Storm Watch Update
ROUGE WAVES & STANDARD DEVIATIONS - PART 2
PART 1
by Jim Puplava
www.financialsense.com
May 17, 2002

By the end of the twentieth century, the world bond market was estimated to be around $31 trillion. The U.S. bond market, at 47% of that total, was $14.6 trillion and the world’s largest holder. The world bond market at $31 trillion was just slightly less than the value of the world equity market which was estimated to be around $36 trillion at the beginning of 2000.¹ As large as these markets are, they pale by comparison to the global market for derivatives, which is believed to exceed well over $100 trillion.

In their study of the world's largest financial markets, the authors of Triumph of the Optimists show that many countries have larger bond markets than they do equity markets. In the U.S., thanks to the bull market of the 90’s, the bond market was 88% of the size of the stock market and 125% of GDP. The U.S. financial market is the largest in the world for both equities and debt. It is also the largest market for derivatives.

Banks Add Ballast in Late Nineties

At the end of 2001, the OCC Quarterly Derivatives Fact Sheet indicated that the notional value of derivatives in commercial bank portfolios had decreased by $5.9 trillion in the fourth quarter to $45.4 trillion.² This was a surprising change. The derivative book in bank portfolios had been growing by double digits throughout the 1990’s. From the beginning of the decade to the recent peak in Q3 of 2001, the derivative holdings of major banks had increased by over 700%. In fact, between Q1 and Q3 of 2001, U.S. banks had ramped up their derivative holdings by $7,362 trillion or 16.8%.³ In many of those years in the nineties, the growth rate in derivatives was above 20%.

The biggest years for growth in derivatives usually occurred during crisis years such as 1997, 1998, and Q3 2001. During these crisis periods, year-over-year growth rates exceeded 30%. Observations show that whenever storm fronts appeared, banks leveraged up their balance sheet by taking on added debt to keep their portfolios balanced. This protective action is similar to a cargo ship adding more weight or ballast to help stabilize the ship in the middle of the storm.

During the storms of 2001, something changed. The first three quarters of the year showed explosive growth in the derivative book of the top seven banks. Derivatives grew by over 34% from the previous year. However, 9-11 changed bank strategies. As the chart below indicates, not since Q3 of 1998 had banks lost so much money in their derivative book. The OCC report indicates that banks charged off $296 million from derivatives. Increased volatility and fluctuating bond markets caused banks to reduce their derivative books substantially. However, the main reduction in derivatives was really the action of one bank -- J.P. Morgan Chase.

Morgan/Chase reduced the notional value of its derivatives by $6.9 trillion to $23.3 trillion from $30.4 trillion in Q3. All other banks increased their derivative holdings by $1 trillion. Morgan/Chase was experiencing a difficult fourth quarter because of losses in several segments of its businesses.

J.P. Morgan Partners, the bank's private equity business, had substantial losses. There was also an overall decline in credit quality in 2001 that affected the bank's commercial and consumer credit lines. J.P. Morgan Chase was a lender to Enron, Kmart, and Argentina and many other companies that were experiencing financial difficulties. The bank also has a huge derivative position in gold, which it is in the process of unwinding. In times of crisis, gold prices rise as greed gives way to fear. I will have more to say on J.P. Morgan Chase later.

Reviewing the recent OCC report, it seems things remained pretty much the same. The top seven banks control 96% of the derivatives market. Close to 89% of those derivatives are over-the-counter (OTC) contracts. These contracts are less liquid and are subject to greater credit risk than exchanged-traded contracts, which are standardized and fungible (or interchangeable). The majority of derivatives are interest rate related and comprise 84% percent of the total. While banks decreased their interest rate position in Q4 2001, credit derivatives rose by $35 billion to $395 billion.

Credit derivatives are used to insure against two different kinds of risk:

Market risk: that the price of the asset in question will rise/fall, or become more/less volatile.
Client specific risk: that the firm itself may run into trouble.

