Thread: REFCO

I apologize in advance for such a long post absent a corresponding link. I don't like it when others do it and I generally don't read them. I receive these email letters daily from the Daily Reckoning and generally give the letters authored by Gary North a closer read. North can be a little wordy and rambly at times but more often than not I glean a few valuable pearls of wisdom after much sifting. The article below takes much less sifting. The article is about derivative risk. Every time I think about REFCO, I think about derivative risk. This article lays out pretty concisely, at least by North's standards, what derivatives are, the personality of the players, and the potential impact. I found it useful...and hope you do also. -- Wimpy
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Gary North's REALITY CHECK
question@kbot.com


Issue 552 May 23, 2006

BERNANKE'S BET ON DERIVATIVES

New data on the size of the derivatives market have
been released. There was a Reuters story last week that
summarized this information. The story received no
attention. It began with a paragraph almost guaranteed to
avoid attracting attention.

The global derivatives market continued to grow
in the second half of 2005, though at a slower
pace as the market matured, the Bank for
International Settlements said on Friday.

This did not sound like anything important. Surely,
it was not the stuff of front-page and network news
stories. But the second paragraph caught my attention.

National amounts of all types of over-the-counter
contracts excluding credit derivatives stood at
$285 trillion at the end of 2005, 5 percent
higher than six months previously. Gross market
values, or the cost of replacing all contracts,
fell 12 percent to $9 trillion.

Let that number sink in: $285 trillion. That is over
a quarter of a quadrillion dollars. Whenever the word
"quadrillion" is applied to dollars, I think the market in
question is worth considering.

This figure does not count credit derivatives. Also,
because the derivatives market is international, no agency
supervises it. No agency mandates that statistics of these
contracts be reported under penalty of law. The Bank for
International Settlements (BIS) reports the statistics it
gathers, but it is not a government agency. It is the
central banks' agreed-upon clearing house.

So, the derivatives market is much larger than $285
trillion. We just don't know how much larger.

Interest rate products saw 5 percent growth in
the second half, slower than in previous years
and bringing the total outstanding to $215
trillion. Growth was faster in the over-the-
counter market than on exchanges, the BIS said.

http://snipurl.com/qqfy

The known market is so huge that for all of the
participants to close out their positions and then rewrite
them, the commissions would be $9 trillion.

That probably doesn't count lawyers' fees.

How much is $9 trillion? It is the entire product of
the private sector of the United States for a year: the
estimated $12.9 trillion GDP, minus the U.S. government's
$2.6 trillion, minus state and local spending/taxing.

Note: The official overview of the Bush
Administration's spending nowhere mentions the
total spending figure. It offers only
percentages. It provides a chart of happy-face
assumptions about the reduction of the budget's
percentage of GDP that will take place between
now and 2009. It does provide specific figures
for popular programs, such as delightfully named
"Health and Compassion."

http://snipurl.com/qssr


WHAT ARE DERIVATIVES?

Over the last two decades, the derivatives market has
come to overshadow all other investment markets, yet few
investors and few business owners use them or even know
what they are.

Derivatives are a form of futures. People speculate
on the move of interest rates and the effects that these
moves will have on specific prices. To play in this
market, you must have a lot of money to lose. Because
margins are low, meaning leverage is high, unexpected moves
in a specific market can produce huge profits for investors
on one side of the contract. These gains are matched by
losses on the other side.

There can be a domino effect, as losses spread for one
derivative instrument to another. These instruments are
specifically designed to transfer specified risks to
parties that are willing to bear such risks in search of a
profit.

Yet these markets allocate more than risk. They
allocate uncertainty. Risk is what insurance contracts
deal with: calculated losses. The law of large numbers
applies to certain categories of events, such as life
expectancy and fire. Uncertainty applies to types of
events for which no widely known statistical formula
applies.

An entrepreneur may believe that he possesses such a
formula, which converts uncertainty to risk. He then
enters the derivatives market and takes a position in the
belief that his formula can beat the market. This is what
bankrupted Long Term Capital Management in 1998. Their
formula, which had been developed by a pair of Nobel Prize-
winning economists, turned out to be the economic
equivalent of a race track tout's easy money system. When
that pony failed to win, place, or show, large
multinational banks had to pony up an additional $3 billion
in loans to keep the $4.6 billion company from defaulting,
which would have threatened the futures markets and the
bank payments system.

