The Beginning Of The End
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When The Derivatives Market Crashes (And It Will) U.S. Taxpayers Will Be On The Hook

Warren Buffett once said that derivatives are “financial weapons of mass destruction”, and that statement is more true today than it ever has been before.  Recently, JP Morgan made national headlines when it announced that it was going to take a 2 billion dollar loss from derivatives trades gone bad.  Well, it turns out that JP Morgan did not tell us the whole truth.  As you will see later in this article, most analysts are estimating that the losses will eventually be far larger than 2 billion dollars.  But no matter how bad things get for JP Morgan, it will not be allowed to fail.  JP Morgan is the largest bank in the United States, so it is essentially the “granddaddy” of the too big to fail banks.  If JP Morgan gets to the point where it is about to collapse, the U.S. government and the Federal Reserve will rush in to save it.  Because of this “security blanket”, banks such as JP Morgan feel free to take outrageous risks.  Today, JP Morgan has more exposure to derivatives than anyone else in the world.  If they win, they win big.  If they lose, U.S. taxpayers will be on the hook.  Not only that, but thanks to Dodd-Frank, U.S. taxpayers are on the hook for bailing out the major derivatives clearinghouses if there is ever a major derivatives crisis.  So when the derivatives market crashes (and it will) you and I will be left holding a gigantic bill.

Derivatives almost caused the complete collapse of insurance giant AIG back in 2008.  But instead of learning our lessons, the derivatives bubble has gotten even larger since that time.

A Bloomberg article that was published last year contained a great quote from Mark Mobius about derivatives….

Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group, said another financial crisis is inevitable because the causes of the previous one haven’t been resolved.

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” Mobius said at the Foreign Correspondents’ Club of Japan in Tokyo today in response to a question about price swings. “Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.”

Never in the history of the world have we ever seen anything like this derivatives bubble.

But instead of getting it under control, we just allowed it to get bigger and bigger and bigger.

Now JP Morgan is in quite a bit of trouble.  A recent Daily Finance article summarized how JP Morgan got into this mess….

Bruno Iksil, a trader working in the bank’s London office, placed a massive bet in the derivatives market. Derivatives “derive” their value from the value of an underlying asset, like stocks, bonds, currencies, or a market index. The specific type of derivative used in Iksil’s bet was a credit default swap index, known as “CDX.NA.IG.9.”

CDX.NA.IG.9 tracks a basket of corporate bonds. Iksil’s positions on the index were so big (one report put it at $100 billion) that they were moving the market and interfering with other traders’ positions. These annoyed traders — hedge-fund managers — dubbed Iksil “the London Whale” for his outsize bets.

So if the real number isn’t 2 billion dollars, how much will JP Morgan eventually lose?

Morgan Stanley says that the losses could eventually reach 5 billion dollars.

The Independent is reporting that the losses could eventually reach 7 billion dollars.

One author featured on Zero Hedge suggested that the losses could ultimately reach 20 billion dollars….

Simple: because it knew with 100% certainty that if things turn out very, very badly, that the taxpayer, via the Fed, would come to its rescue. Luckily, things turned out only 80% bad. Although it is not over yet: if credit spreads soar, assuming at $200 million DV01, and a 100 bps move, JPM could suffer a $20 billion loss when all is said and done. But hey: at least “net” is not “gross” and we know, just know, that the SEC will get involved and make sure something like this never happens again.

The truth is that nobody really knows.  Everybody agrees that the losses will likely far exceed 2 billion dollars, but the real extent of the crisis will not be known until the trades play out.

According to the Huffington Post, JP Morgan recently sold 25 billion dollars of profitable securities to raise some cash.  The profit on the sale of those securities will be somewhere in the neighborhood of a billion dollars.

A billion dollars will help, but it will not be nearly enough.

Many are interpreting this move as a sign of panic by JP Morgan.

Meanwhile, JP Morgan CEO Jamie Dimon continues to do quite well.  In fact, his 23 million dollar pay package was recently approved by shareholders at an annual meeting.

Wouldn’t you like to do your job badly and still make 23 million dollars?

Right now, JP Morgan is essentially in a “staring contest” with those on the other side of the derivatives trades that went bad.  This “staring contest” was described in a recent CNN article….

It’s clear from public data filed with The Depository Trust & Clearing Corporation that JPMorgan Chase hasn’t sold any of its positions yet. The DTCC tracks trading activity and sizes of positions on the IG9 and other indexes, and there haven’t been any big moves since last week.

