But If Not...

November 1967



April 1967




April 3, 1968, the day before he was murdered for speaking truth to power.


A time comes, for every one of us, all children of God, Muslim, Jew, Buddhist, Hindu, and Christian alike, and all who love God and hear these words, when we must choose. We will choose to bear the mark of the dark powers and principalities of this world, or we will refuse, and bind ourselves to the one God in heaven. It may be hard on some, easier on others. But we will all make that decision, and carry the mark of that choice with us forever.

That choice is not made once, but is forged with every action, every day, on our hearts.  So when the final choice is made, we will choose by whom we have served.   And keep in mind that although God is loving, He is also just. And there are sins against the Spirit that even a merciful God will not forgive.

So when you consider your actions, ask yourself, 'Is this God's will? Does it stand in the light of God's witness, His mercy and love? Am I listening to His Messenger, His Word, His Law, and serving the one God, or another, or myself?'

But God reserves justice, and vengeance, and wrath for Himself, and His command for us is simple: 'Thou shalt love the Lord your God, with your whole heart, and your whole mind, and you shall love your neighbor as yourself.'



Someone told me that in Germany these days, no one really knows or cares about Sophie Scholl, and the White Rose Society.

I know. I remember. And I care. And in doing so I save myself, je me souviens.

And if I ever meet her and the others like her, who gave themselves up for what is good, who became beacons of light for us in the long, dark hallways of history, I hope I can say, "I did not forget you."

Gold Daily and Silver Weekly Charts - Bear Raid Marks First Notice Day For Comex Silver

The silver shorts have their backs up against the wall. And that makes them dangerous.

Intraday commentary here.

It looks like there will not be a criminal case in the MF Global theft of customer funds, but they could face a fine of up to $140,000.  

The viral moral hazard unleashed by TARP continues to multiply and reverberate through US financial markets to their detriment.   It has a marked dampening effect on market participants, and encourages unethical behaviour and a spirit of lawlessness.  In that sense MF Global is just one symptom among many of a major set of policy errors committed by the Fed, the Congress, and the last two administrations at least. 

"In economic theory, moral hazard is a tendency to take undue risks because the costs are not borne by the party taking the risk. The term defines a situation where the behavior of one party may change to the detriment of another after a transaction has taken place...Economists explain moral hazard as a special case of information asymmetry, a situation in which one party in a transaction has more information than another. In particular, moral hazard may occur if a party that is insulated from risk has more information about its actions and intentions than the party paying for the negative consequences of the risk. More broadly, moral hazard occurs when the party with more information about its actions or intentions has a tendency or incentive to behave inappropriately from the perspective of the party with less information."

From a practical standpoint, I guess this clears the way for Corzine to be the next Treasury Secretary, a fitting replacement for Geithner the amoral technocrat.

Hide your women, children, IRA's and 401k's.   The economic hitmen are coming to town.

NYT: No Criminal Case, But MF Global May Possibly Face a Fine of Up To $140,000

As Janet Tavakoli said the other day, the media coverage of this scandal has been a comedic lightweight fly by that no one in the know could possibly take seriously.

And as Chris Whalen said, we always have known where the money ended up. And that is a big part of the problem. Corzine is Too Big to Jail and the Banks are Too Big To Fail.

Perfect illustration of the credibility trap that is destroying the economy.

Now the elite New York Times chimes in with its own version of the mysteriously vaporizing, blameless money meme. Maybe someone should look in Judge Crater's pockets, or Jimmy Hoffa's wallet.

Et tu, Gray Lady?

As I said, I have now given up all hope of justice being done in this case. But I think obtaining some of the stolen customer money back from the banks and MF Global Holdings is still possible.

We're not in Kansas anymore, Toto. Smells more like 1920's Chicago.

What we need are The Untouchables, honest public servants not compromised in the web of a credibility trap.

NYT
Doubtful Signs of a Criminal Case Against MF Global
By AZAM AHMED and BEN PROTESS
February 28, 2012, 8:45 pm

Federal authorities are struggling to find evidence to support a criminal case stemming from the collapse of MF Global, even after a federal grand jury in Chicago has issued subpoenas.

Investigators, unable to find a smoking gun amid thousands of e-mails and documents, increasingly suspect that chaos and poor risk control systems prompted the disappearance of more than $1 billion in customer money, according to several people involved in the case.   (Are these the emails that the lawyer for the Creditors in the bankrputcy case had sole possession of for months?  Vaporization by honest sloppiness - Jesse)

When the money first went missing, prosecutors in New York and Chicago scrambled to stake a claim. Now, four months later, both Preet S. Bharara, the United States attorney in Manhattan, and Patrick J. Fitzgerald, his counterpart in Chicago, are shying away from leading the case, one of those people involved in the case said.

Indeed, a number of federal prosecutors have expressed doubts to others involved in the case that anyone at MF Global — including the firm’s chief executive, Jon S. Corzine, and back-office employees in Chicago — intentionally misused customer money, said people involved in the case who were not authorized to speak publicly about the investigation.

The subpoenas by the grand jury in Chicago were disclosed by the CME Group, MF Global’s chief regulator, in a securities filing on Tuesday. But the grand jury, according to the person involved in the case, has yet to hear any evidence on the case — a sign that the investigation has yet to bear fruit.

Still, it is early in the investigation, and regulators and others have yet to finish plowing through the mountain of documentation they recently received from the company. (And what investigative principle suggests the wisdom of allowing the company to go over the evidence first before handing it over to the investigators? - Jesse)  In addition, authorities have yet to interview key witnesses — including a person who is believed to have transferred client funds in the firm’s final days.

The inability to bring a criminal case would certainly disappoint thousands of clients, including farmers, traders and hedge fund managers, who are still without access to at least a third of their money.

The government is still hopeful it can file a civil suit against the company, people close to the case said, though doing so against a bankrupt firm with a long line of creditors could be seen as more symbolic than substantive.

Such a case would most likely center on the firm’s failure to safeguard client money, a cardinal sin in the world of futures firms. The penalty for improperly dipping into customer money is a roughly $140,000 fine, equal to about a thousandth of the overall shortfall that clients are enduring....

Read the rest here.

SP 500 and NDX Futures Daily Charts - Retreat Back to Support

Anyone who thought Bernanke was going to announce QE3 today is delusional.

Today is the First Notice Day for Silver and So We Have This Shameless Bear Raid on Metals

Feb. 29 Comex March silver futures first notice day
Feb. 29 Comex March copper futures first notice day
Feb. 29 Nymex March palladium futures first notice day


Last night Harvey Organ said:

"This is the first time in quite a while that gold and silver rose big time a day before first day notice. The bankers try and influence our longs not to take delivery so they generally raid. Today was different."

Well, Harvey spoke too soon; it really wasn't different. The metals rallied higher yesterday, and then were smacked down in a very calculated and violent bear raid today.

I was expecting something like this, and here it is. These fellows have their backs to the wall in silver.

I have seen reports that 225 million ounces of paper silver were dumped on the Comex in less than thirty minutes.

The last time I checked there were less than 35 million ounces of silver registered with the dealers for delivery in at the Comex.

First day notice is when holders of paper futures give notice to the exchange that they intend to take delivery the silver claims they hold from the Comex warehouse. The amount of paper held is multiples of the bullion that can be delivered at current prices.

