Derivatives Will Take Down the Financial System

by Wes Bridel on August 8, 2012

in Economic Updates

We’ve spoken before about the danger of derivatives to the very core of the financial system and thus to our entire economy.  Our guess would be that when we first began discussing this issue, most of you had never heard of derivatives before.  You probably have heard about them now.  And we believe, it will be a terrible curse word to you in the not too distant future.  We’ve been discussing our economic forecasts for this year and beyond for some time now.  We were open in saying that we did not believe all of our forecasts would happen, but that there was reason to believe a good many of them would (as difficult to live through as those things might be).

However, this forecast is the one that we believe is the thing most likely to happen and it probably has as bad of consequences as any other.  Actually, a derivative implosion will probably be what gets the economic collapse kick started which will lead to some of the other predictions coming true.

What is a derivative?

A derivative is a financial security that has its value based upon another financial security. You’ve probably never directly bought or sold a derivative, but they have become huge business in New York & London.

A stock implies ownership in a company.

A bond implies a loan from you to a company or government.

An option or futures contract on the other hand might be based on the future price of a stock, or bond, or interest rate or any other number of things such as commodities.

There is nothing intrinsically wrong with having derivatives, however, they tend to be a lot more opaque than other markets.  Thus, Wall Street firms find that they can really take advantage of others with options because it’s much more difficult to determine the fair value of an option.  Thus, they make very large profits on these instruments.  Again, nothing particularly wrong there.

Where it gets ugly is when you start to see just how large of bets these firms are making in derivatives.  Off the top of my head, JP Morgan Chase has over $70 Trillion of derivative exposure.  Other large investment banks have similarly large exposure.  Keep in mind that’s about the size of the entire world economy in any given year, or more than 4 times the size of the US economy!

How did their position get so large?  How did these other large investment houses positions get so incredibly large?

What if the US Government/Fed and other western governments were working together with these large banks in certain ways?  What if they pushed interest rates incredibly low so that these banks could borrow limitless amounts of money at practically zero interest?

Well, that’s ridiculous, they would never give these banks such a huge advantage…Oh wait, oh yeah, that’s been going on for some time now.

Well, what if they just needed a couple small, teensy weensy little favors….

1)      Like controlling the price of interest rates with interest rate swaps – so that interest rates stay low even if real borrowers aren’t that interest in lending these money losing, money printing governments money at close to zero for years out at a time.  Both the banks and the governments win, so why not, right?

2)      Like controlling the price of gold and silver so that they rise, but not at too fast a rate – No reason to panic the market by letting them see the value of real money skyrocket which would mean the value of their green paper is plummeting in comparison, right?  And the banks get to make a killing in this market because they are by far the biggest player and thus it’s easy to push the market around most of the time.  This is the most well documented scandal ever, but if the government is behind it, the government regulators aren’t exactly going to do anything about it, are they?

3)      Like pushing the stock market back up whenever it looks like it’s about to go into uncontrollable freefall. It’s almost magical the way the market tends to bounce up every time it appears to be in a technically difficult spot and who’s going to complain about stock market gains right?

These things might sound far out there, but actually at one time or another each one of these things has been readily admitted.  No one is going to admit to them when they’re lined up together and when the dire consequences are discussed, but they look at these things like this…

1)      Low interest rates are good for the economy – Never mind how it kills savers and makes each saver have to become a wild eyed speculator in order to just maintain purchasing power.  Perhaps on average, there’s not as great an effect, but this ignores the moral outrage that should be present that they punish the prudent and reward the bankers and government connected.

2)      It’s good for Americans if the Dollar’s value is stable, so who cares if we hurt gold & silver owners /miners – This ignores a couple important things.  One, by violently correcting gold and silver’s natural response to the excess printing and debt of the US Dollar & other major currencies, they are convincing everyday Americans to keep their money in the foolish bet of the US dollar instead of protecting themselves from the inevitable.  Two, because gold & silver are not making the problem clear in the market, the government and banker types are able to carry their shenanigans much further which will lead to a much more disastrous implosion than would otherwise happen if the normal market indicators were clear.  Three, it’s harder to make money as a minor so not as much gold and silver are mined and thus when everyone is scrambling for the metals to get some safety, there will be a lot less of them to be had and thus lead to much higher prices than they would have to be.

3)      Everyone will be happy with a higher stock price, so what’s the harm? – While most people are, there’s an inviolate rule of economics and finance that when something is manipulated in an unnatural direction, it will eventually snap back in the other direction and overcompensate.  So while people might think this is great in the short term, in the end it will ruin people.  And again, it doesn’t make clear the real problems in the system and allows them to go on perpetrating the fraud.

Ok this post is beginning to get a little long.  We’ve covered why they’re doing the things they are doing.  Tomorrow, we’ll look at what we believe will go wrong with this build up of derivatives.

This is the 31st post in a series.  You should read the initial thoughts on these forecasts here. and the Overall Prediction Page here.  Here are the rest of the posts:  3) Ben Bernanke’s Dollar Devaluation Plan, 4) The Coming US Dollar Devaluation, 5) Stock Market Volatility, & 6) Stocks to Fall in 2012, 7) The European Crises, & 8) European Options, 9) European Prediction, 10) Recession in Japan, 11) Japanese Yen Crash,12) War with Iran, 13) Jewish Perspective on Iran, 14) Commodities to End 2012 Lower, 15) Where Will Gold Go Next?, 16) Gold, Should you Wait?, 17) Will Silver Move Higher?, & 18) Why Buy Silver Now?, 19) Oil Prices to Explode Higher, 20) Bonds Will Fall, 21) US Dollar, 22) European Recession, 23) Sovereign Default in Europe, 24) China’s Slowing, 25) US Recession., 26) Currency War, 27) Deflationary Crash, 28) Hyperinflation, 29) Increasing Natural Disasters, & 30) Fed Announces New Form QE.

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