Best of the Week
Most Popular
1. US Housing Market Real Estate Crash The Next Shoe To Drop – Part II - Chris_Vermeulen
2.The Coronavirus Greatest Economic Depression in History? - Nadeem_Walayat
3.US Real Estate Housing Market Crash Is The Next Shoe To Drop - Chris_Vermeulen
4.Coronavirus Stock Market Trend Implications and AI Mega-trend Stocks Buying Levels - Nadeem_Walayat
5. Are Coronavirus Death Statistics Exaggerated? Worse than Seasonal Flu or Not?- Nadeem_Walayat
6.Coronavirus Stock Market Trend Implications, Global Recession and AI Stocks Buying Levels - Nadeem_Walayat
7.US Fourth Turning Accelerating Towards Debt Climax - James_Quinn
8.Dow Stock Market Trend Analysis and Forecast - Nadeem_Walayat
9.Britain's FAKE Coronavirus Death Statistics Exposed - Nadeem_Walayat
10.Commodity Markets Crash Catastrophe Charts - Rambus_Chartology
Last 7 days
Gold Stocks Autumn Rally - 4th Aug 20
“Government Sachs” Is Worried About the Federal Reserve Note - 4th Aug 20
Gold Miners Still Pushing That Cart of Rocks Up Hill - 4th Aug 20
UK Government to Cancel Christmas - Crazy Covid Eid 2020! - 4th Aug 20
Covid-19 Exposes NHS Institutional Racism Against Black and Asian Staff and Patients - 4th Aug 20
How Sony Is Fueling the Computer Vision Boom - 3rd Aug 20
Computer Gaming System Rig Top Tips For 6 Years Future Proofing Build Spec - 3rd Aug 20
Cornwwall Bude Caravan Park Holidays 2020 - Look Inside Holiday Resort Caravan - 3rd Aug 20
UK Caravan Park Holidays 2020 Review - Hoseasons Cayton Bay North East England - 3rd Aug 20
Best Travel Bags for 2020 Summer Holidays , Back Sling packs, water proof, money belt and tactical - 3rd Aug 20
Precious Metals Warn Of Increased Volatility Ahead - 2nd Aug 20
The Key USDX Sign for Gold and Silver - 2nd Aug 20
Corona Crisis Will Have Lasting Impact on Gold Market - 2nd Aug 20
Gold & Silver: Two Pictures - 1st Aug 20
The Bullish Case for Stocks Isn't Over Yet - 1st Aug 20
Is Gold Price Action Warning Of Imminent Monetary Collapse - Part 2? - 1st Aug 20
Will America Accept the World's Worst Pandemic Response Government - 1st Aug 20
Stock Market Technical Patterns, Future Expectations and More – Part II - 1st Aug 20
Trump White House Accelerating Toward a US Dollar Crisis - 31st Jul 20
Why US Commercial Real Estate is Set to Get Slammed - 31st Jul 20
Gold Price Blows Through Upside Resistance - The Chase Is On - 31st Jul 20
Is Crude Oil Price Setting Up for a Waterfall Decline? - 31st Jul 20
Stock Market Technical Patterns, Future Expectations and More - 30th Jul 20
Why Big Money Is Already Pouring Into Edge Computing Tech Stocks - 30th Jul 20
Economic and Geopolitical Worries Fuel Gold’s Rally - 30th Jul 20
How to Finance an Investment Property - 30th Jul 20
I Hate Banks - Including Goldman Sachs - 29th Jul 20
NASDAQ Stock Market Double Top & Price Channels Suggest Pending Price Correction - 29th Jul 20
Silver Price Surge Leaves Naysayers in the Dust - 29th Jul 20
UK Supermarket Covid-19 Shop - Few Masks, Lack of Social Distancing (Tesco) - 29th Jul 20
Budgie Clipped Wings, How Long Before it Can Fly Again? - 29th Jul 20
How To Take Advantage Of Tesla's 400% Stock Surge - 29th Jul 20
Gold Makes Record High and Targets $6,000 in New Bull Cycle - 28th Jul 20
Gold Strong Signal For A Secular Bull Market - 28th Jul 20
Anatomy of a Gold and Silver Precious Metals Bull Market - 28th Jul 20
Shopify Is Seizing an $80 Billion Pot of Gold - 28th Jul 20
Stock Market Minor Correction Underway - 28th Jul 20
Why College Is Never Coming Back - 27th Jul 20
Stocks Disconnect from Economy, Gold Responds - 27th Jul 20
Silver Begins Big Upside Rally Attempt - 27th Jul 20
The Gold and Silver Markets Have Changed… What About You? - 27th Jul 20
Google, Apple And Amazon Are Leading A $30 Trillion Assault On Wall Street - 27th Jul 20
This Stock Market Indicator Reaches "Lowest Level in Nearly 20 Years" - 26th Jul 20
New Wave of Economic Stimulus Lifts Gold Price - 26th Jul 20
Stock Market Slow Grind Higher Above the Early June Stock Highs - 26th Jul 20
How High Will Silver Go? - 25th Jul 20
If You Own Gold, Look Out Below - 25th Jul 20
Crude Oil and Energy Sets Up Near Major Resistance – Breakdown Pending - 25th Jul 20
FREE Access to Premium Market Forecasts by Elliott Wave International - 25th Jul 20
The Promise of Silver as August Approaches: Accumulation and Conversation - 25th Jul 20
The Silver Bull Gateway is at Hand - 24th Jul 20
The Prospects of S&P 500 Above the Early June Highs - 24th Jul 20
How Silver Could Surpass Its All-Time High - 24th Jul 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Financial Institutions Toxic Securities - Wanted: Market Based Prices