The 'tell' is the lack of a serious sell off in equities. The yawning divergence in the risk trade is hard to miss.

This notion that gold and silver are selling off because Bernanke is not going to do QE3 is ludicrous.  He does not need to do QE3.  The Fed is all over these markets in Operation Twist.  Jim Rickards has explained this scenario many times that I have linked here.

What is the answer? Unless you are a full time experienced trader playing with 'cool money,' stop trading. This market is far too thin and given over to gimmicks for the average person to participate. It really is.

Take long term positions that suit your investment situation, and then ignore the noise that the trading desks throw out to shake people from their positions, painting pictures on the charts to shape perception.

Bernanke is still powerful, but the trends in the longer term are even more powerful.

The volatility and gaming in the markets will only get worse, as they are thinly traded and dominated by a few big trading houses that act as they choose, almost with impunity. And if a major default is coming, the volatily will go through the roof.

You have three choices. Buy, sell, or stay out of the daily trade.

And for the vast majority, the last choice is the best, especially while the markets are given over to such inefficiency and corruption. I'm sorry, but that is the way it is. And its a shame on the government, but unfortunately these days the powerful and the elite have none.

If you have the overwhelming urge to gamble with your money, take a trip to Las Vegas or Atlantic City.  The food is better, the drinks are cheaper, and the games, although still stacked against you, are at least relatively honest.

And you don't have to worry about the Casino looting your accounts and safe deposit boxes to cover their own personal gambling losses.

Long Term Dow Industrial Average Chart

A failure in this broadening top could, if activated, take the DJIA down closer to the bottom of the long term logarithmic trading channel.

The Federal Reserve will do all it can in order to create liquidity to prevent this sort of major market crash.

I can also that resulting in a sideways market, within a fairly broad range of 7,000 to 15,000 on this log chart, until 2020, as we see happened in the 1970's after the 1960's stock bull market. That also fits well with the stagflation forecast.

As a reminder, when looking at a very long term chart like this it is important to remember that it is not adjusted for inflation. 

However this all works out in nominal terms, the Dow/Gold ratio is likely to touch the 1.5 or lower level at some point in the next eight years.

Gold Daily and Silver Weekly Charts - Silver Roars Higher

Silver roared higher cracking up to the 37.00 level as the shorts were on the run.

Let's see if it can hold these levels through the end of the week. There will be very serious resistance around 41 if it should break higher from here.

Gold may be forming a massive skewed W consolidation formation on the daily chart. The neckline is around 1800. From the daily low close at 1550, on a breakout the minimum measuring objective is roughly $2,050.

SP 500 and NDX Futures Daily Charts - Dow 13,000

The Dow Jones Industrial Average managed to eke out a close above 13,000 as the big cap techs roared higher.

There was a bit of a divergence with notable softness in the broader stock averages.

Jamie Dimon today said that JPM would not be buying back their stocks 'at these lofty price levels.'

As a reminder, this is a Leap Year and February will have 29 days. So we may have another day to go in the end of month appliqué.

Are US Corporations Immune From Liability For Rape, Torture, Murder, and even Genocide?

The US Supreme Court will be deciding if US corporations are only people when it comes to peddling influence and paying off politicians with campaign contributions, but not when engaging in promoting and supporting the rape, torture and murder of peaceful protesters.

If the Court finds in favor of the corporations, would it also apply to domestic law?

This might open up exciting new investment opportunities. Private police corporations could be used to limit the local government's liability in violently suppressing the Occupy Movement, for example.

And private police corporations could sell ad space on their shields, batons, and helmets. And there are probably tax and insurance benefits as well. Not to mention the potential for an IPO.   It's a win-win.

NPR
Human Rights Victims Seek Remedy At High Court
by Nina Totenberg
February 28, 2012

Human rights are front and center at the U.S. Supreme Court on Tuesday in two cases testing how American law intersects with international law. At issue in both cases is whether foreign nationals in the United States can sue corporations or other entities in U.S. courts for alleged violations of human rights.

The case that has corporate teeth chattering is a lawsuit against Royal Dutch Shell Oil, which is accused of aiding and abetting the Nigerian government in committing atrocities in the 1990s.

The suit was brought by 12 Nigerian citizens, all of whom have been granted political asylum in the United States. They are natives of the Ogoni region of Nigeria where Shell Oil has conducted oil exploration for decades.

In the mid-1990s, local religious, student and civic leaders began demonstrating peacefully against Shell, protesting that their farmland was being ruined by oil spills and that Shell contributed nothing to the local economy and did not pay for cleanup or environmental protection.

Soon, the protest leadership was being rounded up, tortured and even killed. Those who survived, fled, including Charles Wiwa, who says that after he led a rally in his home village, he was picked up and beaten by 18 soldiers before a crowd of thousands at an open-air market.

"They started beating me — horsewhipping me, clubbing me, [kicking me with their] boots for a really long time," Wiwa says. The beating lasted more than two hours.

There were more beatings, he says, and eventually he was charged with unlawful assembly. Released on bail, he says there were two attempts to abduct him.

"When it was obvious that my life was at risk, I fled Nigeria," Wiwa says.

For the past 16 years, Wiwa has lived in the United States. Now in Chicago, where he works as an export consultant, he is among the Ogoni refugees here who have doggedly pursued Shell, contending that the oil company worked hand-in-glove with the Nigerian military to brutally suppress any opposition to the way the company operates.

Among the others bringing charges is a Seventh-day Adventist bishop and a local leader's widow, who was raped and beaten after her husband was arrested and summarily executed.

They started beating me — horsewhipping me, clubbing me, [kicking me with their] boots for a really long time.

Their lawsuit against Shell is based on the Alien Tort Statute, a law enacted in 1789 by the first U.S. Congress and aimed mainly at pirates. The statute says U.S. trial courts can hear civil damage suits brought by a foreign national for wrongs "committed in violation of the law of nations or a treaty of the United States."

The statute remained largely unused until 1980, when victims of human rights abuses began using it against foreign individuals and corporations. In 2004 the Supreme Court, by a 6-3 vote, upheld the application of the law to human rights abuses, but only for a limited category of crimes — torture, genocide and crimes against humanity. The court said that in modern times the torturer has become like the pirate and the slave trader of earlier times, "an enemy of all mankind."

Unresolved, however, was who could be sued. The case the court ruled on involved a lawsuit against an individual. This case asks whether the victims of such crimes can sue corporations.

Lawyers representing the victims maintain that historically there is a quid pro quo for corporate status. In exchange for the many benefits of incorporation, including limited liability, corporations are responsible for the actions of their employees, known in legalese as their agents.

"All that we're saying in this case is that when a corporation contributes to genocide or crimes against humanity, that they should be held liable ... the same way they would be held liable if one of their agents is engaged in an automobile accident that injures somebody" on the job, says Paul Hoffman, who is representing the Nigerian victims...

Biderman: Real Time Economic Data Shows No Recovery, US Dollar Is a 'Phantom.'

"Gold is not a phantom currency as many say, it is the US currency that is the phantom."

Charles Biderman, February 27, 2012

Charles Biderman gives a step by step analysis of the key data that some say shows an 'economic recovery.'

Accounting tricks, statistical smoke and mirrors, and a stock rally fueled by Fed printing do not reflect the real state of the US economy.

