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The Derivatives Mess

by Robert Chapman

Editor's Note: We continue to get questions about derivatives. This has to be one of the least understood areas of the investment markets today. I recently came across a highly entertaining and instructive article in the Financial Times by John Train of Montrose Advisers in New York City. In it, he summarizes the problem for Long Term Capital Management's John Merriwether as follows: "It was not that his team (which included two Nobel Prize winners) necessarily was wrong in its calculations. It is just that, in the rapture of having made huge amounts of money themselves in recent years, they assumed they could do no wrong and exposed themselves to an unforeseen event which promptly occurred. I do not have precise religious ideas, but I do observe that God is like that. He observes our proud manoeuvres here below and says to himself (or herself, or itself): 'Oh, he thinks that does he? He says that does he?' Zap! Hubris really does lead to nemesis."

He goes on to say that today's derivatives are simply another form of margin, the nemesis which caused the last great market crash. This time though it's "different enough from the last time so no one realizes what is happening." He uses this analogy: "...it is like the floor show in a seedy nightclub. A sequence of girls trots on the scene, first a collection of Apaches, then some ballerinas, then cowgirls and so forth. Only after a while does the bemused spectator realize that, in all cases, they were the same girls in slightly different costumes." In other words he concludes, "the so-called hedge fund actually was an excuse for a margin account." With that more or less philosophical background courtesy of Mr. Train, we introduce Mr. Chapman and his all encompassing rendition of this vast morality play titled simply and appropriately: The Derivatives Mess. He deftly paints the backdrop, candidly introduces the players, intricately weaves the plot dynamics and inevitably leads us to some formidable conclusions.

Sidenote: We do not necessarily agree with Mr. Chapman's strong views. We simply present them for your review. Please direct your comments for further discussion to the USAGOLD FORUM.

Even though there was considerably less volume during the second half of the year, due to the Asian financial crisis, the OTC market had outstanding derivatives contracts with a national value of $29 trillion, up 14.1% from 1996. Turnover in exchange derivatives grew 11% according to the BIS. The survey covers currency swaps and interest rate swaps and options, but does not include credit and equity derivatives. The drop in second half volumes was attributed to a drop in interest rate swaps in EU currencies in the emerging markets. The Chicago Mercantile Exchange is seeking regulatory approval to trade futures and options contracts offering investors a means to hedge their holdings in U.S. real estate. There are some who say that there are $140 trillion in face value of derivatives outstanding in the world today and we agree. As you can see, world markets are a giant casino. The BIS says there are $82.6 trillion worth. That is still twice the world's GDP, and five to six times the world's annual productive product. Those are 1996 figures, so if usage grew 15% in 1997 that figure would be $95 trillion...that they'll admit to.

One-third of the 1996 figures or $27.7 trillion is held by 20 U.S. institutions. That is compared to $12.1 trillion held by nine Japanese institutions, $10.5 trillion at eight French banks, $9.2 trillion at eight English institutions, $7.5 trillion at three Swiss banks and $6.6 trillion at seven German banks. The Japanese government, in closing the Long-Term Credit Bank, is attempting to salvage $350 billion in derivatives. If there is a chain reaction derivative collapse, the U.S. may get hit first and hardest with some 30% of the total or $40 trillion. Even the FDIC says U.S. commercial banks have $26.7 trillion in off balance sheet derivatives. That is over five times their $5.1 trillion in assets. As you can see, world financial markets are vulnerable. One major negative event and it is over. Trading volumes on the world's leading derivatives exchange have soared during late August and in September. The euro-lira interest rate future and the short sterling option posted record activity. The exchange volatility indexes have been going wild.

