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October, Friday 28, 2011


DOW + 22 = 12231
SPX +0.5 = 1285
NAS – 1 = 2737
10 YR YLD – = 2.30
OIL – .47 = 93.49
GOLD –2.30 = 1744.40
SILV +.20 = 35.39
PLAT + 14.00 = 1651.00


It’s Friday!
Just in time; I think my brain is going soft; a spongy degenerative condition perhaps. I just can’t seem to grasp the fine points of the Grand Plan that came out of Europe yesterday. I think I get the dominant theme – the Europeans are going to hand out FREE MONEY to the banks, but I just can’t seem to comprehend the non-existent details.
What has me troubled is the notion that banks will take a 50% haircut but only on the condition that it does not trigger Credit Default Swap hedges. The plan asks Greece’s private creditors to take losses of 50 per cent on the country’s bond they hold. Along with new loans and other measures, that is meant to bring Greece’s debt down to 120 per cent of economic output by 2020.
After the private creditors have swapped their Greek bonds for new ones with a lower value, the country’s rating is likely to remain in the ‘B’ category, only a few notches up from its current CCC grade. Fitch rating agency says the deal would result in a temporary default.
However, the ISDA, the International Swaps and Derivatives Association, claims the default is not a default and will not trigger a payout on Credit Default Swaps because acceptance of the haircut is voluntary.
Apparently the Swaps are unregulated private contracts between private parties. In order to know whether a trigger occurred you have to read each individual contract. As a result, what the ISDA says about whether a trigger occurred as to private contracts that are out there is totally meaningless – I mean they haven’t read all those private contracts.
As to whether the 50% haircuts are voluntary, well that’s kind of like a guy holding a gun to my head and saying “your money or your life.” That’s my choice; I don’t necessarily have to give the robber my money.
Now imagine you bought something – it could be anything, a boat, a car, a widget – but let’s just call that something a “bond” – and then you went to your local insurance agent and said I want to insure this “bond” from going down in value; you pay the insurance company the agreed upon premium and they give you a contract that says if your bond goes down in value – say it drops 20% or more, your insurance policy will pay off the losses.
Next thing you know, you’re walking down a cobblestone street in Brussels, it’s 2AM and suddenly a gang of thugs jump out behind a shadowy corner – and Angela Merkel puts a gun to your head and say give us 50% of your bond or die. You surrender 50% of the value of the bond.
But you live to call your insurance agent who says – don’t get ahead of me – your insurance agent says what any insurance agent always says when you submit a claim – he says “you’re not covered; you see the problem is you made a voluntary choice to give up 50% of the value of the bond.”
You gasp for breath, the spittle forms around the corner of your lips, you feel your left arm go numb, with your right arm you reach for the blood pressure medication and you wash it down with a big slug of tequila.
And then you nearly break your fingers dialing your lawyer.
A little time passes and the billable hours add up and lawsuits are filed. Lots and lots of lawsuits.
And then we learn what Fitch ratings means by the term “temporary default” Greece won’t actually default; the bonds won’t really be cut in half by 50% of the value. Instead, the Europeans will just extend the maturity of the bonds from 5 years to maybe 20 years, but the value remains the same. This is known as the Super Grand Argentine Debt Solution, which was so successful six years ago.
This all seems to make sense, but then I read a very cogent email from a very intelligent listener who very astutely asks: Who in their right mind would buy bonds from the EU at this point as they obviously are manipulative and the bonds are so risky?  They have destroyed their credibility and I think this worsens rates in the long and short run as they have put on more risk that cannot be hedged. 
Yes, well, this is the dilemma. After you learn that insurance companies are in the premium collection business and not the claims payment business, should you still buy insurance?
And then the next part of the equation – if you can’t insure against loss, should you really buy that car, or that boat, or that widget, or that bond?
I suppose only time will tell.
Let me clarify a point here – the Credit Default Swaps aren’t really insurance and they are not really sold by insurance companies, banks sell them; and they are sold to people who don’t have an insurable interest. Insurable interest is important because it may create a moral hazard – for example – you don’t want your pharmacist to buy a life insurance policy on you. “Oh, yes Mr. Noe, here’s your Tylenol tablets. Oh sure, Tylenol always smells like rat poison, why do you ask?”

