Best Financial Markets Analysis Article The credit crisis is forcing the Bank of England to morph the Collaterised Mortgage Backed Securities Market into the Collaterised UK Government Bond Backed Mortgage Market. In effect the Bank of England is swapping 100% guaranteed Government Bonds for illiquid, un-priceable Mortgage backed junk securities. Thus allowing the banks to offer Government Bonds as security on the Interbank Market.

To say that the derivatives market is complicated is an under statement. I have to question if the Chancellor, Treasury or the Bank of England actually understand what is going on or if they have been hoodwinked by the CEO's of the big banks into believing this is a short-term measure and that the Mortgage backed losses will filter out of the system as soon as banks issue further write downs.

Unfortunately the fact of the matter is that the Derivatives market is some $500 trillions in size, and it is unraveling before our very eyes, the only real consequences of the Bank of England's actions is to open the flood gates for not a £50 billion bailout but literally we could see the number double every 3 months for upwards of a year towards how many hundreds of billions ? This is highly inflationary and does not bode well for sterling which will eventually crack under growing government debt levels.

The problem is this....- FRAUD.

FRAUD on an monumental scale, emanating out of Wall Street and across the whole financial sector, and the consequences of this fraud is being borne by the tax payers world wide, American, British, German etc.

The $500 trillion derivatives market is a house of cards that is built on effectively fraudulent securitization of debt. Which basically means debt such as mortgages were packaged, sliced and diced and sold to investors. Investing financial institutions deployed leverage to up the rate of return (i.e. using borrowed money to increase the size of their positions by several orders of magnitude).

The risks associated with the mortgage derivatives was further packaged and sliced and diced and itself sold on by the Financial Institutions without setting aside capital in case of default. No, set aside, all taken and pocketed as profit, free money and hence the current credit crisis in the face of mortgage defaults. As an example it is akin to your car insurer taking your premiums and not setting aside anything against future claims. Normally you would expect car insurers to set aside say 33% of the premiums taken as capital not to be touched in anticipation of claims. The financial institutions that took all the risk on set aside NOTHING against default.

How could they do this ?

Simply, the vast majority of the derivatives contracts are off the balance sheets of the financial institutions and so mislead investors and ratings agencies and counter parties as to the true magnitude of the risk the financial institutions have undertaken against these over leveraged contracts that had ballooned to some $500 trillions. Far beyond the actual capitalization of the banks and institutions.

This set the scene for the ENEVITABLE CREDIT CRUNCH. As the derivatives are off the balance sheet, AND that the actual derivatives instruments such as Mortgage backed securities are un-priceable due to degree of mortgage defaults either real or anticipated, resulting in the inability of the counter parties to determine the risk that the banks are subject to and thus unable to price the assets that banks are attempting to put up as collateral against short-term borrowings on the interbank market.

The Interbank market did not just freeze it actually broke. There is mounting evidence from actual market participants that the official LIBOR interbank rates as reported are FALSE! as the following article illustrates - Credit Crisis SCOOP- LIBOR Is Now Irrelevant to Derivatives Pricing

Now the next phase of the Fraud is for the Financial Institutions to swap the high risk un-priceable effectively worthless junk for risk free gilt edged securities. It will be £50 billion today, then another £50 billion in some more months time.

The consequences for this will be that despite what ever accounting practice the Treasury may use to hide the debt from the Countries balance sheet, it is in effect an increase of Government debt of £50 billion, which has inflationary consequences,as the Government will continue gambling with Tax Payers money that they are able to draw a line under a deleveraging derivatives market. However £50 billion is a drop in the ocean against a £250 trillion market.

Who is Responsible for the Credit Crisis?

The Derivatives market has mushroomed under the US Feds low interest rate policy following the Dot Com crash and Sept 11th, which saw US interest rates fall to below the rate of inflation. The derivatives market having grown from a barely manageable $30 trillions in 2000, to over $500 trillion today that is about 9 times the global annual economy of $60 trillion. The Fed's policies fueled the housing bubble and the dash for yield amongst investors as they sought to increase returns against the negative real interest rates by increasing risks through the use of leverage and derivatives.

Looking at the Feds recent actions to date of again reducing interest rates to levels which provide negative returns to investors, this implies that another bubble will start to appear sooner rather than later, though where ? The commodities markets seem to be saying there.

Looking back at history, delaying the inevitable usually leads to more pain in the long-run.

Whilst on the topic of fraud perpetrated upon tax payers by the financial sector, we don't have to look far to see that the official inflation statistic of 2.5% as measured by the CPI being far from actually representative of the true rate of inflation as experienced by ordinary people, which given the surge in food and fuel costs is probably nearer 8%. Next time your doing your weekly shop in Asda or Tesco, compare your bill against that of a year earlier.

By Nadeem Walayat

Nadeem Walayat has over 20 years experience of trading, analysing and forecasting the financial markets, including one of few who both anticipated and Beat the 1987 Crash. Nadeem is the Editor of The Market Oracle, a FREE Daily Financial Markets Analysis & Forecasting online publication. We present in-depth analysis from over 120 experienced analysts on a range of views of the probable direction of the financial markets. Thus enabling our readers to arrive at an informed opinion on future market direction. http://www.marketoracle.co.uk

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 trading losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors before engaging in any trading activities.

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Comments

Andy
21 Apr 08, 02:54

Set Asides "NOTHING"

Small point of contention. I used to work in structured credit in [will not put investment bank name on a public website], and they did put money aside it just wasn't nearly enough. They were a small bank and put aside $2 Billion (in mid 2005).

Obviously this wasn't enough, as all their models assumed the current "historically low rate of default" would continue forever and was in fact used to work out how much they would put aside compared to the CDS written, as all the investment banks did. They did however make the blatantly bogus assumption that they assumed that a AAA rating meant that a counter party to CDS a trade had a risk of literally 0, but as I've read you know that.

This isn't a defense of their actions at all, but to say they put "NOTHING" aside is just not true, they just put down far, far less than they thought they would need.

Andy

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