Wed Post #1: Details Of The $291 Trillion In Derivatives To Which American Taxpayers Are Exposed

The following article was posted on Seeking Alpha and is reproduced here.

Investors buy derivatives for one of two purposes: either they're speculating about the performance of the market in the future, or they're hedging against the possibility of a loss. The way in which you intend to use derivatives influences your derivative investment strategy.

If you're hedging, you'd buy derivatives as a kind of insurance policy. By having derivatives in place for a nominal fee, you can be certain of buying or selling at a certain price, and you don't have to worry as much about fluctuations in the market. Many corporations use derivatives to hedge against fluctuations in interest rates, foreign-currency exchange or the cost of raw materials.

Speculation is a different side of dealing in derivatives. Investors who engage in derivative speculation have no real interest in the underlying commodities, but instead are trying to predict the behavior of the stock market to make a profit. Unfortunately, derivatives can be manipulated in ways that make speculation dangerous to the economy. The government has some regulations in place to protect against speculative manipulation of the market, such as prohibitions against naked short selling, but it can still be a dangerous practice for the economy.

Recall that Warren Buffet once famously called derivatives "financial weapons of mass destruction" and the sovereign debt problem risks detonating these time bombs.

How big is America's exposure to these "weapons of mass destruction"?

Here is what Seeking Alpha had to say...

Details Of The $291 Trillion In Derivatives To Which American Taxpayers Are Exposed

The entire US GDP is less than $15 trillion each year. The gross notional amount of derivatives issued in the USA is more than $291 trillion. Does that sound like a lot? Apologists for derivatives dealers don't like it when we talk about derivatives in terms of the notional totals. Large numbers, like these, discussed publicly, frighten too many people. According to the apologists, gross "notional" is misleading, because it does not include "hedges," offsets and the limits on interest rate risk.

In fact, the total amount of derivatives cannot be accurately presented in any other form but gross notional obligations. The risk to society cannot be judged in any other way. That's why the FDIC, US Comptroller of the Currency and the Bank for International Settlement (BIS) all use gross notional.

Final net obligations can only be determined when and if derivatives are triggered. The net can be significantly lower, but neither we, nor the banks themselves actually know exactly what that is. It depends upon the balance sheets of every counter-party, and the extent to which interest rates will change in the future. Not even the banks have full information about either topic..

There is another number called the "net current credit exposure" (NCCE) that some erroneously claim represents the risk imposed by derivatives. According to the Office of the Comptroller of the Currency (OCC), the NCCE for American bank derivatives amounts to about $370 billion. That's a huge amount of money, but it's not $291 trillion.

Unfortunately, NCCE provides no information about ultimate exposure to loss. It merely measures the net cost of unwinding the contracts, before the occurrence of any trigger event. NCCE is the current market value of the contracts, and nothing more.

There are also a number of "value at risk" calculations that the banks provide. These are not standardized, and are based upon vastly different models and assumptions, from bank to bank. Unfortunately, a very high level of inconsistency and lack of any standards for measurement causes such models to be highly unreliable. For example, during the 2008 credit crisis, similar proprietary models used to determine subprime credit risk failed, in the infinitely smaller subprime mortgage market.

In reality, it is impossible to know the true risk of $291 trillion in New York issued derivatives (ignoring the additional $417 trillion issued out of London). A sudden very large increase in interest rates, alone, could trigger trillions of dollars in payments. One could argue that the Federal Reserve could force interest rates down at any time, but that is not entirely true.

If the US dollar came under heavy selling pressure, for an extended period of time, as has happened to the British pound, Chinese yuan, Japanese yen, German mark, Austrian shilling, Argentine peso, and a host of other currencies in the course of history, the Fed would be able to defend the dollar only at the risk of inducing widespread systemic failure.

