The Deadly Derivatives

"The problem with Socialism is that you eventually run out of other people's money." Margaret Thatcher

THE REAL BIG DANGER IS DERIVITIVES, NOT SUB-PRIME MORTGAGES. The Bank for International Settlements (BIS) has issued a report stating that Derivatives are now $1.14 quadrillion dollars. That is a one with 15 zeros after it. AIG has now been given $180 billion dollars, with a good portion of that money going to Merrill Lynch, Goldman Sachs, J.P. Morgan, Deutsche Bank and a list of others covering one whole page. These are the counter parties to insurance contracts (DERIVITIVES) written by AIG which, like the money given to the banks, is supposed to keep the world's financial system afloat. But as large as these monies are, it is just like spitting in the ocean. As these Derivatives implode, there will be no end to the monies given to AIG, which has on its books $400 billion of OTC Derivatives and $200 billion of sub-prime mortgages (in a large measure directly due to government involvment).

As AIG comes to the feeding table (remember the size of the problem) for more and more money, they are not the culprits the Government is making them out to be. They are the Government's RED HERRING to deflect scrutiny away from themselves, the real culprits, in their efforts to disguise funneling taxpayer money into the banks to prop up their prime campaign contributors and "frat-buddies". Perhaps by the 10th time, John Q. Public will finally get it with regards to the enormous FRAUD that Socialism really is, as you the taxpayer, are being asked to pay For it.. But the taxpayer is completely taxed out and there will be a great many tax defaults since people cannot pay as they struggle to survive. How much Capital Gains Taxes do you think will be collected next year, regardless of what Congress raises the rates to? What I am saying is that the tax short fall will be tremendous.

WHY IS AIG SO IMPORTANT THAT WE CAN'T LET IT DIE?

This conglomerate insures 70,000 individual businesses, over 100,000 large businesses, and has 74 million customers. Without insurance or bonded coverage, many businesses would be forced to close down operations The $165 million in bonuses is just a ruse to deflect attention away from the ineptitude of Congress. The bonuses are going to over 650 people ( some of which were working for a salary of $1/yr) because the Government put a cap on salaries and the bonuses are exactly what they claim to be: RETENTION bonuses. If the best key people leave, what happens to the $180 billion we have already sunk into AIG? How much can we sell a viable, on-going business for as compared to a failed corporation without its top key executives?

Fannie Mae had a yearly loss of $59 billion dollars and Freddie Mac lost $50 billion for 2008 alone and there is no end in sight to their losses. And that's after buying $5 trillion of their Bonds. If the FED is determined to continue to buy up all the defaulted Derivatives, then the easy conclusion is that the FED will "debauch" the currency. I've also come to the conclusion that hyper-inflation is the inevitable outcome, as there is not enough money in the world to take care of the Derivatives.

According to Schwartzman of Blackstone, 45% of all investment assets have been wiped out across the globe. Fortunately, all my loyal readers have heard this before while there was still time to do something about it, as my past years' forecasts are now being confirmed by statistics and events.

"Nothing goes straight up or straight down". There are always rallies and pullbacks regardless of the market's primary direction. Recently, we went down for 16 days in a row and now we are well into that 3000 to 4000 point Bear Market Rally that I was warning you about that may take us into the summer. But one thing is for sure: It will not be a straight up move. After the rally is over, we will be going down again and a lot lower than we dropped before.

Sell your long term Treasuries, Corporate and most Municipal Bonds. Most have escaped the real blood bath thus far, but they are living on borrowed time. Sooner rather than later, the FED will be forced to raise interest rates in a futile effort to defend the US Dollar. So sell while the selling is good. This Recession/Depression, whatever you want to call it, is not going to be a short term affair, more likely it will last years and Government deficits will grow larger than even the most pessimistic are projecting. But fear not, stay tuned in and just keep looking for that rainbow in the sky so as to remind yourselves that the world is NOT coming to an end.

