Derivatives: The Worlds Biggest Margin Call And How To Play It

Includes: EDV, GLD, TIP
by: Mitchell Harris

Warren Buffett has called derivatives, a "financial weapon of mass destruction." That was 2002. Wall Street never listens to Buffett, which is why he makes billions bailing out the weak and pathetic. Derivatives grew into a massive bubble, from about $100 trillion to $600 trillion by 2011. Mark Mobius said that the total value of derivatives in the world exceeds global GDP by a factor of 10 or more. The problem is that our leaders can't tackle the issue because it's so unregulated, nobody really knows the true value. The low estimate is $600 trillion with the highest estimate at $1.5 quadrillion. What the heck is a quadrillion? It sounds like something you would say in the front yard when you were a kid. "I'll bet you a quadrillion dollars." Who knew one day that number would be as scary as it is.

The derivatives bubble was fueled by 5 key economic/political trends:

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

Data on the six-fold growth of derivatives to $600 trillion in 9 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 everything we buy from them.

To grasp how significant this six-fold bubble increase is, let's put that $600 trillion in the context of some other domestic and international monetary data: (#'s are approximates).

  • Current proposed U.S. federal budget is $4 trillion
  • U.S. money supply is also about $15 trillion
  • U.S. annual gross domestic product is about $15 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

The fact remains, 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, and they will mold to and follow the easiest most crooked, leveraged way to make $, because that what hedge funds need to compete in this environment, the next greatest thing. They don't care about Mr. and Mrs. Jones' money, as long as they make their cut above and beyond the high water mark. One day, some event will happen to cause a sudden shift in world markets (it may be happening now) and trillions of dollars of losses in derivatives will create a tsunami like none other. All of the money in the world won't be enough to bail the system out. Say goodbye to the largest casino ever built. When the wheel stops turning, most of the world's population still won't have a clue what happened.

At this point, for the ultra scared/conservative investor that feels this is imminent, I would simply put money into the following:

iShares Barclays TIPS bond (NYSEARCA:TIP) -- 4.2% yield and this past week had a $93,000,000 inflow, a .5% increase week over week, proving that some people are feeling as I do. Prices will gyrate as you have the occasional sympathy rebound, but the trend for TIP is positive as I see Band-Aids not solutions.

Vanguard Extended Duration Treasury (NYSEARCA:EDV) -- 3.17% yield but this funds gains are up considerably more than its current payout. The EU nonsense is spreading, first Greece, then Italy, now Portugal is junk status, who knows the next contestant to flop as the contagion continues.

SPDR Gold Trust (NYSEARCA:GLD) -- The yellow metal will continue to take its cue from the dollar which is almost as useless as the German Mark was in WW2. You should see gold break $2,000 as the U.S. has no choice but to inflate the problems away. Though it's had problems getting through $1,700, it will find its way back up.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.