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# Financial System is Broken

Author Message
Senior Manager
Joined: 30 Jul 2007
Posts: 385
Location: Europe
Schools: St. Gallen '09
Followers: 6

Kudos [?]: 59 [0], given: 5

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07 Feb 2008, 02:15
This is a missive from my mentor Jim Sinclair. I've been following him for many years, and although his commentary has always been off the mainstream, his authority on the subject of finance is quite high in my opinion. The OTC derivatives that he references comprise the bulk of derivatives that the BIS estimates:

"...positions in the OTC market have increased at a rapid pace since the last triennial survey was undertaken in 2004. Notional amounts outstanding of such instruments totalled $516 trillion at the end of June 2007, 135% higher than the level recorded in the 2004 survey. This corresponds to an annualised compound rate of growth of 33%, which is higher than the approximately 25% average annual rate of increase since the current format of the survey was established in 1998." (http://www.bis.org/press/p071210.htm) What follows is no different than what Warren Buffett was proclaiming way back in 2003, that "derivatives are financial weapons of mass destruction." (http://news.bbc.co.uk/2/hi/business/2817995.stm) http://www.jsmineset.com/ARhome.asp?VAf ... _ARID=5795 The System Is Broken Author: Jim Sinclair Dear Comrades in Golden Arms (CIGAs), There is no question about this fact regardless of the camouflage spin. The system has been derailed by the popular and profitable OTC derivatives that are now melting down, taking institutions and people along with it. Let me explain to you why there is so much fear and distrust between financial institutions, then you will see why the one time hand out of money and interest rates dropping to zero have no hope of doing much more than giving one month of some improved statistics and a decade of hyper-inflation. Lets assume you have entered into an OTC derivative whereby you own (long) the Dow Jones index at 10,000. You are still in the position. Today’s action is your last straw. You decide to take your$1 billion profit.

There is no OTC derivative clearinghouse. You do not get paid every day as a winner, nor do you pay out every night when losing. No one in an OTC derivative has a margin maintenance requirements. You just hold a special performance contract upon which the financial integrity depends on the loser in the arrangement.

Lets assume you have an OTC derivative that results in owning the profit between the Dow index at 10,000 and tonight's closing of that index. Tomorrow you inform the party obligated to deliver you the Dow index at 10,000 that you wish to close the obligation. You would anticipate the other side would simply buy you out of the obligation, having hedged their obligation somewhere else.

The problem arises when the party to the arrangement required to perform simply cannot because of outrageous markdowns and the flight of capital. They have quite simply lost the ability to make good on these many obligations.

So there you are with a one billion dollar profit, marked to model, taken into your earnings statement that does no exists.

As a result both you and your counter-party have problems financially with the need to restate your financials.

I have simplified this so that it is understandable.

As a result of this problem with derivatives triggered by the meltdown of real-estate structured products, no financial institutions trust any other or their paper.

The OTC derivative merchants have turned out to be the merchants of financial death, hidden carefully from the eyes of the public.

Now everyone holding a derivative contract either with a profit or loss fears for its consequences. The loser fears the bankruptcy judge. The winner fears his winnings are phantom gains never to be realized. Every financial entity fears every other financial entity to the tune now of a notional value of over $500 trillion. I recently did an article that demonstrated when a derivative fails, notional value becomes total value. That means the potential problem is over$500 trillion.

No reduction of interest rates, even to zero, can make those that distrust each other believers again.

No one-time gift of money to the hypnotic public will make those that distrust each other believers again.

The CDO market no longer exists. The commercial paper marker is in shambles.

The credit markets are trembling over the needful reduction in the rating of the entities that have guaranteed trillions of dollars of debt in many forms. These entities granted OTC derivatives named default derivatives that are soon to be publicly worthless.

Today it was announced rating companies are considering their methods of rating to distinguish firms that granted derivative products. That might fool the public, but not the skeptical international banking firms. Therefore this game will not make those that distrust each other believers again.

The problem has no practical solution. The methods to make the hypnotic public think the problem is now solved or will be soon will solve nothing and will, without regard for the level of business activity, bring hyper-inflation.

I have told you for months that “This is it” and it certainly is.

Gold will go to \$1650 and the US dollar to .5200.
CEO
Joined: 17 May 2007
Posts: 2959
Followers: 60

Kudos [?]: 601 [0], given: 210

Re: Financial System is Broken [#permalink]

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09 Feb 2008, 06:37
This is useful stuff trader1, and I can't agree more. I like the way he's simplified it. Could you perhaps pm some more of his stuff or his regular blog / commentary page to me ?

ps. just out of curiosity which OTC derivatives does he talk about ? Presumably the Mortgage backed ones which cased the subprime crisis right ?
Senior Manager
Joined: 30 Jul 2007
Posts: 385
Location: Europe
Schools: St. Gallen '09
Followers: 6

Kudos [?]: 59 [0], given: 5

Re: Financial System is Broken [#permalink]

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10 Feb 2008, 05:26
bsd_lover wrote:
This is useful stuff trader1, and I can't agree more. I like the way he's simplified it. Could you perhaps pm some more of his stuff or his regular blog / commentary page to me ?

ps. just out of curiosity which OTC derivatives does he talk about ? Presumably the Mortgage backed ones which cased the subprime crisis right ?

the OTC derivatives can be based on anything two parties could both agree to. since this market has absolutely no regulation or transparency, anything goes. and therein lies a big source of the problem.

i don't have any other special posts of his other than what can be found by some manual searching of his blog at http://www.jsmineset.com

if you click on "Past Editorials", that will pull up a lot of his old stuff.

