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“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system.” “…The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear…” “…In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Warren Buffet, February 21, 2003 “Why is it possible to rescue S & L buccaneers in the early 90s and provide guidance to several Wall Street bankers during the 1998s Long-Term Capital Management crisis, yet throw 2 million homeowners to the wolves in 2007?” Bill Gross, PIMCO, 2007 It is crucial to consider why we are in the (related) liquidity and derivatives crises, why they will inevitably worsen, and what actions one can take to protect one’s assets, and even profit, from these worsening crises. The Liquidity CrisisThe liquidity crisis stems primarily from (ironically) too much liquidity in various forms provided by, or enabled by, the U.S. Federal Reserve and “sister agencies” in recent years. Deepcaster and others have commented earlier on the increasingly threatening explosion in Over The Counter (“OTC”) Derivatives, risky subprime mortgages, and in Money Supply (M3). One of these three species of liquidity - - (M3) - - is directly controlled by The Fed . Moreover, The Fed has encouraged the growth of high risk subprime mortgages and unregulated (per former Fed Chairman Alan Greenspan) OTC Derivatives - - a threatening form of “dark liquidity.” (See Deepcaster’s Alert of April 6, 2007 entitled “Protecting from Dark Liquidity and Other Systemic Risks.”) M3 SkyrocketsOne need only refer to the broadest measure of money in circulation (M3) which has been expanding at an annualized rate of 14% as of September 10, 2007. Compare that with August, 2007 M3 growth rate which was an annualized 13.6% versus 13% annualized in July, 2007. These are the highest levels in 34 years*. More liquidity! An M3 growth rate in excess of 14% means that the U.S. Dollar money supply is increasing at an approximately 5 year doubling time rate! This monetary inflation creates increasing pressure for a further drop in the U.S. Dollar vis-à-vis other major currencies, and, of course, for massive price inflation. It is thus no surprise that The Fed stopped publishing M# in March, 2006 and that we have to rely on “private party” calculations to obtain this number*. Subprime LoansAnother cause of the liquidity crisis is the period of excessively low interest rates created by the Greenspan Fed after the tech-wreck of 2000. This encouraged a proliferation of heavily leveraged “commercial” paper as well as excessive borrowing by sub-prime borrowers and others and risky lending by sub-prime lenders, particularly via adjustable rate mortgages (“ARMS”). This proliferation of ARMS was sure to cause problems when any financial bumps in the road were encountered, and/or when the ARMS interest rates reset to higher levels and the sub-prime borrowers were unable to pay. ARMs are resetting now at $40 billion/month and will continue at this rate into 2008. The resulting growing mountain of risky and imploding debt creates not merely increasing default risk in the real estate sector, but also creates greater systemic risk. In sum, excessive risk taking by mortgage lenders encouraged by low rates and borrower standards has predictably led to increased defaults which has led to heightened perception of risk in CMOs (see below) resulting in the credit markets “seizing up” in August, 2007. And, of course, the Greenspan/Bernanke crew at The Fed surely should have known this - - known in 2001 and following years that, via their rate cuts, that they were setting up a situation which would have resulted in excessive and risky lending, resulting inevitably in large increases in defaults, and that this would result in title to valuable properties passing, dirt cheap, to the Central Banks’ client lenders, just as they did in the Great Depression. CDOs/CMOsYet another financial instrument involved in the current liquidity crisis is simultaneously a major factor impelling the worsening of the current liquidity crisis. This instrument is known as the Collateralized Debt Obligation (“CDO”) whereby debt of all kinds is packaged and sold to investors who are far removed from the original lending transactions. One sub-species of CDOs is Collateralized Mortgage Obligations (“CMO”), to which we referred above, in which a group of mortgages is packaged and sold to these investors. Of course, a major risk in the CDO/CMO financial universe is counterparty failure or the perceived risk thereof. Just this past August, 2007 we see the consequences of counterparty failure (or perception of the heightened risk thereof) when a number of ARM rates were reset upward and the sub-prime borrowers became unable to pay. Now lender/investor holders of CDOs/CMOs (which contain the “bad” loans to these defaulting borrowers) thereby became holders of, or became exposed to, the highly risky portfolios containing sub-prime mortgages. And, coupled with the rampant non-transparency [via a number of “dark liquidity” transactions] of these transactions, great fear was created in the markets. As the credit market freeze-up of the week ending August 17, 2007 showed, the development or perception of any significant increased default risk causes these markets to freeze-up. Moreover, couple the risk of the CDO/CMOs with the massive derivatives risks described here, and the results are a very serious threat to the financial system. OTC DerivativesAlso consider another species of liquidity risk - - the $260 trillion plus interest rate Derivatives reported by the Bank for International Settlements - - the Central Bankers bank in Basel, Switzerland. Consider also the $6 trillion in