Q1 2008 Derivatives Report, Office of the Comptroller of the Currency
"Credit risk is a significant risk in bank derivatives trading activities." page 2
"Credit risk in derivatives differs from credit risk in loans due to the more
uncertain nature of potential credit exposure. Because the credit exposure
is a function of movements in market rates, banks do not know, and can only
estimate, how much the value of the derivative contract might be at various points
of time in the future." page 3
"From 2003 to 2007, credit derivative contracts grew at a 100% compounded
annual growth rate. Given current market turmoil, however, credit derivative
growth has eased." page 5
Click here to review a chart taken from page 6. Please note, the numbers you
are reviewing are in the billions.
The Dept of the Treasury: Blueprint for a Modernized Financial
Regulatory Structure, March 2008
If you know of the problems that arise from giving the government more power,
you have got to read this document. With all of the articles and comments in the
public domain warning of the moral hazard of the Fed constantly intervening to
"stabilize" the markets, this plan, from our highest financial government leaders,
can only be seen as a recipe for disaster. They note:
"The market stability regulator should be responsible for overall issues of
financial market stability. The Federal Reserve's market stability role would
be conducted through the implementation of monetary policy and the provision
of liquidity [a constant euphemism for perpetual debt creation] to the financial
system." page 15
Compare this with my March 10, 2007comments in Herb Greenberg's Wall Street
Journal Weekend column: .
"The reason we don't believe markets will crash, is because we do not want to.
Simply put, we enjoy the wealth that easy credit creates. And who wouldn't? With
easy credit, there's no need to work for years and save, no need for politicians to
ever say no, and no need to wait or do without. If the system has a problem,
liquidity is always the answer. If we encounter a slowdown, just add more
liquidity. After all, it has been working for years. And the long this arrangement
persists, the more this belief is reinforced."
David Walker on America's Financial Crisis, Post from Ross Perot's website,
April 29, 2008
"Tough choices are required. We will not be able to grow our way out of this
problem. Anybody who says that, suffers from two problems. Number one: they
have not studied economic history adequately. And number 2: they probably
wouldn't do real well at math, because the number just don't add up."
- Former Comptroller General of the United States, David Walker
A friend of mine, who started his life in Iraq under Saddam Hussein and fled to
America as a boy, notified me of this film.
Triennial and Semiannual survey of positions in Global OTC Derivatives
Bank of International Settlements, November 2007
The highest authority in global central banking notes that the outstanding
amount of OTC derivatives was $516 trillion as of June of 2007. While we agree
with the BIS's statement that, "a single comprehensive measure of risk does not
exists," an annualized growth rate of 33 percent since 2004 and 20 percent since
1995, is certainly disconcerting. We should not be surprised when markets
fall.
Quarterly Banking Profile, Fourth Quarter 2007, FDIC
Most investment trading models are designed with an "everything stays within
this range" mentality. But the statements found in this document reveal a banking
community that is experiencing historic extremes. The clustering continues to
signal that we have moved outside of the normal range." Understanding the
history of fiat money and the science of unstable systems has never been more
crucial. Click here to subscribe to our ongoing research.
Procyclicality in the Financial System: do we need a new macro
stabilization framework? Bank of International Settlements, William White,
Head of Monetary and Economic Development, January 2006
If you've read extensive amounts of history on events such as the 1929 crash,
the months prior to Pearl Harbor, or the Yom Kippur War during the 1973 -74 oil
crisis, you realize that the reason we don't see watershed events in history prior
to their occurrences, is that we have little knowledge of monetary history, and thus
do not understand that some voices carry further in determining the course of
history. White's position at the BIS, places him at the top of the central bankers'
bank. His comments on pages 5 and 20 should be read by every individual who
uses money, and by that I mean everyone. To examine our research on this
paper, and the history of the BIS, read our May 2006 newsletter: Between Two
Worlds.
Fitch Comments on US Operating Funds, January 14, 2007, Riskcenter.com
If you are with a local or state government agency or you do business with the
same, you need to consider the material discussed in this short report. Risks we
never even consider in our day-to-day business transactions, should now move
front and center.
