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Government action saved us from the recession, right? Not so fast

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Understanding Derivatives-"A Primer"  - Author Unknown
  

Heidi is the proprietor of a bar in Detroit ..

 She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar.

 To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

 Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers' loans).

 Word gets around about Heidi's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit .
 
 By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages.

 Consequently, Heidi's gross sales volume increases massively.
 
 A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit.

 He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral!!!

 At the bank's corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS.

 These "securities" then are bundled and traded on international securities markets.

 Naive investors don't really understand that the securities being sold to them as "AAA Secured Bonds" really are debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb!!!, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.
 
 One day, even though the bond prices still are climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi.
 
 Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts.

 Since Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and Heidi's 11 employees lose their jobs.

 Overnight, DRINKBOND prices drop by 90%.

 The collapsed bond asset value destroys the bank's liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

 The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the BOND securities.

 They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds.

 Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

 Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multibillion dollar no-strings attached cash infusion from the government.

 The funds required for this bailout are obtained by new taxes levied on employed, middle-class, nondrinkers who have never been in Heidi's bar.
 
 Now do you understand?

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It's because of the insane level of derivatives being trading throughout the global financial markets - about $700 trillion.  There's not much new here for me to comment other than I still view derivatives as THE biggest threat to owning dollar-based assets in long term positions.   

However, if this is a new topic for you, the below piece from 60 Minutes does a nice job of explaining what derivatives are and how they work, in common sense language:   

 

 

 

Even if the derivative house of cards does not collapse any more than it already has, I am no less long term bearish on the dollar and other currency-based investments.  Eventually the American greenback will return to its slide in buying power and investors that own hedge positions will be thankful.

My favorite method to hedge against a devaluing currency is with gold - both through direct ownership in gold bullion and by owning shares of a gold-mining mutual fund.  So if you have concerns over the Fed's devaluation of our currency then this is where you should be. 

To put the Fed's actions in perspective, consider this:  Eight years ago there were just over $5 trillion circulating through the system.  At last check this number had risen to nearly $9 trillion - almost a double in the quantity of paper money.  That action, historically, spells inflation. 

Recently I returned from Europe to see firsthand how our friends across the pond were being impacted by this economic environment.  Not surprisingly, things seem very similar to life in the States.  The shopping centers were busy, the restaurants were full, and the only negatives I witnessed were in regard to the financial industry and media's drumbeat of doom and gloom. 

Purchasing power parity tells me that the dollar is currently undervalued compared to the euro and the fact the stock market is rising in the face of negative economic data tells me there is a very good chance that we saw the market bottom back in November. 

Of course there are no guarantees but what I do know is that the economic news will continue to worsen but the upside to ownership investments look a whole lot more promising than the downside.

As of now, it looks like by mid-2009 we will be facing a rapidly improving economy and that's why the stock market has been rising in the face of all the current bad news. 

    

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Be sure to tune in to our radio show each week for more discussion. 

Have thoughts or questions?  Leave them in the comment field below.

Related Articles:

• Stock Market Volatility & Investor Expectations
• Gut Check Time and the Transfer of Wealth
• Lessons from an Innovator in Global Investing, Sir John Templeton
• The Story On Derivatives

  

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Aron Huddleston talks with WOWT in Omaha about what investors should be focusing on in today's market environment:

 Video used with permission of WOWT

Update:  The transcript to Roland's video can be viewed by clicking the link below.

(more...)

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A question I often get is, "What, in your opinion, is the biggest threat to the global financial markets?"

The mainstream media never touches on this but I believe that financial derivatives are the biggest threat.  These highly speculative instruments, most often used by big money center banks, are what I think would most likely trigger the collapse of the world's debt structure.

Here's the story.

Financial derivatives are simply man-made bets consisting of two parties.  Party A enters the bet in hopes of earning massive profits but in order to create the derivative, they need a counter party to wager against them.  This is where Party B comes in.  They enter the bet looking to hedge against some form of risk.

Say you are a financial derivatives trader.  You can speculate (or hedge against) the movement of interest rates, commodity prices, exchange rates, or just about anything else you wish to gamble on.

Those who participate in this global casino are required to place only a fraction of their bet down thus enabling derivative traders to control an enormous amount of assets using a tiny amount of money.  This is where the danger comes in.

While traders can make big bucks being on the right side of the bet, there is also the risk of crushing losses.

This is what happened recently when a rogue trader for the second-largest bank in France made a bad bet totaling over $7 billion in losses, the largest in banking history. 

But despite instances like these, the monstrous growth of financial derivatives continues.

Over 20 years ago, with derivatives trading around $1 trillion on a daily basis, I upped the gold hedge position in our portfolios to offer additional safety.  That decision protected us during the huge stock market crash of 1987 brought on by derivatives.

Today, on the same daily basis, derivatives are trading at $500 trillion.  To put that number in perspective, the U.S. has an annual GDP of $14 trillion.  That means a 3 percent decline in the derivatives market would be greater than the total annual economic output of the world's richest nation.  Scary stuff.

If the derivative dike ever breaks, a panic would sweep the financial world.  Bonds, money market accounts, bank CDs, cash, and all other dollar-based assets would plummet in value instantaneously.

History tells you that in these cases gold, common stock, and other tangible assets not linked to paper money become a source of value for investors.  Derivatives alone are reason enough to keep a small portion of your wealth in gold-related assets. 

For the remainder of your serious money, globally and geopolitically diversify it across ownership positions for maximum safety.

How large the derivative mess will grow to before the bottom falls out is anyone's guess.

I predict we'll continue muddling through just as we always have but just in case this house of cards one day comes crashing down, I know my investments will be safe when the dust settles. 

That's what I call peace of mind - and real world financial safety.    

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Read related articles on financial safety that we've published.

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