Credit Derivatives

Essentially, through credit derivatives, risk is transferred to various parties using OTC transactions. They can be either “on-balance sheet” or “off-balance sheet” in nature. Credit derivatives are contracts that are used to transfer credit risk from a credit protection buyer to a credit protection seller. There are generally two forms of credit derivatives as defined below:

Off-balance sheet: Credit default swaps, total rate of return swaps, etc.
On-balance sheet: Credit linked notes; CDO’s (collateralized debt obligations)⁴

It is the investment banks, and not the commercial banks, who dominate this credit derivative market. However, the vast majority of derivatives are used for hedging or reducing interest rate costs or exposure. The bulk of derivatives are interest rate related. Of the total of $45,386 trillion in derivatives, $38,305 or 84% are interest rate related with $25,645 trillion of that total made up of interest rate swaps.⁵

Interest Rate Swaps

The Rogue Wave Risk
The greatest risk of a rogue wave or a ten-sigma event lies in the area of interest rate swaps and in the smallest category of derivatives which is gold. Before getting into the risk that is mounting within the system, I must digress first and explain the purpose of interest rate swaps. There are two basic ways in which a borrower or lender can protect themselves from a rise or fall in long-term interest rates. The easiest way is with options that put a cap, floor, or collar around interest rates. The second form of protection is through interest rate swaps. Options require a premium payment to be made to acquire the hedge or protect against adverse movements in interest rates. In the case of interest rate swaps, no payment is made. Instead, a contract is entered into that ties the client into a legal obligation to make or transact at a guaranteed interest rate, and on specific dates, no matter the current rate of interest in the market place. Usually, there is no problem if the markets remain stable or if the general level of interest rates is worse than the rate originally contracted.

Interest rate swaps are used as a means of managing interest rate risk by transforming a fixed rate into a variable rate or a variable rate into a fixed rate depending on one's market perspective or financing needs. Essentially, a swap is an agreement between two parties to exchange cash flows in the future. The derivative contract defines the dates, when the cash flows are to be paid, and the way the cash flow payments are calculated.

Comparative Advantage
The reason for the popularity of interest rate swaps can be explained by the concept of “Comparative Advantage.” Certain companies may enjoy an advantage in the fixed income markets because of their credit rating. Companies with a high credit rating can borrow money at a lower rate of interest than a company with a lower credit rating. Other companies of lesser credit quality may find better rates in the floating-rate or variable rate markets. For example, a company with a lower credit rating or a large company that is trying to lower its interest rate costs may borrow at a fixed rate of interest and then swap that loan through an interest rate swap for a variable rate which is much lower. This enables a company to borrow fixed when it desires a floating rate or to borrow at a floating rate when it really desires a fixed rate.

A good example of this is General Electric Capital, the financing arm of General Electric. GE Capital paid an average rate of 3.23% on its long-term debt last year by swapping its fixed rate debt for floating rate obligations. This enabled the company to bring its cost of funds down dramatically.⁶

Interest rate swaps are a two-edge sword if interest rates suddenly take a dramatic change in direction as they did in 1997-98. Recently there has been some criticism of the comparative advantage argument. The problem with floating rate debt is that the lender has the option of increasing the variable rate of interest to the borrower if the borrower’s creditworthiness has declined. Under extreme circumstances, the lender can refuse to roll over the loan. A lender on a fixed-rate loan doesn’t have the option to change the loan in the same way as a floating rate loan. With credit ratings dropping each quarter, companies have used the swaps markets to lower their overall cost of borrowing. Other creditworthy borrowers have used swaps to lower their cost of funding as shown in the example of GE above. The problem arises when short-term rates suddenly spike up. Short-term rates are much more vulnerable to a sudden change in perceptions by the market place.

The Beast in the Beauty of Interest Rate Swaps
To explain the inherent risk in an interest rate swap an example may best serve this purpose. Let's suppose there are two companies that enter into a transaction. Company A is getting ready to build a new plant at a cost of $10 million. Long-term borrowing rates are at 7.5%, which the treasurer of the company considers too expensive. The company could take out a floating rate loan, which would rollover every six months. However, this would expose the company to rising interest rates. The company can instead take out a floating rate note, which is based on LIBOR (London Inter Bank Offering Rate) plus 0.5% for a floating rate loan. Currently 6-month LIBOR rates are at 1.94%. Add the 0.5% premium over LIBOR and the company can borrow at a rate of 2.44% instead of the fixed rate of 7.5%. On a $10 million loan, the savings are substantial. However, LIBOR rates can change so the company is still exposed to rising interest rates. In order to reduce this risk, the company may enter the market through an intermediary such as a bank to exchange its floating rate note for a fixed rate note with another party. In this way, the company can exchange its variable rate loan into a fixed rate loan at a lower rate than it could achieve by a direct fixed rate loan from a bank.

