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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Seeking Alpha: Canadian Market Collapse

Seeking Alpha has joined the cavalcade of articles on a pending Canadian Real Estate collapse.  Of all the ones recently I found theirs particularly relevant.

Here is the body of their latest post on the topic...

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Canadians like to think they are 'different' than their southern neighbors. That is certainly true in some respects, but not in the accumulation of debt. Canadian households debt to disposable income versus that in the USA is shown in the above chart, however Canadians went quite a bit further in debt! Well at least that's different, right?

The above chart shows how Canadian households compare to their American counterparts. Canadian households held more debt (to disposable income) than Americans for every single year of data shown. American households started the process of deleveraging in 2007, but Canadians have yet to start.

Mark Carney, the Governor of the Bank of Canada (BoC), made a speech last year at the Vancouver Board of Trade about the Canadian housing market. Some of the highlights included:

• The value of housing-related debt in Canada has nearly tripled over the past decade to $1.3 trillion.
• This debt is also the single largest exposure for Canadian financial institutions, with real estate loans making up more than 40 per cent of the assets of Canadian banks, up from about 30 per cent a decade ago.
• The average level of house prices nationally now stands at nearly four-and-a-half times average household disposable income. This compares with an average ratio of three-and-a-half over the past quarter-century.

Another difference between Canada and the USA is that you can't get a 30 year fixed rate mortgage in Canada, but you can in the USA. Canadians have to use ARMs (adjustable rate mortgages), or a maximum of 10-year fixed rate, but most Canadians use 5-year fixed rate mortgages and hence have to refinance every 5 years.

The day the BoC start raising rates (which they will one day), there will be homeowners in every market that cannot afford to refinance at higher rates and hence the default rate will rise.

Clearly there is a downtrend in the mortgage rates over the last 25 years, and this can't last forever.

The BoC will raise rates eventually and when they do a lot of households are going to have difficulty adjusting to the higher interest payment.

Canadian Banking System

Something should be said about the 'rock solid' Canadian banking system, which is another point of pride for us Canucks! I read a great article on ZeroHedge titled: Is The Next Domino to Fall… Canada? (Aug, 2011), which discusses the (in)solvency of various banks around the world.

The authors compared 30 of the world's large banks and ranked them by their TCE ratio (tangible common equity). One might expect most of these banks to be European, which is true, but 6 of them (or 20%!) come from Canada. Even worse, 30% of the banks that have 4% TCE or less are Canadian.

TCE is used to measure how much leverage a bank has based on its assets, and hence the lower this ratio, the more highly levered the bank is. TCE is a better judge of the financial strength of a bank than the average pundit's preferred measure: Tier-1 capital. This is because Tier-1 capital can be generated with snazzy accounting tricks, whereas TCE is based on actual equity (i.e.: customer deposits).

A McKinsey paper (Capital Ratios and Financial Distress: Lessons from the Crisis, Dec 2009) stated the following about TCE versus Tier-1:

• Specifically, our analysis of bank distress during the credit and liquidity crisis of 2007 to 2009 suggests that the tangible common equity to risk-weighted assets ratio (or TCE to RWA) was the strongest predictor of future bank distress (with a Gini coefficient of 0.42) of the commonly measured capital ratios, and appears to be a significantly better predictor than other traditional risk-based measures of capital, including Tier 1 capital to RWA (Gini coefficient of 0.27) and Tier 1 capital plus Tier 2 capital to RWA (Gini coefficient of 0.26).

When one considers the following points, it's easy to see that Canadian banks are not as 'rock solid' as commonly believed:

• Canadian banks have some of the worse TCE ratios in the world (i.e.: they are extremely over leveraged), even worse than many of Europe's sick banks.
• Governor Carney noted in his speech that more than 40% of bank assets are in mortgages.
• If I'm right, Canadian real estate prices will likely drop around 30% on average across all markets. These losses will show up on the balance sheets of the banks.

It's interesting to see that Canada's banks are already Basel-III compliant and also rated number 1 for soundness (and may need a government bailout) by the World Economic Forum, Global Competitiveness Report 2010-11. Regardless, when mortgage default rates start to increase in Canada, banks with low TCE ratios may quickly see their losses dwarf their assets, and it's possible Canada will have a banking crisis that requires a US-style bailout.

Conclusion

It is clear that the Canadian housing market has undergone a debt-fueled asset price inflation (i.e.: a bubble) that has greatly outpaced inflation. It is equally clear that Canadian home prices have not yet begun their price reversion to the mean.