That is why interest rates cannot rise for many years, regardless of whether that destroys its status as the world's reserve currency, and/or creates extreme levels of inflation or hyperinflation. It is also one more reason for the government to lie about the true inflation rate, to avoid pressure to raise interest rates (see shadowstats.com.)

All the too-big-to-fail (TBTF) banks, with the exception of Morgan Stanley (which uses its SIPC-insured division) are using FDIC-insured depository divisions to house derivatives. That provides them with lower collateral requirements because FDIC depositary units usually have higher credit ratings than investment banks and/or bank holding companies. It also means that, ultimately, the American people will pay for losses.

While no one can determine the exact exposure, it is safe to say is that the risk is astronomical, and imposes a grave risk upon American taxpayers. It is not surprising that FDIC staff is not thrilled with US bank derivative exposures. In fact, Sheila Bair, who until recently ran the FDIC, is as disgusted with the Federal Reserve slush fund and the banking cartel as you and I. A few days ago, she penned a satirical article heavily critical of Fed policy and published it in the Washington Post.

The FDIC staff doesn't like the fact that the Federal Reserve keeps allowing banks to put their derivatives inside insured depositary institutions. This is mostly for the same reason the banks want to put them there. Insolvency laws provides priority to derivatives counter-parties over the FDIC. If and when a bank is liquidated, the FDIC will be on the hook to repay depositors, but the failing bank will be stripped of all assets.

The US government's full faith and credit guaranty means massive amounts of new US Treasuries will need to be sold, massive numbers of new counterfeit dollars will need to be printed under color of law, and significant tax hikes will need to be levied to pay the bill.

FDIC opposition, however, has had little to no effect on keeping derivatives out of insured units. The Federal Reserve, and not the FDIC, has the authority to approve the practice and it keeps doing so. The FDIC staff can complain privately, and issue regulations forcing disclosures, but little more. But, because of the disclosure requirements, more detailed information than ever is now available concerning derivatives.

In fact, FDIC has made far more information about derivatives public, over the last 3 years, than the Fed and OCC ever disclosed over decades. The numbers reveal a frightening concentration of risk. Five large "TBTF" US banks hold 96% of derivatives issued in the United States.

But the Bank for International Settlements in Switzerland reports that about $707.6 trillion worth of derivative obligations have been issued worldwide as of the end of 2011. That leaves about $417 trillion worth of derivatives that are not accounted for, in the FDIC records.

The surplus derivatives have been written mostly in London. Part of the exposure is held on the balance sheets of foreign, mostly European banks, including Deutsche Bank, PNB Paribas, Credit Suisse, UBS et. al. But, a large number of seemingly foreign derivatives is also hidden inside bank divisions, owned by American institutions, who do business in London. Such derivatives are not reported to the Fed, the OCC or the FDIC. Lenient British banking laws insure that these opaque obligations are not subject to public scrutiny.

Ultimately, if London-issued derivatives eventually cause massive losses to a UK bank division, the US based bank that owns it would end up being closed or bailed out. Ultimately, just like the derivatives issued in New York, the American taxpayer and dollar-denominated saver will pay the bill. Unfortunately, in spite of this, details about London-issued derivatives are not publicly disclosed or I cannot find them. If such data exists, a British lawyer or someone knowledgeable enough about UK regulations and bureaucracy would be needed to ferret it out.

Even in the absence of London data, however, investors should find this incomplete article enlightening. It is useful to obtain a general picture of the risk of investing in shares of the five big derivatives dealers. Here's how the dollar amounts break down, as of December 31, 2011 in thousands of dollars.

