaps" are approximately 8 times the size of "credit default swaps" in the over-the-counter derivatives market.
   
   

Why Were "Interest Rate Swaps" (a Type of Derivative) Developed?

In the simplest terms, the reasons are as follows:

1. as always, large Wall street firms such as J.P. Morgan Chase, Goldman Sachs, Citigroup and Bank of America were able to make outlandish profits and bonuses from the manufacture, sale and/or distribution of this form of derivatives;
   
   
2. "interest rate swaps" were used to keep interest rates artificially low. All of us now understand that artificially low interest rates led to indiscriminate and irresponsible lending by financial institutions of all types, as well as out-of-control borrowing by consumers, businesses and governments.
   
   

Where Are We Headed with "Interest Rate Swaps?"

In summary terms, I expect the following to occur:

1. continued disenchantment on the part of the United States’ creditors, especially China, Russia, Japan and various Middle East countries due to the out-of-control spending policies of the United States government.
   
   In fact, in mid-May, at a town hall meeting in Rio Rancho, New Mexico, President Obama said, "We can’t keep on just borrowing from China. We have to pay interest on that debt, and that means we are mortgaging our children’s future with more and more debt." In spite of these words, government spending continues at a break-neck pace;
   
   
2. an "accident" with respect to "interest rate swaps," probably prior to year end 2009 and possibly within the next 90 days leading to the following:
   
   
   • an across-the-board collapse in confidence by our creditors in the United States dollar as the world’s reserve currency;
     
     
   • an across-the-board collapse in confidence by our creditors in United States Treasury instruments (bonds, notes and bills);
     
     
   • the need for the Federal Reserve (which is neither federal nor does it have a reserve) to substantially increase its purchase of United States Treasury instruments as our creditors, especially our foreign creditors, become increasingly reluctant to do so. Such an action by the Federal Reserve will lead to much higher inflation, especially for the everyday necessities of life (food, medical care, gasoline, heating oil, natural gas, etc.);
     
     
   • higher interest rates;
     
     
   • bankruptcy of additional major financial and/or industrial institutions which will rival that of Bear Stearns, Lehman Brothers, General Motors, Chrysler, etc.;
     
     
   • continued increases in the unemployment rate so that it eventually exceeds the 25% - 30% unemployment rate of the 1930’s Great Depression. Our unemployment rates as of May 31, 2009 were as follows (refer to point #2 in my April 2009 Commentary for definitions of U-3, U-6, and Shadowstats.com unemployment rates):
     
     
     • U-3 - 9.4%
       
     • U-6 - 16.4%
       
     • Shadowstats.com - 20.5%
       
       

Also, please note that we have lost approximately 5.4 million jobs since the "recession" officially started in December, 2007 of which about 3.6 million jobs or 67% have been lost in the last 6 months.

Actions You Can Take To Defend Yourself And Your Loved Ones

1. don’t believe the "spin" that things are getting better! This will only encourage you to overspend and/or spend on the wrong items at a time when you can least afford to do so;
   
   
2. make sure you secure fixed (not variable) rates of interest on any debt you have. This will protect you from the coming higher rates of interest;
   
   
3. try to locate additional part-time opportunities to earn income as your full-time job just might evaporate in the months to come. Especially focus on part-time opportunities that have the potential to become full-time opportunities;
   
   
4. if possible, have a few months of cash available in a safe place outside of the existing banking system in the event a "bank holiday" is declared;
   
   
5. if possible, have a few months of non-perishable food supplies, medicines, and other necessities available in the event of any significant disruption in our "just-in-time" distribution system;
   
   
6. if you have any discretionary investment funds available, consider purchasing a few gold and/or silver coins from a reputable dealer.
   
   

In closing this month’s commentary, I’d like to leave you with the words of noted author, historian and economist John Kenneth Galbraith:

"There is the dangerous cliché in the financial world that everything depends on confidence. One could better argue the importance of unremitting suspicion."