There is evidence that the situation has stabilized.  The problem is that the stimulus which the Fed is providing is not directed towards productive activity sufficient to spark a genuine recovery with a rising median wage. Rather, it is being used to prop up a dysfunctional economy that is still rife with corruption, malinvestment, and insider dealings designed to transfer even more wealth to the top one percent.   And the prescription being offered by the perpetrators, for the maladies of their crisis, is to take more from the poor and the weak, and pay for an excess of fraud with their pains.

And those who know better, with the exception of a notable few, either stand aside and are silent, or sell their integrity to a partisan cause, self-interest, or the highest bidder.

The financial crisis has provided the excuse for what has the appearance of institutionalized looting by a powerful elite through a dual standard of justice and the steady debasement of the national currency. Neither austerity or stimulus will work until the economy is restructured and reformed.   But stagnation is achievable, as long as the dollar lasts.  Or until the great reckoning comes, and the grapes of wrath are pressed.

Tavakoli: The Great MF Global Comedy Cover Up

Powerful interests are involved. Too Big To Fail and Too Connected To Jail.

This brief piece by noted financial analyst and author Janet Tavakoli is the sharp edge of her incisive wit.

The coverage of MF Global by the financial print media has been laughable, with the notable exception of Forbes. MF Global was the eighth largest bankruptcy in the US, with thousands of customers victimized by theft, and yet one hardly ever hears about it.

I have had a few conversations with people knowledgeable about Fedwire, the most reliable system for wire transfers in the states for large transfers between financial entities, and the one that MF Global might have used. After all, they were one of the Fed's own Primary Dealers. If so, is the Fed withholding information about the transfers? The problems in finding out who received certain transfers in excess of $100 million left the people I discussed this with incredulous.

"The Fedwire Services are the premier electronic payments and securities transfer services that banks, businesses and government agencies rely on for mission-critical same-day transactions. When it absolutely matters, trust Fedwire Services to deliver transactions with certainty and finality."

I wonder which mainstream news media program will finally interview someone informed and honest on the MF Global story, and bring this injustice to the awareness of the public. I have heard that they will attempt to drag this investigation out until after the national elections in November, but if it comes out before that it will be wrapped up in a "don't ask don't tell admit no guilt" settlement.

"Our government...teaches the whole people by its example. If the government becomes the lawbreaker, it breeds contempt for law; it invites every man to become a law unto himself; it invites anarchy."

Louis D. Brandeis

Someone like the maverick Jon Stewart might break ranks from the corporate allegiance and political partisanship of the major television outlets. Corzine is a powerful figure in the Democratic funding machine, and JPM is the biggest kid on the Street.

And where better to discuss the protection of the US public trust from well-connected financial predators than on Comedy Central, which is fast becoming the premier news outlet in post-corporate America.

Huffington Post
MF Global: Crime, Comedy and the Cover-Up
By Janet Tavakoli
2/28/2012 5:37 am

MF Global's October 2011 bankruptcy was the eighth largest bankruptcy by assets in the United States. James Giddens, the bankruptcy trustee, issued a press release on February 6 stating that his investigation found that money from customer accounts that was supposed to be segregated was improperly used to fund MF Global's daily activities. Improper transfers of customer money occurred regularly in amounts under $50 million before MF Global's bankruptcy. MF Global wasn't caught, because it put the money back before customers knew it was missing.

On January 30, 2012 the Wall Street Journal did a hilariously bad job of reporting when its front page article stated that a "person close to the investigation" said that as a result of chaotic trading in the week before MF Global's October 31 bankruptcy, customers' money "vaporized." Money doesn't vaporize. It's true that tracing money transfers can be tedious, but that's why we call it work.

As for the Wall Street Journal's article, the editor should have made it vaporize. I was having breakfast with several traders at Chicago's East Bank Club. One trader read the passage aloud. The entire table burst out laughing. Then he got up and ceremoniously threw the paper in the trash. The entire table applauded.

Fox Business News had people in stitches when it reported that federal investigators are saying that this wasn't criminal, it's just a matter of sloppy bookkeeping.

The habitual filching of customers' funds -- even if the funds are later replaced -- goes way beyond sloppy bookkeeping. It goes way beyond bad judgment. Just because MF Global got away with it for a long time before it blew up in its face doesn't mean one can call it sloppy bookkeeping and have any reasonable person believe it. If federal investigators and law enforcement people want to make public statements like this, one should investigate corruption in their ranks. They seem to be providing undeserved excuses as a trial balloon to see if it will fly. Nice try, but it's not working.

According to the bankruptcy trustee, money was repeatedly filched from customers' accounts. That goes way beyond sloppy bookkeeping.

Senior officials of the Chicago Mercantile Exchange and of MF Global's regulator, the U.S. Commodity Futures Trading Commission (CFTC), have already testified to Congress their belief that MF Global violated regulations -- it broke the law -- because using customers funds, money that was supposed to be in segregated accounts, to pay off MF Global's creditors or to use that money to fund MF Global's day-to-day operations is not permitted.

MF Global CEO Jon Corzine, a former head of Goldman Sachs, signed off on statements that said his internal controls were adequate. After Enron, the Sarbanes Oxley Act was meant to assure Americans that officers that signed such statements would be held accountable for their accuracy....

Read the rest here.

Scientific Study Shows That The Powerful and Privileged Are More LIkely to Lie, Cheat, and Steal

I seem to recall my grandmother telling me this about 50 years ago.

I have encountered quite a few of the nouveau riche, barely upper middle class, that are unscrupulous and almost unbearable. And I have met a number of very wealthy people, both old money people and the accidental rich, who are kindly, enjoyable, and exceptionally hospitable.

From my own experience it is not whether a person has money per se. Rather it is the perceived power that a person feels that they have and their attitude towards it, and how differently they consider themselves to be therefore from others.

I have heard that it is easier for a camel to pass through the eye of a needle than a rich person to get into heaven. Perhaps it is a simplicity of heart that opens such doors for us, and the baggage of pride that closes them. None of the spirit can justly feel such pride compared to another. Our comparison, our aspiration, is not to the fellow next to us, but to a model so perfect and so loving that it leaves us equally alike in our unworthiness, attempting that which is unattainable to us on our own, except for the undeserved gift of grace.

But the world says 'Greed is good, baby.' Build the foundations of society on that historically untenable aphorism and enjoy the ride. It's been done many times before.

"Seven studies using experimental and naturalistic methods reveal that upper-class individuals behave more unethically than lower-class individuals. In studies 1 and 2, upper-class individuals were more likely to break the law while driving, relative to lower-class individuals.

In follow-up laboratory studies, upper-class individuals were more likely to exhibit unethical decision-making tendencies (study 3), take valued goods from others (study 4), lie in a negotiation (study 5), cheat to increase their chances of winning a prize (study 6), and endorse unethical behavior at work (study 7) than were lower-class individuals.

Mediator and moderator data demonstrated that upper-class individuals’ unethical tendencies are accounted for, in part, by their more favorable attitudes toward greed."

Higher Social Class Predicts Unethical Behaviour, Proceedings of the National Academy of Sciences of the United States of America, February 27, 2012 Paul K. Piffa, Daniel M. Stancatoa, Stéphane Côtéb, Rodolfo Mendoza-Dentona, and Dacher Keltnera

"According to Piff, unethical behavior in the study was driven both by greed, which makes people less empathic, and the nature of wealth in a highly stratified society. It insulates people from the consequences of their actions, reduces their need for social connections and fuels feelings of entitlement, all of which become self-reinforcing cultural norms.