Stock-Markets / Credit Crisis 2009 Mar 03, 2009 - 07:56 AM GMT

By: Axel_Merk

Stock-Markets Best Financial Markets Analysis ArticleShaken insurance giant AIG has argued that fair value accounting is what got the world into this financial crisis. This debate is flaring up once again as it becomes ever more apparent that many of the world's largest banks would be insolvent if they priced their securities at “fair” market prices.


Recently, Goldman Sachs CEO Lloyd Blankfein, wrote in an editorial to the Financial Times: “ For Goldman Sachs, the daily marking of positions to current market prices was a key contributor to our decision to reduce risk relatively early in markets and in instruments that were deteriorating. This process can be difficult, and sometimes painful, but I believe it is a discipline that should define financial institutions.”

To be fair, Goldman Sachs has managed this crisis better than most. However, the day after his editorial was published, Blankfein testified in Congress that Goldman uses models to value its assets based on future expected cash flows. Said differently, even one of the more prudent financial firms continues to use models based on subjective inputs to value their securities. Granted, some assets may be difficult to value, but for many of the securities it has come to the point where no one even wants to trade them for fear that they and others would need to price them down significantly, to match the price any rational buyer would be willing to pay.

AIG (which has long advocated abolishing fair value accounting) comes from an insurance culture. Insurance companies are used to model based valuations, such as calculating the life expectancy for life insurances; or the probability of natural disasters striking an area where policies were written that need to pay when disaster strikes. In the insurance world, insurance companies don't pay into an escrow account if the beneficiary of a life insurance and the policyholder fall gravely ill.

But that's mostly because the risks are well quantified and insurance firms are typically sufficiently capitalized. When it comes to derivatives, however, a new world of opportunity and risk opens up. “Insurance” can be written on third parties. Joe can agree to pay Mary if General Electric (GE) fails. GE doesn't know about the contract; indeed, a corporate event, such as a re-organization or a takeover, may trigger payment, depending on how the agreement is structured. For years, writing “policies” on credit defaults (commonly known as credit default swaps) was an immensely profitable business, as firms would collect premiums on, say, the likelihood that GE is going to default on its obligations. Impossible, right? Well, not anymore according to the present default swap spread on GE.