And you may wonder –  why are banks selling an unregulated version of insurance? And the answer is they get paid for selling this stuff.
And you may ask – wouldn’t it be a big problem if there were an actual default? And the answer is maybe, maybe not. Since banks are not really insurance companies, and since Credit Default Swaps are not really insurance and because the whole market is not really regulated, the banks don’t really have any money to pay off a claim in the event of a default.
When you consider that the entire worldwide global domestic product, everything produced in the entire world every year is valued at about $60 trillion dollars – and when you consider the entire US banks derivative exposure is somewhere between $250 trillion and $600 trillion (nobody really knows).  And when you consider that the total value of notional derivatives held by Goldman Sachs is 537 times its total assets. And when you realize that the top four banks control 94% of all derivatives. And when you realize that 25 banks worldwide control all derivatives.
And when you realize the derivatives markets are just one big, incestuous pool of greed that does nothing to hedge risk – at that point you may very well ask – why do we have this stuff anyway?
And this is where my brain feels like a sponge and I have a craving for tequila shots, even though I don’t drink tequila.
Meanwhile, let’s get back to analyzing the details of the Super Grand European Debt Solution that was announced yesterday.
It appears the indebted European Nations will borrow money, or create money out of thin air to bail out other indebted nations, who will in turn ask insolvent banks to accept a 50% off deal on the bonds of the indebted nations that are borrowing money from the insolvent banks that are given loans in order to recapitalize through raising capital which they will of course accomplish by borrowing from the indebted nations they just gave the money to.
So, we’re all reminded of Occam’s Razor which says: the simplest explanation is most likely the correct one.
Problem solved. Glad I could help.
Hello Doctor Sinclair Noe:
I appreciate the opportunity you provide for email questions.  I am unable to listen or call into your show live but I religiously listen to your show later after work thanks to the Money Radio 1510 archives.
My question relates to the derivatives at Bank of America where the derivatives were moved from the investment banking side to the FDIC deposit insured side.  I have personal and business accounts with Bank of America.  Of course, I am upset with this change not only as a user of Bank of America but also as a taxpayer that may be called on to bail out the FDIC should the derivatives “blow up”.
My specific question relates to the overall exposure the derivatives place on the FDIC.  I believe the Bank of America derivatives exposure is approximately 57 trillion.  However, FDIC insurance is capped at 250,000 per account.  Does this imply that only a small portion of the 57 trillion or so in derivatives would be covered by the FDIC insurance making the risk to the taxpayers less than it may appear on the surface?
Thank you for any insights you may have,
loyal listener from Mesa, AZ.
Don’t thank me yet.
Here’s the deal. Bank of America might have $57 trillion in derivatives in the retail bank, backed up, in part by $1 trillion in deposits held by widows, orphans, Mom and Pop retail investors in checking and savings accounts with FDIC insurance up to $250,000 per account.
And you’re thinking that if just 2% of that $57 trillion goes bust, it’s the end of the world – But don’t worry – I mean, what could go wrong?
Actually, that $57 trillion dollar figure is misleading – that is a notional figure. In other words, they have taken bets on both sides at the same time. For example – let’s say BofA is betting on whether an apple will turn rotten. They write a derivative for one million dollars that says the apple will rot. They write another derivative for one million dollars that says the apple will not rot. They now have $2 million dollars in notional value. BofA pockets the commissions for writing the derivatives.
The apple rots.
The two derivatives contracts cancel each other out. Net loss is about 50 cents for the rotten apple. BofA keeps the commissions.
Now, let’s look at the quality of the underlying apple. The best estimates I have seen show that out of the total notional value of credit derivatives held by bank of America, approximately 37% are non-investment grade credit derivatives – just over one-third are bad apples. While that may sound incredibly reckless and dangerous, it is actually in line with industry standards. Citi holds about 55% in non-investment grade, Goldman Sachs around 52%, and JPMorgan about 35%.
Let’s put this in perspective; back in February 2008, Bear Stearns had total net derivative exposure rated BBB or below stood at about 17%. In May 2008 Lehman Brothers non-investment grade derivatives exposure was at 9.2%
But again – not to worry – even though there is a whole bunch of junk – it all cancels out – almost.
I’ve seen estimates that Bank of America has about $32 billion in un-hedged or naked swaps – which sounds like a lot considering the entire market capitalization of BofA is about $74 billion. But again, not to worry – it is highly unlikely that the entire $32 billion in naked swaps would all go bad at one time – that would have to be like some sort of contagion from Europe or a credit freeze like Lehman, and you really shouldn’t worry about such things.
Especially when you consider that those naked swaps would be covered, because under the 2005 bankruptcy act, derivatives counterparties are first in line and they get to grab assets first and leave everyone else to scramble for the crumbs. So the naked swaps get paid first, and if that means dipping into the retail checking and savings accounts – well there’s about $1 trillion just sitting there and it’s protected by the FDIC, which is guaranteed by the full faith and credit of the United States Government – you know – we the people.
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