“When pursuit of self-interest is allowed to run unchecked, it can lead to socially pernicious outcomes,” said Piff, who noted that the findings are not politically partisan. “The same rules apply to liberals and conservatives. We always control for political persuasion,” he said."

Greed Is Not Good, Wealth Can Make People Unethical

Gold Daily and Silver Weekly Charts - SP Cuts Greece to 'Selective Default'

Metals were capped most of the day. Could just be a consolidation.

Breaking news after the bell, S&P has cut Greece to 'selective default.' The action is based on the modification of the terms of the debt with some of the bondholders.

SP 500 and NDX Futures Daily Charts

Looks toppy here.

Feds Key In on $325 Million Wire Transfer Made in Last Hours of MF Global

I wonder if this newly released MF Global information is some of the data that the creditor team has been examining and only recently released to Federal investigators.

It was surprising to hear that JPM as a creditor gets to decide how and when customers can have information about their MF Global accounts as reported here.

The truth may come out some day, but will be heavily coated in sugar. They will try to drag this out until the public loses interest and becomes distracted by something else.

A last minute wire transfer of a large cash amount, not to mention a transfer almost certainly involving customer money, would be an automatic clawback in any bankruptcy I have ever heard about. I saw a trial balloon floated out a week or so ago that put forward the theory that the money would not be returned because it was protected by a 2005 bankruptcy law regarding the sanctity of 'commercial paper' payments.

That rationale might work in a friendly court, but would establish an unbelievable precedent about the ability of banks and insiders to seize funds from the carcass of any failing enterprise ahead of other creditors.

Keep in mind that customers who had requested their money DAYS before the 31st were sent checks instead of the customary wire transfers which they had requested, and those checks were not honored. And I have heard of at least one instance where a customer's wire tranfer was reversed a day later by the banks, which I had thought was not even possible.

This looks like a fraudulent conveyance, and possibly a conspiracy of theft of customer money amongst financial insiders as MF Global slid into bankruptcy.

The more I hear about this, the more outrageous it gets.

Dealbook
Investigators Scrutinize MF Global Wire Transfers
By AZAM AHMED and BEN PROTESS
February 26, 2012, 9:07 pm

Federal investigators examining the final days at MF Global and how customer money went missing are poring over scores of wire transfers in and out of the brokerage firm, including the possible movement of $325 million that may have belonged to customers, according to people briefed on the matter.

The suspicious transfer, which until now has not been made public, was first discovered in the early hours of Oct. 31, the day the firm filed for bankruptcy. Initially, the firm attributed a shortfall of more than $1 billion in customer money to an “accounting error,” records show. But after hours of searching, executives acknowledged to regulators in the firm’s offices in Chicago that the shortfall was real — and may have been caused in part by the $325 million transfer, said one of the people briefed on the matter.

It remains unclear where that money went, or even if it belonged to customers. (Did they lose the receipt?  LOL - Jesse)  But it is one of many significant wire transfers that federal authorities — including the Commodity Futures Trading Commission and the Federal Bureau of Investigation — have spent months reviewing to piece together MF Global’s final days.


Investigators have also reviewed another transfer, of $220 million on Oct. 31, which represented a last-ditch attempt to patch the hole discovered in the customer accounts.

Once the firm disclosed the shortfall to officials from the C.F.T.C. and the CME Group, the giant exchange that also regulated the firm, MF Global shifted $220 million in customer money from the securities side of the business to its commodities brokerage unit, where the shortfall in client cash was discovered earlier.

Ultimately, the final attempt came up short. Just hours after the transfer, the firm filed for Chapter 11 bankruptcy...

Read the rest here.

Performance of Stocks, Bonds, and Gold In an Inflationary Environment

Jeremy Grantham's GMO group has produced an interesting study showing the performance of three asset classes against inflation.

I think the true correlation is with negative real interest rates rather than inflation itself. In an inflationary period, interest rates tend to lag the increase in inflation, producing negative real rates.

But in a period of economic decline in which the Fed lowers rates artificially, negative real rates can also be created and rather more easily than some amateur economic theorists believe.

To slightly complicate matters, the markets tend to anticipate, tend to act on expectations before the reality of something. So we might see something like gold or interest rates signaling a period of inflation well ahead of its appearance, if they are allowed to seek their own levels in the market.

If you think about it, the correlation with negative interest rates makes sense. In a period of negative rates, all currency heavy financial instruments are probably facilitating the confiscation of wealth by the official banking system. Since gold has relatively little counterparty risk if properly held, it is likely to be considered a safe haven, in addition to other hard assets and stronger alternative currencies if such things are available.

Unfortunately for analysis, things are never so simple in real life.

In addition to negative interest rates, there are other forms of wealth confiscation, including the fraudulent mispricing of risk, outright fraud itself, and currency devaluation.

And finally, there is the sort of price manipulation which the Western central banks engaged in for a long period of time in strategically selling off portions of their gold in order to hold the price lower in a disastrous attempt to manage the financial markets and silence the warning signal from gold as asset bubbles began to build in the credit markets and the Bretton Woods global monetary agreement began to fall apart.

And so what might have been a gradual price increase in gold and silver instead became a powerful rally as the markets sought to correct to the primary trend once the banks stopped being net sellers of gold.   Now the financial system can only use other means in order to try and control their ascent to a genuine market clearing price based on years of monetary inflation.  There are various estimates of what that eventual price might be, but it most certainly is much higher than where the price is today.

Years of underinvestment in mining has created a dangerous shortage of gold and silver relative to potential demand.  Various financial instruments have been introduced to provide 'paper gold and silver' to meet that demand.  In addition, even physical exchanges like the LBMA have been pushed to dangerously high rates of leverage as demand for bullion outstrips available supply.  And so the markets drift inexorably into great opaqueness and repeated frauds because the world of paper has unhinged itself from reality across multiple fronts.   The problem is that the state of the currency feeds into all finanical markets and so a mischief done there spawns its children everywhere.

As one might suspect, the credibility trap in which the financial engineers find themselves causes occasional outbursts of hysterical animosity and antagonism against the reactions of the markets, and the reality of their own economic chickens coming home to roost. 

This is a recipe for disaster, and we can thank the Anglo-American banking cartel, and their gullible accomplices in the other western banks, for it when it happens.  When Dick Cheney said, "Reagan proved that deficits don't matter" what he did not realize was that he was reading the epitaph for the dollar reserve currency system that had been in place since the end of WW II.   They do matter, but sometimes the lags in time between cause and effect can be deceptively reassuring.

Debt may not matter in the short run, and Keynes had some very good and valid points to make about government stimulus during short periods of economic slumps to avoid feedback loops and the spiral of decline.   As an aside I wonder, if Keynes came back and saw what his acolytes were saying in his name, if he could stop throwing up.  When he found new facts he changed his mind, and I suspect he might have changed his and strongly cautioned against turning a remedy into an addiction to support  habitual corruption and unsustainable privilege.  But I do not know if he was that honest of a intellect, or would have merely gone along with the rest for the benefits of his class.

Huge deficits over long periods of time to finance non-structural consumption and underwrite malinvestment and currency manipulation are almost invariably toxic.  The 'vendor financing' that gave rise to the age of 'Asian miracles' is the rope which will be used to hang the capitalist system unless strong measures are taken to clean up the corrupt system that grew up to support and profit from this economic Frankenstein.