Derivatives focused on managing the crude oil and natural gas market. Such Derivatives positions are obviously used by The Cartel of Central Bankers** to intervene in the interest rate, crude oil, and a variety of other key markets. Consider further, the trillions of dollars in “private party” OTC Derivatives which also provide much of the liquidity needed to grease the wheels of the markets, so to speak. These derivatives provide such liquidity, until, that is, they “seize up” or fail, due to counterparty default. “Private” OTC DerivativesSpecifically, consider the increasing mountain of OTC “private” derivatives estimated to be at $20 trillion. Certainly, $20 trillion in unregulated “dark liquidity” is a sufficient amount (if there are defaults or a perception of increased likelihood of defaults) to threaten the entire system. The $20 trillion in OTC derivatives positions typically embody the following risks: they are not exchange traded, not guaranteed, not transparent, not regulated, traded without a market determination of price, unfunded by any guarantor financial agency, and, worst of all, their integrity depends upon the ability of the counterparty to pay. If counterparties default, there is immediate trouble with huge “ripple effects.” Yet an additional risk is that derivatives are typically purchased for a fraction of their total notional value. Therefore, they incorporate much leverage. Leverage, when it works in one’s favor, can be quite profitable, but can also greatly magnify default and systemic risk, as the principals of Long-Term Capital Management well know. Thus, the facts that the liquidity and derivatives crises have begun in earnest, and that they will worsen, were entirely predictable. In the future, as ARMS continue to reset, sub-prime borrowers continue to default in increasing numbers, foreclosure rates increase, and companies with sub-prime exposure suffer even greater losses, there will likely be more such market freeze-ups. Since lenders and investors often do not know which CDO/CMOs have default risk and since counterparty default is always a risk to the OTC Derivatives “market,” there is an ongoing and increasing risk of additional market freeze-ups in the OTC Derivatives market as well. Thus the credit market “seize up” of the week ending August 17, 2007 in which, for example, commercial paper outstanding plunged by $91 billion, $90 billion and $63 billion in the weeks ending August 15th, 22nd and 29th* is both a harbinger of, and an object lesson for, the future. The Fed’s “Cure” Worsens the DiseaseHowever, as a “temporary cure” on August 17, 2007 The Fed decreased the discount rate (whereby banks can borrow directly from The Fed) by ½%. The result was that borrowings (!) by banks (so they could do more lending) jumped from a daily average of $6 million to $1.3 billion in the two weeks ended August 29, 2007. A staggering 21,600% increase. The key point is The Fed administered a cure (enabling even more debt) which, in the long run, worsens the “excessive lending disease.” The Fed’s discount rate cut (i.e. enabling more borrowed liquidity) “cure” is simply creating more of what created the crises in the first place, which was excessive borrowed liquidity. Coupled with non-transparency and excessive fiat currency monetary printing, the liquidity increases and easy credit have led to, among other negatives, the moral hazard of lenders lending recklessly to borrowers who should not be borrowing to begin with. Even so, The Fed’s “solution” of allowing even larger injections of “borrowed liquidity” as opposed to “earned liquidity” (which is healthy liquidity achieved through savings out of earnings) temporarily calmed the markets. Yet it is increased “borrowed liquidity” which worsens mid and long-term systemic risks, not to mention sector risks as well. For this crucial “borrowed vs. earned” liquidity distinction we are indebted to Dr. Kurt Richebacher (R.I.P.) whose sensible prescriptions have been utterly disregarded by the U.S. Federal Reserve and which prescriptions, had they been followed, would have resulted in our not being in today’s liquidity and derivatives crises. [May Dr. Richebacher rest in peace. He passed away in early August, 2007.] Dr. Richebacher explains why credit (i.e. debt) financing, or “borrowed liquidity” as he calls it, is so pernicious: “Available liquidity is, of course, most important. Nevertheless we find it most important to distinguish, first of all, between two different sources of liquidity: borrowed and earned liquidity. Present excess liquidity in the United States and several other countries is of a peculiar kind. It does not come, as would be normal, from unspent current income – in other words, from saving. In the absence of any new savings, all the liquidity creation occurring in the United States is borrowed liquidity. Generally, borrowing against rising asset prices is in diametric contrast to earned liquidity from savings out of current income. By definition, this is liquidity from credit inflation. One thing is certain about borrowed liquidity; it depends on rising assets prices. Once asset prices stop rising (see current U.S. housing prices) this liquidity suddenly evaporates. Moreover, ever larger credit injections are needed to keep asset inflation - - like any other inflation - - rising. Nevertheless, there inevitably comes a point in which assets prices, for one reason or another, refuse to rise further and then the big selling without buyers begins. Never before in history has there been an exception from this disastrous end of asset inflation.” Strategic Investment, February, 2007 And for an unfortunately accurate view of the risks and consequences