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Derivatives...what the heck were they for?

|Includes: GS, JPMorgan Chase & Co. (JPM)
Let's discuss a few things regarding money. The creation of money as I have indicated in previous article on my blog is the creation of debt. (See: More dollar what-if discussion, crash warning and recommendations and The Future of the Dollar - the biggest short squeeze ever and The EURO - starting a trip to oblivion). We know from my earlier posts on the subject, that it is a banker's fantasy to dilute a currency while selling it for a positive return at 30 to 300 times leverage.

How about a story
I am a factory owner. I make widgets. I am the only one who makes these particular widgets and they are terrific and everyone wants them. Now, I have a new and improved widget which I have not sold to anyone yet. An intelligent entrepreneur comes to me with an idea after he sees them. He thinks they are the best thing since sliced bread, so, he wants me to lend him 100 improved widgets and he promises to return my original 100 improved widgets in five years plus 8 of my improved widgets per year over a term of 5 years. 
Its an unconventional deal - but I think about it. "Good deal" I say "ok...lets do it". Now I like this deal be cause he is effectively short 40 improved widgets of which I control the supply. So, if he wants to get those 40 and they are not available I will control the transaction terms. 
He signs on the dotted line and we are all done. He now has an obligation to repay me 100+40 improved widgets. His first year in business goes very well with my improved widgets. And at the end of the year he attempts to locate 8 of them to give to me according to our deal. He looks in the market and is unable to locate any of my improved widgets anywhere. So, he says what the heck, business is good - I'll just deliver 8 of my 100 widgets and then I'll figure out how to get more later. So, our hapless entrepreneur is continuing on in his pursuits - business is going well - until next year when he is on the prowl for those widgets to deliver as per our transaction terms. He is astounded to find out that, I only created 100 of these things and I loaned them all to him. Clearly this is an unworkable situation and he should try to renegotiate the terms. But that's not the point of the story. 
When the entrepreneur borrowed 100 of my improved widgets...I created 100. He promised to repay 140. But I never created the additional 40. Ordinarily, you would think that me being a clever business man, I would want to sell as many of these new things as possible - thereby giving him a market to locate these 40 widgets he is short. However, that would only mask the conflict in the transaction. 
In order for me to create widgets based on the agreed terms, I need to create the stock and I need to create the 40 widgets that the entrepreneur is obligated to deliver. This is technically, a monopoly game. And the important point is that if I never create the additional 40 widgets, for what ever reason...the agreement falls apart but the entrepreneur is still obligated to deliver. If i create a lot of widgets, ultimately there is still an imbalance of 40 widgets that should be returned to me that theoretically do not exist - even though the market place would have plenty of stock available and would likely allow that imbalance to go unnoticed...until it mattered. 
The book report
Well, what I have described above? Its the mechanism by which money is created. Money is created when the factory (bank) loans you principle. An imbalance is created when you promise to repay money that does not exist - in the form of interest.
 
I know this is difficult to rationalize. But its the way things work. As long as ponzi scheme bankers can keep giving out loans and increasing the money supply the imbalance is not apparent. Until it is of course.
 
Now, if I was a smart ponzi scheme banker (and they are). What I would do is, try to create theoretical money. Imaginary money that everyone believed actually existed and could be used to settle future obligations - such as Warren Buffett's potential $50 billion+ obligation on his european style puts. (see: Warren Buffett - the ultimate bull-market manifestation)

This is like creating imaginary widgets in the story above. If the guy could simply turn over an imaginary widget to me and I would be satisfied with it - then he's fine and business goes on smoothly.
 
The vast pools of money
You have probably heard of the vast global pool of money - its supposed to be around $70 trillion. This pool of money simply trades the debt money created by fractional reserve lending activity - paper. $70 trillion does not even begin to touch the amount of debt + interest obligations there are in the world. One of the key elements of fractional reserve lending is that once a credit is created...a note or paper is created that represents the value of the borrowers promise to repay and assets he posts as collateral. That is what trades in the vast global pools of money. And as long as the music is playing - everyone is dancing. Credit (Money), however, is not for the most part created by these pools of money (theoretically that could represent value and that would not be good for growth). In the majority, it is created by regulation via fiat when fractional reserve lending takes place. And this is why the dollar chart looks the way that it does. The banks have shorted the dollar into oblivion and sold it to suckers who think buying a depreciating asset and paying interest for it is great if they can invest that money in inflating assets that theoretically outperform the depreciation of their dollars. Obviously, this is a hair brained plan and can not work when the music stops. It also blows up when your inflation assets depreciate.
 