"Fitch's survey of state investments has sought to identify exposure to credit -
impaired and illiquid assets, and the consequent risks to investment principle
should such investments fail to perform. To the extent that state operating funds
are invested in credit-impaired and illiquid instruments, these states face the risk
of delayed access to principal, if not losses of such principal."
Though this primarily addresses the US, individuals from other countries will
likely find this information helpful, as well.
OCC's Quarterly Report on Bank Derivatives Activities Third Quarter 2007
"U.S. commercial banks generated $2.3 billion in revenues trading cash and
derivative instruments in the third quarter of 2007, down 62% from the $6.2 billion
reported in the second quarter. This decline is attributed largely to the difficult
trading environment in credit markets." To see derivatives' exponential growth
and their heavy concentrations in "five large [U.S.] commercial banks," read on.
FDIC Quarterly Banking Profile, Third Quarter 2007, FDIC
"Loan-loss provisions totaled $16.6 billion, more than double the $7.5 billion
insured institutions set aside for credit losses in the third quarter of 2006 and the
largest quarterly loss provision for the industry since the second quarter of 1987.
Loan losses in the third quarter were $3.6 billion (49.9 percent) higher than a year
earlier. The largest increase occurred in loans to commercial and industrial (C&I)
borrowers, where charge-offs were $796 million (91.4 percent) higher than a year
earlier. Charge-offs of consumer loans other than credit cards had the second-
largest increase, rising by $702 million (46.1 percent). Net charge-offs of
residential mortgage loans were up by $676 million (164.8 percent)."
And, this is not just a U.S. problem..
The Risk Outlook for Mortgage Lenders, December 4, 2007,
Clive Briault - Financial Services Authority Managing Director of Retail Markets
"You need to consider contingency plans against the worst outcomes. These
plans might include the very practical issue of how you would cope with an
upsurge in retail deposit withdrawals, both from your branches and over the
internet; how you could access emergency funding; and the circumstances in
which you might need to curtail or wind down your business. Again, any such
plans need to be considered well before you are engulfed by a crisis since by
then it will almost certainly be too late to develop practical responses."
An Investor's Guide to Asset Backed Securities (2004),
The Bond Market Association
Asset Backed Securities will be remembered as one of the most unsound
investment structures of "modern finance." As you read this brochure, recall
what has transpired in the commercial paper markets, in which money market
mutual funds invest. Then you will understand why this brochure is one more
reflection of the credit mania. As more "surprises" surface, complacency
regarding due diligence will become more costly.
August 2nd, 2007 Updates:
First Quarter 2007 Derivatives Report, Office of the
Comptroller of the Currency
"What goes up, must not come down," has become the creed of our
largest banks. As you review these astronomical numbers, consider the
following definitions of risk from the Investment Planning textbook
developed for the College for Financial Planning.
1.Business Risk is the risk associated with the nature of the enterprise
itself.
2.The use of financial leverage is the source of financial risk.
3.Market risk refers to the tendency of security prices to move together.
4.Interest rate risk refers to the tendency of security prices, especially
fixed-income securities, to move inversely with changes in the rate of
interest.
Equipped with these simple definitions of risk, check out pages 12, 16,
22 and 26. Are our largest banks showing any concern for risk?
Personal Income & Outlays, June 2007, Bureau of Economic
Analysis
After reviewing pages 4, 7, 8 and 9, look at pages 6 and 7 in the March
release from the same agency. What gives? Paul Kasriel gives accurately
assesses the damage the "wealth effect" has had on our nation.
Second Quarter 2007 Gross Domestic Product, Bureau of
Economic Analysis
Knowing that very few people ever read numbers outside of the current
financial headlines, our government seems given to excessive revisions
Compare this first quarter GDP report with the revisions made in the 2nd
quarter report. What will the revised 2nd quarter numbers look like in the
3rd quarter report? If you're losing confidence in the BEA, check out John
Williams, who recently notes, "GDP contracted 0.9% net of revisions for the
second quarter."
