Thursday, March 12, 2009

A Chris Laird "Must Read" - Central Banks In A 'Pickle'

Excellent article discussing global financial system exposure to derivatives (1,200 TRILLION OTC - answers our question Jerry) and the US Treasury/Federal Reserve's attempts to stay ahead of the unwinding catastrophe.

A small excerpt:

"If the Fed chooses not to monetize, then, well all the derivatives continue unwinding relentlessly, in this secrecy, where no one knows who is next. Unless the Fed uses the public purse to sweep more and more unwinding derivatives under the rug, the entire world financial system collapses. I am serious….I am not exaggerating. We almost had this happen on two or more occasions that I recall since Aug 2007."

Central Banks In A 'Pickle'

Hat tip FOFOA!


Russ said...

I would say the total of CDS's that exist is large and all of them unwinding would be very bad. But the real unanswered question is how many are at risk of unwinding.

Jordan Greenhall said...

I've also got a question that I'd like to pose to someone who knows more about derivatives than I do. Chris Laird describes a pickle. He uses an example where you and I create a $1Bn derivative contract - putting a small amount of actual capital (say $1k) behind our bet. The $1Bn is the "notional" value of the derivative contract and the legendary 1,200 Trillion in the derivatives market is its notional value.

So here is my question - what happens if we simply cancel those contracts? If you and I write a $1Bn contract - clearly neither of us can pay it. Now one solution would be to have whichever of us is the loser go immediately into liquidation and then I guess indentured servitude. But another solution would simply be to cancel the contract and say "hey dumbfucks, you can't bet what you don't have".

Right now what it seems I am seeing is that when the Fed honors even a dime of these things it is suddenly converting our bullshit $1Bn bet into a huge windfall for one of us (whoever won the bet) and death for everyone else who is paying that dough. This seems to make all the sense in the world to me - what really happens if we just cancel all of these things? Maybe we have to put some banks and insurance companies in the ground (or bankruptcy) but who really cares - especially compared to the scylla and charabdis of hyper inflation or hyper deflation that Chris describes? The whole real banking system (that is actual money that flows through the sytem to do real work) is smaller than what we have already signed-up for. We could flush the whole lot of them down the drain, create wholly new banks and completely avoid this derivatives mess.

What am I missing?

Virgo said...

So basically CDS's are insurance contracts against default of banks & companies. Apparently thousands if not millions of insurance contracts were written against a single bank/company. That's like me selling 1000 insurance policies against my neighbors house burning down. I collect a ton of money in fees & everything is fine & dandy. And then my neighbors house burns down. And all these people come knocking to collect on the insurance- money which I obviously don't have. So I tell them that I'm sorry but I don't have the money. And they get really mad because they have deposited these insurance policies in their bank accounts & counted/pretended it was 'money in the bank'. Except now that money just went 'poof'& that account went to a big fat zero. Now, in the real world there are 1200 trillion of these CDS's floating around in the bank system, pretending its money.

Meanwhile, we just entered into the beginning stages of a deflationary depression in which countless companies & banks will go bankrupt due to the inability of the broke consumer to buy more 'stuff' from these companies or buy more debt from the banks. Ok, so this is really bad because the US is the worlds 'economic engine' because we consume 50% of the worlds 'stuff'. As the the US consumer stops buying 'stuff' the companies selling 'stuff' go out of business. As these companies go out of business (house burns down)hundreds, thousands, millions & apparently trillions of CDS's/pretend money written against these companies goes to zero in the world's banks. Several billions & possibly trillions of dollars of CDS's were written against a SINGLE company/bank. One big company goes down, trillions in bank accounts all over the world go 'poof'. The US Fed has been quietly covering these contracts since 2006, when they quite publishing M3 money supply. It was a tiny little fire that has turned into an inferno that no longer can be hidden from the public. These insane contract can not be covered so what the government has resumed to doing is injecting money into banks/companies directly (AIG anyone) to pretend that everything is ok, these companies are solvent, the house is not on fire, we don't need to pay out these CDS's. But this is happening all over the world so the whole world has to inject money into zombie banks/companies & pretend that everything is ok.

And this brings us to the ultimate question, which is (lets take US): can the US create enough $ to continuously inject into companies/banks? So far we've been borrowing money for this insanity but today China said that it is pretty nervous about its 'assets'- trillions in US $- due to the US 'fiscal irresponsibility'(this story was on Marketwatch). So China starts demanding higher interest on bonds, which is paid for with federal income taxes. There was a story on marketwatch that reported a 60%+ DECREASE in income taxes last month from the previous year. That is just incredible. No way are we even going to cover the existing interest on the federal debt with half as much taxes coming in, not to even mention more borrowing that has to be done in order to cover the budget holes CAUSED by a decrease in income taxes. So the Fed prints money to cover these 'obligations' & the dollar is screwed.

So why can't we just cancel these CDS's, seeing that this was craziness that was never meant to be payed out? We can't cancel these damn things because these CDS's are in banks all over the world PRETENDING TO BE MONEY!. This is ASSETS in books all over the world, from banks to retirement funds. The whole (western mostly)world has long run out of real money & has literally been playing pretend with 1200 trillion of CDS's. Seriously. I bet you all have this toxic crap in your retirement funds right now. So pretend money, held in accounts as real money, is demanding to be traded for real money or the entire world financial system collapses.

So you see, we are so very screwed.

Mark said...

Excellent Virgo - very succinct. China is warning us against printing, but that is the only way out. Because they are still buying, they have a legitimate say, but the amount of bond expansion needed will be too great. That balloon will pop, and trillions more will evaporate. More deflationary unwinding is the current prescription, kicking the can a little longer. The porkulus sham is being exposed daily. Randy, did you see the story that 1 in 5 earmark dollars to the state of MA was going to "Kennedy legacy" projects?
Unreal Spending

JeremyC said...

Virgo, great explanation. That is just scary!

Randy said...

Virgo, I concur - superb explanation! Much appreciated...

Jordan Greenhall said...


I get it - but I still don't see why we are screwed (at least why we are "really, really, really" screwed. I look at the M0 - M5 money supply and *nowhere* do I see 1,200 Trillion. If those CDS are sitting out there pretending to be money, they aren't actually actively in the money-supply, at least not very much.

So going back to your example. I write an insurance policy of $100k against your house and sell that to 1000 people (who all pay me $100 for the privledge). So we've got $100M in "notional" derivatives sitting out there. On its face, not that big a deal - cancel the damn things and the folks who bought the contracts are out only what they paid for it - a survivable total of $100k. So everyone thinks that they lost more money - so what, we are deeply in the shit and better to cut to the chase than play ring around the roise. If its not real, kill it and move on. Worst case peoples bank accounts and retirement funds go to zero.

But not so easy - each of these dumbfucks took their $100k insurance policy and borrowed against it. They took $100k of fame money (bought for $100 of real money) and then borrowed (lets say) $1,000 of real money against it. So now if we cancel the underlying $100k as fake money they suddenly have no collateral and all get called on their $1k of debt. Now that *is* a problem - because then they go not to zero but to negative. Possibly a lot of them.

This, of course, is why the hedge funds are burning (have burned). As the reality that their $100k is infact vapor has sunk-in they have been called for their $1k debt and have had to sell everything real that they have to get there - causing our fun fund deleveraging spiral.

So, what is the gap? Lets think way outside the box. You are only trapped as long as you allow the prison to be a prison.