Drowning in Derivatives

The inherently unstable, fundamentally unsound and immoral worldwide financial system organized out of intrinsically worthless debt has exploded into derivatives and imploded into a greater depression. Several of the stronger voices in the financial press evade the 'D word' which hangs over the world economy like the Sword of Damocles.

But Yahoo Finance! reports:

The Obama administration is asking Congress to extend its oversight of the financial system to include the shadowy market of derivatives, the kind of complex financial instruments that helped bring down the giant insurer AIG. … The global business world holds a staggering $600 trillion of these [over-the-counter] contracts.

The Obama administration is already doing everything they possibly can to intentionally exacerbate the greater depression. The use of political debt-based currency is destined to either implode in a deflationary depression or explode in hyperinflation. As the Treasury bubble predictably bursts interest rates will rise. The bond market is trembling as recognition that a 30-year bull market is coming to an end.

DERIVATIVES

Wikipedia gives a fairly clear definition of a derivative:

Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else. … Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.

Wealth can be either a tangible or financial asset. Tangible assets have intrinsic value and can never become worthless while financial assets can. Often times financial assets are subject to counter-party risk. Counter-party risk is the risk of loss due to a counter-party’s non-performance and is contingent upon their financial ability to pay.

In the shadowy world of derivatives there are many counter-parties potentially liable for hundreds of trillions of dollars. These derivative assets infect the balance sheets of many public and private corporations, local and state governments and other institutions. Through the use of fair-value lying the value of the derivative assets is hugely overstated while the value of the derivative liabilities is hugely understated. Even worse is that the contingent liabilities have no basis in reality because they are based on nominal market value and not notional value.

Credit default swaps insure against a counter-party failing to make their payment. Currently premiums for credit default swaps are twice as high on British sovereign debt as Cadbury. In other words, a company that makes chocolate eggs is a better credit risk than a major western government.

APPLICATION TO PENSIONS

A good example of a derivative is a pension. For example, an individual works for Chrysler for 40 years and retires. Chrysler agrees to pay $2,000 per month for the rest of the retiree’s life. The value of the pension is derived from the value of the underlying (Chrysler).

Chrysler will use actuarial methods under GAAP, which can now be based on fair-value lying, to calculate the estimated pension liability. We will assume it is exactly 15 years or $360,000 which would then be adjusted to the net present value which we will assume is $150,000. This nominal market value would then be carried on Chrysler’s balance sheet as a liability.

On the other hand, the individual uses their own method of fair-value lying to calculate the value of the pension. They may be optimistic and overstate their expected remaining life span at 40 years and use a more friendly discount rate to arrive at a net present value of $450,000, or three times as much as Chrysler’s valuation.

Viewing the balance sheets systemically there is an asset of $450,000 with a corresponding liability of $150,000. But the value of that $450,000 asset is also contingent upon Chrysler’s ability to pay and therefore subject to counter-party risk.

If Chrysler goes bankrupt then there is potentially at least $300,000 of illusory capital in the financial system that evaporates. Of course, some creative investment bank who has loaned currency to Chrysler may actually profit from their bankruptcy and the greater the disparity of illusory capital and real capital than the greater their profit.

GOVERNMENT HELPLESSNESS

During the great inflationary credit expansion the use of illusions, irredeemable government or central bank tickets, as currency in ordinary daily transactions has become universal. Their legal tender status, which is in complete conflict with the United States Constitution, is massive government regulation and the chief cause of all the current financial problems. By violating the supreme law of the land Congress has created this massive mess.

Now the Obama administration wants Congress to engage in more regulation and intervention. But why would these costumed officials be able to fix the problem they created? Indeed, the only real tools they have are either their little intrinsically worthless tickets, which function like their common stock, or their guns.

Indeed, if the Obama administration sincerely wanted to fix this mess then they would remove the 28% tax on gold and then repeal the legal tender status of the FRN$.

The common stock of America’s owner has recently declined to around 82 and is looking increasingly unattractive. As Vladimir Putin observed “The only problem: your results were poor and this will always be the case because the work you do is unfair and immoral. In the long run immoral policies always lose.”

But the truth of the matter is that the little tickets are subject to an incredible amount of counter-party risk. Federal government liabilities are estimated to be around $100T. When the tax eaters and soldiers no longer get paid with currency that will purchase anything and the purchasing power in their pensions are gone then things will get particularly interesting.

