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Last night, when Ben Bernanke cut the discount rate … made a loan of $30 billion to cement the Bear Stearns buy-out … and flung open the Fed’s coffers to the next major investment banks that may be on the brink of failure … he must have thought that investors around the world would applaud his actions.
Not quite!
Overseas investors didn’t exactly like the idea that the value of Bear Stearns fell about 90% over the weekend.
Nor did they look very kindly on the fact that, for every dollar of loan money that the Fed put up for Bear Stearns, JPMorgan Chase is putting up less than a penny of capital.
And they’re downright terrified about the inflationary implications of the Fed’s monetizing hundreds of billions of dollars in private debt.
Last week’s near-collapse of Bear Stearns has brought us closer to a financial meltdown than at any time in our lifetime.
And for the first time, the mainstream media is recognizing the real dangers that Mike Larson and I have been warning you about for so long:
The New York Times, for example, headlines the “run on big Wall Street bank” and “a Wall Street domino theory.”
Bloomberg says Fed Chairman Bernanke was forced to “throw out four decades of monetary history by a financial system choking on miscalculated risks and a deepening recession.”
And The Wall Street Journal asks:
“Does the move by Bear suggest the markets are closer to their nightmare scenario, in which doubts about financial companies that serve as counterparties in billions of dollars of transactions suddenly freeze trading, or force investors to unwind existing trades, causing a domino effect that cripples the markets?”
The media — and the authorities — are asking the right questions. But they dare not provide answers.
They think about possible consequences, but talk only about probable causes.
They frequently worry about how to protect their own families from future scenarios, but usually believe their job is to “protect the public” from knowledge of present realities.
They rarely mention the next likely victims … never tell you what the domino theory might lead to … and never guide you to true safety. We do. And this morning, we will again.
The Containment Myth
Last June, when Bear Stearns was the first major firm to announce multi-billion-dollar losses from the subprime mess, Wall Street and Washington made a tacit pact — to persuade the world that Bear Stearns was “alone,” and to artificially create a fantasy world in which “the crisis was contained.”
But from the facts Mike Larson brought out before and after June of last year — on subprime lending, the housing crisis, the broader financial crisis and the likelihood of an S&L-type meltdown — it was obvious that Bear Stearns was not alone; the crisis, not contained.
Precisely as Mike warned, in the days and months that followed, America’s largest banks and brokers revealed subprime losses that greatly exceeded those of Bear Stearns: First HSBC … then Merrill Lynch, Citibank, UBS and many others.
And sure enough, the estimates of the industry’s total losses continued to escalate with each new revelation: First, Wall Street analysts said it would be under $50 billion. Then, Fed Chairman Ben Bernanke said it could be as much as $100 billion. Next, the OECD estimated it could reach $300 billion. And now, even estimates as high as $1 trillion do not draw widespread criticism.
But despite all the revelations and shocks, no major Wall Street firm confessed to its gambling habits. None admitted its debt addiction. None seemed to realize that the first step toward resolving a problem is recognizing its very existence.
Each time, the truth was suppressed. And each time, when the reality was finally revealed, the public was shocked, caught off guard and left wondering who the next victim might be.
No Lessons Learned
Now, at long last, looking back at the truths — and deceptions — revealed in recent months, you’d think someone might have learned a lesson from this experience.
Instead, here we ago again in a typical 1-2-3 pattern …
- Like June of last year, Bear Stearns is the first to reveal a disaster.
- Like last year, the authorities have been huddling through the weekend, poring over Bear Stearns’ books. And …
- Like always, they are trying to come up with a story to spin the facts.
But this is not June of 2007, when it was still easy to fool most investors most of the time. Too much has changed too quickly, and the crisis has already progressed to a more advanced phase. Now …
- Revelations of big losses are being replaced by fears of big bankruptcies.
- The collapse of subprime mortgages has been replaced by the collapse of nearly all major credit markets.
- And most worrisome of all, these fears and collapses are threatening to freeze up the greatest grand casino of all: Derivatives.
The Truth and Consequences
Of $172 Trillion in Derivatives
Derivatives are essentially bets … and … debts.
As an illustration, if you and I were players, I could bet you that a particular firm will go bankrupt between now and year-end … and you could bet me that it won’t.
Or I could bet you that interest rates on junk bonds will rise more than interest rates on Treasury bonds … and you could bet they will rise less, or not rise at all.
