"Derivatives Time-Bomb Update: Regulators Match 80% of Credit-Derivatives in Late 2006
Today's comment is by Eric Roseman, The Sovereign Society's Investment Director and editor of Commodity Trend Alert.
Dear A-Letter Reader:
One of the greatest mysteries on Wall Street isn't about market timing or which investment strategy will lead to the next big stock market rally. Rather, the greatest challenge facing America's largest investment banks is how to control the credit-derivatives market, now home to a massive $26 trillion (with a "T") dollars - which more than doubled in size over the last 12 months.
I've written and warned about credit derivatives many times over the last several months and I remain committed to keeping you informed of the massive risks inherent to the global financial system. The pace of derivatives growth, a market often viewed with deep suspicion because of its complexity and lack of transparency, has raised concerns that investors may not understand the inherent risks associated with these products.
It's truly amazing that many of the banks and hedge funds which use derivatives don't always understand these securities. (Imagine - the brokers not understanding the investments they trade!) Sometimes, these trades are placed without identifying the other counterparty to the trade (i.e. the person they're trading with). Credit default swaps trade away from exchanges in the over-the-counter market, and tend to be negotiated privately and over the phone between traders. That's what makes them very risky because nobody is policing these trades, which start at $5 million dollars.
The credit protection industry has mushroomed over the last few years. Credit default swaps offer protection against the possibility of default by a debt issuer. By using these swaps, traders, including hedge funds, can offset potential losses from risky fixed-income positions. In many ways, credit derivatives almost encourage traders to assume greater risk, and the amazing outcome of this pseudo-bond market protection is the outstanding number of unmatched trades still unsettled by Wall Street's largest banks.
Over 12 months ago, fourteen high profile Wall Street investment banks, including a former Federal Reserve regional board member, gathered in New York to tackle the growing monster of unmatched credit-derivative trades. Indeed, progress has been made in just over a year as 80% of all unmatched trades have now been identified. That's the good news.
But just in case this whole mess blows-up in our faces, I would seriously recommend holding chaos investment insurance - gold bullion. Let's not forget that over 20% of all credit derivatives trades have yet to be matched. That's a formidable $5.3 trillion dollars - approximately half the size of the American economy.
Wall Street might ultimately fix the derivatives time-bomb before it explodes. Lower long-term interest rates since July and a slowing housing market almost guarantee the Federal Reserve's next move will be to lower short-term rates early next year. Lower rates ease pressure on the financial system, especially one that is marked by huge amounts of leverage. This is the first credit-tightening cycle in over thirty years where more risk, not less, has been accumulated since June 2004 when the Fed began raising its benchmark lending rate. Higher rates squeeze global markets, including credit markets, which historically have collapsed under the weight of tighter credit conditions. Remember Orange County in 1994 and Long Term Capital Management in 1998?
With short-term interest rates heading lower next year, I think the worst of this credit cycle has already passed. But just in case, I've got gold and some cash reserves in my portfolio.
ERIC ROSEMAN, Investment Director
on behalf of The Sovereign Society "



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