On October 1, 1998, Alan Greenspan sat before the
House Banking Committee and defended the decision of the
head of the New York Federal Reserve Bank to call the
bankers into an emergency meeting to suggest that they
cough up more loan money. In his speech, he rejected the
word "pressure." New York FED officials merely
"facilitated discussions."

It was in this speech that Greenspan referred to the
possibility of a worldwide financial domino effect, which
he called "cascading cross defaults."

In that environment, it was the FRBNY's judgment
that it was to the advantage of all parties --
including the creditors and other market
participants -- to engender if at all possible an
orderly resolution rather than let the firm go
into disorderly fire-sale liquidation following a
set of cascading cross defaults.

http://snipurl.com/cascading

For some reason, this speech, which I regard as the
most important public speech that Greenspan delivered in
his 18 years as Chairman, has disappeared from the list of
speeches by Board members on the FED's site. You cannot
find it, even if you know the year he gave it. The
speeches are listed chronologically by each FED Board
member. There is no speech listed for October 1, 1998. It
used to be there, but no longer.

http://snipurl.com/fedspeeches1998

Google can locate it if you search for "Alan Greenspan" and
"Long Term Capital Management."



Continued....

MORAL HAZARD

The phrase "moral hazard" refers to a condition of the
not quite free market that arises when investors believe
that the government or its licensed central bank will
intervene in a specific market to keep it from harming the
interests of investors. The belief that the government
will intervene leads investors to ignore market risks.
They believe that the government will bear the worst of
these risks. This leads to a higher level of prices in
this market, or a larger number of participants who put
more of their money at risk than is warranted by the safety
of the market.

Greenspan usually was content to say that moral hazard
is a bad thing. He did so in his 1998 speech -- briefly.

Of course, any time that there is public
involvement that softens the blow of
private-sector losses -- even as obliquely as in
this episode -- the issue of moral hazard arises.
Any action by the government that prevents some
of the negative consequences to the private
sector of the mistakes it makes raises the
threshold of risks market participants will
presumably subsequently choose to take. Over
time, economic efficiency will be impaired as
some uneconomic investments are undertaken under
the implicit assumption that possible losses may
be borne by the government.

But then he invoked moral hazard to justify the
Federal Reserve System's interference in the LTCM crisis.
This crisis was larger than LTCM. It called into question
the solvency of an entire market. Here, the price system
must not be allowed to operate.

But is much moral hazard created by aborting fire
sales? To be sure, investors wiped out in a fire
sale will clearly be less risk prone than if
their mistakes were unwound in a more orderly
fashion. But is the broader market well served if
the resulting fear and other irrational judgments
govern the degree of risk participants are
subsequently willing to incur? Risk taking is a
necessary condition for wealth creation. The
optimum degree of risk aversion should be
governed by rational judgments about the market
place, not the fear flowing from fire sales.

What is a "fire sale"? He did not say. Apparently,
it is any sale in which losses will spread to a large
segment of the capital markets. But the question remains:
Who is competent to judge when a fire sale has begun?
Greenspan elsewhere insisted that no one knows when there
is a bubble market. How can central bank officials know
when a sale is a fire sale?

In other words, he was arguing that the free market is
just not good enough. What is needed is intervention by
wise men who have access to fiat money.

He argued that moral hazard does not apply when the
goal of the intervening agency's officials is to keep fear
from spreading inside a highly leveraged, low-margin
market, which the futures market surely is.

The Federal Reserve provided its good offices to
LTCM's creditors, not to protect LTCM's
investors, creditors, or managers from loss, but
to avoid the distortions to market processes
caused by a fire-sale liquidation and the
consequent spreading of those distortions through
contagion. To be sure, this may well work to
reduce the ultimate losses to the original owners
of LTCM, but that was a byproduct, perhaps
unfortunate, of the process.

Six months later, Greenspan told that same House
committee that bank account deposit insurance, i.e., the
FDIC, is an example of moral hazard at work. First, he
explained the nature of moral hazard.