Floor traders and others say the final culprit in the Monday 6.37% plunge of the Dow was a flurry of mutual fund sell orders executed in the final 40 minutes of trading, when index levels peaked the cost to investors of protecting their gains began to soar. It had become practically impossible to use derivatives for their main purpose: to protect a portfolio. That being so, investors resorted to the ultimate hedge, or protective strategy: selling their holdings. It was the absence, rather than the presence, of the right kind of derivative products at an affordable price that made the sell-off almost inevitable. Due to downward market pressure it is not surprising that the cost to hedge portfolios doubled or trebled during the course of August. Moreover, even at those hefty premiums, many of the large banks and investment dealers that traditionally sell that kind of downside protection effectively retreated from the business. Liquidity dried up. The cost of derivatives had doubled. In the past when put options became costly, investors sold call options and used the premiums received from those transactions to finance the cost of the puts. As you can see, derivatives continue to distort markets unnaturally heightening the casino atmosphere.

Those in the yen carry trade received quite a jolt as hedge funds headed for the exits, as they had been forced to repay the yen loans they took out earlier to finance investments in the U.S. market. As they repay the loans, the demand for yen rises causing it to get stronger and incurring losses for the yen borrower. That in turn encourages profit taking and the sale of dollars. Now you can see why the yen rallied to 1.1173. The FED has to lower interest rates to take the heat off of world currencies. That will allow the yen to remain in the 1.15-1.25 area and the D-mark to trade 1.50-1.65.

The Japanese daily Kochi Shimbun, says the top 19 Japanese banks have potential derivatives losses of $180 billion. Fuji Bank's national volume of outstanding derivatives contracts at the end of March was $3 trillion. The estimated figure of derivatives worldwide from all sources is $140 trillion. Russian default has frozen settlement of $100 billion in contracts. We recently had a broker ask if the figure of $140 trillion in derivatives outstanding a misprint. He is a friend and has been a broker for 25 years. We mention this because the implications of derivatives are staggering, and we see few articles in the media pertaining to their negative possibilities.

The losses due to Asia and Russia will be $250-300 billion and a global loss of liquidity of 16%. That means world monetary authorities will have to increase monetary aggregates by that amount or face a sharp contraction in lending activity. All the figures you see regarding derivative exposure are guesses, because no one really knows for sure. Just one segment, equity derivatives, alone has and could further stagger the stock market. As the market plunged, dealers had to rebalance their portfolios by selling stocks to reduce exposure to further declines. This increased volatility, expedited the downside and caused costs to soar, which rendered averaging impossible. Many dealers closed up shop because they had mispriced their product. This mispricing was widely prevalent.

Major dealers, such as Merrill, Morgan Stanley, J.P. Morgan, Bankers Trust and Goldman Sachs, holding equity of $33 billion had exposure of over $400 billion. This tremendous world derivative exposure explains the 50% retreat of the stocks of many excellent companies. Drops now have little to do with reality but more to do with derivative gambling. The Comptroller of the Currency guesses that the national amount of derivatives in the portfolios of U.S.-based banks is $28.2 trillion, of which 95% is held by the eight largest banks and their off-balance sheet exposure is 243% of their risk based capital. Not to make this exposure diminutive, but Japanese banks have exposure four times their GDP. As we can see, derivatives have already inflicted incalculable collateral damage to the global economy, which we sadly predicted. Now concentration of the primary market makes vulnerability even greater as derivatives grow 4-5 times faster than GDP. This could well leave us in a situation like we just witnessed at Russian banks. One dealer will go bust sooner or later, and the whole house of cards will collapse.

Long-Term Capital management was bailed out by 14 institutions to the tune of $3.6 billion. An example of too big to fail or let's throw good money after bad, so we don't have to show the losses now. This piece of wayward financial management was rewarded by S&P with a downgrade to negative, or junk bond status, of Lehman Bros., Merrill Lynch and Goldman Sachs. Long-Term's fallout was reflected in Convergence Asset Management, which so far shows losses of 30%. At its height, Long-Term's actual total market exposure was $200 billion, or over 300 times its capital base. This is what we have been warning about month after month and no one would listen. Convergence was never that wild they only leveraged 15 times assets. For eight years we told you this was coming and it is here. Feigning concern, Robert Rubin has called for an inter agency study of hedge fund operations and the House Banking Committee will hold hearings. Don't hold your breath. The financial community has 90% of these politicians bought and paid for. Nothing will happen and we'll have a financial collapse.