JPMorgan Chase (JPM)

Description		Amount
	Total Derivatives	70,268,515,451
	Notional amount of credit derivatives:	5,775,740,000
	Bank is guarantor	2,920,886,000
	Bank is beneficiary	2,854,854,000
	Interest rate contracts	53,708,319,000
	Notional value of interest rate swaps	38,805,453,000
	Futures and forward contracts	7,033,041,000
	Written option contracts	3,841,178,000
	Purchased option contracts	4,028,647,000
	Foreign exchange rate contracts	8,799,397,451
	Notional value of exchange swaps	2,934,191,451
	Commitments to purchase foreign currencies & U.S. Dollar exchange	4,521,035,000
	Spot foreign exchange rate contracts	116,741,000
	Written option contracts	674,276,000
	Purchased option contracts	669,895,000
	Contracts on other commodities and equities	1,985,059,000
	Notional value of swaps	453,521,000
	Futures and forward contracts	137,101,000
	Written option contracts	746,259,000
	Purchased option contracts	648,178,000

Bank of America (BAC)

It should be pointed out that BAC has recently moved a nominal value of about $22 trillion worth of derivatives from Merrill Lynch, into its FDIC insured division. This does not appear to be showing up, yet, in these numbers. The total for BAC's FDIC insured division is now closer to $72 trillion.

Derivatives	50,407,550,785
Notional amount of credit derivatives:	4,720,320,266
Bank is guarantor	2,342,544,257
Bank is beneficiary	2,377,776,009
Interest rate contracts	40,832,704,946
Notional value of interest rate swaps	29,707,570,138
Futures and forward contracts	8,203,345,962
Written option contracts	1,430,677,395
Purchased option contracts	1,491,111,451
Foreign exchange rate contracts	4,676,887,004
Notional value of exchange swaps	1,425,870,031
Commitments to purchase foreign currencies & U.S. Dollar exchange	2,839,430,866
Spot foreign exchange rate contracts	254,990,960
Written option contracts	204,427,019
Purchased option contracts	207,159,088
Contracts on other commodities and equities	177,638,569
Notional value of swaps	76,992,166
Futures and forward contracts	343,077
Written option contracts	44,438,807
Purchased option contracts	55,864,519

Citigroup (C)

Derivatives	52,620,696,000
Notional amount of credit derivatives:	2,975,096,000
Bank is guarantor	1,439,748,000
Bank is beneficiary	1,535,348,000
Interest rate contracts	42,568,376,000
Notional value of interest rate swaps	31,525,209,000
Futures and forward contracts	3,279,189,000
Written option contracts	3,842,701,000
Purchased option contracts	3,921,277,000
Foreign exchange rate contracts	6,488,019,000
Notional value of exchange swaps	1,349,909,000
Commitments to purchase foreign currencies & U.S. Dollar exchange	3,910,599,000
Spot foreign exchange rate contracts	518,436,000
Written option contracts	601,793,000
Purchased option contracts	625,718,000
Contracts on other commodities and equities	589,205,000
Notional value of swaps	116,124,000
Futures and forward contracts	36,180,000
Written option contracts	215,205,000
Purchased option contracts	221,696,000

Goldman Sachs (GS)

Derivatives	44,195,386,000
Notional amount of credit derivatives:	499,741,000
Bank is guarantor	203,723,000
Bank is beneficiary	296,018,000
Interest rate contracts	41,737,737,000
Notional value of interest rate swaps	29,901,018,000
Futures and forward contracts	4,361,219,000
Written option contracts	3,553,371,000
Purchased option contracts	3,922,129,000
Foreign exchange rate contracts	1,945,805,000
Notional value of exchange swaps	1,623,260,000
Commitments to purchase foreign currencies & U.S. Dollar exchange	134,300,000
Spot foreign exchange rate contracts	2,912,000
Written option contracts	89,612,000
Purchased option contracts	98,633,000
Contracts on other commodities and equities	12,103,000
Notional value of swaps	11,885,000
Futures and forward contracts	0
Written option contracts	111,000
Purchased option contracts	107,000

Morgan Stanley (MS)

According to the US Comptroller of the Currency, the Morgan Stanley holding company has about $52 trillion worth of derivatives obligations, but only $1.7 trillion show up in the detailed FDIC statistics. It is not worth listing that small fraction as it would give an incomplete and misleading picture. Unlike other banks, MS is storing most of its derivatives in its SIPC insured investment bank, rather than its FDIC insured commercial banking division.

