Saturday, September 12, 2009

All we need now is a big hit to theoretical money - derivatives anyone?

Apparently, not for the chinese. 
Now, think about this for a second. China has engaged in hedging and speculation that has not resulted in benefits to its economy. Quite the contrary actually. Their perception is that we have played games and manipulated financial markets. [surprise, surprise since they thought they were free markets ;-) ] In any event, China owns tons of treasuries. Say we were to get an implosion of theoretical dollars within the financial system via some sort of large defaults...that would trigger real dollars to rise in value immeadiately, likely over the longer-term interest rates would also go up, and bonds down. In the big picture, that would further stress the chinese overall, stress their derivatives exposure and their most popular investment - treasuries plus the derivatives on those treasuries. The implications are not a funny thought. 

Now there is an interesting possible scenario here for the shorter term, one I am quite partial to...the chinese know that we need to keep interest rates low to even attempt to keep deflation at bay and that there is a shortage of real money dollars. If they were to force the collapse of large financial institutions, the buying power of their US treasuries paper could increase dramatically. If this were to happen their influence over the US Government would likely also increase dramatically. Also, their ability to influence our economy would also increase dramatically - at least temporarily. This condition would only be possible if interest rates were to remain low for some time after china's defaults forced major banks into receivership. So, if indeed this scenario were to play out, there could be a lot in it for china, since its reasonable to assume they could generate potentially dramatic positive returns by owning cash dollars while collapsing our debt money based financial system and then hijacking it. (see: Derivatives...what the heck were they for?)

Keep in mind that though the article posted below does not specifically discuss oil...oil is one of the markets that china has been playing in the biggest way...and the impacts of their gamesmanship would likely effect oil even more than soybeans, gold and cotton. This is why oil likely was down so substantially on Friday even though the dollar was weaker than the prior day.

In any case, back to the theoretical world of the fed and out financial system, derivatives are only agreements and agreements are susceptible to be broken and altered. Remember, that JP Morgan has 89 trillion of  purportedly "perfectly hedged derivatives".

"Perfectly Hedged"? We know this to be a lie. Why? It is impossible in the first place and secondly the very nature of a derivative agreement makes it highly improbable. So let's keep it simple and examine just the spread risk on those derivatives, despite what they or the fed may try to say, its in the trillions of dollars. 

Imagine if you will, owning one trillion dollars of some index leaps. Just look at the spread in the market now, do the math and then try to get filled at that spread. That risk alone will be 5 to 10% of capital easily - so, you place your order and immediately lose 100 million when you turn around and try to sell it. Now take the instrument make it 100 times more obscure and transacted in a private market that has limited liquidity...and the spread risk on the equity leaps look tame. Now for each component of a derivative position and its hedges there is spread risk. Unlike a simple directional leap position, which itself has 10% risk in taking into account both buy and sell sides...creating a complex position with hedges adds significantly more spread risk relative to capital required to maintain the position. To see this in real life simply model up a butterfly or any limited risk option strategy and then try to execute it. You will see large losses immediately relative to capital employed and the size of the trade. JP Morgan's spread risk (which is much more substantial than a simple options combination trade) alone makes the bank insolvent. Funky accounting and supportive manipulations of accounting rules, off balance sheet entities and SIV's make it possible to hide these inefficiencies by reflecting theoretical or derived values on the balance sheet - where everything can look - well, "perfectly hedged". 

All of these techniques are tacitly endorsed, lobbied or promoted by the Fed...and follow the pattern of regulation created to legalize criminal or inappropriate activity. In fact, the Fed itself uses these conventions themselves in a lot of cases. The fed's reported balance sheet is supposedly up to around 2 trillion dollars...up some 500% or so...their off balance sheet "balance sheet" makes that sum look like peanuts. So, not only does the spread risk alone accomplish that task of bankrupting JPM but that spread risk likely will add trillions  to our national debt when the JP Morgan's obligations are transferred to the tax payer (to be nice, lets assume 5% of 89 trillion is 4.5 trillion). Notice however, that I did not even mention the china situation yet - that's called counter party risk and that risk is much bigger than china alone. Add that to the equation, and the banking system in the US takes a 20 trillion or greater hit from JPM alone (and quite likely much more)....and guess who gets the bill? 

That's a lot of liquidity to take out of a theoretical and fiat system... the shortage of dollars will be tremendous. (see: Derivatives...what the heck were they for?, More dollar what-if discussion, crash warning and recommendationsThe Future of the Dollar - the biggest short squeeze ever,  The EURO - starting a trip to oblivion and Warren Buffett - the ultimate bull-market manifestation) 

Now you know why the fed has tried like hell to bail out JP Morgan at every turn (starting with Bear Stearns) and especially tried to protect their reputation and image of solvency. But JP Morgan is broke and when they are proven to be broke the whole system will be broke since most banks will be impacted directly and some indirectly.