Most money managers, stock brokers and analysts that I talk to ARE ACTING LIKE OSTRICHES and keeping THEIR HEADS IN THE SAND. Without any justification they feel that, by the end of 2009, we will be in a recovery stage. Unfortunately, most do not have a clue as to what is going on. Any up-tick in reported earnings or in home sales are met with great glee as a sign that the bottom is at hand. HOPE is a negative word and actually means nothing. People will buy into almost any rhetoric if it is repeated often enough, especially by the media and their latest Hero. The lack of pent up demand for anything is staggering as this nation is bloated with DEBT and saturated with things that they did not really need in the first place. Inventories of unsold houses are at all time record highs and that is not counting all the homes taken off the market by people who refuse to accept the fact that their homes are no longer worth what they thought they were.

Life cannot now be fixed by the smoke and mirrors of eliminating the mark to market requirement and additional low or even zero Interest rate loans. Bernanke's announcement that the FED is buying $1.3 trillion of agency debt and treasuries emphasizes that this country is crippled, especially with the government attacking all of the mechanisms of productive capital formation. This nation has drained its people's integrity by spending their life savings, including their home equity.

The main point is that the Government and Bernanke will make all the exact same mistakes of the 1930's and will tax the people into poverty (not just the rich). They won't call it an income tax, but nevertheless they will tax the middle class as well as the poor because that is where the real money is. They will call it a Green Energy Tax, a Sin Tax, or a Save the Planet Tax. But whatever they call it, they are all taxes on the poor and middle class. Remember, if taxes on companies cannot be passed on, then the companies go out of business and all their workers join the ranks of the unemployed. Don't listen to the rhetoric: A tax on companies is a tax on people. THE CONSUMER ALWAYS ends up PAYING.

We need to unfreeze the credit markets so that everyone can borrow more.? Is that not CRAZY? How about saving some money and building up your cash reserves, which is exactly what the people are now doing, having gone from -1 ½% to a +4 ½% savings rate in less than 6 months. During times of crisis, the people are always smarter than the government. The Keynesians call it the Fallacy of Savings but that is exactly what it is a FALACY. Elementary Economics teaches that one persons Savings is another's Investment.

President Obama talks about job creation. What jobs? Created by whom? By the private companies both large and small that he is attacking, taxing and demanding that they pull in their belts and sacrifice? How about some government sacrifice such as passing up their coming pay raises and at least deferring their pet welfare (redistribution) projects, at least until we can afford them?

TODAY'S Government solutions are: Print more, borrow more, then encourage everyone to go deeper into debt. The US DEBT to INCOME ratio has risen higher in the past 5 years than in the last 40 previous years combined.

HYPER-INFLATION IS INEVITABLE

If you want to think that we are on the way up now and this disaster is over, THEN THINK AGAIN. For me, a hyper-inflationary outcome is inevitable. That is because the public, the ones who are on the feeding tube of entitlements (growing by 10 million a year as the baby boomers retire), will demand to be kept there and will expect that their collapsing incomes be made whole (most have lost 30% to 70% of their 401K funds). Whenever I mention the word entitlements, you must realize that no one wants to ever give them up. When I mention trillions, most do not have a concept of the money involved. Budget deficits will grow more in the next 4 years than in all of American history combined.

I cannot see how the Chinese will be inclined to lend the US substantially more money, certainly not enough to stop the printing presses from having to run 24/7, 365 days. Hilary and Geitner have already insulted the Chinese and they have already warned the U.S. about guaranteeing their Treasury Bonds. But with what? Now they are talking about a new Reserve currency or new SDR'S that would include Gold.

I repeat, the idea of selling or shorting bonds into every Bernanke induced Bond rally is a most prudent strategy and nearly a sure thing. Besides, how much lower than zero can Bernanke continue to lower rates to? The risk coming in the bond area is not palpable for me. Thus, I buy Gold that brings no income, but I know my capital (principle) will be there, no matter what.

The risk is that the accumulated wealth of perhaps 50 years for some individuals will be mostly lost. It is my contention that our national debt, in the form of Treasury Bonds, cannot possibly remain viable. You have to think about and realize what is taking place. Already Pelosi is talking about another Stimulus Package. Again, it is Socialism and the Over-the-Counter Derivatives (unregulated and a form of Socialism) that are destroying our financial system. Most people, including all Ivy League educated economists, do not seem to understand what they are or their potential to destroy.