It is now clear that the market had it wrong. Whilst the likelihood of GE defaulting was low two or three years ago, firms such as AIG should nevertheless have allocated adequate reserves to cover such a situation transpiring. Incidentally, White House Press Secretary Robert Gibbs ridiculed CNBC's Rick Santelli as he called for a “Chicago Tea Party” protesting government policies. In the process the Press Secretary tried to discredit the traders at the Chicago Board of Trade (CBOT), grouping them with those bankers that are to blame for the mess we are in. To be sure, there is a lot of blame to go around – from bankers to policy makers to consumers, to name a few. However, Mr Press Secretary: if all derivatives were traded on a regulated exchange such as the CBOT, we wouldn't be in this mess.

Here's why: derivatives at the CBOT are marked to market every single day. For any position taken, a deposit (margin requirement) is made. If the position shows a loss for the day, a margin call is issued and the trader has to supply additional funds. Conversely, he or she receives funds if there is a gain for the day. When volatility rises, the margin requirements tend to be increased. There is a good reason why margin requirements are low. Traditionally, derivatives were set up to hedge against risks, say hedge your corn production against a decline in corn prices between planting the seeds and the crop. If hedging becomes too expensive as margin requirements are raised, farmers don't hedge their production anymore, leading to overall lower output and potential supply disruptions. But the producers require that speculators be on the other side of the trade. Without speculators, the producers don't have anyone to hedge their production with. Please note: this is not supposed to be an encouragement to start trading derivatives, but to highlight some of their attributes and mechanisms.

If a trader cannot meet a margin call, the broker will close the position – the “grace period” may be a few days at most; in a volatile market, the grace period may be as little as a few hours. The counterparty risk is virtually eliminated as the exchange guarantees the functioning of the markets. Let's take a situation where, say, the price of oil rises to over $140 a barrel before plunging to less than $40. On a regulated exchange, the speculator who shorted oil when it soared above $100 would have ultimately been proven right, but likely was out of money and had the position closed. In comparison, firms such as AIG had never factored in such volatile price movements into their off-exchange derivative exposures. They had, in essence, become the speculator of perpetually favorable economic conditions.

Should we now bail out the speculator because he or she may ultimately be right? No. What is required are fair rules that minimize systemic risks. If derivatives were all traded on an exchange, the systemic risk would virtually be eliminated. We don't need to restrict speculators from engaging in risky bets, but we need to make sure that if the speculators fail, the rest of the system does not fall apart. Currently, everyone cries for more government intervention, more help. But there is the real risk that the baby is thrown out with the bathwater. Mr. Press Secretary, if you want to destroy the CBOT, Singapore will be waiting to welcome those traders.

Let us consider if these off-exchange derivative products had been regulated and market to market. Take as an example a derivative that insures against the risk of Iceland defaulting on its debt. A few years ago, this may have seemed like easy money (collecting the premiums) for those writing the policies. However the writers of these policies would have likely been forced to close their positions well before disaster struck. And that's precisely the point – the risk to the system must be contained.

The regulators can influence how much collateral is required – mindful that speculation itself is not the root cause of all evil; instead, given our present situation, we urgently need more risk takers! Odds are that many of the positions in the derivatives market in the hundreds of trillions would have never been taken because more transparency would have made the speculators realize just how risky their bets were.

We need a banking system that encourages sustainable risk taking. All of us have a stake in this; risk is the life and blood of capitalism, but it needs to be applied prudently. The right incentive is not that Uncle Sam takes your jet away, but that there are market incentives to control risk. Creating clearing places for financial instruments should be one of the top priorities of both industry and government. By the way, exchanges are profitable enterprises and profits generate tax revenue; restricting bonuses also restricts tax revenue.

That's the type of public-private partnership required – not government run banks. Those financial institutions that are insolvent must be dismembered. We need good banks, not bad banks. It's not just our wish, it's the law. The FDIC improvement act of '91 (FDICIA) requires that prompt and decisive actions be taken when financial institutions run into trouble. The act further requires that the action taken minimizes losses to taxpayers. Buying bad assets from banks doesn't live up to that test. Let's bite the bullet, do what's necessary and not drag the economy down further by losing trillions of dollars in taxpayer money through propping up a broken system.