The diagram below illustrates the payment flows between the bank and Company A and Company B. In this hypothetical example, Company A is lowering its effective cost of interest. Normally these transactions occur with companies that have a lower credit rating and those who have a lower comparative cost of borrowing. Higher quality companies with better credit ratings can usually borrow at lower fixed and variable rates than lesser quality companies.

All swaps have one common characteristic: each party is exchanging a benefit it has in one financial market for a corresponding benefit available to another party in another market. This occurs when one company may have an advantage in the bond market such as comparatively cheap long-term fixed rates. Another company enjoys a comparative advantage in the variable rate market with its bankers. Each party in a swap is using the most advantageous market to borrow physical money, and then through an interest rate swap, changing the interest basis on which their loan is based.⁷

The swap market enables a company, who can't borrow favorably at a fixed rate of interest, to borrow at a variable rate of interest and then swap into a more favorable fixed rate as a result of a swap. In effect, the swap allows the client to borrow wherever the company can find the cheapest rates and then exchange those rates into an interest rate that best suits their borrowing needs. The swap market rose in popularity because of financial institutions like banks or building societies like Fannie and Freddie who experience an interest rate gap.

The credit markets are made up of different interest rates for different maturities. Because the interest rate markets are made up of different interest rates along the maturity continuum, financial institutions and companies exploit these differences. Many financial companies borrow short-term from the money markets and lend to client companies at a higher interest rate. The financial institution makes money on the spread between what they can borrow at and what they charge others to borrow from them. The lower the cost of funds, the greater the profit potential for banks to lend money in the market. Mortgage lending institutions such as Fannie and Freddie receive mortgage payments that are fixed on a monthly basis, but have funded those loans in the 3-month LIBOR basis in the wholesale inter-bank market. These entities will then use the swap market to hedge part of their exposure and correct the mismatch between borrowing short-term and lending long-term.

Playing The Yield Curve

What these companies and financial entities are trying to do is play the yield curve game by borrowing at lower short-term interest rates and lending at higher longer-term rates. There is a risk of doing this in that long-term rates are fixed while short-term rates can fluctuate and rise. To mitigate part of this risk, companies use swaps to correct the imbalance.

Borrow Short - Lend Long
Borrowing short and lending long has been the bread and butter business in banking for the last two centuries. It has also become a staple of the investment industry -- especially hedge funds. The result is that investors, through their participation in the bond market, have become exposed to the fundamental risk of mismatched interest rates. Even though the demand for money through borrowing has grown and savings as a source of capital has diminished, interest rates have fallen.

Normally, with an increased demand for money accompanied by a lower supply of capital through savings, interest rates would have risen. Instead, they have fallen. In his book Debt and Delusion, Peter Warburton explains, “The coincidence of rising capital demands and falling bond yields is explained by two factors: first, a portfolio shift in the savings market away from low-yielding bank deposits into higher-yielding bonds; and, second, a huge tide of speculative investment in the bond markets financed at historically low cost in the U.S. and Japanese money markets and the opportunities for gearing offered by the derivatives markets.”⁸

Yield Curve Speculation
The key argument that Warburton makes regarding interest rates is that they have been artificially lowered given the huge demand for money. This is a result of yield curve speculation. Yield curve speculation involves borrowing short and lending long. This investment technique works well and is extremely profitable as long as markets remain stable. When they change and become volatile as they did in 1997-98, the result can bring destruction to investment portfolios, as was the case with LTCM. What we don’t know at this point is how well these markets will react, especially highly leveraged derivatives, to a prolonged and sustained bear market in paper assets such as bonds and equities. The problem lies in the tail end of the curve. Most derivative models are based on linear assumptions that do not exist in a non-linear world. When volatility rates increase because of investor angst, that unforeseen volatility can lead to legendary profits (George Soros’ $1 billion currency market profit) or bankruptcy (LTCM) in a matter of a few days of trading.

The bond markets, which have gone through many previous shocks in the past, could experience the same consequences in the future with more devastating consequences because of the potential gearing of the markets through derivatives.

Warburton's 3 Shocks

Commodity Prices
Warburton identifies three types of shock to the system. The first type of shock could come from a sudden jump in oil or other commodity such as we are now seeing in oil. The bond markets would react to higher prices because of fears of inflation or a loose monetary policy by central banks to overcome the crisis. In my opinion, we have this exact kind of potential shock to the system right now in the oil markets. The forward interest rate swap market is already pricing a 100-200 point interest rate rise in the next 3-6 months. The international oil price may be the key to whether the Fed will increase rates to ward off inflation or protect the vulnerability of the U.S. dollar.