“Whatever the size was, it’s clearly not something that you can call one or two dealers and sell,” said Garth Friesen, a co-chief investment officer at AVM, a derivatives hedge fund that’s not involved in these trades.

As soon as it becomes clear that JPMorgan Chase is unwinding its position, it will be obvious to players on every major trading desk. Hedge funds will immediately start piling into that index and buying protection, driving up the bank’s losses.

Until then, it won’t cost the hedge funds much to sit and wait.

JP Morgan is desperately hoping that the markets move in their favor.

If the markets move against JP Morgan in a big way it could potentially be absolutely catastrophic for the biggest bank in America.

An excerpt from an email that Steve Quayle recently received from an anonymous international banking source contained some chilling analysis of the situation….

The derivative market that JPM plays in is the CDX.NA.IG.9, when factions within their London office (London Whale) made overly leveraged swaps, hedge funds smelled blood and so did a few banks. You see any moves that JPM does here on out exposes their weakness further. Which they can not afford any more exposure thus they are not buying back any more shares which is the equivalent of cutting an artery in a pool full of sharks. The strategy they are taking right now is to sit through the storm and ride it out as they can do nothing else for any action will make them even more vulnerable. They can not absorb hits in both JPM SLV and CDX.NA.IG.9. Inactivity is not something they want to do it is something they have to do. There is no other choice for them.

So what will happen if JP Morgan loses too much money?

Well, it will beg the U.S. government and the Federal Reserve for money and the U.S. government and the Federal Reserve will comply.

There is no way that they are going to let the largest bank in America fail.

In addition, as I mentioned earlier, Dodd-Frank has put U.S. taxpayers on the hook for future bailouts of derivatives clearinghouses.  This was detailed in a recent Wall Street Journal article….

Little noticed is that on Tuesday Team Obama took its first formal steps toward putting taxpayers behind Wall Street derivatives trading — not behind banks that might make mistakes in derivatives markets, but behind the trading itself. Yes, the same crew that rails against the dangers of derivatives is quietly positioning these financial instruments directly above the taxpayer safety net.

One of the things that Dodd-Frank does is that it gives the Federal Reserve the power to provide “discount and borrowing privileges” to derivatives clearinghouses in the event of a major derivatives crisis.

This is what our politicians love to do.

They love to have the U.S. taxpayer guarantee everything.

Our politicians look at us as one giant insurance policy.

Apparently they believe that if anything in the financial world goes wrong that U.S. taxpayers should be the ones to clean up the mess.

But will we really have enough money to bail everyone out when the derivatives market crashes?

Today, the 9 largest banks in the United States have a total of more than 200 trillion dollars of exposure to derivatives.

That is approximately 3 times the size of the entire global economy.

The U.S. government is already nearly 16 trillion dollars in debt.

How in the world can we afford to keep bailing out the huge messes that Wall Street makes?

Sadly, most Americans have no idea how vulnerable our financial system really is.

It is a poorly constructed house of cards that could come crashing down at any time.

If you still have faith in our financial system you are being quite foolish and you will soon be bitterly, bitterly disappointed.

  • geophysique

    The problem is not (just) the gambling of debt, it is the creation of debt in the first place, because it gives us outlandish funding to destroy the planet in the name of profit, but the profit is not realized because the money was fake it is all garbage credit so the matter is not us paying…the matter is that everybody on this planet pays every day, and even more so, the other inhabitants of this planet that are driven to extinction and suffer for our ‘economic growth’

  • geophysique

    the result is not that taxpayers eat the bill. the result is that there are no resources left for humanity. no old growth trees, depleted and sick populations of all life forms, poisoned and irradiated lands and waters, no oil, no iron, everything tapped out to build enormous temples to consumerism and banking in our major cities, buildings which are entirely useless and unsustainable under an energy crunch. we have wasted everything

  • ndrainmkr

    why do i never hear the most obvious question being asked? i’ll finally have to just ask it. Where did the money go? if money is lost, who found it? did it go into orbit or get put under a big rock? if money is lost here on earth it is still here. if the money is lost from one major banker to another, there should be some very happy bankers out there. truth is, the money went from the left pocket into the right pocket. one definition for a derivative is that it is a gamble leveraged on and derived from something of value. sounds to me like that is us. we are the cows for the system, collateral if you wish. we have no say even though we are the value from where the trade is derived. our cusip number tells us how much skin we have in this game. the bankers have no skin in the game. we are just the pawns in this big game of life. let’s wake up and demand a halt to the foolishness. let’s let them know we are on to their deceit. the only thing they fear is the mass’s awakening. there are legion of us and few of them. those of us who read these blogs know the truth. if we don’t spread the truth now that we know it it becomes our responsibility for the coming disaster.
    the rainmkr from north dakota nb.
    remember, all contracts require full disclosure to be valid. no one told me i was party to this fraud.