Observe the chart below. Each large move in the SP500 was preceded by  period of correlated behavior between treasuries and stocks. We are presently in a significantly correlated pattern.
see the original reuters article here or read it below:
US commodities rattled by China derivatives stance

* China lets state firms default on derivative contracts- report
* US soy, gold and cotton pressured by report
* Lawyers doubt legal standing of the move
* Market suspects more potential losses prompt the move
* Foreign banks dismayed (Updates with US gold, soy and cotton markets weighed down by reported move; adds analyst quotes, adds CHICAGO to dateline)
By Eadie Chen and Chen Aizhu
BEIJING/CHICAGO, Aug 31 (Reuters) - U.S. gold and soybean markets fell on Monday following a weekend report that China's state companies may default on commodity derivative contracts with banks providing over-the-counter hedging services.
Traders in other commodities markets in the United States were cautious, underscoring China's predominance as a buyer in global markets from metals to grain to oil after it played a key role in rallying prices to record highs last year.
In a measure of the country's influence over the global economy, U.S. stocks fell after the Shanghai Composite index .SSEC fell nearly 7 percent to a three-month low on fears Beijing is trying to moderate growth and choke off speculation in its stock market by tightening bank lending.
Commodities markets were chilled by a report in Caijing magazine quoting an unnamed industry source as saying Chinese state-owned companies will be allowed to default on commodity derivative contracts. The report provoked anger and dismay among investment banks that feared a damaging precedent.
China's regulator of state owned enterprises, the Assets Supervision and Administration Commission (SASAC), has told six foreign banks that SOEs reserved the right to default on contracts, the magazine said in an article published on Saturday.
A government official said that the Bureau of Financial Supervision and Evaluation under SASAC was handling the issue. The official declined to be named and did not elaborate.
"A Chinese agency said they reserve the right to walk away from bad derivatives contracts and that stirred up a lot of worry not only about the stock market but soybeans as well," said Paul Haugens, vice president at Newedge USA.
China, the world's top importer of soybeans, has been an aggressive buyer of U.S. supplies, helping drive prices higher as stockpiles fell to the lowest level in over three decades.
Chicago Board of Trade soybean futures for November delivery SX9 fell 31-1/2 cents, or 3 percent, to $9.79-1/2.
December gold GCZ9 fell $5.30 to $953.50 an ounce at the New York Mercantile Exchange's COMEX division. U.S. cotton futures fell in early trading due to the news, but closed higher on month-end position squaring.

"Historically, it is not so unusual for China to either renegotiate or abandon some deals that have been made. Some traders who have been around for a while are certainly aware of that possibility," said Bill O'Neill, managing partner at New Jersey-based LOGIC Advisors.
Spokespersons at Goldman Sachs (GS.N), UBS (UBSN.VX), JPMorgan (JPM.N) and Morgan Stanley declined to comment, along with the Securities Industry and Financial Markets Association and International Swaps and Derivatives Association Inc.
The reported letter to the six banks follows an order from SASAC in July that required all state companies trading in derivatives to make quarterly reports about their investments, including details of holdings and performance.
"I won't be surprised if more state firms emerged with big derivatives trading losses. Or else SASAC won't come out with such a radical move," a Hong Kong-based derivatives analyst said.
"As far as I know, there are another number of state firms bogged down in such losses besides those surfaced ones," said the analyst, who declined to be named due to the sensitivity of the issue.
A SASAC media official said he was waiting for the "relevant department's" official comment before clarifying the situation with the media.
The report deals another blow to investment banks hoping to sell more derivatives hedges in China, the world's fastest-expanding major economy and top commodities consumer.
"It's a handful of companies who are being encouraged by regulators to renegotiate. It's outrageous, but it's China so everyone is treading very carefully," said a banking source.
Beijing-based derivatives lawyers said the so-called "legal letter" has no legal standing -- SASAC as a shareholder of SOEs has no business relationship with international banks.
"This can also lead to market chaos. For example, a foreign bank can tell its Chinese clients that it can reserve the right to default on contracts that will bring losses to the bank," said a lawyer from the derivatives risks committee of the Beijing Lawyers Association.
No bank names were reported in the Caijing report. The SASAC media officer also declined to specify any.

Chinese state firms, especially those that have suffered big losses in derivatives trading, have been complaining that their foreign banks sometimes did not disclose full information of potential risks when selling them complicated products. 
© 2009 m3, ltd. All rights reserved.