The reason it is doing that are unclear. Unlike the FDIC, which opposed the addition of $22 trillion in Merrill Lynch obligations to FDIC insured Bank of America's balance sheet, diligent search indicates that the SIPC does not bother keeping track of derivatives. If we did have details on the MS derivatives, the company would rank number 3, slightly above Citigroup.

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Sat Post #2: Canadian Bank sues JP Morgan (and others) over interest rate swap suppression

Interesting little development in the world of high finance today.

Bloomberg has announced that an unnamed Canadian bank has filed suit against at least seven firms including JP Morgan over conspiracy to manipulate the price of interest rate swap derivatives for more than three years.

The lawsuit is contains a trove of documents that are shedding light on the manipulations going on. The issue is significant because Interest rate swaps artificially support the bond market by creating massive demand for bond trades that are embedded into these swaps.

From Bloomberg:

JPMorgan Chase, Deutsche Bank AG (DBK) and HSBC Holdings Plc (HSBA) are among at least seven firms accused by another bank of participating in a conspiracy to manipulate the price of derivatives worldwide for more than three years.

The unnamed bank, seeking immunity, told Canada’s Competition Bureau that traders and cash brokers conspired to influence the Yen London interbank offered rate from 2007 to 2010 to profit on interest-rate derivative positions linked to the benchmark. The bureau spelled out the probe in documents it filed with the Ontario Superior Court in May.

The documents, shown yesterday to Bloomberg News by court clerks, offer one of the most detailed accounts yet as watchdogs in Europe, Asia and the U.S. look into concerns that firms conspired to manipulate interest rates serving as benchmarks for trillions of dollars of financial products. Canada also is investigating Citigroup Inc. (C), Royal Bank of Scotland Group Plc (RBS), ICAP Plc (IAP) and RP Martin Holdings Ltd., the court documents show.

It is important you understand the volume and value in this market.

Current figures aren't available but as of 2007, JP Morgan held $61.53 trillion in total OTC swap derivatives. BOA held $23 Trillion, Citibank $19.9 Trillion, HSBC $2.1 Trillion and Wachovia held $3.1 Trillion in OTC swaps, which are probably now on Wells Fargo's books. Combined, the top 5 US banks held $110 Trillion in OTC swaps as of 2007.

These figures has likely increased significantly in size over the past 5 years as the financial system teeters on the verge of collapse.

Compare this $110 Trillion with the next next top 20 banks (they held a mere $1 Trillion in OTC swaps combined!)

Of this total $111 Trillion, an astonishing 65% of these books are Interest Rate (IR) Swaps.

This massive trading of OTC Interest rate swap derivatives creates massive artificial demand (no end user is purchasing the bond...this is merely trading for trading's sake), which results in an artificially high price for said bonds. This suppresses interest rates and keeps them at severely and artificially low levels.

As the blog Silver Doctors outlines, this is how you can see 3.5% 30 year rates when actual inflation is running 8-10% annually. Massive artificial demand is created for bonds due to an unimaginable volume of Interest rate swaps tradei back and forth among the US Treasury's proxies of JPM, Citi, HSBC, etc.

JPMorgan's interest rate swap book alone requires $41.4 BILLION in bond purchases PER DAY in order to properly hedge the growth in these swap books, plus an additional $30.3 BILLION in bond purchases PER DAY to hedge maturing interest rate swaps that need to be rolled-over and replaced. All just to keep a static book.

It has been documented that just during Q4 of 2007, JPMorgan alone required $71 Billion worth of bonds daily just to hedge its interest rate swap book.

