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Trading Lessons

Derivatives, The Gift That Keeps On Taking

Stock-Markets / Derivatives Sep 19, 2013 - 05:01 PM GMT

By: Raul_I_Meijer

Stock-Markets

If there's one lesson to be drawn from the Federal Reserve's non-taper decision yesterday, September 18, it's that the Fed will continue to ignore the interests of the real economy, even if that's what's supposed to be its task and mandate. The Federal Reserve is part of the financial system, and as such it represents the interests of that system, not the people in the street. It will do whatever benefits the former, and whichever choices it makes will always drain ever more resources away from the latter.


There is no US economic recovery, quite the contrary in fact, there is at best a set of seemingly good looking numbers that indicate good news for financial institutions, and bad news for everyone else. In the same vein, the financial markets don't reflect what goes on in the streets of America (and beyond). If they did, the Dow and S&P could not reach new records at a point in time when Bernanke himself claims the real economy's numbers are too weak to taper.

So quit expecting Bernanke or his successor to do anything that would benefit you personally. The longer you keep hoping for that, the more you will be puzzled and disappointed. Central banks and governments worldwide have made the financial system their sole priority, and they will bleed their people dry in order to serve that priority. This should not come as a surprise, since it's inevitable that if you allow money to enter into your political system, money will end up buying it outright. This happens for the same reason that bad money will always drive out good money from an economy. It's elementary.

The Federal Reserve doesn't give a hoot how many Americans are unemployed, how many children live in poverty, and how many millions survive on foodstamps. Their policies, all of them, are geared towards maximizing the profits in the financial system. If that is achieved by raising your standard of living, it will go up. If it's achieved by making you poor, you will be made poor. In the present situation, where the financial system sits on trillions of dollars in debt and trillions more in highly leveraged wagers, your money, the fruit of your labor, is badly needed to not let the financial system go bust. The Federal Reserve's iron hold on your money makes the outcome obvious and predictable (and for any loose ends, there's always the Treasury department).

One area where we will see this inevitable outcome play out is in derivatives. Nothing in the system is riskier, more highly leveraged, or potentially more lethal to our real economies and societies. The political/financial system has made provisions for this in the form of legislation. Under Clinton, regulation of derivatives was strangled, under Bush, bankruptcy law was adapted to accommodate the derivatives markets, and under Obama, the proposed Dodd-Frank legislation is being molded to deliver the few remaining blows.

Dodd-Frank should have been a contemporary Glass-Steagall, but the area of the world where politics and finance converge has both changed and expanded too much over the past 80 years to make that possible. Legislation ostensibly aimed at protecting the people will instead turn out to do the exact opposite.

A good description on how it all works was quoted yesterday by Ellen Brown, and since she had only minor points to add, I'll turn to the original, two years old, by writer and (documentary) filmmaker David Malone, who also writes a blog as Golem XIV, and add a few bits from Brown afterward.

Plan B – How to Loot Nations and Their Banks Legally

If [governments convince their populace that private debts should be taken on to the public purse], then the banks are ‘saved’ with the added bonus that democracy and the ‘Rights’ it once guaranteed will all have been redefined as subordinate to finance and its contracts, and our citizenship will have become second to one's contractual place in a web of private debts. Debts to the private lenders will become more important than taxes to the public exchequer. [..]

MF Global imploded when it could not get the short term funding it needed. There were two kinds of funding MF Global relied upon for its liquidity/cash flow: repo and hypothecation. For those not familiar, Repo is when a bank or brokerage ‘sells’ an asset for cash but with the agreement that it will re-purchase – hence ‘repo’ – the asset at an agreed date for an agreed price. It is not really a sale but a loan. Repo is the oxygen the financial world breathes. Repo is a $10 Trillion market.

The other main source of the essential short term funding was Hypothecation. This is when a bank or brokerage pledges an asset to a ‘lender’ in return for cash but the asset remains in the possession of the borrower. What the ‘lender’ gets is hypothetical control of the asset. Although the asset never actually changes hands, the new ‘owner’s’ hypothetical control of the asset allows her to do what she wishes with the asset. Including re-hypothecating the asset to another bank or brokerage. If she does so then the hypothetical control passes to yet another ‘owner’. Even though physically it remain where it started.

As I said before, Ellen Brown adds her own few bits to this yesterday:

The Armageddon Looting Machine: The Looming Mass Destruction from Derivatives

Increased regulation and low interest rates are driving lending from the regulated commercial banking system into the unregulated shadow banking system. The shadow banks, although free of government regulation, are propped up by a hidden government guarantee in the form of safe harbor status under the 2005 Bankruptcy Reform Act pushed through by Wall Street. The result is to create perverse incentives for the financial system to self-destruct. [..]