here's another one of his classic posts:

http://www.jsmineset.com/home.asp?RQ=ED ... inkid=3806

Jim’s Formula:
September 1, 2006

1. First interest rates rise affecting the drivers of the US economy, housing, but before that auto production goes from bull to a bear markets.
2. This impacts many other industries and the jobs report. An economy is either rising at a rising rate or business activity is falling at an increasing rate. That is economic law 101. There is no such thing in any market as a Plateau of Prosperity or Cinderella - Goldilocks situations.
3. We have witnessed the Dow rise on economic news indicating deceleration of activity. This continues until major corporations announced poor earnings, making the Dow fall faster than it rose, moving it deeply into the red.
4. The formula economically is inherent in #2 which is lower economic activity equals lower profits.
5. Lower profits leads to lower Federal Tax revenues.
6. Lower Federal tax revenues in the face of increased Federal spending causes geometric, not arithmetic, rises in the US Federal Budget deficit. This is also true for cities & States as it is for the Federal government.
7. The increased US Federal Budget deficit in the face of a US Trade Deficit increases the US Current Account Deficit.
8. The US Current Account Balance is the speedometer of the money exiting the US into world markets (deficit).
9. It is this deficit that must be met by incoming investment in the US in any form. It could be anything from businesses, equities to Treasury instruments. We are already seeing a fall off in the situation of developing nations carrying the spending habits of industrial nations; a contradiction in terms.
10. If the investment by non US entities fails to meet the exiting dollars by all means, then the US must turn within to finance the shortfall.
11. Assuming the US turns inside to finance all maturities, interest rates will rise with the long term rates moving fastest regardless of prevailing business conditions.
12. This will further contract business activity and start a downward spiral of unparalleled dimension because the size of US debt already issued is of unparalleled dimension.

Therefore as you get to #12 you are automatically right back at #1. This is an economic downward spiral.

I heard all this "slow business" as negative to gold talk in the 70s. It was totally wrong then. It will be exactly the same now.
Senior Manager
Joined: 30 Jul 2007
Posts: 385
Location: Europe
Schools: St. Gallen '09
Followers: 6

Kudos [?]: 59 [0], given: 5

Re: Financial System is Broken [#permalink]

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11 Feb 2008, 02:42
Recently, my mentor Sinclair was called to weigh in on an article in the New Yorker magazine:

http://www.newyorker.com/talk/2008/02/1 ... paumgarten

How ’Bout Them Economy
by Nick Paumgarten February 11, 2008

Nobody knows anything, although some know-nothings know more than others. The economy is a stalwart, a shambles, or some combination of the two. The pronouncements and analogies fly: we’ve reached the end of a sixty-year cycle, or a twenty-five-year cycle, or a six-year cycle, or the end of nothing. It’s 1929, 1969, 1981, 1990, 1997, or 2001 all over again. The closer you are to the markets, the gloomier you are, although the less likely you may be to suffer the consequences, and the more likely you are to act as though nothing were wrong: first rule of recession is you do not talk about recession. That is, unless you are in Davos, or heavily invested in gold. The preferred terms are “softening,” “crunch,” “correction,” and, best of all, “interesting,” as in “This is an interesting time”—a grudging corollary to the popular and meaningless Wall Streeter declaration “It is what it is.” Yes, and the faster we go the rounder we get.

The debate over whether we’re in (or slipping into) a recession is not purely semantic—a recession, capital “R,” is a term of art—but it recalls the argument over whether the Sunni insurgency in Iraq was actually an insurgency or merely stuff happening. Whatever you call it—“rough patch,” “adjustment process,” “perfect storm”—it’s here. Stuff is happening.

What’s most befuddling is the question of the worthless paper. By worthless paper, the experts don’t mean the one that people no longer read in the morning. They mean the I.O.U.s that stand no chance of being paid—the debt held by the person or institution who or which was foolish enough to buy it from the next-most-foolish person or institution, who or which may in fact have been not so much foolish as conniving (the F.B.I. is on the case). In recent years, the financial industry has concocted an arcane array of structured investment vehicles, in which the debts of individuals are bundled together by banks, stripped into pieces, and sold to investors. Many of these individual debts will not be repaid, and yet, once they’d been bundled and stripped, they were magically reconstituted as investment-grade debt products—worthy paper. Now the alchemy is coming undone; unpaid debts are revealing themselves to be unpayable. The extent of the damage will determine whether 2008 is 2001 or 1929, or something in between.

Although anyone making the case for looking on the bright side or the dark has to be suspected of talking his position, each argument is seductive, in its way. A call the other day to James Sinclair, a well-known gold bug, suggested that by decade’s end we’ll all be living in caves, or, at least, be carting our worthless paper around in wheelbarrows. “The geeks have killed us all,” he said, referring to the math whizzes who devised all the fancy, inscrutable derivatives. “There are more than five hundred trillion dollars’ worth of these things floating around in cyberspace. There’s no money in them.” As for the dollar, he said, citing the Weimar Republic, “How long can you monetize bankruptcy?”

A few minutes later, it was Arthur Gray on the line, from the Virgin Islands. Gray, who is eighty-five and a money manager at a firm called Carret, has been in the game since 1945. Age and experience incline him to the long view. “As Herman Kahn pointed out, two hundred years ago almost everyone was poor,” he said. “Today, somebody on welfare in our country lives better than a maharaja did two hundred years ago. The maharaja had two hundred slaves fanning him; today, you push a button and have air-conditioning. So, as Kahn said, two hundred years from now everybody will be affluent. I think it’s a wonderful world. I can’t call this thing more than a hiccup.” Hold your breath.
Re: Financial System is Broken   [#permalink] 11 Feb 2008, 02:42
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