CONCLUSION

The golden Sword of Damocles has begun moving because the great deflationary credit contraction has begun. As the common stock of nations continues evaporating civil unrest will increase. The greater depression will make servicing debt increasingly difficult and many derivatives will continue to trigger and decimate entities during this deflationary crash. Confidence, already slightly eroded, will be completely destroyed as counter-party risk continues materializing. Corporations and governments will DEFAULT resulting in complete worthlessness of those assets. But who needs the dangerous costumed Washington clowns anyway?

Through all of this chaos and change there will be at least one brilliant asset. At all times and in all circumstances gold is money. Gold is the only major currency not subject to counter-party risk. Gold cannot default. Therefore, during deflation if the like-cash FRN$ is king, then the real form of cash, gold, is emperor.

Disclosures: Long physical gold and silver with no position in TLT.

Comments

[andypandy:]

Do you like funds like CEF or GTU, if not how can I hold gold in my IRA>?

May 14 08:43 AM

[erniem:]

unfortunately gold is also an illusory investment. Neither gold, silver nor any commodity has any value other than perceived.

May 14 09:03 AM

[Vuke:]

Good article. Those denigrating gold should carefully look again at the inverted triangle and imagine the growing floods of money attempting to get into gold.

The consternation at realizing their paper pyramids may be next to worthless must feel really awful. No wonder gold is being seen as a necessary insurance policy.

Those fearing a "collapse" in gold as "everyone rushes to sell" should ask themselves one question.

Sell for what?

May 14 09:06 AM

[yellowhoard:]

Granted, gold will not grow your money like a well run corporation.

It will, however, protect your wealth when currencies are being debased.

Right now, the odds of having your currency debased far outweigh your ability to choose long term equity winners.

Gold is only valuable as it relates to the amount of currency available to buy it. There is nothing mystical about it's value.


On May 14 09:03 AM erniem wrote:

> unfortunately gold is also an illusory investment. Neither gold,
> silver nor any commodity has any value other than perceived.

May 14 09:21 AM

[Market Sniper:]

You are correct to a point. NOTHING has value other than perceived value in monetary terms. We do have value in use or utilitarian value which applies to the basic necessities of life. HOWEVER, throughout the history of man, gold has been perceived as a store of wealth and also as true "money" (value in exchange). Now your going to argue with history? Central bankers have done that as well. That is part and parcel of why we are where we are now. This is a very old, old well trodden road we are going down here. It does not end in a good place.


On May 14 09:03 AM erniem wrote:

> unfortunately gold is also an illusory investment. Neither gold,
> silver nor any commodity has any value other than perceived.

May 14 10:15 AM

[Whippet:]

<<Currently premiums for credit default swaps are twice as high on British sovereign debt as Cadbury. In other words, a company that makes chocolate eggs is a better credit risk than a major western government.>>

And to think there is a direct lineage between the current British Pound Sterling and one that represented one troy pound of silver less than a century ago. You'd need three or four now just to buy a pound of chocolate.

There are only 2 ounces of gold on the planet for each living person, and one has been mined. There are 34 ounces of silver per person. The only risk to the long term values of these assets is a Steven King "The Stand"-like scenario.

May 14 10:32 AM

[Jasper M:]

Excellent article.

Vuke
In the intermediate term, Many players have debts denominated in dollars, so they will sell for dollars.
I like gold, but I recognize that a Lot of it is in Very weak hands right now. IMF has a record of selling stupidly (who would have guessed?). And the Russians are an oil based economy, and a depression would kill demand, so they would sell to avoid austerity.

Whippet, you are the only other person I've heard that knows that about the "pound". Good for you!
I have a question about your silver figure - is that 'out of the ground'?

May 14 04:01 PM

[Trace Mayer:]

Whippet, and to think that of the gold available for sale were distributed according to a standard bell curve if one has 0.8 ounces, current market price of about $740, then they would be in the top 80%. Cash balances in checking accounts are surely higher. Of course, there is not too little gold or silver; only too much paper which will evaporate.

erniem, you argument is effective currently only in the micro but not the macro. There has never been a single period in the history of mankind where all of humanity assigned no value to gold. Sure, you could assert the black swan argument. I suppose with nanotechnology, free energy and Star Trek replicators that gold could become valueless but I would not apply that future hypothetical to current events and calculations of value as that would be insane. You or Cetin can do it though as my portfolio, investments and trading activities are doing very well and I need someone to take the other side of the trade.