inherent in the OTC Derivatives situation consider Jim Sinclair’s evaluation: “The present situation is based on the ultimate sin of greed called over-the-counter derivatives. This mountain of unfunded special performance contracts is shaking and, as a product of declining US business activity and profits, will fall precipitously. Before the fall of this unimaginably large mountain of garbage paper, all central banks in concert will prime the pump any way they can. Priming for this purpose has no practical way of being drained. What is going to get out of control now is monetary inflation to offset the shaking mountain of over-the-counter derivatives. The beginning of this fall is in progress and will be history by 2012 or sooner.” www.jsmineset.com, September 6, 2007. Thus, it is not too great an oversimplification to conclude that because The Fed’s solution entails more “borrowed liquidity” and derivatives creation which caused the problem to begin with, we shall surely have ongoing liquidity and derivatives crises resulting in ever increasing systemic risk. Yet The Fed’s response will doubtless be to print more money (i.e. increase M3) and enable even more “borrowed liquidity.” The Fed response will also likely be to continue to try to manage the economic data via pressuring U.S. Government Agencies to issue “happy,” but entirely bogus, figures. And we can expect The Fed-led Cartel of Central Banks to continue to try to paper over their and our problems with ever-increasing Market Intervention. As Deepcaster and others, including the Gold AntiTrust Action Committee (www.gata.org) pointed out on many occasions, The Fed-led Cartel’s Market Intervention Regime appears to have great breadth and to include periodic attempted takedowns in the Gold and Silver market prices, Crude Oil, and Equities markets. But Cartel market intervention efforts are increasingly challenged by market realities, including especially those we have described here. Thus interventional attempts cannot be successful “forever” because the massive “paper” (in the form of derivatives, borrowed liquidity and all the rest) necessary to implement their Interventions have created ever-increasing systemic risks, the first iteration of which we have seen in August, 2007. So the key question for investors and traders is what assets will most likely hold their value in the looming stagflationary era with great systemic risk and in which prices will be relatively resistant to price capping and takedowns? In response we reiterate: 1) Acquire tangible assets for which there is great need (i.e. those with a relative inelasticity of demand) is important. Essential Food Assets are one example of these. Consider recent corn, wheat and soybean prices which are at or near record levels. And an investment in the most essential asset is currently reflected in one of the selections in our Deepcaster Fortress Assets Letter Portfolio. 2) Sell short assets which are subject to suffering from the stagflationary syndrome we described above (e.g. home prices). Deepcaster DHPS Speculators recently were able to take a significant profit from a short position which Deepcaster recommended a few weeks ago in real estate industry equities. 3) Select assets not easily subject to price manipulation. Historically and today, Gold and Silver are the assets inherently most resistant to stagflation (i.e. most resistant to deflation or inflation and/or a stagnant economy). Indeed, typically they would be the assets which would appreciate most in fiat currency terms in a stagflationary period. Yet in recent years both have been subject to the manipulative price suppression policies of the Fed-led Cartel. But although The Cartel’s price suppression attempts days are numbered The Cartel is not entirely impotent. Thus timing and an evaluation of “The Interventionals” are still important. In sum, The Cartel’s interventional moves are meeting increasing resistance. The magnitude of credit market, budgetary, geopolitical and other challenges are unprecedented as well. And, increasing demand for the physical metals puts significant upward pressure on monetary metals prices. Deepcaster has evaluated these competing forces, and has just issued a Forecast and investment recommendations regarding Gold and Silver. Moreover, there is one subsector in the Gold and Silver sector which should prove relatively immune to any price suppression attempts. Deepcaster has published a list of companies in this subsector in its April, 2007 Deepcaster Fortress Assets Letter. 4) Since the interventional tendencies of The Cartel are still strong and effective, attempt to determine key interventional tendencies, trends and patterns. Even though interventional attempts may not ultimately succeed, they do still have an effect. Deepcaster does this regularly, and determining the “interventionals” (as well as the fundamentals and technicals) is key to Deepcaster’s recommendations. 5) Consider the thrust of the Interventional Attempts. That is because The Cartel Intervenors (via their Primary Dealers) are the largest players in certain key markets. And that is why it is essential to monitor the Interventionals and to determine whether one thinks the Interventional Actions will be successful. 6) Finally, certain sectors in certain Asian economies should be relatively insulated from the coming American and European economic woes. Deepcaster has listed these in its recent Letter posted at www.deepcaster.com. Following the guidelines listed above should enable maximizing protection and profit and minimizing risk, as we all suffer through the worsening liquidity and derivatives crises..
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