Four LTCM partners personally borrowed and speculated $43 million. This underscores the extent partners are personally on the hook. They'll probably go bankrupt and the lenders will eat the losses. Our question is how did these people get such enormous loans to gamble with? How did the banks and the FED allow this major breech of lending ethics?

As a result of Long-Term capitals' problems, Julian Robertson's Tiger Management with $20 billion in assets, has unilaterally imposed a 5% exit fee on investors who want to cash out of Tiger and Jaguar in less than 12 months. On 10/7/98 Tiger lost $2 billion while unwinding its yen carry position. They had to buy $10 billion worth of yen. They are still up 10% for the year. Chase has total exposure to hedge funds of $3.2 billion or 2% of its loans, 9% or $300 million is unsecured.

The daily volume of OTC, currency and interest rate derivatives in London has more than doubled from $74 to $171 billion, over the last three years, outstripping New York and Tokyo turnover, which increased from $464 to $637 billion, or 37%. The BIS estimated daily global trading averaged $1.26 trillion in April, 1995, so our $140 trillion figure three years later has to be conservative. The daily average exchange traded interest rate derivatives increased from $177 to $345 billion.

We think that hedge funds are the New Barbarians at the Gate. Had not the FED and the lenders stepped in on LTCM the markets would have had to absorb a $80 billion hit. Tens of billions of illiquid securities would have been dumped on an already brutalized market. The tip off to the gravity of the situation was UBS (Union Bank Swisse) has taken a $700 million writeoff due to LTCM's collapse. LTCM was too big to fail. Now, who is going to bail out the rest of the collapsing hedge funds, most of which are offshore, outside U.S. jurisdiction. Intervention has created the same moral hazard problem that the IMF is so guilty of. If unsuccessful funds are not allowed to fail someone will have to bail them all out. Then maybe they'll bail out the losing margin stock buyer. There is no discipline left. The international monetary system is out of control. Saving LTCM was cronyism at its finest. Look at the connections of the so-called geniuses who ran the fund. And the sanctimonious U.S. turns its nose up at cronyism in Asia and Latin America. We have plenty of the home grown variety right here. Than again isn't membership in the Council on Foreign Relations and The Trilateral Commission supposed to mean something? Those of you who would like to see how it works get a copy of the Brotherhood of the Bell, starring Glenn Ford, produced in the late 60s or early 70s. LTCM was bankrupt and its rescue was funded by banks, the FED engineered the entire operation. This rescue can only lead to loss of credibility and stability in world markets. There is no transparency in world markets and no regulation of derivatives, which we've been calling for since 1974 when we said they would eventually destroy the stock market.

Now, how can the U.S. ask its Japanese counterpart to clean up its banking system and let the weaklings fail? How can we chastise China, Hong Kong, Taiwan, Thailand, Malaysia, India, Argentina and Brazil for intervening in supposed, purported free markets? There are no free markets, they are obviously all rigged. Just as the junk bond craze ended we are now seeing the beginning of the end of the abuses in hedge funds sponsored and natured by the international banking community in their greed and lust for more wealth and power. Congress having been paid-off will produce little if any meaningful legislation and regulation. The banks will cut back exposure and most of the excesses will die for lack of funds. Banks don't like losing money or being wiped out. And those noble nitwits should return to their ivory towers where they belong. The majority of hedge funds are operated offshore outside of U.S. jurisdiction, so they can't be controlled by U.S. regulations. It's the banks who have to be brought to heel before Congress and that is never going to happen, because the bankers own 90% of Congress. You can be sure eventually hedge fund losses will be shared by government guaranteed deposit institutions, which means you'll pay these losses.