The only reasonable course of action is for the West to nationalize its TBTF banks, dismantle them gracefully while keeping their depositors whole, and give up their dreams of global and domestic financial domination by adopting a system of real capitalism based on market pricing, price discovery, competition kept intact from monopoly through effective regulation and law enforcement, transparency and a climate of honesty.  But that would visit restraint, inconvenience, and even some pain on the powerful and privileged, those who have benefited greatly from this long charade, so it will be resisted to their bitter end.

While the stock and housing market bubbles have burst, the bond bubble, which includes the US dollar as a bond of zero duration, remains to be resolved and marked to market.

Source: Jeremy Grantham's 4Q 2011 Investment Letter

What Is the 'Spot Price' of Gold and Silver?

This is a partial reprise of a post from two years ago. The question has again arisen about the discrepancy between the spot price of gold and silver, and the prices shown on the front month of the futures market.

When you ask even an experienced trader, or even an economist who may have received a Nobel prize, 'What is the spot price, where does it come from, who sets it?' you will often hear that this is the last physical trade, or the current market price of physical bullion for delivery. 

Here is a fairly typical explanation one might get from an 'industry expert.'

"That is why the New York Spot Price is different from the London Gold Fix price. The spot price changes on a regular basis, just as stock prices do, and reflects the bid and ask prices quoted by wholesale dealers for spot delivery."

Well, does it?

Actually despite what you might think or what you might have heard, it does not.

There is no centralized and efficient national market in the US for the sale of physical bullion at anything resembling a 'spot price.' What is their telephone number, where are their prices and trades of actual transactions posted?   Who collects and is privy to that knowledge, and how are they regulated?  Who is buying and selling TODAY, with real delivery of bullion as the primary objective?

There are a few large wholesale markets for physical bullion in the world, where real buying and selling can occur, with delivery given and taken. The most famous is the London Bullion Market Association, which is a dealer association, an over the counter market where the price is set twice a day and called the 'London fix,' but each counterparty stands on their own with no central clearing authority.

As an aside, there are credible claims and factual evidence that the LBMA has slipped into a paper market with multiple claims on the same unallocated bullion with daily trade volume in multiples of available supply, a fractional reserve bullion banking as it were. Some say the leverage is 100:1.

The reason that physical trading in bullion became so highly concentrated in London was best explained to me by a large bullion dealer. "This situation exists because of the gold confiscation in the US in 1933. When that happened, physical metal trading in the US came to a complete stop. When gold ownership was again made legal on December 31, 1974, the physical metal trading had become so developed outside of the US that it stayed there and never really returned."

But once the London Fix is over, and the trading day moves with the sun, the New York markets open and become the dominant price setting mechanism. Where and how is that price obtained? Where is the price discovery?

I will not delve into it here, but there is credible evidence that shows that the price changes for gold in the NY trading window are heavily skewed to price decreases as compared to the other periods of the day, beyond any reasonable statistical expectation.  It is so obvious as to be almost notorious amongst seasoned traders.  That alone should raise alarms with the regulators.  No honest market has such obvious anomalies unless there is something terribly wrong in its structure.

The bullion market in the US is highly fragmented among many dealers who do not set the prices amongst themselves as in London. Yes they have their 'wholesale' sources, but even those sources are more fragmented than one might imagine.

The fact of the matter is that the spot price of gold and silver is nothing more than a type of Net Present Value (NPV) calculation based on the futures price in the nearest active month, or the front month.

I have not been able to obtain the specific formula used by any of the principal quote providers such as Kitco for example. And I am not saying that they are doing anything wrong at all. Or right for that matter.

The spot price is calculated from the futures in much the same way that the 'Fair Value' price is derived for a stock index like the SP from the futures trade, which is essentially an NPV calculation.

FORMULA FOR DETERMINING FAIR VALUE

F = S [1+(i-d)t/360]

Where F = Fair Value futures price

S = spot index price

i = interest rate (expressed as a money market yield)

d = dividend rate (expressed as a money market yield)

t = number of days from the current spot value date to the value date of the futures contract.

So like most net present value calculations we would have some 'cost of money' figure used to discount the time decay from the strike time of the contract to the present. There is no dividend with gold, but there is a forwards rate and a least rate, and a proper calculation should include some allowance for this opportunity cost.

Given that the 'cost of money' or short term interest is roughly zero, the time premium of the futures over spot is likely to be negligible.   But since the methods of calucating spot are not public, I cannot speak to this now.

What is important to remember is that the spot price follows the futures front month by some calcuation. And rather than a physical market setting the price in fact almost all retail transactions for physical bullion in the US key off a 'spot price' that is derived from a paper market which is not based in the currently available physical supply.

Further, the futures exchanges explicitly allow for the settlement in cash if physical bullion is not available. In fact, the vast majority of transactions are settled in cash, and are little more than derivatives bets, and trading hedges related to other things like another commodity or interest rates.

I am not saying that anyone is doing anything wrong or illegal. I am saying the system is inefficient in that it suffers from the lack of a robust physical market to 'keep it honest.'

It does seem a bit ironic by the way, that the most popular provider of spot price information for gold and silver is currently operating under charges of fraud in a scheme involving a conspiracy to defraud their government in Canada. And yet the consumer must take their price quotes on faith, since there is no apparent disclosure of how their price quotes are obtained. Perhaps their case has been resolved, and I am not aware of it. But the irony remains.

The spot price of gold and silver is therefore subject to manipulation. So it is incumbent on the regulators like the CFTC to be mindful of any price fixing activity in the metals futures, particularly in the 'front month' which directly influences the going rate for many if not most of the retail bullion transactions in the States.

I am surprised that some smart entrepreneur has not consolidated the buying and selling of physical bullion on demand into a highly transparent and efficient market which is the real price setter, rather than the commodities exchanges in which arbitrage can be easily crushed by the very rules of the exchange that allow for virtually unlimited position size, extreme leverage, cash settlement as an easy alternative to shortage, 'naked shorting,' unaudited and unallocated stores of supply, and above all, the veil of secrecy.

We even recently saw the scandal where a large Wall Street broker was selling bullion and even charging the customer annual storage fees without ever having purchased the bullion for them in the first place. Not to mention a situation in which a large futures broker was able to steal the gold and silver on deposit from their customers with little recourse and limited remedy against one of the bullion banks who may have received the goods as it were.

Since the futures market sets the national price for retail transactions that have nothing to do with the futures market per se, there a significant need for tighter reins on short term speculation including position limits, accountability for deliverable supply, and limits on leverage and speculation.

The metals markets are thin and small compared to the forex and financial asset markets, and therefore the most vulnerable.

The futures market will be efficient and honest the more it takes on the rigors of the physical market.

What about the usual argument that the self-regulating proponents trot out that if the metals pricing is inefficient, it will create artificial shortages, and physical buying will break that scheme down over time?

Participants in the futures are not able to seriously address a significant market mispricing because the prices set in the paper markets are not conducive to efficient arbitrage of inefficiencies. The rules of the exchange sets limits on the delivery of physical bullion, favoring cash settlement and the positions of insiders and those who make markets in paper shorts that may be in multiples of physical supply. The CFTC has shown a remarkable inability and some might say unwillingness to address this in the silver market for example, which is a scandal.