THE PENSION BENEFIT GUARANTEE CORPORATION (PBGC)

It is broke, just like the FDIC that insures your bank deposits. Shortly, the PBGC will be asked to takeover the CAR INDUSTRY'S Pension plans among other newly bankrupt companies. But the printing of money cannot be endless. I anticipate the time where the whole system will implode to be in the neighborhood of ONE to THREE years. All of the US Pension Plans are heavily invested in real estate, stocks, bonds, and other asset classes that have seen tens of trillions of dollars disappear in a matter of months and are now far behind in their funding due to their ludicrous underlying assumptions about return on investment. They are effectively bankrupt and they too will have to be bailed out.

Unless another bailout is orchestrated to save all these middle class pensions, they will never recover. However, I do not think the Government can bail out everyone's pension. Most likely you are going to see the PBGC follow in the footsteps of The Socialist Government of Argentina and nationalize the private pension money (including IRA and 401K) and mix it with Government entitlements. This pension money seems like it would make an excellent source of new funds: Which Obama is already eyeing. Don't think that it can't happen. We have just witnessed how easy the Government breaks contracts and how little regard they have for our Constitution.

FOR YEARS I HAVE BEEN WARNING YOU THAT IT WAS THE GIANT LEFT WING CONSPIRACY THAT YOU HAD TO WORRY ABOUT AND THAT A GIANT RIGHT WING CONSPIRACY WAS AND IS AN OXYMORON.

DERIVITIVES

This is a market of bets on the performance of "something" other than a stock (mostly interest rates, currency ratios and credit worthiness). It is so huge that not even the Fed, Treasury nor anyone else knows who owes what to whom, or who has lost what and how much. Yet this Derivative Market is still growing at about 15% a year, which means that more than $200 trillion is being added each year and nothing is being done about it except getting rid of the only people who do (at AIG).The reason for this is that most of these derivative contracts are being rolled over each year into new ones that are being formed and the losses to one or the other party are also being rolled over. The losses are temporarily being swept under the rug with the rest of the toxic assets.

To clarify what I am talking about: You and I can make a bet in which the winner must be paid $1 billion dollars, and each of us puts up only a $1000 (even if it was a $1 million) to seal the deal. We then both agree by contract that gains and losses will be carried forward. But eventually settlement must be made at some point in the future, so we both buy insurance to cover potential losses. This $1 billion for the winner and loser becomes the "NOTIONAL" value of this derivative. That is the exposure to both parties. The Notional value is the $2 billion being leveraged. The agreement is a private agreement and not regulated. Eventually Notional Value becomes the actual value to be paid off. But in the meantime, the winner is using the NOTIONAL profit to pad his balance sheet, report a profit and increase his leverage ability. The amounts are astronomical and will have to be paid. When one party asks to be paid off, Notional value becomes the ACTUAL amount demanded. When one party wants payment, and it is a big company (like Bear Stearns), often times this Notional loss has been insured by a third party insurance company that also cannot make good (such as AIG) - that is when the FED has to step in to what is really a never ending black hole.

THE ROOT OF AN UNFOLDING DISASTER

In 1990, the total value of these OTC Derivatives was about $100 billion. At that time, major banks and institutions the likes of GE, JP Morgan, Bank of America, Citi, AIG, and especially insurance companies, money market funds and every type of bond market all around the world, started to play the game of insuring, "securitizing" (similar to the portfolio insurance of the 1980's that ended with the 1987 crash) everything in sight, in what they thought was REDUCING RISK so that they could increase their leverage. So we now have a market that has grown to over $1 quadrillion. AIG was especially profuse (in its London Branch) writing insurance on every kind of Derivative. The idea was why not take big fees on insuring something that would never happen. Kind of like a flood happening in the Sahara Desert. But you know what, a flood did happen and AIG, which never put enough reserves away because they thought the event could never happen, found itself owing potentially $ trillions. The Government (bought and paid for by Wall Street) has made you, the taxpayer, the PAYER OF LAST RESORT. The potential exposure to these immense losses is not being revealed as long as the FED can keep interest rates from rising. However, once rates start to go up, the flood gates will break wide open. It's taken the Fed, Treasury, Paulson and now Geitner to sweep all the trillions of losses into the future - which has already cost the US Treasury $11 trillion dollars so far. Sooner or later, the Piper Must Be Paid. Are You Prepared?