Political Instability
A second shock to the bond markets could come from political instability. The markets fear war and the rising fiscal deficits of governments that accompany them. Wars and political tension create uncertainty because of the monetary expansion, fiscal deficits, and higher taxes, which are used to finance them. There is also the uncertainty of the war's outcome on the parties involved in the conflict and the length of the conflict itself, which could do irreparable harm to the economy and the financial markets.

Financial Disaster
A third type of shock to the bond markets could come through a financial disaster that results from financial speculation or fraud that causes the markets to reassess credit risk in the wake of the disaster. We are seeing this now because of the bankruptcy of Enron, Global Crossing, Kmart, and Argentina. When the risk of bankruptcy and default increases, credit spreads widen as investors demand higher returns to compensate for the added risk. The bond market abhors uncertainty -- especially default risk. If defaults continue to increase or credit downgrades rise as they are presently, bond yields could rise parabolically.⁹

Dangerous Days Ahead

I can think of no other time in the last two decades when the outlook for economic, financial, and political stability was this uncertain. Events in the credit markets, the bear market in stocks and the terrorist attacks of 9-11, coupled with the political events unfolding in the Middle East and elsewhere, present us with a world that seems to have been turned upside down. All three examples of shocks to the financial system now exist at the same time. We have rising oil prices, political instability and large-scale credit defaults in Enron, Global Crossing and in Argentina. The financial system is highly geared. This is our Achilles' heel. All of these events have enormous implications for the interest rate markets and interest rate swaps, which have been based on certain linear assumptions. The problem is we live in a nonlinear world. What we simply do not know at the moment is how a highly leveraged market will react to a prolonged bear market in paper assets. To better understand this risk, it is necessary to return to the topic of derivatives.

The reason derivatives have become so popular is that they supposedly enable buyers and sellers to choose how much risk they wish to carry. That risk can come from many quarters such as interest rate risk, credit risk, currency risk, and market risk. With the end of a stable currency regime in August 1971 when the world’s financial system went off fixed exchange rates, interest rate and currency risk has accelerated. With the introduction and use of powerful computers, the world of derivatives rose in response to the emergence of these two added risks.

The Meteoric Rise in Derivatives
As the credit markets have grown over the last three decades -- in large part due to the growing deficits of governments -- the derivative market has grown alongside the debt markets. In some part, this has been the response to the growing risk of the credit markets. Over the last decade, it has become a means of speculation. Because of the enormous potential for leverage, derivatives have enabled banks and hedge funds to place sizable bets on the direction of interest rate and currency movements. If they bet wrong, enormous losses can result. Or in the extreme case, we have seen bankruptcy with Barings, LTCM, Orange County, and more recently, Enron. These catastrophes are made possible because of gearing.

Gearing

Gearing is a process that allows a user to control a market through very little cost with the use of derivative products. Because of the potential amount of leverage employed, it creates the possibility for spectacular gains as well as catastrophic losses. An example can best illustrate this concept. Suppose a trader felt that the Euro was going to appreciate against the dollar. The trader could physically buy the currency and wait for it to increase in value and then sell it for a profit.

An alternative would be to use derivatives to profit from the same situation. Instead of buying Euros outright, the trader or speculator could buy an option to purchase Euros at a fraction of the cost. In this case, the trader would pay about a 2% premium on the face value of the currency contract. Therefore, if the trader wanted to buy $100,000 worth of Euros, he would buy an option for only $2,000 (2% of $100,000). If Euros moved in the direction he anticipated, he could then sell the option back at a profit. He then makes the same profit for substantially less money.

Let's review. If the physical Euro contract appreciated 10% from $100,000 to $110,000, he would make a 10% profit by physically buying the particular currency. In contrast with options (or derivatives), he could profit by the same amount with less capital ($2,000 vs. $100,000). In the case of options, he would still have a $10,000 profit. However, his investment return would be 500% instead of 10% had he paid the entire amount of $100,000 to own the Euro contract outright.