The global credit collapse was triggered, it seems, not by wild subprime lending but by the rush to grab collateral by players with congressionally-approved safe harbor status for their repos and derivatives.

Bear Stearns and Lehman Brothers were strictly investment banks, but now we have giant depository banks gambling in derivatives as well; and with the repeal of the Glass-Steagall Act that separated depository and investment banking, they are allowed to commingle their deposits and investments. The risk to the depositors was made glaringly obvious when MF Global went bankrupt in October 2011. [..]

In light of all this, it may perhaps seem a bit odd that I originally started out writing this piece after reading the first installment of a Bloomberg series on US crop insurance, but don't let's forget that that is where derivatives originated: in farming. Stories about them go back at least as far as the Roman Empire, and probably further if you start digging, because some way or another of insuring a crop against failure makes a lot of sense, unlike the purely financial and highly explosive instruments derivatives have become today, where nobody cares what the underlying tangibles are, or even if there are any.

Still, reading what is going on with crop insurance may have a message for us when it comes to modern day "non-farming derivatives": there are parties that engage in such high risk behavior that they need indemnity from losses lest they go under. They purchase this indemnity by buying national and international political systems, which allows them to transfer their losses to (the people in) the real economies, and keep the profits. Once this model is established, nothing bars them from adding ever more risk and leverage (and so they will), until the economy and society they rely on to cover their losses is wholly gutted to the bare and dry bone.

The "original" derivatives may come in an entirely different order of magnitude, but the mechanism by which they operate is remarkably similar. Perhaps they can thus make it easier to understand what goes on with their far more opaque and bloated siblings. Here's David J. Lynch for Bloomberg:

Taxpayers Turn U.S. Farmers Into Fat Cats With Subsidies

A Depression-era program intended to save American farmers from ruin has grown into a 21st-century crutch enabling affluent growers and financial institutions to thrive at taxpayer expense. Federal crop insurance encourages farmers to gamble on risky plantings in a program that has been marred by fraud and that illustrates why government spending is so difficult to control.

And the cost is increasing. The U.S. Department of Agriculture last year spent about $14 billion insuring farmers against the loss of crop or income, almost seven times more than in fiscal 2000, according to the Congressional Research Service.

The arrangement is a good deal for everyone but taxpayers. The government pays 18 approved insurance companies to run the program, pays farmers to buy coverage and pays the bills if losses exceed predetermined limits.

Lynch so far talks about individual farmers and their lobbies, he doesn't even yet mention the involvement of the larger parties that everyone knows have a huge influence in Washington. There's not a single politician on the Hill who would risk being caught on the wrong side of a discussion with Archer-Daniels-Midland, Cargill, Monsanto, ConAgra or Tyson. And there can be no doubt that is a major factor in the shape crop insurance is taking. Americans are very much the prisoners of their own food industry in the same way they are of their banking industry.

When you sit down and absorb this sort of information it should become clear quite rapidly that your options to shake off the shackles of the politico-financial system are really quite limited. When everyone on both - or even all - sides of the aisle represents the same interests, and these are not yours, voting for someone else is not going to do you a lot of good.

It's not a good idea to depend for your well-being on a system that's geared towards taking from you all you have whenever that's seen as the best you can do for it, when you can no longer be useful for it in other ways. And in view of the trillions in losses already in the - hidden - books, plus those yet to be incurred from ongoing wagers, what other use could you possibly have?

There are very few voices today calling for immediate action to make sure the 66% of youth that are unemployed in Greece and Spain become useful members of their societies. Greek PM Samaras picked a random number out of a hat this week and claimed that Greece would recover by 2019. He has no clue what will happen by 2019. What's clear is that his younger countrymen and women can't even get a job sweeping their streets today, or cleaning up other people's dirt. And those very streets by 2019 will be owned by foreign investors. Privatize the planet.

So what makes you think you will be better off than them by 2019? Anything more, anything else, than just wishful thinking? If so, why is that? Do you feel useful, do you think that whatever you do in your day job is indispensable?

US unemployment numbers look somewhat bearable only because they hide so much. Like a plummeting labor force participation rate. What stands between your present situation and becoming an anonymous number in some statistic like that? For most of you, only an eerily thin line does. But then, most of you think Ben Bernanke wants what's best for you.

Maybe it's time to smarten up and, just in case, move what you have left to a place where Bernanke and the system he represents either can't find it or can't touch it. Just saying. The derivatives trade is a real threat to you and all those around you; it may still largely be hidden from view, but it's not some fantasy tale.

When Bernanke et al are talking about recovery, they don't mean you.

By Raul Ilargi Meijer
Website: http://theautomaticearth.com (provides unique analysis of economics, finance, politics and social dynamics in the context of Complexity Theory)

© 2013 Copyright Raul I Meijer - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.

Raul Ilargi Meijer Archive

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