The benefits of deposit insurance, as significant
as they are, have not come without a cost. The
very process that has ended deposit runs has made
insured depositors largely indifferent to the
risks taken by their depository institutions,
just as it did with depositors in the 1980s with
regard to insolvent, risky thrift institutions.
The result has been a weakening of the market
discipline that insured depositors would
otherwise have imposed on institutions. Relieved
of that discipline, depositories naturally feel
less cautious about taking on more risk than they
would otherwise assume. No other type of private
financial institution is able to attract funds
from the public without regard to the risks it
takes with its creditors' resources. This
incentive to take excessive risks at the expense
of the insurer, and potentially the taxpayer, is
the so-called moral hazard problem of deposit
insurance.

Second, he raised the question of that most feared of
all economic conditions, systemic risk.

Thus, two offsetting implications of deposit
insurance must be kept in mind. On the one hand,
it is clear that deposit insurance has
contributed to the prevention of bank runs that
could have destabilized the financial structure
in the short run. On the other, even the current
levels of deposit insurance may have already
increased risk-taking at insured depository
institutions to such an extent that future
systemic risks have arguably risen.

Third, he justified the need for government regulation
of a government-protected market, since the protection --
or perception of protection -- undermines the free market's
phenomenon of self-policing.

Indeed, the reduced market discipline and
increased moral hazard at depositories have
intensified the need for government supervision
to protect the interests of taxpayers and, in
essence, substitute for the reduced market
discipline. Deposit insurance and other
components of the safety net also enable banks
and thrift institutions to attract more
resources, at lower costs, than would otherwise
be the case. In short, insured institutions
receive a subsidy in the form of a government
guarantee that allows them both to attract
deposits at lower interest rates than would be
necessary without deposit insurance and to take
more risk without the fear of losing their
deposit funding. Put another way, deposit
insurance misallocates resources by breaking the
link between risks and rewards for a select set
of market competitors.

http://snipurl.com/depositinsurance

The problem with this argument in the capital markets
today is that there is no government agency that regulates
the derivative markets. If that is what is needed to
overcome moreal hazard -- I mean other than removing the
cause, government intervention in the first place -- then
what protects the world from systemic risk of a bank
payments gridlock?

continued...

FAITH IN CENTRAL BANK INFLATION

Modern capital markets rest on the assumption that
central bank's monetary policies should, can, and will
protect investors from a systemic breakdown.

The modern division of labor has come into existence
because investors have faith in two factors: (1) the free
market's ability to allocate risk and uncertainty in an
efficient manner; and (2) central banks' ability to insure
against the breakdown of the fractional reserve banking
system. In other words, investors believe that systemic
risk can be mitigated by central banks. Or, more to the
point, investors believe that the inherent risk of
fractional reserve banking can be overcome by the concerted
intervention into the capital markets by central banks.

Greenspan in 1998 warned Congress about cascading
cross defaults. Cascading cross defaults impose the threat
of gridlock on the bank payments system -- the ultimate
fire sale.

Investors today believe that Milton Friedman was
correct in his 1963 book, "A Monetary History of the United
States." They believe that the Federal Reserve System
could have intervened to save the American banking system
from a wave of bankruptcies in 1929-32.

It is not just investors who believe this. Most
economists also believe it. Most important, Ben Bernanke
believes it. He said so in his 2002 speech congratulating
Friedman on his 90th birthday. I have never seen any more
laudatory review of Friedman's book. He wrote that "the
direct and indirect influences of the Monetary History on
contemporary monetary economics would be difficult to
overstate." He was quite correct in this assessment.

Today I'd like to honor Milton Friedman by
talking about one of his greatest contributions
to economics, made in close collaboration with
his distinguished coauthor, Anna J. Schwartz.
This achievement is nothing less than to provide
what has become the leading and most persuasive
explanation of the worst economic disaster in
American history, the onset of the Great
Depression--or, as Friedman and Schwartz dubbed
it, the Great Contraction of 1929-33.

Bernanke identified the book's major discovery: "the
Great Depression can reasonably be described as having been
caused by monetary forces."

Rothbard made the same argument in "America's Great
Depression," also published in 1963. But his book was
ignored by the academic world for the opposite reason that
Friedman's was accepted: He showed that the FED's policies
in the 1920s had caused the boom, which produced the bust
when the FED ceased inflating. Friedman's book was a call
for further FED inflation. Rothbard's was a call for no
more inflation. It is available free of charge here:

http://mises.org/rothbard/agd.pdf

The cause of the depression, as Bernanke described
Friedman's conclusion, was the gold standard.