If the trader really wanted to leverage his bet, he could use the entire $100,000 to buy options on the Euro and control a position 50 times the size of the original investment of $100,000 (50 X 2% = 100%). Thus with the same amount of money, the trader would now control $5,000,000 in currency versus the original $100,000. If Euros moved 10% as originally anticipated, the trader would now have a profit of $500,000 instead of $10,000 for the same original cash outlay. If his speculative guess was right, he would earn 50 times the profit. In this instance, his position is geared by a factor of 50. The downside is if the trader was wrong, he would lose his entire investment of $100,000 if he held on to his option position and the currency didn’t appreciate as originally planned. The original cash position of owning the actual currency could also lose money. However, by gearing his position, the upside potential is far greater.

In the case of hedge funds, they can use gearing to increase their returns, but they may also borrow money to leverage their returns even further. In the example above, a hedge fund could use $100,000 of their own money and borrow up to 10 times that amount from a bank. With $100,000 down and $1,000,000 in borrowed funds, the hedge fund could now control up to $55,000,000 in the same Euro trade. If the currency moved 10%, they would make $5,500,000 on their original $100,000 investment. Of course if they were wrong, they would lose everything.

This may sound impossible, but it occurs more frequently than is generally reported. In the case of LTCM, they had $3 billion in equity, $140 billion in debt, and controlled $1.25 trillion in notional value of derivatives. Many hedge funds positions are geared by as much 100 times. The only problem with leverage of this magnitude is that a 1% move in the wrong direction can wipe out your entire equity when you are geared by 100:1. Gearing a particular asset can be done at a fraction of the original cost of owning the asset outright and can produce explosive and unheard of gains. The other side of the coin is that when you are highly geared, a small movement in the wrong direction turns out to be catastrophic. During the weeks of its final demise, LTCM was losing as much as $553 million in a single session. This is a big loss when you only have $3 billion in equity. They lost as much as 20% of their capital in a single session.

Examples of today's highly geared markets are silver, gold, oil, and most major commodities. A small fraction of funds estimated to be around $200 billion controls the entire physical market in commodities.¹⁰ The graphs below taken from Hubbert's Peak & The Economics of Oil show how large short positions in energy last fall caused energy prices to fall dramatically even though worldwide demand for oil in the fourth quarter rose by 100,000 barrels a day.

    
Source: www.sharelynx.net 
"Below the line" or "below 0" means "Net Short."

Traders' excessive short positions contributed to lower prices
in energy during the second half of 2001.

The problem with gearing financial markets, or a particular asset class, is that there will come that day when the sharp edge of leverage comes home to roost. Most of Wall Street and the financial world have been educated and inoculated with the concept of risk as confined to volatility only. This concept of risk permeates most trading rooms on Wall Street. It is this concept and its conceit, that the day’s closing price of an asset is a predictive and reliable source of the future, that has become the Achilles' Heel of the derivative markets. The system is vulnerable. In the minds of most traders and the firms that employ them, volatility has supplanted leverage as the best proxy for risk. In the words of Roger Lowenstein, “There is a reason why financial markets run to extremes more often than coin flips—and more often than the “hundred-year storm” that Long-Term’s partners would later cite as the culprit behind their disaster. A key condition of random events is that each new flip is independent of the previous one. One coin doesn’t remember that it landed on tails three times in a row; the odds on the fourth flip are still fifty-fifty."¹¹

What Were They Thinking?

Gearing in Silver
Various examples exist today of markets, companies or hedge funds that are highly geared. Some of the most ominous are J.P. Morgan Chase, Barrick Gold, and the silver short position on the COMEX. The net silver short position of commercials on the COMEX is 45,000 contracts or roughly 225 million ounces of silver sold short. The COMEX has only 103 million ounces available in its warehouses. Of that 103 million ounces, 32 million are eligible, but not yet registered and available for delivery. In other words, the short position is three and half times greater than ready supply should investors suddenly demand delivery of physical silver.

It doesn’t take much to control the actual physical market. The annual production of silver is only about 500 million ounces a year. At today’s market price of $4.60 an ounce, the annual revenue from silver production only amounts to about $2.3 billion. This is pocket change for the financial markets. Furthermore, silver has been running an annual deficit of roughly 100 million ounces a year. CPM Group estimates that the cumulative drawdown of silver stockpiles is estimated to have been 1.5 billion with only 403.7 million of refined silver remaining in inventories globally.¹² Given current annual deficits of about 100 million a year, that leaves about 4 years of known reserves left. There are an estimated 467.5 million ounces in silver coins. However, those coins are not located in large warehouses and aren't easily accessible in case of a silver short squeeze.