  • Bradley

    I can only say what I have learned from my dreams. The collapse isn’t the end of the world. Maybe a devaluation of 90 to 95% (pretty standard for a collapsed economy) but life goes on. The fed becomes a bad footnote in history, talked about the way people today talk about the Nazi regime. People pull together, pool resources, and make life happen. Those are my observations, anyway.

  • DomRat

    Some wag sharper than I once wrote to the effect that ‘this is all a game of musucal chairs and too many players with far too few chairs so everyone is still waltzing around humming after the music has stopped hoping no one will notice while the sidle up to any available chairs’.

  • http://None Leland Mellott

    There are no moneylenders in the House Of The Word. So that, we must save the doomed souls of the Powerfully Rich and the Richly Powerful by assuring that they die destitute and powerless.

  • Ben Dover (America)

    Time to load up, on silver and gold, baby!

    It’s July 4th, 2012 – Do YOU KNOW what time it is?
    (It’s time to pass H.R. 459, and AUDIT THE ‘FED’!)

  • Doc Holliday

    Alright then.
    How do you reconcile the burning desire on the part of so called “Conservatives” to completely deregulate the fiancial sector with the damage of an unregulated derivatives market.
    Can’t have it both ways.
    Either there are rules of no rules.

    • Donald Foster

      I’ll take no rules then. As long as the Corporations and Big Business dont have physical force on their hands (guns/military). Losing money is horrible, losing life is worse.

  • marc

    Everything is money even love sometimes…and since money is about creativity America will be just fine, I just hope I have money to invest when comes the big bull market of the 21st century…soon

  • Anon

    These financial scandals, and the ‘Fed’ won’t be going away anytime soon, UNLESS YOU GET UP OFF YOUR FAT, LAZY A**ES, and DO SOMETHING!

    HR 459 passed by an overwhelming majority in the House, by a vote of 327-98!
    Now, this bill (S.202) needs a vote in the Senate!



    End the Fed! Whether Congress Wants Us To or Not!

  • AnotherAnon

    What is very interesting is the shear amount of money involved in financial speculation. I’ve heard it put that for every $2 coin in your pocket, there is about $100 betting on where you are going to spend it. This might not be entirely accurate, but with the derivatives market at over 1 Quadrillion dollars, it really shows that the majority of decisions made about where money moves in the economy are not being made by people buying and selling physical items, or even the mega-rich buying and selling private jets, but rather by a small number of traders ‘trying to outsmart the people in the building next door’. There is much evidence that these traders act in a far from rational manor. This seems to invalidate the assumptions of classical economic theory – that markets are composed of consumers and producers of physical products and services.
    In the equilibrium theory popular in economics, the size of the futures and derivatives market can be considered to contribute to instability – causing large overshoot at the peaks and troughs.

    A second point of interest is the US budget, which in 2011 was paying back into the US economy about $1.3Bn more than it took out. This is allowing citizens and banks to de-leverage and corporations to amass large amounts of cash-on-hand. On the one hand, continued high spending will eventually hit a limit, but on the other hand, that deficit spending is probably a major contribution to the current economic growth. Any significant cut to spending (ie. enough to close the gap on the deficit) will probably send the United States into a recession.
    The only bit of good news is that taxes as a percentage of GDP are quite low, particularly in comparison to spending. so any move to fix the deficit – should it be required, will be best accomplished by relatively mild spending cuts, and relatively large (but easily achieved) tax increases. The current euro zone crises is leaving risk-averse investors with few places to put their money, so there should be capital available for quite significant bailouts in the near future.

    In regards to how the US might actually fail, my bet will be on a Greece style failure. The entire economy is adjusted to a government sector that is spending well beyond its means. Eventually, the politicians, in competition for votes and campaign funding – will push the debt beyond the limit of the capital markets, but will continue to have low interest rates until the next financial ‘blip’. At this point, there will be a run on treasuries, forcing steep austerity measures, and sending the US economy into a prolonged recession.

  • Barry Kelly

    $7bn isn’t even 2 days worth of borrowing for the U.S. so will it really make much difference to their debt?

  • ofe_2002

    Governments all of the world for thousands of years have FORGAVE entire trade balances, and so on and so forth. Solution dissolution of the machinations … DONE.

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