We could bet on virtually any market that moves, or even bet that it won’t move.
For each wager, we’d likely borrow huge amounts of other people’s money. And in each case, we’d have a contractual obligation (or right) to consummate the deal: To pay up if we lose (or collect if we win).
That’s the essence of each transaction in the frenzied, hectic world of derivatives.
But what was once a small sideshow in the traditional world of stocks, bonds and loans has become the towering center ring in the big-top: The derivatives market has now ballooned into a monster of unimaginable dimensions.
At U.S. commercial banks alone, the total notional value of the derivatives is $172.2 trillion, according to the latest report by the U.S. Comptroller of the Currency (OCC). Plus, the OCC reports that:
- In over 90% of these derivatives, there is no established exchange that helps protect either party from default.
- Just FIVE major U.S. banks control 97% of all the bank-held derivatives in the United States, a concentration of power — and risk — unsurpassed in the history of finance.
- All five of these major players would likely be severely crippled, or even bankrupted, by the default of just a few major counterparties like Bear Stearns.
- Four have more credit exposure to counterparty defaults than they have capital.
- Two have over four times more credit exposure than capital. (More details in a moment.)
The Potential Damage of Bear Stearns’ Demise
Today Is Far Bigger Than the Feared Impact of
Long Term Capital Management’s Fall in 1998.
Ironically, the OCC has been reporting large numbers for a long time, and we’ve been bringing them to your attention from the very outset.
But it wasn’t until about 10 years ago that you saw the first widely recognized threat to the derivatives bubble: The demise of Long Term Capital Management.
Long Term Capital was simply a hedge fund, far off the radar screen of most investors. It was also relatively small.
Nevertheless, the potential damage it could cause was obvious: It had its tentacles in enough large Wall Street firms that it was widely agreed its collapse could trigger a financial meltdown similar to the one feared today. And that fear was seen as serious enough to warrant an emergency intervention by the Federal Reserve Bank of New York, much as occurred last Friday.
But the differences between 1998 and today are equally obvious:
- Bear Stearns is many times larger than Long Term Capital ever was, or could have dreamed of becoming.
- Bear Stearns has bigger, more varied and more complex linkages to other major Wall Street firms than Long Term Capital ever had, or could have dreamed of creating.
- Bear Stearn’s demise is just one aspect of a massive U.S. credit market collapse that makes the problems of 1998 pale by comparison.
- This time, the Federal Reserve Bank of New York is doing far more than just orchestrate an industry rescue. It’s directly providing the bailout funds to cover the bad assets, while JPMorgan Chase walks off with the rest.
- And since 1998, the total notional amount of derivatives held by U.S. banks has more than tripled!
So last night’s moves by the Fed come as no surprise. Nor will it be a surprise if the Fed announces a bigger-than-expected rate cut tomorrow.
So in the days ahead, don’t be surprised by new announcements of “big, bold steps” being taken by Washington and Wall Street. Also don’t be surprised by a bigger-than-expected rate cut by the Fed tomorrow.
But throughout it all, don’t let them fool you when they again put out the word that “Bear Stearns is alone” or that “the crisis is contained.”
Not true.
Why JPMorgan Chase Is
Among the Most Vulnerable
Logic alone dictates that containing the crisis is highly unlikely. Let me walk you through the facts, and you’ll see what I mean …
- All major Wall Street firms engage in the same kind of trading strategies that entrapped Bear Stearns.
- All use the same kind of high-powered leverage that sunk Bear Stearns.
- And perhaps most important, all are joined at the hip to each other as counterparties (trading partners) in derivatives, including Bear Stearns.
Indeed, even as you read these words, derivatives are emerging as the new core of the crisis. And derivatives are definitely not limited to Bear Stearns.
Among investment banks that do not report to the Fed, the biggest players are Lehman Brothers, Goldman Sachs, Morgan Stanley and Merrill Lynch.
And among those who do report to the Fed, the five dominant players in derivatives that I mentioned a moment ago are Citibank, Bank of America, Wachovia, HSBC and the biggest of them all: JPMorgan Chase.
We believe all are vulnerable, in varying degrees, to the kind of crisis that struck Bear Stearns last week.
We believe JPMorgan Chase could ultimately be the most vulnerable.