You have to wonder what COMEX officials are thinking by allowing such a huge short position to exist given the tight and diminishing supply of inventory left around the globe to cover annual deficits. As these graphs from the most recent CPM Group Silver Survey 2002 illustrate, silver is rapidly becoming a scarce resource. The COMEX has put into position a congestion rule that allows only 7.5 million of ounces of silver to be taken in delivery in any one month. This would restrict a short-term run on silver but only momentarily. If congestion took place in only one month, it wouldn’t be too hard to imagine where the price of silver would be heading. It is one reason that silver lease rates jump parabolically whenever such occurrence seems likely as it did last December and this January.

Source: CPM Group's Silver Survey, 2002

Gearing in Derivatives - J P Morgan Chase
Another example of a company that has become highly geared is J.P. Morgan Chase. According to the recent OCC Derivatives Fact Sheet report, the bank held $23.5 trillion in notional value in derivative contracts as of  December 31^st, 2001.  Those contracts were backed by only $693.6 billion in assets and only $41.1 billion in equity. In terms of the bank's assets, J.P. Morgan Chase has implied leverage of 34 times its asset base ($23.520 trillion divided by $693.6 billion in assets). However, the bulk of those assets of $693.6 billion don’t belong to the bank. The bank has only $41.1 billion in equity to cover any losses that might occur because of holding those derivative contracts. In this case, it is the bank's equity that backs the derivatives which means the bank's real leverage is 573 times. That is insane! In his testimony before the Senate, Professor Frank Partnoy said that Enron made LTCM look like a lemonade stand. If Enron made LTCM look like a lemonade stand, then JPMC makes Enron look like your kid's Christmas Club Fund at your local bank.

You have to wonder what goes on in the minds of management at this company when there are so many 10-sigma events on the horizon. It may be one reason why the newly combined Morgan Chase reduced their derivative book by $6.9 trillion in the fourth quarter of last year. At year-end, the bank reported non-performing loans represented 10% of the bank's equity and non-performing derivative contracts were $170 million. Losses from J P Morgan Partners, the bank's private equity business, amounted to $1.857 billion; while charge-offs of bad loans for the year were $2.582 billion against recoveries of $247 million for a net charge-off of $2.335 billion. This is a bank that was in all the wrong places last year. They still have to contend with problem loans this year too. A recent rumor denied by the bank is that one of its chief derivative officers, Dinsa Mehta, is thinking of leaving the bank. Mehta still works at Morgan, but his responsibilities as head of global commodity risk management and global foreign exchange have been reduced.

Gearing in Gold - Barrick Gold
Another example of a company that has become highly leveraged is Barrick Gold. The company is one of the largest hedgers of gold and silver in the mining industry. Barrick is known for its hedging operations in gold and in silver. Recently, a $23 price movement of gold turned Barrick’s hedge book from positive to negative in the blink of an eye. The company reported a $46 million profit for Q1. The real number should be $437 million when you take into consideration the loss in the company’s hedge book from Q4 of last year. At that time, the company’s hedge book was in the black by $356 million. As of the end of Q1 of this year, the hedge book was negative by $127 million -- a change of $483 million from the previous quarter.

The stories above are just a few of the examples of companies or markets that have become highly geared. I’ve just scratched the surface by discussing a few of the more obvious ones. Many more cases of highly geared markets, asset classes, companies and hedge funds exist that would take too much time and effort to review. Suffice to say the financial markets are ripe for exploitation to those who are curious to learn more. Which brings me to some very important conclusions.

Personal Conclusions

There are plenty of rogue waves or 10-sigma events lurking out there that pose very serious risks to the financial system. In my 23 years in the business, I can’t remember a time when the outlook for the financial, economic and political system has been this uncertain. Everywhere you look there are potential rogue waves that are capable of toppling the system. The current war against terrorism, the Middle East, the growth of militant Islam, gyrating financial markets, trillions in escalating debt levels in the U.S., and a worldwide recession are just a few potentials. However, of all of these potential rogue waves, the biggest ones lie in the derivative and in the political arenas. I can’t ever recall a time except for the 1930’s or the 1970’s where the political and economic risks have held the potential to disrupt and create a swath of chaos across economies, financial systems and in governments.