Brooksley Born, CFTC Chairwoman, has been against all odds trying to get OTC-derivatives regulations, but Congress, the Treasury, the SEC and the FED have stopped her. You talk about a conspiratorial cabal. Banks have gotten filthy rich off derivatives and, of course, cheap give away money from the FED. Born says, "we are the only federal agency with statutory authority to regulate hedge funds and a certain portion of the swaps market" and she is right. It should be noted Richard Lindsay of the SEC said, "uncertainty created by concerns about the imposition of new regulatory costs may stifle innovation and push transactions offshore." Alan Greenspan testified that "no doubt derivatives loses will mushroom at the next significant downturn" he nevertheless saw "no reason to question the underlying stability of OTC markets, or the overall effectiveness of private-market discipline, or the prudential supervision of the derivatives activities of banks and other regulated participants." They knew we would have major hedge fund or bank failures, but were unwilling to do anything to stop it, so banks and their clients, hedge funds, could continue to enrich themselves and destroy whichever economy or country they were directed too. It is not only the money these entities made, but the destruction and recolonization of countries throughout the world. The operation was one of financial and political warfare, a context our kept media dares not discuss.

Just to show you how dishonest and corrupt Congress is during this stock market correction and hedge fund debacle, the House and Senate agreed on Monday 9/27/98 to a six-month moratorium of any expansion of OTC-derivatives authority for the CFTC. This follows a one-year moratorium. Now we ask you, does this smack of cronyism? This moratorium was backed by Senator Robert Smith (R-Ore.) and Senator Richard Lugar (R.Ind.), Chairmen of the Congressional Agriculture Committees that oversee the CFTC. You might write and ask them to explain such behavior in the midst of a multi-trillion dollar crises. Of course, the banks, brokerage houses, hedge funds, the Treasury and the FED were jubilant. Let the looting continue.

The point everyone misses is buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing. Rick Grove, top man at the International Swaps and Derivatives Association defends the lack of legislation contending it inhibits investment. What investment? Thus hedge funds will be studied to death and legislation will be forthcoming when it is too late and the world's financial markets will have collapsed.

Recent volatile markets have allowed market makers to again cheat buyers and sellers. Orders are being broken into pieces and being scaled up for buyers and down for sellers and with little or no regulation they can do as they please. Many traders have been running naked, having avoided hedging options they sold, because contracts were too expensive to be effective hedges. Stocks have fallen so much that many traders lost money. Some will go out of business.

Finally Alan Greenspan painted a frightening picture of the potential damage LTCM's failure could have inflicted in an address to Congress on Oct. 1. He said,

"on occasion there will be mistakes made, as there were in LTCM and I will forecast without knowing who, what or where, that there will be many more. I would suspect there are potential disasters running into a very large number, in the hundreds."

Where has Greenspan been for the last six years as the derivative problem was building to a climax? We were one of only three publications, that we know of, that consistently warned the world public of the impending problem. With all of this said, Greenspan said he didn't think more regulations would work, using the old canard that the funds would go offshore. Legislators responded by saying oversight was lax and that the bailout was an improper helping hand to rich speculators. Jim Leach (R.Iowa), who is a darling of the banks, suggested that the consortium violated anti-trust laws and questioned its financial concentration. He urged the Justice Department to review the bailout. John Meriwether was a consummate Wall Street insider who manipulated the FED and was able, through whatever devices, to coax billions of dollars in uncollateralized loans from Wall Street. Why was LTCM leveraged some 300 times its capital base? Why was Warren Buffett's offer rejected? He was willing to put up $4 billion with $3.75 billion going to run the portfolio. The cartel put up $3.65 billion for 90% of the fund, leaving principals and investors with a 10% stake, worth $405 million. That left Meriwether and crew with almost twice as much as the truly private bid they turned down. The principal beneficiaries of the rescue, however, were the lenders who advanced the money that built the 300 to 1 leverage. This exercise in crony capitalism, this sweetheart deal, was used to pay deferred management fees that were owed the management company that created the disaster. The fees were used to pay off a $38 million inter company loan, another $50 million loan owed to a bank that was part of the consortium and about $7 million in non-partner deferred employee compensation. The bailout was a back-room deal.