The Fed will attempt to monetize everything in sight, but then the US dollar will definitely collapse. By choosing to buy these $ trillions in toxic waste, you will get what might be called terminal inflation in the US, where the value of the dollar collapses in about 1 to 3 years. Did I hear someone say HYPER-INFLATION?

The question then arises: Is it possible to avoid this uncontrolled inflation and/or the destruction of the US dollar or uncontrolled deflation and a total implosion of the $1200 trillion of World Derivatives? Any answer has to be negative. WHY? Simply because the world's financial system is "de-leveraging" and its $1200 trillion in size and affecting every institution that you can name. How can the the $11 trillion stop it? That is less that 1% of the amount out there. The Fed actually has spent $11 trillion in paying off just a fraction of these Derivative bets, most visible to AIG, the gigantic insurance company who made these bets or acted as a third party insuring one side or the other or both. The money has gone to many third parties such as Goldman Sachs, Merrill, Society General, UBS, etc. to pay for the Derivatives coming due.

The question then becomes who else, other than the Fed, can possibly raise another $11 trillion each year for two or more years? There is no one central bank that can, except possibly if a combination of China, Japan, the ECB and the FED all get together and handle this emergency. That is why Bernanke continually says he needs more authority to deal with "systemic" risk, why President Obama just said the G-20 needs world stimulus and why Geitner just agreed to consider a new world reserve currency. The estimated money spent so far to stop this de-leveraging comes to about $20 trillion, which is not even 2% of what is out there.

The truth is that the Central Banks are running out of money. Interest rates will soon start creeping up because of this perceived demand for more and more financing. At this point, I do not know the eventual solution to this problem or if there even is one. But, what I do know is that unless it is a Free Market Capitalist Solution, it cannot and will not work.

There is no difference between what is being done by the US Treasury and Fed from what the IMF and World Bank lectured all the developing countries not to do because of the hyper-inflationary implications implicit therein.

NON COMPREHENSION

"Facts do not cease to exist just because they are ignored."
       - Aldous Huxley

The Fed just recently announced that it will be buying $300 billion of US Treasuries and another $1 trillion of agencies (FNM &FRE). Of course, with no one wanting more of our debt, the only action left to do is for the Fed to buy our own debt. Try to understand that buying our own debt is the beginning of the end. It is the final 1st step towards hyper-inflation. It is called "monetizing" the debt and is the most dangerous thing any Central Bank can do. On this news, the stock market turned around and the media bobble-heads could not control their glee. Either they do not understand finance or are fully controlled by others. For Bernanke to say that he will re-absorb the excess money later on is sheer fantasy that even he does not believe. It is lying to the public but then what else is new?

Interest rates must be kept down at all costs so as to save the housing industry, or so they say. But it won't work. In a free market, interest rates must be allowed to find their own true level. If we have a mortgage interest rate of perhaps 4%, it will not save the industry, it will lay the foundation for next S&L type crisis. It's called UNINTENDED CONSEQUENCES. Monetizing is the red flag that tells people that the US dollar must go down in value as more money enters into circulation. While the dollar does not have to go down right away, it is easy to see a decline of 50% in a year or so. What the media bobble-heads did not tell you is that Gold also went up $50 right away and the dollar sank. This $ trillion created out of thin air, will be followed by other trillions till we come to a financial crisis and the present Government or Congress is thrown out on its ear. The desire to get re-elected is so strong that they are overcome with madness. But that is what Socialism is. The real scary thing is that the Republicans now in Congress are not any better. Money is going to flow out of over priced assets and into cash. The definition of cash according to our U.S. Constitution is defined as Gold and Silver. As asset prices start to crater (and they will), their value in Gold terms will fall. Gold is not a commodity; it is the only real money. As your Government buys US Treasuries because they have to, they will try desperately to hold the price of Gold down. But, they too, will fail.