On average, I suspect that housing prices will correct by about 25-30% across Canada, with some of the extremely overvalued markets (i.e.: Vancouver) declining more like 40% or more.

(Note: I still maintain Vancouver will decline in excess of 70% - Whisperer)

If the Canadian housing market crash behaves like the USA one, expect most of the losses to occur in the first two years, and then slow down after that.

Canadian banks will suffer, and may need a bailout. They are over-leveraged and over-exposed to housing market debt. I will not be surprised to see a Canadian banking crisis emerge in the next few years, and government bailouts to go with them.

Investment Action: shorting Canadian banks such as CM, BNS, RY, and TD. Also, shorting some home construction companies or commodity companies may work.

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To plunge or not to plunge?

Will Canadian Real Estate plunge dramatically over the next few years or not?

Recently Garth Turner opined:

"Most commentors decry my estimate of a coming 15% reduction in the national average, followed by a lengthy period of real estate decline. They want bloody intestines. They want it now. Phoenix is their idea of a good market (prices off up to 80% in some hoods). They relish the thought of screaming Boomers in white golf shoes clinging to a shard of granite c-top while a front-end loader turns their McMansion into landfill. As appealing as that may be, it won’t happen here... What took years to swell will take as long to contract. Remember, the US housing market peaked in the last few months of 2005, and is still correcting more than six years later

It seems many of our delusional visitors have no idea what 15% means. First, this average number would translate into a 0% change in, say, La Broquerie or Chicoutimi (or Fredericton and Thunder Bay), but something closer to 20% in Brampton and 30% in Surrey. Given local conditions, there’d even be individual neighbourhoods exceeding that. As for a comparison with US prices, it’s simply a myth they have plunged 50% across the country."

Turner's excellent post on the issue can be read here.

On the other end of the spectrum is this article by Seeking Alpha titled: Phoenix Phenomenon: Why Real Estate Everywhere Will Eventually Drop Over 50%.

"In cities like Atlanta, Detroit, Las Vegas, Minneapolis, Orlando, Phoenix, and Tampa-St. Petersburg, housing prices have fallen sharply and had lost more than half of their value in many neighborhoods... The question is whether (these) cities are the exception to the rule, or simply experienced their pullbacks earlier than most other places. In other words, is Orlando the anomaly, or will most of the remainder of the United States, Canada, Australia, China, Brazil, and the rest of the world eventually behave like Orlando?"

Personally I'm willing to bet Vancouver will write it's own story and that the story - ultimately - will be just as horrific as Pheonix or Orlando.

However, because of our bankruptcy laws and process, the unwind will be maddenly slow.

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The ride back up and the Silver lease scam

Well... I told you Silver was in for a volatile period and it's not disappointing us.

Yesterday I wrote that Silver's 'correction' will probably end by Thursday (at the latest) and the metal will start a rally back towards $50.

Yesterday Silver was at $45.30. 

Today the US Federal Reserve Chairman held an unprecedented press conference.  And in anticipation Silver started climbing.

When Bernanke spoke, he made it was clear that the Federal Reserve was signalling it is in no rush to scale back its extensive support for the U.S. economy. The Chairman said the run-up in commodity prices that has dented growth should be fleeting (???).

Meanwhile the Fed's policy-setting Federal Open Market Committee said in a statement that it intends to complete its $600 billion bond buying program in June as scheduled and that despite some headwinds, it believed that the economic recovery was proceeding at a moderate pace, with little risk an inflationary psychology would take hold (????).

In other words... "inflation? what inflation?"

The response to this fairy tale outlook sent Silver soaring back up $3.08.  As this is written, Silver sits at $48.38...

... wheeeeeee!!!! And the roller coaster starts it's climb upward again.

They will try and beat the price back down again, but we are probably going to see Silver go to between $50-$52 in the next couple of weeks.

Yesterday I referenced this excellent article over on Seeking Alpha.  It talked about a Silver storage scam that is an important part of the Fractional Reserve Silver system being practiced by the banking cartel as part of their Silver price suppression scheme.

The public is finally becoming aware of this storage scam as a result of a couple of important lawsuits.

The first involved Michigan resident Laurin Ramsey.

In 1984, Ramsey purchased ten 100 ounce pure silver bars from the Swiss bank UBS (or its Paine Webber subsidiary). Since that purchase, he had paid $25 per month for storage fees to UBS to keep the silver.

A few years ago, he tired of paying the storage fees and contacted the bank to arrange delivery.