Russia's debt moratorium has forced restructuring of its Treasury bill (GKO) market and has sparked a flood of disputes between western banks over repayment of debts associated with their holdings of such ruble-denominated debt. Derivative protection bought from Russian banks to protect investments is worthless since the government declared a 90-day moratorium and there is no reference rate for the ruble. The derivative credit default swaps at issue should be paid out, because a moratorium is a default. But in a criminal society it might mean something else.

There is growing concern over the credit profile of some of the world's top banks and it has sparked a demand for credit derivatives to insure against possible loan defaults and to limit exposure to these banks. Banks are also taking out protection against each other as a perception grows that they need to insure against banks failing to repay anything from commercial loans to bonds issued by banks themselves. Premiums for AA rated European banks has widened by 1/2% in the last two months due to exposure to Russian and emerging market debt. Credit risk is everywhere. The total outstanding value of credit derivatives is expected to jump to $350 billion by the end of this year and reach $740 billion by 2000. Who writes this insurance and how solvent are they? There are few publications in the world where you can get this kind of information early enough to protect yourself. What the biggest banks in the world are saying is we could all go under. That is right, the credit system could well collapse. The answer is to have small denomination U.S. currency, gold and silver coins and stocks and food and protection. You may well need them if panicking bankers are any indication.

Lipper Analytical Services, says the best performing equity fund in the work, is a hedge fund called Lancer Voyager Fund. Their data base shows assets of $30 million, but no information on what those assets are. Lancer is promoted to the public by web site from So. Africa. If one accesses the Edgar Online web site their securities are shown to be illiquid, highly speculative and of dubious promise. All Lancer does is promote 122% growth in 1997 failing to disclose what their portfolio holds, unless you hunt for it. Only Lancer knows for sure what is in its portfolio. Investors, unless an investment has fully and total transparency, don't buy it.

The BIS survey says, buying and selling of the dollar accounts for 85% of total turnover in London, the world's leading center for foreign exchange. Forty percent of those trades are dollar-euro trades. Turnover in New York has grown 43% since 1995 or an average of $351 billion a day in April versus $224 billion in 1995. In N.Y. swaps accounted for 47% of the foreign exchange volume compared to 42% spot volume. Foreign exchange and interest rate derivatives have increased 75% in 3 years, compared to a 42% increase in spot volume. London OTC derivative currency trading rose 131%. London overall volume is double that of N.Y. This shows you the real derivative exposure and problems could be twice as bad in London than in N.Y.


The exposure of derivative losses continues. Cargill, member of the commodity cartel, lost $200 million. Brooksley Born, head of the CFTC, has called for more transparency in OTC derivatives by demanding more information for creditors and counter parties and the reporting of certain positions to federal regulators. The LTCM, registered with the CFTC, is being investigated. She said, regulators needed to address the issue of excessive leverage by hedge funds and insufficient prudential controls. An Ohio hospital was awarded $21.5 million in arbitration against Kidder Peabody regarding derivative transactions. Turnover in the OTC derivative market soared by 85% since 1995. The D-mark has overtaken the dollar as the most important currency in OTC rate swap transactions with 30% of the market. Volume has risen seven fold. George Soros is shutting down his emerging markets hedge fund Quantum Fund, which lost 31% of its value this year.

The explosive growth of credit derivatives is causing great concern. Some banks may be exposed to significant risks they still do not fully understand. Credit derivatives allow investors worried that a borrower may default or a bond may not be repaid to sell the risk to a third party. Essentially an insurance or bookmaking transaction. The global market for credit derivatives will grow from $180 billion in 1997 to $740 billion in 2000. Experts say there are dangerous hidden risks and that the market has moved far beyond the present, almost non-existent, regulatory environment.