Not even a motivated buyer with deep enough pockets would take on this market openly because all they would do is buy against themselves, and drive a default which would be cash settled by force. More likely they would be labeled as trying to 'corner' the market and punished severely.

You might ask at this point, why would anyone ever wish to engage themselves in this market, besides those who must obtain supply for industrial or cosmetic uses? Few do actually, except to buy physical bullion at the retail level.

From a purely economic perspective if I were going to set up a mechanism to allow price fixing and fraud to occur, I could do little better than what exists in the US today, except perhaps to set up something more like an opaque and self directing monopoly such as the Federal Reserve and its Banks have in their ability to create money virtually out of nothing.

The retail buyers and producers are largely at the mercy of those who control the paper markets, and these are a relatively few bullion banks and hedge funds. And this says nothing about the involvement of the central banks in influencing the price, which they sometimes admit that they do.

Reform is generally slow to come when a powerful status quo benefits from such a financial arrangement and price fixing such as this. Economic theory indicates that underinvestment and shortage will result, and if the artificial pricing is sustained over time, that shortage and systemic underdevelopment could lead to a severe market break and even a default.

We saw something similar to this when Enron was actively fixing the national energy markets in the US.  What will happen in the metals markets will be at least an order of magnitude more disruptive.

I think that a default is becoming more likely every day that the regulators refuse to act in the interests of promoting honest price discovery and fairness, which is their very reason for being.

And when the bullion banks cry for exchange intervention and government relief, keep in mind that their problems are the result of no acts of God or anything other than a protracted abuse of the market and the public for the personal benefit of a few at the expense of many.

Warren Buffett Buys US Precious Metals Business from Cookson Group

Apparently Berkshire's Richline Group didn't get the memo that Warren doesn't like silver or gold.

Richline is involved in the fabrication of precious metals into jewelry. The acquisition of US Precious Metals will bring them into the mill and findings portion of the precious metals industry, as well as acquiring European and Asian distribution channels.

A small deal for Berkshire, but it is a bit of fun.

I wonder if Warren will have an introductory note to Richline's next company report, "May Is Gold Month." lol.

RTTNews
Cookson Group Sells US Precious Metals Business To Richline Group
2/23/2012 4:00 AM ET

(RTTNews) - Cookson Group plc reached an agreement to sell its US Precious Metals business, an operation that forms part of its Precious Metals division, to Richline Group Inc., an unit of Berkshire Hathaway Inc.

Earlier, Cookson announced that, following the US Precious Metals business becoming loss-making, it had begun a strategic review and significant downsizing of the business. Subsequently, Richline expressed an interest in buying this business, and on 22 February 2012, Cookson and Richline inked a deal for Richline to acquire the business, subject to normal legal and regulatory closing provisions which may be completed in the 2012 second quarter.

The net cash consideration is subject to closing balance sheet adjustments but is expected to be sufficient for Cookson's exit from the business to be cash neutral, including taking into account the restructuring and other costs incurred in preparing the business for sale. The gross assets of the businesses being acquired by Richline are nearly $69.8m or 44.4 million pounds, while the net assets are about $60.2 milion.

JCK
Richline Acquires U.S. Precious Metals Business
By Rob Bates
February 23, 2012.

Richline Group will acquire the U.S. precious metals division of the Cookson Material Products Group in the second quarter of 2012.

According to a Cookson statement, the gross assets of the businesses being acquired by Richline are approximately $69.8 million, and net assets roughly $60.2 million. It said its U.S. precious metals business had become “loss-making.”

Businesses in the United Kingdom, France, Hong Kong, Japan, and China that will distribute and sell Richline product are part of the acquisition, Richline said.

Richline, owned by Warren Buffett's Berkshire Hathaway, said this deal demonstrates its commitment to the mill and findings segments of the businesses...

A Richline spokesman declined comment on a Reuters report that suggested it is about to purchase Italian jeweler UnoAErre.

Tokyo Based Hedge Fund AIJ May Have Lost/Stolen All Customer Pension Fund Money

Some of my friends in Japan are keeping an eye on this one for me, and I thank them for their help. I never learned to read Japanese beyond memorizing subway stations and street signs and the like, in addition to the usual polite conversational ability which has badly faded with the years.

The problem I have is finding good articles in English. The Japanese Shimbuns are also notoriously circumspect and polite, even when it comes to institutional fraud and the loss of pensioners money.

While they keep talking about 'lost money' and 'hiding losses' it looks more like embezzlement on the surface for at least part of the funds. It appears that virtually all the customer money has 'vanished.'

It will be interesting to see which European bank received the customer money once it hit Hong Kong via the Cayman Islands. It is not a good sign for customers that a European or American bank was involved. That smells more like theft than loss.

The Asahi Shimbun
AIJ moved huge sums to Cayman Islands, Hong Kong
February 25, 2012

AIJ Investment Advisors Co. transferred huge sums in corporate pension assets it manages to a fund in the Cayman Islands and then moved the money to the Hong Kong account of a major European bank, sources said.

The Securities and Exchange Surveillance Commission has not been able to trace where the money went after reaching Hong Kong.

The sources said the SESC was investigating the motive for transferring the funds overseas, including the possibility that the money may have been misappropriated.

It turns out that several of the companies and organizations that entrusted assets in pension funds to AIJ may lose up to half of what had been set aside to make pension payments.

In the worst-case scenario, some of the corporate pension funds may have to be dissolved because of the loss of the assets. In other cases, some individuals who are members of the corporate pension funds could see part of their pension benefits reduced.

The Financial Services Agency ordered AIJ on Feb. 24 to suspend business operations for one month. The company had collected about 210 billion yen ($2.6 billion) from about 120 corporate pension funds.

However, AIJ officials told investigators with the SESC that the company was now only managing an investment portfolio worth about 20 billion yen, meaning that about 90 percent of the assets deposited by the corporate pension funds are wiped out.

The FSA also instructed AIJ to explain to corporate clients what went wrong. The agency will begin an investigation from Feb. 27 of all 260 or so investment advisory companies to search for possible problems in their pension fund management practices.

Neither the FSA nor the Ministry of Health, Labor and Welfare have disclosed the names of the 120 or so corporate pension funds that placed their assets with AIJ...

AIJ officials have not divulged to the SESC how the assets were lost. The assets may have been lost due to bad investment decisions by AIJ or company officials may have diverted the money for their own use. AIJ officials apparently also made false statements to their corporate clients about the gains earned for the pension funds.

Investigators will look into where the assets flowed as well as the extent of the false statements made to determine if criminal charges should be filed against AIJ and its officials.

Bloomberg
AIJ Suspension Undermines Japan Pensions Hedge Fund Appetite
By Tomoko Yamazaki and Komaki Ito
February 26, 2012, 11:10 AM EST

Feb. 27 (Bloomberg) -- The suspension of AIJ Investment Advisors Co.’s operations amid concerns hedge funds it manages had lost pension money may undermine plans by Japan’s retirement funds to boost returns to meet demand in an aging society.

The Financial Services Agency on Feb. 24 ordered the Tokyo- based firm with 183.2 billion yen ($2.3 billion) of client money to stop business for a month as the regulator investigates “possible losses” at AIJ’s hedge funds. The FSA also will undertake a nationwide probe of 263 asset managers.

