Monday, April 28, 2008

Winter Warning: Chaos Chronicled

Winter Warning: Chaos Chronicled
Click here for a link to complete article:

By Ian Gordon/Alf Field | 28 April 2008

Ed. Ian Gordon, Economic Forecaster & Interpreter of the Kondratieff Cycle: Winter Warning this week is entirely the work of Alf Field who has written a very good piece entitled "Chaos Chronicled" Alf leads you through the history of the world financial crisis. He begins with an explanation of Goldsmiths, the original bankers, followed by the development into the Fractional Reserve Banking system. Alf then discusses the International Monetary System based on the dollar and the inherent weakness in such a system due to the ability of banks around the world to consistently add massively to loans. This is followed by an explanation of the OTC derivatives market and the crisis which has developed in that milieu. "Chaos Chronicled" is a coherent and chronological evolution into the crisis that has now enveloped the world.

[ Normxxx Here:  The following is only the conclusion of this very erudite piece by Alf. See the link above for the remainder.  ]

It does not take a genius to work out that the US Dollar Standard (with the US dollar as the reserve currency) has to go, but it will take a genius to work out what the new system should be. The new system will require sound money that cannot be manufactured at will by Governments, money that performs the 3 basic functions of medium of exchange, unit of measurement and store of value. A new international monetary system needs to be developed. It seems that the eternal money, gold, will have to be returned to the monetary systems, both national and international, to provide the necessary discipline. That is all for the future. Meanwhile there is a mess to clear up and how that occurs will have investment consequences and implications.

There was a crisis in the US banking system during the 1970’s with major loans to South American Governments going sour. South American countries actually defaulted on their sovereign loans, leaving the American banks with large losses. If these losses were brought to account, the banking system would have wiped out its reserves. Special permission was granted to allow the loans to be carried at book value until the banks raised new capital and/or accumulated sufficient profits to write off their South American loan losses. The banks were allowed time to trade out of their losses.

The current situation is different. In the 1970’s crisis it was possible to identify where the losses would fall and the individual banks could quantify their losses. In 2008 it is impossible to identify the degree of loss within an order of magnitude or determine where or how they will fall. The US banking system has already recognised losses that have wiped out bank reserves to the extent that the banks can only continue operating with aid from the Fed. The losses written off to date are likely to be augmented by substantial additional sub-prime and CDS losses of presently unknown magnitude. Moreover, it is unclear where those losses will finally appear. Every bank is suspect.

The mountain of OTC derivatives is one of the major problems facing the world’s banking and financial systems. Unfortunately there is no easy way of getting rid of these derivatives. George Soros recently suggested that a clearing house system should be established for the OTC derivatives. This is an impractical suggestion as a brief example will quickly illustrate.

Assume that investor A buys $100m of 5 year bonds in XYZ Company. He is unsure of the strength of XYZ Co. so he also buys a 5 year CDS from B to cover any loss in the event of XYZ Co defaulting on its bonds. The investor pays a premium of say $2m per annum. Two years later it is desired to close down this transaction. If A and B were still the only parties to the transaction, they could sit around a table and discuss how to determine the current market value of the CDS. IF they could agree a market value for the CDS and IF both parties were willing to cancel the CDS, it could be cancelled by one party paying to the other the mutually agreed amount.

In reality B will probably have arbitraged its position to a number of other parties and the investor A may have sold his bonds to a number of other investors with the CDS protection attached. It is a practical impossibility to get all parties to this 'simple' transaction together to discuss a possible settlement and cancellation of the deal. This is just a single 'simple' transaction without the complication of additional features such as collars, caps, swaptions, etc. It is also only one of zillions of OTC transactions that are in existence. To expect any clearing house to be able to settle these derivative contracts is just wishful thinking.

Nevertheless, this mountain of OTC derivatives has the capacity to bring down the entire international financial system, including the banking systems of the key players in the event of the bankruptcy of one or more of the larger counter parties. Some way has to be found to reduce or eliminate this OTC derivative overhang which would otherwise eventually prove fatal to the present system [[In past, whenever a default threatened or was realized, this could be largely 'papered over' with further derivatives; this is no longer true.: normxxx]]. History has shown that when debt becomes excessive, the lenders almost always lose.

They lose either because their debtors go bankrupt or they lose because they are repaid in currency which has been debased by wholesale printing, making the currency worth very little in real terms. There is no doubt that the world has reached an extreme level of debt creation. The only question is whether the debt will be settled by bankruptcies or whether the debt will be repaid in largely worthless currency. Fed chief Ben Bernanke has made it quite plain that his plan is NOT to allow debt to be repaid by bankruptcy and deflation. All his actions to date are in line with his proclaimed policy. There is no reason to think that he will change his thinking or modus operandi. Thus we have to believe that USA has embarked on a voyage that will allow debts to be repaid in debased, largely worthless currency.

Jim Sinclair has drawn an analogy comparing the Weimar Republic in 1919 with the present mountain of OTC derivatives. After World War I the Allies imposed excessively large reparation claims on the German Republic. The Germans objected to the magnitude of the claims, but finally agreed when the Allies allowed the Germans to settle the reparation payments in Reichsmarks. The Germans then adopted the attitude that "if they want Reichsmarks, we will give them Reichsmarks". They then proceeded to print new Reichsmarks at an accelerating rate to settle the reparation debts and keep abreast of the ensuing inflation, eventually causing the classic hyperinflation that destroyed the German currency [[and, collaterally, the German economy, all Reichsmark 'savers' and, eventually, also the Weimar Republic: normxxx]].

Jim Sinclair suggests that if one crosses out the words "reparation payments" and replaces them with the words "OTC derivative contracts" one would have a clearer picture of the current circumstances. The suggestion is that the OTC derivative problem can only be settled by creating sufficient additional currency to inflate the current currency to the point where it is largely worthless. That would allow all these derivative contracts and other loans to be settled in debased currency [[where everyone shares in the world bankruptcy— many, by giving up eating. Too bad everyone didn't share in the preceding boom.: normxxx]]...

  Much, Much, M O R E. . .


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