According to the US Treasury, during Q3 of 2007 the Treasury required a total of $105 Billion in debt borrowings. Assuming the treasury sold 100% of its Q3 2007 offerings to JPMorgan, $105 Billion would satisfy about a day and a half of hedging requirements for JPM's swap book. Clearly it is physically impossible for JPM to be hedging this type of volume and is one of the reasons critics say it is clear that JP Morgan is actually an arm of the US Federal Reserve. 

Critics also say that this is why gold and silver are so stridently suppressed, as they would otherwise blow the whistle on this whole ponzi game of finance.

It is also why the developments in Europe with Greece, Portugal, et al is so important.  If default takes place, not only would there be a serious mainstream move into gold and silver (and the metals would significantly rise to their unmanipulated, free-market values) but at this point JPM's OTC derivatives would kick in JP Morgan would have to pay out on their $61.53 Trillion derivative position.

This would without question take down the entire financial system.

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Keeping the balls in the air

The email inbox overflows from yesterday's posting on the political attack video about Vancouver's Mayor Moonbeam, clearly striking a nerve on various sides of the civic political spectrum.

Today, however, we switch gears and go back to world's debt problems.

As we have commented before, debt will be the issue of this coming decade... specifically Sovereign Debt. 

The ticking time bomb in this mess is the financial product known as 'derivatives', vehicles which Warren Buffet labeled as "financial weapons of mass destruction".

I am fond of saying that what we experienced in 2008 was a deep, financial earthquake - the repercussions of which we do not fully appreciate nor understand.

I maintain that viewpoint even today.

The chain of events set into motion in 2008 still has a long way to play out. A massive amount of private and public debt  has accumulated and the system needs to allow this debt to unwind, no matter how painful this process will be (and it will be painful).

We cannot have meaningful recovery until this happens.

But Western governments have not allowed this to happen. They have intervened to prevent the pain.

The slate needs to be wiped clean but the problem is eliminating all these debts, deficits and unfunded social entitilements will trigger the gorilla in the room: the $600 trillion of derivatives created by the banks.

This is why the Euro zone and the PIIGS is such an important topic.

Bloomberg hilighted this today by reporting that JP Morgan and Goldman Sachs have disclosed to shareholders those two banks alone have have sold protection on more than $5 trillion of debt globally (much of it dependant on the debt of Greece, Italy and Spain).

Bloomberg notes, "as concerns mount that those countries may not be creditworthy, investors are being kept in the dark about how much risk U.S. banks face from a default. Firms including Goldman Sachs and JPMorgan don’t provide a full picture of potential losses and gains in such a scenario, giving only net numbers or excluding some derivatives altogether."

The banking system has enabled the creation of an unsustainable mountain of debt.

What we have watched since 2008 has been nothing more than a complex juggling act that has - so far - failed to deal with the root of the problem: eliminating the debt.

The crisis that looms on the horizion will be the biggest event in our lives and understanding/preparing for it will be the most important step you will ever take.

Future generations will look back upon the 25-year period after 2008 in a way that dwarfs the 25-year period that followed 1929.

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Desperate times, desperate measures

The idea that the Federal Reserve might need to 'engineer' a stock market crash has been brought up numerous times over the past two years in the blogosphere by other commentators.

Articles like "Will the Fed Engineer a Stock Market Crash to Flood the Bond Market With Much Needed Demand?" have surfaced on many occasions.

As the current year has moved along, it has become abundantly clear that the Federal Reserve must initiate another round of Quantitative Easing.

The problem is that, rather than helping the economy, the last round of Quantitative Easing just pushed commodity prices through the roof. Especially the price of Gold, Silver and Copper. 

So the pressure on the Fed not to ease has become immense.

It has lead many to wonder if the Fed might allow the stock market to tank in order to facilitate demand for QE3.

In the midst of this debate, as commodity prices have gone through the roof, the topic of derivatives has added an interesting angle.

The latest quarterly report from the Office Of the Currency Comptroller was just released and it presents in a crisp, clear and very much glaring format the fact that the top 5 banks in the US now account for a massively disproportionate amount of the derivative risk in the financial system.