And we believe this may help explain why JPMorgan Chase is the Wall Street firm that’s buying Bear Stearns. If they didn’t, and Bear Stearns defaulted on its derivatives, JPMorgan is the firm that would have the most to lose.
But you don’t have to take our word for it. Nor do you have to look very far to validate our view. All you have to do is …
- Click on this link to pull up the latest derivatives report by the U.S. Comptroller of the Currency (OCC) …
- Scroll down (about 24 pages) to Table 1, “Notional Amount of Derivatives Contracts” …
- Take one look at who’s at the top of that chart — JPMorgan Chase — and see for yourself the unimaginably large quantities of derivatives it is trading.
Wait. We’ll make it easier for you. Here’s the guts of the OCC’s Table 1, showing just the top five players and excluding a few of the less important columns:
The undeniable truth: In the grand casino of derivatives trading, JPMorgan Chase is overwhelmingly and unabashedly the biggest player of them all. As you can plainly see in the table above, it controls …
- $91.7 trillion in derivatives, or over 53% of all derivatives held by U.S. commercial banks, among which are …
- nearly $7.8 trillion in the oft-inflammable credit derivatives, or 55.6% of the total.
- And all with little more than $1.2 trillion in assets!
Or scroll back up a few pages in the OCC’s report to the table under Graph 5A, which I’ve also reproduced here:
The table shows how much each bank has in credit exposure to defaults by trading partners (like a Bear Stearns). And it measures that credit exposure in proportion to the bank’s capital. For each one dollar of its capital …
- Wachovia has 83.3 cents in exposure …
- Bank of America has $1.12 in exposure …
- Citibank has nearly $2.53 in exposure, and …
- JPMorgan Chase has more than $4.16 in exposure!
In other words, if its counterparties default, JPMorgan Chase’s capital could be wiped out more than four times over.
Now, HSBC’s exposure is greater. But that reflects strictly its U.S. operations. Overseas, recent profits indicate that it’s in a relatively stronger position. That leaves JPMorgan Chase as the most vulnerable, in our view.
Two Scenarios
Too many pundits assume that simply because a future scenario is unimaginable, it must therefore be impossible.
But the pattern of human events has never before been bound by the limits of someone’s imagination; and it never will be. Anything can happen. To some degree, anything will happen.
We foresee two scenarios:
Scenario A
The Greatest Federal
Bailouts of All Time
Create Rampant Inflation
In this scenario, Fed Chairman Ben Bernanke continues to do precisely what yesterday’s New York Times says he has already been doing since last year:
- Tossing out the rule book of monetary policy,
- Abandoning his prior concerns about the moral hazard of financial bailouts,
- Inventing new policy on the fly, and …
- Creating history’s greatest and most radical money-pumping machines —$100 billion per month in loans to banks in exchange for shaky collateral … an extra $100 billion in money infusions announced on March 7 … an additional $200 billion in loans to brokers in exchange for sinking mortgage bonds … and more.
Ironically, though, in this scenario, despite all of the money pumping already in the pipeline, the loudest voices will be those who cry out for even more.
They will be voices like …
- Citigroup’s economists who bemoaned on Friday “the self-feeding downturn now in place” and who forecast a Fed rate cut tomorrow of a full percentage point. Or …
- Merrill Lynch’s chief economist who argued that the Fed’s policy so far “does not address underlying credit problems, does not materially improve the solvency of the institutions exposed to assets under stress, and does nothing to put a floor under home prices.” The implication: Bernanke must do much more.
But Gretchen Morgenson, also writing in yesterday’s New York Times, leaves little doubt as to the ultimate price to be paid for Bernanke’s new follies:
“What are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in? Will the consequences be an even weaker currency, rampant inflation, a continuation of the slow bleed that we have witnessed at banks and brokerage firms for the past year? Or all of the above?
“Stick around, because we’ll soon find out. And it’s not going to be pretty.”
No. It’s not.
That’s why this scenario — the greatest federal bailout of all time — inevitably comes with the most rampant inflation we’ve seen in our lifetime. And it has already begun.
Scenario B
Financial Meltdown
This is the scenario that nearly everyone on Wall Street is thinking about … but virtually no one dares talk about. They can’t imagine what it would be like. Or they fear that the mere discussion of its possibility will bring it closer to a probability.
But nothing could be further from the truth.