Just to announce it formally - the MUSIC HAS OFFICIALLY STOPPED...but the fed is still dancing.
 
So this brings is to derivatives. 
Ok, we have all heard of naked shorting. This essentially means that people are selling shares that don't even exist. I have seen instances where the float of a company was tripled due to naked shorting. This operation creates theoretical shares. This is what the banks do with our financial system every day - only with currency.
 
Now what are derivatives? Who came up with them? Why did they come up with them? 
There are a lot of reasons that people will give as to why a derivative is useful or required.
  1. Hedging
  2. Risk Management
  3. Speculation
But do we need them and why were they created?
 
Let me answer that question in two parts. Firstly, people who work at banks do not ask themselves what money is. The question seems almost too ridiculous. So, most bank employees can not give you the correct answer as to what money is and how it is created. So, we have a lot of smart people furthering a scheme that they don't even know they are participating in. As long as its not illegal they go along with it.
 
With derivatives we have a similar situation. A lot of brain surgeon types who never asked essential questions about what the real impacts of their work was. But lets look at what that is.

Theoretical money
  1. Asset appreciation
  2. Credit
  3. Interest on credit
  4. Modeled Obligations
When stocks or real estate go up, money is created that never existed before. When they go down the opposite happens.
 
When a loan is given, money is created.
 
Interest on credit theoretically exists...but the credits (Money) for that interest money need to be created somehow. This is why we need derivatives or vehicles like them, to create the money for the interest due on debt money that is created by banks.

Details:
 
If I loan $100,000 to someone on a 30 mortgage at 7.5%. I create $100,000 of new money...but the person promises to repay me  $251,717.22. So, I need to create $151,717.22 somehow. If on the basis of that issue of credit I create more credit, I will have to create a lot more than $151,717.22. In any case, the only way to create the interest money is to create credit - which creates interest obligations (and that debt money does not exist)and ultimately blows up the system.

Modeled Obligations - to the rescue - they can create money at a whim similarly to how the stock market does...theoretically with no standard interest requirements and very few participants which is rather advantageous when compared to the stock market or other publically owned and priced assets.
 
 If I have credit based money. I need mechanisms that can create money (Debt) without requiring interest. That's what derivatives are for. And that's why we had 790 trillion dollars of them at one point and why JP Morgan currently has 89 trillion of them on their books (all perfectly hedged mind you).
 
But what are derivatives?
Derivatives are Modeled Obligations.
  1. Options
  2. Futures
  3. Exotic Agreements 
  4. CDS's
  5. CMO's
  6. CDO's
  7. Structured Products
Options are fairly simple - though spreads and volatility make them complicated. All derivatives have option characteristics. Options themselves do not usually create very much new money.
 
Futures are also quite simple. However, highly leveraged. With 1 future you can control 40, 50, 60, 80, 100 times the money requirement to trade the future. Guess what? That creates money...theoretically of course. Since you have agreed to take on all the risks of that position - the 100,000 of theoretical money can be written into the books - again theoretically of course. If you look at what it costs you to control that amount of money there is a problem. Clearly this credit is being supplied at such a high discount that there is barely a cost in the standard form of credit issuance. Therefore the money system is creating new money that can be theoretically used to pay the interest on existing credit with debt money that creates very little interest. Remember, how our money system operates - theoretically - of course.
 
Most of the other structured products and other derivatives operate on the same basis except even more leveraged and primarily based on ratios of one agreement to another...bundled up as a unit they can considered a single derivative - i.e. a derivative is usually built out of multiple subordinate derivatives.

What's our total debt?
The total dollar debt in the world is roughly in the 350 trillion area...with interest requirements that over the term of those notes requires 500 to 600 trillion of theoretical money to be created...this can be done as I indicated earlier through inflation or through theoretical mechanisms. Derivatives are the Fed authorized/endorsed/promoted mechanisms capable of theoretical money creation that does not implicitly create large interest obligations and can be used to support expanding asset inflation and as a result create enough money to theoretically repay all the interest on the total outstanding obligations.
 
When Tim Geithner discusses the need for Derivatives regulation, keep in mind that the development of derivatives was explicitly developed under his watch and Greenspan's auspices. These guys knew we needed derivatives. It was their only way out. And they implemented the scheme deliberately, promoting SIV's and off balance sheet transactions combined with flakey accounting along the way for spice, so that Bank balance sheets could be manipulated and theoretical money could be created without standard interest obligations.
 
The Fed is the driver of the Fraud. JP Morgan is one of the primary vehicles for it and the most dangerous bank in the world.
 
This is big subject I will follow up with a lot more details as I get time... theoretically of course.
 
Disclosure: none