Friedman and Schwartz's insight was that, if
monetary contraction was in fact the source of
economic depression, then countries tightly
constrained by the gold standard to follow the
United States into deflation should have suffered
relatively more severe economic downturns.
Although not conducting a formal statistical
analysis, Friedman and Schwartz gave a number of
salient examples to show that the more tightly
constrained a country was by the gold standard
(and, by default, the more closely bound to
follow U.S. monetary policies), the more severe
were both its monetary contraction and its
declines in prices and output. One can read their
discussion as dividing countries into four
categories.

The tragedy, according to Friedman, was that Benjamin
Strong, the head of the New York FED, died in 1928. Strong
could have staved off the great contraction. Bernanke
believes this: "Friedman and Schwartz argued in their book
that if Strong had lived, many of the mistakes of the Great
Depression would have been avoided." Rothbard's book shows
that it was Strong, in association with his close friend,
Montagu Norman, the head of the Bank of England, whose
policies created the boom.

Then Bernanke told us in 2002 what he and the world's
central bankers have learned from Friedman.

For practical central bankers, among which I now
count myself, Friedman and Schwartz's analysis
leaves many lessons. What I take from their work
is the idea that monetary forces, particularly if
unleashed in a destabilizing direction, can be
extremely powerful. The best thing that central
bankers can do for the world is to avoid such
crises by providing the economy with, in Milton
Friedman's words, a "stable monetary
background"--for example as reflected in low and
stable inflation.

Let me end my talk by abusing slightly my status
as an official representative of the Federal
Reserve. I would like to say to Milton and Anna:
Regarding the Great Depression. You're right, we
did it. We're very sorry. But thanks to you, we
won't do it again.

http://snipurl.com/benmilton

The reigning assumption in this speech is obvious:
Central banks can offset systemic risks in a market,
thereby transforming them into nonsystemic risks. Money
creation is the ultimate risk-reducing tool.


WARREN BUFFETT'S WARNING

In the 2002 Annual Report of Berkshire Hathaway,
Warren Buffett's famous firm, he issued a warning on
derivatives. He said they are like hell: easy to get into,
but difficult to get out. He warned of systemic failure.

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. In these industries,
firms that are fundamentally solid can become
troubled simply because of the travails of other
firms further down the chain.

Buffett might ask today: "Given the size of the
derivatives market -- over $285 trillion -- what world
central bank could deal with cascading cross defaults?"

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. And, on a micro level,
what they say is often true. Indeed, at
Berkshire, I sometimes engage in large-scale
derivatives transactions in order to facilitate
certain investment strategies.

[Close associate] Charlie [Munger] and 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
counterparties. Some of these counterparties, as
I've mentioned, are linked in ways that could
cause them to contemporaneously run into a
problem because of a single event (such as the
implosion of the telecom industry or the
precipitous decline in the value of merchant
power projects). Linkage, when it suddenly
surfaces, can trigger serious systemic problems.

http://snipurl.com/buffett2002

The derivatives market is much larger today than it
was in 2002.

CONCLUSION

The problem today is simple to state but difficult to
solve: The derivatives market is huge. It is far beyond
the ability of any or all central banks to solve, once
cascading cross defaults spread to the international bank
payment system. The modern division of labor, which keeps
billions of people alive, has a sword of Damocles above it:
the threat of fractional reserve banking's gridlock in a
wave of defaults. This is the ultimate fire sale.

The combination of moral hazard, fractional reserve
banking, faith in central banking, and speculators' desire
to make a bundle of money from highly leveraged futures
contracts has created a time bomb condition.

Bernanke, following Milton Friedman, thinks that a
government-licensed monopoly, the Federal Reserve System,
can overcome cascading cross defaults. He has bet your
life on this.

I hope he wins the bet. But I always keep assets on
the other side of the table.

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last week:
rumors flew about another refco imploding...so far no substantile evidence of such an occurance. it's the jpm's that scare the hell outta me with the derivatives off book.

here is so more "tilted" news...LOL

http://www.informationclearinghouse....ticle13141.htm

Great read!

The only way the U.S. can protect the dollar's rapidly declining popularity is with a rapid increase in interest rates or by threatening to nuke every country desiring to dump dollars. This has had a marginal degree of success with small third world countries, but it will be interesting to see if the tactic works with the bigger countries that have a little more capacity to shove back (nuclear capable).