Instead of delivery, Ramsey only got the runaround. When he finally asked to be given the serial numbers on the bars and the location of the vault where they were stored, he was told that the bars did not have serial numbers (which wasn't true!).

At one point, the bank said his only option was to sell the bars back to the bank for cash... he could not take delivery of his silver bars. But Mr Ramsey did not want to close out his position.

On February 23, 2011, the Ramsey Personal Trust, by Laurin D. Ramsey was the lead plaintiff in a suit filed in the Federal District of Southern New York against UBS Financial Services, Inc., et al. The charges are that UBS had never purchased, segregated, or stored the silver, then had illegally charged storage fees for the phantom silver.

The lawsuit can be found here.

Seeking Alpha detailed the significance of the suit:

• "According to the lawsuit, customers were charged storage fees every month, even though the bank was not actually storing anything. It never purchased any physical silver. Instead, the bank allegedly used customer cash for its own purposes. In effect, customers ended up buying a non-interest bearing silver bond. Such bonds, based on a promise of repayment in precious metals, were typically issued in the late 19th and early 20th century. Back then, they bore a nice interest rate, payable in gold or silver. Today’s version of the precious metal bond is unallocated storage, which takes money from investors but pays them nothing at all."

S.A notes that a very similar lawsuit was filed in 2007 against Morgan Stanley.

In that case, small investors were also claiming they had been defrauded into participating in unallocated metals storage. The bank defended itself by alleging, among other defenses, that it was simply following standard industry practices.

In other words, the amount of information given to customers, the unallocated nature of the scheme, as well as the charging of “storage fees” for imaginary metal were “standard industry practices”.

In light of what we now know, maybe they were telling the truth. Morgan Stanley did eventually settle for a multi-million dollar payout, but it continued to deny liability.

UBS has not yet answered the allegations put forward by Ramsey. We don’t know yet what their response may be. The law firm representing Ramsey is Schoengold & Sporn, P.C. The individual attorney handling the case is Samuel E. Sporn and Sporn was the attorney who won the $4.4 million judgment in 2007 against Morgan Stanley.

But it begs the question... what happened to the silver that was supposed to be in storage?  If it is "standard industry practice", what have they been doing with the silver that was 'supposedly' stored?

It is clear to any rational person that the leasing scam has been an important component of the fractional reserve silver system that the banking cartel has been employing for years.

The cartel has been taking that silver that many depositors believe is being stored on their behalf and has been using that silver elsewhere to deliver on paper shorts they have issued on the COMEX.

The key element here is that the whole system is starting to unravel.

The collapse of Lehman Bros, the 2008 financial crisis, and the massive money-printing under Quantitative Easing has triggered a rush into precious metals which is intensifying with each passing month.

Central Banks around the world are now net buyers of Gold and Silver, not net sellers.

Individual investors are starting to pour into Gold and Silver in unprecedented numbers.

And intense upward pressure is being placed on silver prices because physical silver is being purchased as never before and actual physical silver is becoming incredibly difficult to source. The fractional reserve silver system has sold out paper silver at a 100-1 ratio to physical silver.

Upward pressure is not stemming from trading on COMEX. In fact, deliveries at COMEX have been relatively small for several months. The process that is now ongoing is one that no performance bond committee can stop... an overwhelming demand for the delivery of the actual metal. COMEX could declare liquidation-only, as they did in 1980 to stop the Hunt Brothers, but the only result would be to catapult the demand for the price of physical silver even higher.

COMEX is now irrelevant except as a way for banks to bankrupt themselves if they continue to try to reduce the price of physical silver by manipulating futures prices and taking on more short paper positions to do it. They can crash the paper futures price as much as they wish. It won't stop buyers from demanding physical silver in the real market outside COMEX.

The price of silver for the past 40+ years were a result of a naive market, overwhelming short positions at the futures exchanges, manipulative trading techniques and a deceitful unallocated storage arrangement.

The current silver pricing surge may look like a typical short squeeze, but it is nothing of the kind. It represents a permanent change in market perceptions. That is not to say that silver prices cannot fall, but the pressure to buy physical silver will continue to mount.

When silver prices finally reach equilibrium, the bellwether level of $50 per ounce will be the floor, rather than the ceiling.

Tomorrow we will look at another evolving story of the COMEX suddenly losing over 20% of it's "registered" silver over the past week.

Was it actually there? Or is the short squeeze  and the demand for physical silver forcing the COMEX to admit that much of the 'supposed' silver they have in their vaults is nothing more than a paper entry and isn't actually there?

More tomorrow.

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Email: village_whisperer@live.ca
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