On May 14 10:32 AM Whippet wrote:

> There are only 2 ounces of gold on the planet for each living person,
> and one has been mined. There are 34 ounces of silver per person.
> The only risk to the long term values of these assets is a Steven
> King "The Stand"-like scenario.

May 14 04:43 PM

[Alan Young:]

This article is absurd.
You rightfully criticize the dangerous aspects of derivatives, but fail to assess how much of the danger is due to their being exempted from regulatory oversight. Where there are no regulations, the financial markets have made their own games, created extraordinary risks, and left all of us holding the bag. Any prudent government would see regulation of these instruments as at least a first step toward stabilization.

But you don't want any first step; you don't even want stabilization--you want revolution. Shades of Lenin! Well, fine, but meanwhile we have to live with what we've got.

May 14 05:58 PM

[Alan Young:]

yeah, the CDS rates can be perverse....

But I gotta nail you on "pound sterling." The English "pound" was indeed worth a pound of silver, but not a century ago: that measurement dates back to the time of Charlemagne.
In 1816, the rate was set by law at "5s. 2d. per oz. of silver," so a pound (20s.) was worth a little less than 4 oz. of silver.
[source: chestofbooks.com/finan... ]


On May 14 10:32 AM Whippet wrote:

> <<Currently premiums for credit default swaps are twice as high on
> British sovereign debt as Cadbury. In other words, a company that
> makes chocolate eggs is a better credit risk than a major western
> government.>>
>
> And to think there is a direct lineage between the current British
> Pound Sterling and one that represented one troy pound of silver
> less than a century ago. You'd need three or four now just to buy
> a pound of chocolate.
>
.

May 14 06:16 PM

[Vuke:]

Jasper, is it not likely most weak hands have been or are now being shaken out? Gold did fall a lot recently.

In addition, given the rolling presses, there should be plenty of dollars to pay debt. Too many in fact so the surplus will gravitate towards gold.

Russia still has quite a cash surplus and is apparently, right now, converting some to gold. That despite the very low oil prices recently.

At $925/oz. there just isn't enough gold, anywhere, to balance out the massive debt positions in the world. Now, move it to $3,000/oz. and you've got some leverage.


On May 14 04:01 PM Jasper M wrote:
> Vuke
> In the intermediate term, Many players have debts denominated in
> dollars, so they will sell for dollars.
> I like gold, but I recognize that a Lot of it is in Very weak hands
> right now. IMF has a record of selling stupidly (who would have guessed?).
> And the Russians are an oil based economy, and a depression would
> kill demand, so they would sell to avoid austerity.

May 14 09:12 PM

[Jasper M:]

Vuke,
One of the largest holders of gold in the world today is the freakin' IMF. These idiots actually sold gold (and a lot of it) upon the inauguration of the euro, fer cryinoutloud. Do you Seriously think they are smart enough to hold on to the whole of their pile, when everyone and his uncle has his hand out to them? I think not.

As for the Russians, you haven't Seen low oil prices, not yet. Remember that most petro demand is commercial. As the depression slows the wheels of commerce, that demand wll plummet. Everywhere. They had terrible trouble at $30/barrel - what will they do at lower? Among other things (most of them bad), they will sell some gold.

I reiterate, I LIKE gold. But I doubt it can get to where it is going until it passes from the idiots to the wise.

As for debt, most of it will be defaulted on, or otherwise repudiated.
But your figure is close to a data point I worked out: if the US were to back Only its physical Reserve Notes with its current gold on hand, price would be $2800/oz.

May 15 03:27 AM

[norom:]

Um, thats not how derivitives work. You cannot claim to know the liability potential of every derivitive contract on the planet earth, and these agreements have done wonders offsetting risk for companies that actually make things. Hedge funds and banks lost their pants because they speculated on derivatives, which is not what the derivative is designed to do.

May 15 08:23 AM

[arel:]

Have you considered?
1- As the price of gold increases the economics of removing gold from sea water becomes
viable.
2- Subsea mining of gold re the seamounts and gold linked to subsea (on the surface of the ocean bed) copper also becomes economically justifiable.

May 15 09:42 AM

[silver-bullet:]

In that case, anything and everything can be an illusion, including you.

Are you out of your mind?!!!

On May 14 09:03 AM erniem wrote:

> unfortunately gold is also an illusory investment. Neither gold,
> silver nor any commodity has any value other than perceived.

May 16 02:13 PM