“If the funds actually suffered losses, this could potentially have a massive impact on pension plans that actually invested with them,” said Taro Ogai, who oversees consulting for pension fund investments at Towers Watson in Tokyo. “Pensions already face difficulties. At a time when they are trying to boost returns and cut risks, investing in hedge funds may become difficult for them.”

The inquiry is a setback for Japan’s pension industry that has been looking to diversify away from bonds and equities into alternatives investments, including hedge funds, to maintain steady returns and fund retiree benefits in a country with the world’s fastest-growing aging society and two decades of slumping markets...

Regulators have been investigating AIJ, which invests in futures and options of equities and bonds, since the end of January, and discovered that the company has been unable to explain to investors the current state of the way their money is being managed, according to the FSA...

AIJ’s funds have been traced from Japan to the Cayman Islands, followed by a trust bank in Bermuda and ultimately to “a major European Bank” in Hong Kong, the Asahi newspaper said Feb. 25, citing an investigation by Japan’s Securities and Exchange Surveillance Commission. AIJ kept money-flow records up to the unidentified bank in Hong Kong and no further records have been found, the newspaper said...

AIJ may have lost most of the 200 billion yen it manages for companies’ pension plans, the Nikkei newspaper reported Feb. 24, citing unidentified securities investigators...

Japan’s financial regulator is also planning to investigate trust banks that handle pension money as well as corporate pensions, the Nikkei newspaper reported over the weekend. The regulator penalized at least 35 financial institutions last year including Citigroup Inc. and UBS AG for breaching securities rules, according to its website...

AIJ, led by Kazuhiko Asakawa, was established in April 1989, and had 120 clients including pension plans with 183.2 billion yen in assets as of the end of 2010, according to a statement from the FSA. It has 12 employees. Phone calls to AIJ’s main office were answered by an automatic recording which didn’t allow messages to be recorded. Asakawa was a former employee at Nomura Holdings Inc., according to a person familiar with his employment. Keiko Sugai, a Tokyo-based spokeswoman at Nomura, declined to comment...

AIJ’s fund was ranked top among pension funds in 2008, said Fujio Nakatsuka, a spokesman at Rating & Investment Information Inc. in Tokyo. He said the rankings were based on responses from pensions and not what R&I had recommended to investors...

Reuters
AIJ Investment routed pension money to Cayman Islands
Fri Feb 24, 2012 1:11pm EST

Feb 25 (Reuters) - AIJ Investment Advisors Co is believed to have channeled about 200 billion yen ($2.48 billion) of corporate pension assets in custody into private investment trusts in the Cayman Islands, making it difficult to track the missing funds, the Nikkei said.

Japan's financial regulator on Friday temporarily shut AIJ on suspicion it may have hidden losses in the $2.6 billion pension funds it managed.

The Securities and Exchange Surveillance Commission (SESC) suspects that the Tokyo-based investment advisory firm may have used the tax haven to hide information on its investments. AIJ registered three investment trusts there, the Nikkei said.

Pending the results of the SESC's investigation, the Financial Services Agency plans to rescind AIJ's registration, the business daily said.

About 90 percent of the corporate pension assets managed by AIJ have disappeared, the daily said.

AIJ, after signing discretionary investment agreements with the corporate pension funds that worked with it, had the money put into the Cayman Islands investment trusts, the daily said.

AIJ is believed to have instructed that the money, once put into the investment trusts, be managed via a British-affiliated bank in Bermuda...

AIJ Tokyo Asset Management: Billions In Customer Funds Are Missing

This is more Madoff than Corzine, but the song of unforeseen counterparty risk remains the same.

The Japanese regulators have decided to take a closer look to see how many more of the 299 asset management firms have funding problems like this.

Don't it always seem to go that you don't know what you've got 'til its gone?

Wall Street Journal Japan
Missing Funds at AIJ: Watchdogging Japan
By Kana Inagaki and Phred Dvorak
February 24, 2012, 1:53 PM JST

The revelation that billions of dollars may have gone missing from client funds managed by a little-known Tokyo asset management firm highlights a sobering fact about Japanese financial regulation: It’s pretty spotty.

Japan’s financial watchdog Friday said investigators were looking into the alleged disappearance of “most of” the 183 billion yen, or about $2.3 billion, in pension-fund assets managed by AIJ Investment Advisors Co. Details are sketchy: regulators haven’t said exactly how much is supposedly lost, how many clients AIJ had, nor even whether they suspect foul play.

But we do know that if AIJ was doing anything wrong, the chances of its being caught out by Japan’s regulators were pretty slim.

Investment managers like AIJ are required to submit business reports to regulators once a year, Japan’s Financial Services Agency says. If those regulators suspect problems, they can carry out hearings. And some companies actually conduct voluntary audits of their own businesses. (AIJ was not one of them.)

A firm involved in dubious activity would need to be fairly unlucky to find itself caught in the net of one of the Securities and Exchange Surveillance Commission’s annual audits. The regulator conducted inspections of 15 investment managers in the year ended March 2011. Since there were 299 such firms in total, the chances of getting audited were about one in 20.

The FSA says it’s now going to do an audit of all 263 firms that have similar investment-management mandates to AIJ’s.

According to Japan’s Nikkei daily, AIJ may have misled clients for years, claiming they had cumulative returns as high as 240%.

It all makes for a fairly bleak spell for Japanese financial regulators. After all, the discovery of pension funds missing at AIJ comes only months after camera-maker Olympus Corp. admitted to it successfully hid more than $1.5 billion in losses for 13 years.

“To the economist embezzlement is the most interesting of crimes. Alone among the various forms of larceny it has a time parameter. Weeks, months or years may elapse between the commission of the crime and its discovery. (This is a period, incidentally, when the embezzler has his gain and the man who has been embezzled, oddly enough, feels no loss. There is a net increase in psychic wealth.) At any given time there exists an inventory of undiscovered embezzlement in – or more precisely not in – the country’s business and banks. This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle. In good times people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly.”

John Kenneth Galbraith, The Great Crash of 1929

Ellliot Wave Projection for the Price of Gold

Thanks to my friend Nick Laird at Sharelynx for this.

Critical Mass: The Mispricing of Derivatives Risk And How the Financial World Ends

Jim Sinclair does a good job of explaining the difference between the notional and real value of derivatives, and how that real value comes to bear on the financial system in the event of a default. You can read this here for a review of the basic concept if you do not understand it.

Within my own view of money, uncollateralized financial instruments like derivatives are credits, or potential money. When an event triggers them so that they become real, with a significant presence on the balance sheet and the income statement, then they become money.

In the financial world we see the extraordinary growth of derivatives in notional value, to almost unbelievable proportions. This mass of derivatives facilitates the withdrawal of money from the real economy in the form of wealth transferal, such as bonuses and commissions for example. But they do not become actual money themselves until some trigger event. To perhaps stretch our analogy to the physical world, it could be described as the withdrawal of the ocean, as money is siphoned from the real economy by the financial world, in advance of the arrival of a tsunami as derivatives start hitting the balance sheets and are transformed into 'real money.'

This could be the cause of a hyperinflationary policy error which I have been alluding to for the past several years.  The policy error is not in the simple setting interest rates, but the Fed's failure to regulate the banking system and manage its risks.   In this the Fed, particularly under Greenspan, was an abysmal failure, and improvement has not been forthcoming.