When unreasonable people conjure up future events with no basis in fact, it’s never taken seriously enough to notably alter the script of history. By the same token, when there is concrete evidence of a future disaster, realistically exploring its ultimate consequences can only help the actors prepare for the future.
I’m talking about the possibility of a wholesale market shutdown.
On a much smaller scale, you’ve already seen bits and pieces of something akin to this phenomenon. You’ve seen stocks stop trading in the wake — or in anticipation — of major news. You’ve seen futures stop trading when a particular market rises or falls by the daily allowable limit.
And on a broader scale, history has seen the nation’s banks declare an extended holiday, the nation’s stock exchanges close down for a week or more, and a particular industry shut down for extended strikes.
Now, put those together and try to visualize a similar situation on a national scale.
Why? Because the entire country runs on credit. But in a financial meltdown, the essence of credit — trust — is destroyed. Therefore, the country cannot run. It must shut down temporarily while the authorities sort out the mess and come up with a plan that can restore that trust.
Is this likely? It’s too soon to say. But there’s one thing we do know:
It was precisely to avoid such a scenario that Mr. Bernanke has abandoned the Fed’s rules and loaned money to banks in exchange for bad collateral … trashed the rules again to loan even more to brokers … and thrown the entire Fed rule book into the Potomac by bailing out Bear Stearns on Friday.
And that’s why Mr. Bernanke has vowed to continue doing everything in his power to prevent more dominoes from tumbling.
The ultimate question is: Is his power enough?
Your Best Defense and Offense
I sent you a Money and Markets flash on Friday afternoon with some specific steps to take:
Step 1. If you own vulnerable assets, don’t be afraid to dump them. If you’re taking a profit, pay the taxes. If you’re taking a loss, bite the bullet and move on. In either case, just sell. And if you have a personal adviser, be sure to work as a team to reduce your exposure.
Step 2. Get your money to safety as quickly as possible. Years ago, for maximum safety and liquidity, short-term U.S. Treasury bills would have been all you needed. Today, given the threat to the dollar, we feel you need a prudent balance among:
- U.S. Treasury bills or Treasury-only money market funds such as American Century Capital Preservation Fund (CPFXX), Dreyfus 100% U.S. Treasury Money Market Fund (DUSXX), Fidelity U.S. Treasury Money Market Fund (FDLXX) and Weiss Treasury Only Money Fund (WEOXX) plus …
- Strong foreign currencies like the CurrencyShares Japanese Yen Trust (FXY), plus …
- Gold, using an ETF like streetTRACKS Gold Trust (GLD).
Step 3. For protection — and profit — seriously consider inverse ETFs. For months now, we’ve been sending readers a link to my special report on what they are, who they are and how to use them. We’ve posted it prominently on our Web page. And we have made it free.
Did you use it to build a firewall of protection around you? If so, great. If not, what are you waiting for?
The title is How to Protect Your Stock Portfolio From the Spreading Credit Crunch.
To review it now, along with the accompanying list of inverse ETFs, just pull it up on your screen with this link:
http://legacy.weissinc.com/files/documents/
MAM767_Special_Report.pdf
A Final Thought
I leave you with one last thought you should never forget: No matter how dark things get in the days and weeks ahead, it’s not the end of the world. Our country has been through worse, and we survived, even thrived.
You can do the same, especially if you take prudent, protective action today.
Good luck and God bless!
Martin
About Money and Markets
For more information and archived issues, visit http://legacy.weissinc.com
Money and Markets (MaM) is published by Weiss Research, Inc. and written by Martin D. Weiss along with Sean Brodrick, Larry Edelson, Michael Larson, Nilus Mattive, Tony Sagami, and Jack Crooks. To avoid conflicts of interest, Weiss Research and its staff do not hold positions in companies recommended in MaM, nor do we accept any compensation for such recommendations. The comments, graphs, forecasts, and indices published in MaM are based upon data whose accuracy is deemed reliable but not guaranteed. Performance returns cited are derived from our best estimates but must be considered hypothetical in as much as we do not track the actual prices investors pay or receive. Regular contributors and staff include John Burke, Amber Dakar, Adam Shafer, Andrea Baumwald, Kristen Adams, Maryellen Murphy, Red Morgan, Jennifer Newman-Amos, Julie Trudeau, and Dinesh Kalera.
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