FDIC Quarterly Banking Profile, First Quarter 2007
If the year-over-year loan loss increases in our banking system continues it's
current trajectory, we may well have cause for concern. From the 1st quarter of
2006 credit card charge-offs have increased 29 percent, individual loan charge-
offs are up 60 percent, commercial and industrial loan charge-offs are up 78
percent, and residential mortgage loan charge-offs are up 93 percent. Noncurrent
loan rates are also trending higher.
SEC to End Short Sale Tick Test on July 6, 2007, SEC News Digest, Issue
2007-124, June 28, 2007
"On June 13, 2007, the Commission voted to remove the tick test of Rule 10a-1
and to amend Regulation SHO to provide that no short sale price test, including
any price test of any exchange or national securities association, shall apply to
short sales in any security." As we discuss in Riders on the Storm, excerpted
here, the tick test rule began in 1938, after the Crash of 1929 and a 47 percent
decline in 1937, and though it has always been ineffective, we have some
concerns about its removal at a market top, before a major decline occurs.
Conclusion to the 77th Annual Report, Bank of International Settlements,
June 24, 2007
"There seems to be a natural tendency in markets for past successes to lead
to more risk-taking, more leverage, more funding, higher prices, more collateral
and, in turn, more risk-taking. Should liquidity dry up and correlations among
assets rise, the concern would be that prices might also overshoot on the down-
side. Such cycles have been seen many times in the past. "
BIS Quarterly Review: International Banking and Financial Market
Developments, June 2007
When the Bank of International Settlements comments that "global issuance of
CDOs (Credit Default Obligations) in the first quarter of 2007, at $251 billion, was
the strongest on record," and that the "bust cycle" in the credit card market begins
with "the recognition of excessive indebtedness amid rising delinquencies" thus
resulting in "tighter lending standards, contractions of credit, and prolonged
balanced sheet adjustments, affecting the real side of the economy," can these
global officials claim surprise at the Bear Stearns debacle? "Strongest on record"
sounds a lot like 1999.
Global Financial Stability Report, Chapter 1, Assessing Global Financial
Risks, April 2007, International Monetary Fund, Washington DC
If you are making long-term investment or business decisions, this report
might alter your view of risk. While couched in the typical conditional phrases,
which act to negate that of which they warn, we find some disconcerting
comments. The following are just two examples.
"The benign external environment and accompanying rise in risk appetite -
reflected in the rapid rise in capital flows to some EM [Emerging Markets]
countries - pose challenges for those authorities and could threaten financial
and economic stability, especially if capital flow reversals were to occur." Or,
"ABX indices, which are indices on ABCDS [Asset Backed Credit Default
Swaps], started trading January 2006." As of April 2007, "Spreads on the BBB-
subindices of the three most recent ABX series have widened sharply since
November 2006, reflecting increasing defaults and stress in the lower quality
home equity loans." And, "the 06-02 series has experienced delinquencies 60
percent higher than those of the 06-01series at comparable seasoning."
I continue to be amazed at the total lack of explanation of how we got here in the
first place, and find it incredible that our own media never refers to this ongoing
commentary of global financial risk presented by one of the most influential
banks in the world.
Are High Foreign Exchange Reserves in Emerging Markets a
Blessing or a Burden? March 2007, Russell Green & Tom Torgerson,
Department of the Treasury, Office of International Affairs
"The practice of preventing upward real exchange rate adjustment can be
harmful by distorting the price signal for resource allocation. Reserve
accumulation may render a false sense of security, delaying necessary
reforms. Large fiscal deficits, for example, may crowd out private sector
investment or create debt overhang problems." These statement are true
for the U.S. as well as the intended audience. Once again, finger pointing
is preferred to addressing the root cause of the problem.