Specifically, of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks, a mere 5 banks account for 95.9% of all derivative exposure.

Earlier today Zero Hedge pondered if Morgan Stanley is sitting on an FX derivative time bomb.

And just last Saturday this blog wondered about the almost $80 trillion dollar derivative monster that JP Morgan was sitting on.

JP Morgan's massive short position in Silver is tied to a substantial number of derivatives which are triggered if the price of Silver remains above $36 per ounce for more than 60 consecutive trading days.

Is it a coincidence that the last time this deadline loomed (in early May, 2011) we saw a giant Silver smackdown?

Back then five margin hikes on traders in 8 days forced massive liquidation by investors trading on credit.

It triggered a sell-off that cascaded the paper price of Silver down to the mid $32.00 level, thus defusing the looming derivative time bomb.

Fast forward to September 2011.

After the May smackdown, Silver rebounded into the low $40 range despite massive shorting by JP Morgan.  On September 14th we outlined for you how the September CFTC Bank Participation report indicated that the four large US banks (primarily JP Morgan) had increased their silver shorts by 809 contracts in August from 23,775 to 24,584.

This was an increase of 4.05 Million ounces to the manipulative short position in silver in a single month. More importantly the total naked short position is up to 24,584 contracts.

It meant that JP Morgan has rebuilt their massive silver short position almost entirely back to the 25,412 contract position held prior to the giant short squeeze of August 2010.

This was all done in a frantic effort to beat Silver down below $36. But despite this massive manipulative downward pressure on the spot paper price of Silver, JP Morgan was facing another showdown with the Silver derivative time bomb.

Worldwide demand for Silver and Gold during this latest phase of the Sovereign debt crisis failed to dampen demand. Rather than drive drive investors away from the metal after the May smackdown because it is too volatile, buyers continued to accumulate Silver and the spot price was nearing another 60 consecutive trading days above the crucial $36 mark.

Derivative contracts on Gold were also nearing their tipping point.

When the Federal Reserve held their rare 2 day FOMC meeting last week, expectations were rampant that QE 3 would be announced in addition to measures like 'Operation Twist'.

When the Fed failed to impliment QE 3, the market tanked.

Was it a deliberate move?

Is a temporary minor market collapse a much lesser evil than allowing the top bank on the derivative list (JP Morgan) to implode from derivative exposure?

Not announcing QE 3 triggered a collapse in stock prices which had been pricing in the QE 3 announcement.  This forced liquidation.

And when we say 'liquidation', we mean wide-spread liquidation. Massive liquidation across asset classes such as currencies, bonds, commodities and stocks. All moved swiftly and sharply in a direction that screamed - Seek safety! Raise cash! Get liquid.

It's hard to imagine the Fed was ignorant of the impact not moving forward with QE3 would have.

Then, on Friday while stocks and the dollar all paused from the frantic selling, Gold and Silver were hammered. And the selling looked to be more calculated than incidental as it has been throughout the week.

There is little doubt that some of this is the association with usual gaming of the COMEX option expiration next week, and the potential delivery situation on that exchange with their unusually thin supplies and concentrated short positions held by a few of the banks.

But the trading volume in Gold on Friday was monstrous...in the neighbourhood of 340,000 contracts net.

In Silver net volume was an out-of-this world 114,000 contracts. This volume represented more than 100% of silver's total open interest. Just think about that for a second.

Then came the CME announcing a margin increase of 21% for Gold and 16% for Silver.

Warren Buffet famously called derivatives "financial weapons of mass destruction."

We were reaching a point where those derivaties could have wiped out JP Morgan and the other big four banks.

Desperate times called for desperate measures.  And it was desperate measures that were enacted this week to bring commodities down.

I would suggest to you that the stock market collapse this past week was but collateral damage in a far more significant battle.

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