Credit default swaps offers insurance against defaults and total return swaps allow an institution to acquire the cash flows of a bond or other investment without holding the instrument physically. The big buyers are banks, insurance companies and corporations. Both vehicles carry a predetermined premium calculated on the perceived risk. Analysts say there is insufficient liquidity in the credit default swap market to be able to extract enough information about default probability for pricing purposes. There is no model for pricing because the information about default probability isn't there. Who knows the price of a defaulted asset? Then there is the risk of the sellers. Buyers cannot be sure they'll remain in business. Buyers cannot always be sure they are risk-free, such as large hedge funds, which borrow heavily to fund risky positions.

The whole use of derivatives as hedging instruments has come into doubt because many of the counter parties have become dubious. There is a risk of a chain reaction through the entire system. The contracts and terms used from country to country in derivatives are wide open to conflicting interpretation, particularly when it comes to determining if a credit event has occurred, such as with Russian banks. A moratorium has been called. The banks won't pay because they say that doesn't constitute a default. As you can see, derivatives can be classed with land mines. You never know when you'll step into the wrong one and be destroyed.

Julian Robertson said his Tiger funds had lost 17%, or $3.4 billion, through October and he has reduced his debt ratio to 4 to 1. The large cash position is to meet potential demands for more collateral from lenders and requests by investors to cash out at year-end. The 450 investors at the annual meeting were feted to a sumptuous gala diner and dance at the Metropolitan Museum of Art. Speaking was Dame Margaret Thatcher, a Tiger board member.

Over the past few years we have warned repeatedly that the derivative markets would be the undoing of the financial system. We just had the first close call with LTCM. In spite of the fact Brooksley Born, chairman of the CFTC, is a long time friend of Hillary Clinton, we think she's done a great job over the past year of warning Congress and the public that OTC derivatives were out of control. Arthur Levitt, Robert Rubin, Alan Greenspan and a purchased Congress have tried to muzzle her, much as they did Henry Gonzalez when he confronted the Fed. Then came the LTCM collapse of Fed sponsored bailouts which rocked already-shaky world financial markets. Ms. Born has resisted intense pressure to back off but hasn't done so. This is the woman who almost became Attorney-General. Ms. Born is an idealist who isn't going to back down. That is until she's told, if you don't, you'll have some very permanent problems.

There is absolutely no regulation or control of the privately traded OTC derivatives market. All those instruments have little collateral, they are off balance sheet and their complexity makes monitoring them extremely difficult, as we've seen with LTCM. If one goes they could all go and bring down the whole financial system. That is why rules and regulations are needed. Alan Greenspan contends hedge funds and others are sophisticated investors and lenders already provide plenty of oversight in the interest of protecting investments. Well, if that were so LTCM would never have happened. Derivatives are out of control and should be strictly regulated by the CFTC.


Reuters reports that UBS entered into its investment with LTCM knowing its leverage was 250 times, breaching the Swiss bank's own guidelines of 30 times, which we consider preposterous. UBS invested $800 million, wrote off $733 million and contributed $300 million to LTCM's rescue. UBS said, "given the very high leverage, we must place great reliance on LTCM's risk management and controls. The business imperative is that this is an important trading counter-party for the bank." LTCM had eight strategic investors, "generally government owned banks in major markets," which owned 30.9% of its capital. They gave LTCM "a window to see the structural changes occurring in these markets to which the strategic investors belong."

There you have it. The Fed was bailing out central banks who owned almost 1/3 of the fund. As you can see UBS and others were also involved with LTCM because they were able to see central bank moves prior to their being known by the public, which is called inside information.

by Robert Chapman, Editor / The International Forecaster
November 9, 1998

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Copyright © 1998 by Robert Chapman. All Rights Reserved.

Reprinted by USAGOLD with permission of Mr. Chapman. No further reproduction without permission.

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