Capitalizing on Sustainable Development: Making Gold out of
Green, Spring 2007, Joan Veon, Women's International Media Group
To those who are new to such discussions, this missive will likely
make more sense after viewing "The Great Global Warming Swindle"
documentary below. As a member of the press who has covered more
90 global government meetings over the last 15 years, though Veon's
views may differ from one's own, they merit a great deal of respect.
The Great Global Warming Swindle, British TV Channel 4,
March 8, 2007
As you form an opinion on this issue, review this film and listen to these
comments of scientists from around the world. When we study various
global government agencies' trends, we begin to see a completely
different set of events developing.
Fiscal Stewardship: A Critical Challenge Facing Our Nation, January
2007, United States Government Accountability Office.
"As of September 30, 2006, the U.S. government reported that it owed
more than it owned by almost $9 trillion. In addition, the present value of
the federal government's major reported long-term "fiscal exposures" -
liabilities, contingencies, and social insurance and other commitments
and promises - rose from $20 trillion to about $50 trillion in the last 6
years ...These structural deficits - which are virtually certain given the
design of our current programs and policies - will mean escalating and
ultimately unsustainable federal deficits and debt levels. Based on
various measures - and using reasonable assumptions - the federal
government's current fiscal policy is unsustainable. Continuing on this
imprudent and unsustainable path will gradually erode, if not suddenly
damage, our economy, our standard of living, and ultimately our domestic
tranquility and national security. "
BIS Quarterly Review: International Banking and Financial Market
Developments, December 2006, Bank of International
Settlements, My Highlighted Version
"This general [optimistic] confidence could also be discerned in the
behaviour of a number of other market indicators. In mid-November,
implied volatilities in bond and stock markets reached their lowest levels
in years, while measures of risk appetite showed that the retrenchment
by investors after the sell-off in May and June had been largely reversed."
History has always shown, that when appetites for risky assets increase,
we're a long way from a market bottom. Review the constant proportion
debt obligations (CPDOs) on page 8, and then review the Moody's piece
we placed on the website in the fall. This will be one for the history books.
Who Predicted the Bubble? Who Predicted the Crash?
Summer 2004, Dr Mark Thornton, Ludwig Von Mises Institute
My Highlighted Version
As 2007 begins and the bullish buzz abounds, some think that, after the
strong equity returns of 2006, maintaining a bearish view is arbitrarily
pessimistic. Yet, Dr. Mark Thornton reminds us that these conditions
must exist in that they are indicative of a market top. On a pragmatic note,
it is also helpful to read the thoughts of those who were able to step
outside of the euphoria of 1999.
Financial Market Update, Monetary and Capital Markets
Department: Global Markets Monitoring and Analysis Division,
December 2006, International Monetary Fund
My Highlighted Version
"Investors continue to move out the risk spectrum in search for yield, and
risky assets continue to perform well. At the same time, volatility has fallen
to generational lows across a wide range of assets, and many investors
appear to have adopted similar trading strategies, in many cases ones
predicated on a continuation of the benign scenario."
Sounds like the IMF has read our research paper, Riders on the Storm:
Short Selling for Contrary Winds. Now may be a good time to do the
same. So, subscribe to The Investor's Mind and obtain access to our
entire 154 page paper. Click here to review samples of both.
How Active is Your Fund Manager? A New Measure that Predicts
Performance August 7, 2006, Martijn Cremers & Antti Petajisto,
Yale School of Management
"Nearly one third of the U.S. mutual fund industry is comprised of 'closet
indexers” – funds that claim to be actively managed but passively invest
most of their assets in the benchmark index – while truly active funds
account for only about a quarter of the market. Furthermore,only the most
active funds outperform their benchmark indexes while all other active
funds underperform after expenses."
FDIC Outlook: Summer 2006
This FDIC report discusses the effects of lending cycles on the business
cycle, provides a good explanation of why credit default swaps have
grown exponentially (page 11), and discusses commercial real estate
lending (page 14). Pages 24 and 25 show growth rates in non-traditional
mortgage loans, which are of particular interest. We have also provided a
non-hi-lighted version for those who would prefer it.