The explosion of the realization of derivatives would create enormous fortunes and unpayable debts. Depending on how the monetary authorities deal with it, the potential for a Weimer experience is there. Nationalizing the banks and canceling the transactions is one way out. Attempting to sustain these mythical financial structures will take the existing currency system down. That is the limit of the Fed's power.

Most theories and models are tested at the extremes of their limits, and I suggest that the coming financial crisis will wash many of the current economic and monetary models away, scouring the detritus of years of conflicting interests and fanciful adornments down to their foundations.   But the responsible parties will all sit back and say, "We did not know."    But of course they did.  They just did not care, as long as it paid them handsomely.

Taking this discussion of derivatives an important step further, the most significant elements of concern in derivatives are the same as they are in all financial schemes: unsustainable leverage and the mispricing of risk.

In derivatives the unsustainable leverage arises from the fact that the impact or risk magnitude of the derivatives, which are often uncollateralized, are artificially reduced by the assumed effects of 'netting.' And the risk is mispriced, not only in the terms of the agreement itself, but in the failure to properly account for counterparty risk as the instrument plays out in a larger risk portfolio. There is individual contract risk, and then there is the cascading risk of a highly compacted financial system.

We see situations today in which a single bank may have a hundred or more trillion dollars of notional value in derivatives on their books, against much less than a trillion in assets.

But the risk in such a large position is allowed because the banks can show that they have supposedly 'netted out' the risk by making other derivative arrangements that offset their own risk, in the manner of a hedge. As the amounts of derivative netting grows larger and more intertwining, the secondary effects of counterparty risk become tightly compressed.

What if a counterparty fails? Then all its own agreements fail, many of which may be hedges that also fail, and a cascading failure of these financial instruments in a tightly compressed and overleveraged system becomes catastrophic.

In 2002 Warren Buffett famously referred to derivatives as 'financial weapons of mass destruction.' But beyond that headline, few in the media took the time to actually communicate what Buffett was really saying, and the risks that the unregulated derivatives markets posed to the banking system.

The collapse of Lehman Brothers threatened to trigger a financial meltdown. A panicked leadership of the country was able to stop it, but at the cost of many trillions of dollars, and a distortion in the real economy that still goes largely unmeasured. And this was by intent, because the leaders feared a loss of confidence in the system. And so while the meltdown was averted, a credibility trap was created that is the epitome of moral hazard.

The influence and knowledge, call it soft blackmail of mutually assured destruction if you will, that the 'Too Big To Fail' banks obtained in this coverup of the depths of the fraud and mispricing of risk in the financial system has given them enormous power over the political process. It would have been more effective to have nationalized the banks and cut the risk out at the source, but the new president Obama was badly advised to say the least, by advisors he himself appointed, who were in fact long time insiders in the creation of the risk situation itself.

The global financial system is like a nuclear bomb. At its center are at most ten banks whose financial posture is overleveraged and interdependent not only amongst themselves but also with their national economies. It is not a question of 'if' they fail, but 'when,' and what is done about it.

The bailouts become geometrically larger given the size and interwoven complexity of the bets. The only feasible solution is to nationalize the banks, keep the real parts of the economy whole, and restart the system in a more sustainable manner. This is essentially what Franklin Roosevelt did in 1933, and to a more limited extent what J.P. Morgan did with the NY banks in 1907. In both instances they dictated terms and made the banks sign to preserve the system.

In the case of the 2008-9 crisis, Bush-Obama failed to dictate terms, and essentially allowed the banks to do whatever they wished to keep going without reforming the system, taking huge sums of money and paying off their bets while maintaining their bonuses and most of their positions. And this was a monumental political failure indeed, and history will probably not be kind.

When the next crisis occurs, there are still a variety of responses. The monied interests will wish to promote another bailout, with harsh terms being dictated to the public, rather than to the banks. This is what is happening in Greece. The terms will be so draconian and unsustainable that state fascism is the most likely longer term outcome. Germany is struggling with that decision today, in light of  bad results in their last two experiences along those lines. 

I am not hopeful that the leaders of the political world will have the resolve to do what it takes to bring the banks back under control, given the power that big money has obtained over our worldly leaders.


Following are edited excerpts from the Berkshire Hathaway annual report for 2002.

I view derivatives as time bombs, both for the parties that deal in them and the economic system.

Basically these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices, or currency values. For example, if you are either long or short an S&P 500 futures contract, you are a party to a very simple derivatives transaction, with your gain or loss derived from movements in the index. Derivatives contracts are of varying duration, running sometimes to 20 or more years, and their value is often tied to several variables.

Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them.

But before a contract is settled, the counter-parties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated. That’s because today’s earnings are in a significant way based on estimates whose inaccuracy may not be exposed for many years.

The errors usually reflect the human tendency to take an optimistic view of one’s commitments. But the parties to derivatives also have enormous incentives to cheat in accounting for them. Those who trade derivatives are usually paid, in whole or part, on “earnings” calculated by mark-to-market accounting. But often there is no real market, and “mark-to-model” is utilized. This substitution can bring on large-scale mischief.

As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years.

In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham.

Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties. Imagine then that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company.

The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

In banking, the recognition of a “linkage” problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. (Such as in the case of AIG for example - Jesse) In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain.

Many people argue that derivatives reduce systemic problems, in that participants who can’t bear certain risks are able to transfer them to stronger hands. These people believe that derivatives act to stabilize the economy, facilitate trade, and eliminate bumps for individual participants.  (This is the Greenspan argument for example, but he and others went further in fighting any sort of regulation in this area. - Jesse)

On a micro level, what they say is often true. I believe, however, that the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others.

On top of that, these dealers are owed huge amounts by non-dealer counter-parties. Some of these counter-parties, are linked in ways that could cause them to run into a problem because of a single event, such as the implosion of the telecom industry. Linkage, when it suddenly surfaces, can trigger serious systemic problems.

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so  far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

As an endnote, it appears that the money in derivatives was too good for even Mr. Warren Buffett to pass up. Berkshire Profit Falls 30% On Insurance, Derivatives.

Netting

Here is a fairly simple financial industry explanation of 'netting.'

"Rather than execute a disastrously complicated web of transactions, swap dealers, and ordinary banks, use clearing houses to do exactly what we just did above, but on a gigantic scale. Obviously, this is done by an algorithm, and not by hand. Banks, and swap dealers, prefer to strip down the number of transactions so that they only part with their cash when absolutely necessary. There are all kinds of things that can go wrong while your money spins around the globe, and banks and swap dealers would prefer, quite reasonably, to minimize those risks.  (Presumably by assuming them away, as in the case of Black-Scholes. Except the assumptions made in netting as compared to the risk handwave in Black-Scholes seem like planet killer class ordnance compared to conventional bunker busters. - Jesse)

An Engine Of Misunderstanding

As you can see from the transactions above, the total amount of outstanding debts is completely meaningless. That complex web of relationships between A, B, and C, reduced to 1 transaction worth $1. Yet, the media would have certainly reported a cataclysmic 2 + 3 + 4 + 5 + 2 + 6 = $22 in total debts.  (But borrowing from Sinclair's description, if a major counterparty in this daisy chain fails, the notional netting can become 'cataclysmic,' and enormous losses can be realized, especially if there are linkages to the commercial credit and banking systems. And this is where 'mark-to-myth' and bailouts come in. - Jesse)

Charles Davi, Netting Demystified

Here is a visual representation of what a Lehman size failure would look like in today's financial markets.