Taxpayer money is being squandered by a bunch of idiots in Congress that have caused the problem in the first place. If they were forced to live by the laws that they passed and that everyone else has to live by, every single one of them would be in jail. You will notice that they NEVER swear to tell the truth, only you and I have to do that.

Obama has readily announced being in favor of taxing capital and imposing some protectionist policies which, to me, is a clear indication that he, like Bernanke, has learned nothing from the Great Depression. No one that I either heard or read about has any access to power, is capable of straightening out this economy. All the answers so far can be summed up into one solution; the printing of unlimited money. The Democratic super majority is hell bent on totally remaking the economy JUST AS WAS DONE IN the days of Wilson, FDR and Carter administrations. There will be hyper-inflation, runaway regulation, no incentives to produce, innovate or invest, confiscatory tax rates and collapsing incomes from reduced business activity and inflation combined with rising unemployment. These people in Congress are economic ignoramuses and they are in the process of nationalizing the domestic energy, banking, automobile and healthcare sectors just for starters. What will be left? Is WWIII our only way out?

THE STOCK MARKET AND THE ECONOMY

First things first: There are times when the stock markets and economy go their separate ways and NOW is one of those times. The reasons are usually varied and complex, but today they are quite simple. The level of economic illiteracy around the world is outstanding. It seems that ALL the politicians and their economic advisers are all Keynesian Socialists and therefore in the words of Obama, all believe that there is a worldwide hole in economic demand. Yet not one journalist or opposition leader has even asked, "Where did this shortfall in demand come from?" It certainly was not due to a lack of Government or public spending. Yet their solutions are all in unison, SPEND MORE. Doing more of the same as what got the world and especially the USA into this mess in the first place is the height of insanity.

But, enough of that for now, let's get back to the market and make some money. I have warned you time and again that we are in a period that closely resembles the 30's, so we are now in a period similar to 1930. The N.Y. government in their infinite wisdom, has come up with a passel of massive spending plans that the world, and especially the American press, politicians and of course Wall Street think will work. Before their audacious plans are actually put into practice, the ever optimistic stock markets, living on hope are now in that RALLY MODE that I have been expecting for the last 4 TO 6 weeks. This is the rally that could set us all up to become Rich by first making a nice profit on the upside and more importantly, giving us our last chance to liquidate and build up our cash positions. Then we will be ready to go short into what will probably be the biggest crash of our life time; maybe of all time?: BUT only if we each have the courage to stand alone against the maddening crowd.

SHORT TERM

We are extremely overbought. So try to cash in your profits; if we are lucky enough to get a 100 to 300 point rally into the option expiration day (Friday). OR if you have stock positions instead of options, you can buy some April Puts to protect your profits into option expiration on Friday and then CASH IN. Continue to sell OUT OF THE MONEY PUTS or buy Calls on the TBT into any Bond Market Rallies. You want to bet on long treasuries crashing eventually.

GOLD: WHAT TO DO NOW?

Not much NEW to say about Gold other than what I have been saying for the last year and a few months: Gold is in a consolidation phase until the ultra high levels of optimism are worked off. In the meantime, continue to accumulate Gold and stock positions into sell offs toward the $750 to $800 range. Now is a time for patience as everyone besides Gold Bugs begin to realize the ever improving Fundamentals for Gold. The next WAVE up will be an explosive 3rd Wave so sit back, build your positions and get ready for the 2nd best ride of your investing life. The best ride will be the 5th Wave starting in 3 to 5 years from now. So take it easy, stay calm. I have not missed a major move yet and neither will you if you stay tuned and keep the faith.

 

 

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UNCOMMON COMMON SENSE
Aubie Baltin CFA, CTA, CFP, PhD.
2078 Bonisle Circle
Palm Beach Gardens FL. 33418
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561-840-9767