Operational Risk - US Treasury Requests Public Comment on
Securities Lending Facility - April 27, 2006, www.riskcenter.com
"An SLLR [Securities Lender of Last Resort], or repo facility, is a
mechanism for providing an additional, temporary supply of Treasury
securities used on rare occasions when market shortages threaten to
to impair the Treasury and financial markets' functioning."
Global Derivatives Explosion
A few years ago, I came across a 1994 Bank of International Settlements
paper voicing concern over the inherent risks in the derivatives industry
after the conclusion of Carry Trade 1(at that time). To make it easier to
digest, I have highlighted the issues I found alarming. With the plethora of
information available today, I welcome any reader's insights on
subsequent publications on this topic.
When we consider the unsustainable growth rate of the global futures and
options markets, evidenced in the January and February 2006 data,
the concerns addressed in the 1994 BIS paper become even more
pronounced. This May 22, 2006 Market Commentary shows that
these concerns are well founded.
This information was obtained from Risk Centers' Risk Alert services.
Lights out on M3
In our May 2004 newsletter, we discussed inflation and deflation using
historical M3 values from the Federal Reserve. Since March 16, 2006
marks the last public money supply report that contains M3 values,
and March 23, 2006 begins the new report format without M3 values,
you may want to save both of these reports as a reminder of this
period in our nations history.
Shadowing Reality - Welling@Weeden interviews John Williams,
February 21, 2006
"Real unemployment right now - figured the way that the average person
thinks of unemployment, meaning the way it was estimated back during
the Great Depression - is running about 12%. Real CPI right now is
running about 8%. And the real GDP probably is in contraction." To find out
just how distorted our government economic reporting numbers have
become, read on.
BIS Working Paper No 193, Procyclicality in the financial system:
do we need a new macrofinancial stabilisation framework?
William White, Economic Advisor, Head of the Monetary and Economic
Department for the Bank of International Settlements, January 2006
Now don't let the title of this paper fool you. This is not your typical dry
rhetorical economic jargon that leaves you clueless after reading it. It is
probably one of the most accurate pieces written by a central banker on
the current state of the world's economic environment, what central
bankers have learned over the last several decades, and possible
solutions for our current juncture. This is one for the history books.
The January 2006 working paper gives some specific solutions that are
not found in the April 2006 working paper. Let me also encourage you to
read the definition given by Merriam-Webster of inflation before and after
you read these working papers.
White refers to the "Austrian school of economics." If you are unfamiliar
with this school of thought, watch Money, Banking and
The Federal Reserve, by the Ludwig von Mises Institute. You can access
the streaming version of the video at http://mises.org:88/Fed or
download it from http://mises.org/multimedia/video/Fed.wmv.
Bear & Bull Cycles: A 102 Year Look At The Dow , January 31, 2006
The historic record, as displayed in this great chart, makes it painfully
clear that bear cycles have lasted, and therefore can last, for years. To
deny this fact by not altering your investment strategies accordingly, is to
invite the claws of the bear to shred your financial capital.
Same Play, Different Actors, Kevin Duffy and William Laggner,
Bearing Asset Management LLC, December 2005
As memories of the stock market bubble of the late 90s grow dim, we do
well to take the time to review it. These slides show that the same drama
is about to unfold again, only this time with different actors. Click here for
one more reality check.
Will a Bursting Bubble trouble Bernanke? Center for Economic and
Policy Research, November 2005
As Baker and Rosnick point out in this paper, one of the Federal
Reserve's mandate's is to seek price stability. This paper cogently argues
that the policies of the Federal Reserve have fostered price instability in
the housing sector.
A Speech at the Credit Risk Conference, John C. Dugan, Comptroller
of the Currency, October 27, 2005
"One of the striking findings in our 2005 survey was the breadth and extent
to which banks relaxed their lending standards. We readily understand
why these products [interest only loans, ARMS,etc.] have become fixtures
in the marketplace in such a short time. One reason is that they have
helped to sustain loan volume that would otherwise almost certainly be
falling, because rising interest rates have brought an end to the refinance
boom."
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