Mankind has tried to reduce risk, but has never been able to manage and master it. It is not for want of trying. Going back to ancient augurs and oracles, man has always tried to forecast the future for one reason or another. Kings would want to know if their armies would be victorious or if their queen would bear a son. Farmers would ask the soothsayer if tomorrow’s weather would bring rain or sun. Whether it was for profit, political gain, romance or for the sheer pleasure of winning, people have gone to experts to forecast the future. Everyone -- from the oracles and soothsayers of old to today’s scientists and mathematicians -- everyone wants to know what the future will bring. Many have tried, but most have failed.

Just a Standard Deviation Away . . .
Today the modern version of the soothsayer is built into the derivative models that run the financial markets. The Black-Scholes formula, which has become the basis for the formulaic trading that permeates the financial markets, deals with a world that is certain. In fact, the only certainty is in the universe sample of the models. Factors left out of the universe are depicted at the tail end of the curve which has become more swollen in today's international environment. This is where the extremes lie. They are rife with implications for the financial markets. As I wrote in my original Rogue Wave article from The Perfect Financial Storm Series, “There will come a day unlike any other day, an event unlike any other event and a crisis unlike any other crisis. It will emerge out of nowhere at a time no one expects. It will be an event that no one anticipates- a crisis that the experts didn’t foresee. It will be an exogenous event -- a rogue wave.”

It is this unexpected event that always surprises the markets. Despite the certainty promised by the models, we know from history that certainty is an impossibility. The nearest we can ever come to is to say, with a degree of hesitancy, "The sun will come out tomorrow." So it is with a great degree of hubris and folly that those who have failed to anticipate events find blame in nature or in acts of God. This lack of clarity in defining risk is what causes events such as Barings, Orange County, Metallgesellschaft, LTCM, and Enron. With the advent of technology and the growing sophistication of the financial markets, we have increased our ability to manage risk. But, we haven’t been able to replace common sense. We can define, analyze, and predict probabilities, but we can’t eliminate uncertainty. What the models can never do is predict those unpredictable events in history that are reoccurring. A President is assassinated, an Archduke is shot, bombs are dropped on Pearl Harbor, a plane is flown into a building, and suddenly a tinderbox is lit, a chain reaction begins, a crisis erupts, and the world becomes a different place.

The companies, funds, investors, and governments best able to withstand a crisis are those who are unleveraged, liquid and have access to cash. Having no debt enables one to ride out a storm. Leverage becomes a ticking time bomb that offers few avenues for escape. In summary, the best protection against adversity is to have minimal debt and plenty of liquidity.

The point of these recent monographs is that all of the conditions are in place for a repetition of the financial calamities that beset the financial markets in the late 20’s and 30’s. Those events eventually led to war. Investors and authorities are complacent, money and credit creation are proliferating, debt and leverage within the financial system are at record levels, and ignorance of risk is everywhere. If I were to make a prediction, it would be simple and would be as follows: recession, depression, and then war. You, the reader, must decide and then prepare. ~ JP

Neither a borrower nor a lender be,
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.
This above all: to thine own self be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
William Shakespeare (1564–1616), Hamlet (I, iii)

ENDNOTES

 1   Dimson, Elroy, et. al, Triumph of the Optimists, Princeton University, Princeton, 2002, p. 14.
 2   OCC Quarterly Derivatives Fact Sheet, 4th Quarter Report, p.1
 3   OCC Quarterly Derivatives Fact Sheet, 1st, 2nd, 3rd Quarter Report 2001.
 4   Taylor, Francesca, Mastering Derivatives Markets, Second Edition, Prentiss Hall, 2000, p. 272-273.
 5   OCC Quarterly Derivatives Fact Sheet, 4th Quarter Report, p. 7-8.
 6   Goldenberg, Liz, "Companies May Hide Risk," Bloomberg.com, 04/10/02.
 7   Hull, John C., Options, Futures, & Other Derivatives, 4th Ed., Prentice Hall, Upper Saddle River, 1989-2000, p. 128-131.
 8   Warburton, Peter, Debt & Delusion, Trafalgar Square, 1999, p. 134.
 9   Ibid., p. 235-236.
10  Warburton, Peter, "The Debasement of World Currency: it is inflation, but not as we know it," Gold-Eagle.com, 04/09/01.
11  Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, 2000, p.72.
12  CPM Group's Silver Survey, 2002, p. 13.

Acknowledgement
Cover graphic by Adam Puplava

© 2002 James J. Puplava
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