Insolvent banks may need to be dismembered anyway, but the longer it is dragged out, and the more money that is thrown at the problem, the more the purchasing power of the dollar gets eroded. And that closes the loop of why we take an interest in this. We manage the Merk Hard and Asian Currency Funds, no-load mutual funds seeking to protect against a decline in the dollar by investing in baskets of hard and Asian currencies, respectively. For those interested in an in-depth analysis on the dollar and the euro, please see our recent analysis on whether there are any hard currencies left at merkfund.com. To be informed as we discuss other currencies, from the Swiss franc to the yen to the Australian dollar, subscribe to our newsletter at www.merkfund.com/newsletter .

To learn more about the Funds, or to subscribe to our free newsletter, please visit www.merkfund.com .

By Axel Merk

Chief Investment Officer and Manager of the Merk Hard and Asian Currency Funds, www.merkfund.com

Mr. Merk predicted the credit crisis early. As early as 2003 , he outlined the looming battle of inflationary and deflationary forces. In 2005 , Mr. Merk predicted Ben Bernanke would succeed Greenspan as Federal Reserve Chairman months before his nomination. In early 2007 , Mr. Merk warned volatility would surge and cause a painful global credit contraction affecting all asset classes. In the fall of 2007 , he was an early critic of inefficient government reaction to the credit crisis. In 2008 , Mr. Merk was one of the first to urge the recapitalization of financial institutions. Mr. Merk typically puts his money where his mouth is. He became a global investor in the 1990s when diversification within the U.S. became less effective; as of 2000, he has shifted towards a more macro-oriented investment approach with substantial cash and precious metals holdings.

© 2009 Merk Investments® LLC

The Merk Asian Currency Fund invests in a basket of Asian currencies. Asian currencies the Fund may invest in include, but are not limited to, the currencies of China, Hong Kong, Japan, India, Indonesia, Malaysia, the Philippines, Singapore, South Korea, Taiwan and Thailand.

The Merk Hard Currency Fund invests in a basket of hard currencies. Hard currencies are currencies backed by sound monetary policy; sound monetary policy focuses on price stability.

The Funds may be appropriate for you if you are pursuing a long-term goal with a hard or Asian currency component to your portfolio; are willing to tolerate the risks associated with investments in foreign currencies; or are looking for a way to potentially mitigate downside risk in or profit from a secular bear market. For more information on the Funds and to download a prospectus, please visit www.merkfund.com.

Investors should consider the investment objectives, risks and charges and expenses of the Merk Funds carefully before investing. This and other information is in the prospectus, a copy of which may be obtained by visiting the Funds' website at www.merkfund.com or calling 866-MERK FUND. Please read the prospectus carefully before you invest.

The Funds primarily invests in foreign currencies and as such, changes in currency exchange rates will affect the value of what the Funds owns and the price of the Funds' shares. Investing in foreign instruments bears a greater risk than investing in domestic instruments for reasons such as volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. The Funds are subject to interest rate risk which is the risk that debt securities in the Funds' portfolio will decline in value because of increases in market interest rates. The Funds may also invest in derivative securities which can be volatile and involve various types and degrees of risk. As a non-diversified fund, the Merk Hard Currency Fund will be subject to more investment risk and potential for volatility than a diversified fund because its portfolio may, at times, focus on a limited number of issuers. For a more complete discussion of these and other Fund risks please refer to the Funds' prospectuses.

The views in this article were those of Axel Merk as of the newsletter's publication date and may not reflect his views at any time thereafter. These views and opinions should not be construed as investment advice nor considered as an offer to sell or a solicitation of an offer to buy shares of any securities mentioned herein. Mr. Merk is the founder and president of Merk Investments LLC and is the portfolio manager for the Merk Hard and Asian Currency Funds. Foreside Fund Services, LLC, distributor.

Axel Merk Archive

© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules