I receive a lot of hate mail from
loyal Barrick shareholders accusing me of
"plunging my little dagger into Barrick's back
out of spite". I can assure readers that my time is more precious than
wasting it on petty revenge or indulging in Schadenfreude**. I am not
trying to make Barrick appear smaller than it is.
In fact, I am suggesting that Barrick is the modern
Atlas carrying the entire derivatives market, currently estimated at $300
trillion, on its shoulders. The global derivatives market and Barrick's 'hedging' program stand or fall together. In
particular when Altas shrugged, there would be an
earthquake measuring ten on the Richter-scale, and the derivatives market
would go down the drain causing unprecedented economic pain in the world
through the destruction of bond, stock, and real estate values.
It is amazing that the exploding derivatives
monster finds apologists in the "free market" camp. This monster
has been called "the most toxic element of the financial markets
today" (Howard Davies, Chairman, U.K. Financial Services Authority),
"a financial weapon of mass destruction carrying dangers that, while now
latent, are potentially lethal" (Warren Buffett). Yet if you read the
opinion of some people associated with the the
Ludwig von Mises Institute and the Lew Rockwell
website, then you get the impression that the $300 trillion derivatives
monster is benign, even ingenuous, if misunderstood and unfairly maligned.
Derivatives are good because they allow banks, industrial companies, and
private individuals to shift risk to speculators who are happy to shoulder
it. Risk people are ill-equipped to deal with is "traded away" so
that they "can focus on tackling tasks in areas in which they
specialize". A typical example is an import/export company using foreign
exchange derivatives to neutralize risks inherent in buying and selling
abroad due to the fluctuation of the exchange rate. Another example is
provided by people carrying a variable-rate mortgage, who are allowed to
switch to a fixed-rate mortgage when they expect a rise in interest rates.
The free market helps those who help themselves. This is what 'division of labor' is all about, the source of economic efficiency of
which Adam Smith spoke.
This apology is rather grotesque. It ignores
the fact that gyrating foreign exchange and interest rates are far from being
free market institutions. They were created by the government in order to
strangle the free market. These rates were stable under the gold standard. It
is one thing to shift risks created by nature to the shoulders of
speculators who are better able to deal with them, for example, in the case
of the futures markets for agricultures products. It is another thing if the
risks have been created by men (read: the government). In the former
case speculation has a legitimate role; in the latter, the word 'speculation'
is a misnomer. Dealing with risks created by man is not speculation. It is gambling.
Failure to make this distinction is to play into the hands of the enemies of
the free market. They suggest that speculation in foreign exchange and
interest rate futures has a 'stabilizing' effect on these rates, no less than
speculation in grain futures has on grain prices.
The message is that there is nothing to worry about. The regime of
irredeemable currency is here to stay and it will create its own institutions
to confront economic problems as they come along.
This message is false. Speculation in foreign
exchange and interest rates does not have a stabilizing effect.
As in the casino, more bets do not subdue the gambling spirit; rather, it
will heighten it. Moreover, not all derivatives have arisen out of 'risk
management'. An unknown but apparently very large part takes its origin in
the 'carry trade', the practice of creating something out of nothing (more
accurately described, clandestinely siphoning off value from the balance
sheet of the producing sector and transfer it to that of the financial
sector). It consists of borrowing at a low and investing the proceeds at a
high rate of interest. For example, consider the yen carry-trade involving
the sale of high-priced Japanese bonds and the purchase of cheap U.S. bonds
with the proceeds, thus swapping a 2 percent per annum outlay for a 5 percent
per annum income. Since it takes a long time for the interest rate spread
between the U.S. and Japan to close, pyramiding can be continued
indefinitely. It cannot be denied that the carry trade adds materially to the
$215 trillion 'notional' value of the Bond Derivatives Tower of Babel.
Government bonds today are not a legitimate
instrument of saving as gold bonds of yesteryear were. They are supposed to
have value because they are payable in FR notes at maturity. But what gives
value to the FR notes? Why, it is the fact that they are liabilities of the
issuing FR bank, backed by assets such as government bonds. Thus, then, there
is an official check-kiting between the US Treasury and the Federal Reserve.
The former issues bonds with which FR notes are backed; the latter issues
notes used to pay off the bonds at maturity. This is no free market. It is a
parody of the free market or worse. It is a charade designed to fool and
defraud people. In effect the government bond is irredeemable, no less than
the FR note.
If the bond appears to have value it is solely
because bond speculators are, for the time being, willing to bet that
producers will continue to accept it in exchange for real goods and services,
and that there will be a demand for the notes by taxpayers anxious to pay
their taxes. But don't take this willingness for granted. Bond speculators
are not running a charity to bail out profligate and bankrupt governments.
If, in their judgment, too many of those bonds are owned by foreigners who
are not subject to the taxing authority of the U.S. government, or the
producers of crude oil, for example, are increasingly reluctant to accept FR
credit in payment, then bond speculators will, without prior notice, withdraw
their bets -- with fatal consequences to the fortunes of Treasury
obligations. Note that the term "bond speculator" covers big-league
banks and hedge funds with bond positions running into trillions.
Whitewashing illegitimate derivatives using
free market rhetoric will not legitimize them. To sing a song of praise of
'financial innovations' designed to justify and perpetuate official
check-kiting is not fitting for a defender of the free market.
It was not until 1973 that the Chicago Board
of Trade opened its Options Exchange to trade options on financial futures
marking Big Bang, the beginning of the explosive growth of the derivatives
market. Notice the coincidence of Big Bang with the U.S. government's default
on its international gold obligations. Incidentally, the same year marked the
explosion of volatility in commodity prices as well.
The derivatives market grew from zero to $865
billion during the 15 years from 1972 to 1987. During the next 15 years, from
1987 to 2002, it grew to $100 trillion, or more than 100-fold. It
trebles on average every four years. The latest report of the Bank for
International Settlements states that the gross market value of amounts
outstanding in the over-the-counter derivatives markets at the end of
December, 2005, was $285 trillion, of which the largest component, the
interest-rate derivatives contracts was $215 trillion.
The amazing thing is that the total value of
bonds outstanding world-wide is estimated at only $45 trillion. How can you
write contracts to buy bonds, five times greater in amount than all the bonds
in existence? Does this not give the lie to the word 'derivatives', meaning
that these contracts 'derive' their value from the underlying assets? What
kind of 'musical chairs' game is this? When the music stops, what will happen
to those who are out of luck and hold the bag?
Defenders of the derivatives market insist
that its growth is quite benign. Malignancy is explained away by the need of
banks and other financial institutions, as well as industrial corporations,
to hedge their interest-rate risk-exposure. The word 'notional' was
introduced to cover up dangers involved in constructing this unprecedented
Tower of Babel. The word means 'fictional', or 'not having a real existence'.
The idea is that behind the growth of the derivatives markets there is an
increasing chain of swaps as companies are switching their debt-servicing
back-and-forth between fixed-rate and fluctuating-rate income streams. There
is nothing to worry about that, the defenders of this Ponzi-scheme say,
because of the 'telescope effect' operating on income-stream swaps. The
notional value of swaps may appear very large and seems to be growing very
fast. But all this is an optical illusion, they say, because swapped
payment-streams net out or cancel. No party to the contract demands that
non-existent bonds be delivered upon expiry.
One defender takes the example of a company
wishing to change its floating-rate loan into a fixed rate loan because it expects
that interest rates will rise. It could renegotiate the loan with lenders, or
it could retire the debt and reissue a new fixed-rate debt. However, these
are expensive maneuvers. It is cheaper to find a
counter-party who will take over the floating-rate payments for a
consideration, while the company will make fixed-rate payments to it. The two
swap. They do not swap the actual underlying bonds. They swap income-streams
represented by the semi-annual interest-payments.
Conversely, if interest rates are expected to
fall, then the company will want to change its fixed back into a
This argument ignores the problem of what
happens in a panic when interest rates take off and bond values start falling
like a rock. Then everybody wants to dump the obligation of making floating
payments, but there will be no counter-party to assume it. An additional
criticism is that the 'telescope effect' operates on the string of
payment-stream swaps only if made between the same two parties, which is
hardly ever the case. In general, the market value of the right to receive
the fixed payment stream does not 'telescope'. Every swap adds the value of
the underlying bond to the balance sheet of one party or the other, without
the benefit of the 'telescope effect'. Yes, there is pyramiding of
derivatives. It is foolish to think that 'derivatives' will retain their
value when the bonds from which this value is supposed to have been 'derived'
have lost theirs.
A third criticism concerns the fact that the
bond and gold derivatives markets are interdependent. As in the former the
long-interest and in the latter the short-interest gets bloated,
disequilibrium keeps growing. It will ultimately act as a trigger. This will
be more fully explored in Part 2.
In the absence of derivatives the panic would
run its course and bond values, having absorbed the loss, would eventually
stabilize at a lower level. In 1980 the runaway train could still be stopped
before it derailed. But with a derivatives market of the present size such a
panic would be tantamount to a stampede to sell up to $200 trillion worth of
bonds which nobody wanted to buy. Nothing could stop this runaway
train. The credit of the U.S. government would be ruined.
The problem is not that delivery of
non-existent bonds is expected at the maturity of contract. The problem is
that there will be an irresistible run to dump non-existent bonds when the
underlying bond starts losing value precipitously, that is, when interest
rates repeat or surpass their 1979-80 performance of entering stratosphere.
In that episode, it will be recalled, the largest American banks became
insolvent as the value of bonds in their portfolios collapsed, making huge
holes in the balance sheet.
Fate of Sodom
What is surprising is not that it could
happen. Government bonds are the tangible result of check-kiting pretending
that 'NSF' checks have value. For a time people accept them as such but
sooner or later the truth will dawn on them. At that point the value of
bonds, whether fixed or floating rate, is doomed and will be wiped out like
the biblical towns of Sodom and Gomorrah have been.
What is surprising is that economists, among
them free-market protagonists, fail to see in the derivatives market and in
its unlimited exponential and cancerous growth the very mechanism, the fire
and brimstone ordained by God that, in the fullness of times, will annihilate
Sodom and Gomorrah. Instead, they sing a praise of "market innovation",
of "economic efficiency", of the "Wonderful Wizard of Risk
Control", and of the "neutrality and usefulness of
derivatives", when they should sound the alarm and forewarn people of
the impending catastrophe.
The latest report of the Bank for International
Settlements on the over-the-counter derivatives of major banks and dealers in
the G-10 countries for the period ending December 31, 2005, lists the total
notional value of all gold derivatives outstanding as $334 billion at
year-end, an increase $46 billion from $288 billion at midyear. Gold
available for delivery has not increased nearly at this rate and the total
value of outstanding gold derivatives exceeds the value of gold available for
delivery by a large and increasing factor. Clearly, there is no 'telescope
effect' at work here.
It is no coincidence that the amount of
outstanding contracts is so much larger than the amount of underlying assets,
both in the case of gold and bond derivatives. The dynamics of the growth of
the derivatives market is hardly spontaneous. Here is the reason why.
The government has the following desiderata:
(1) to have a floor
below the bond price;
(2) to have a ceiling above the gold price.
Indeed, without such a floor and ceiling, the
bluffing epitomized by check-kiting could be called, and the international
monetary system would unravel.
The lure of
To promote these desiderata, the bond and the
gold markets are manipulated. It is true that the Treasury and the Federal
Reserve prefer not to play a direct role in it. Speculators are induced to do
it for them through the lure of risk-free profits.
Simply put, the role of the derivatives market
is to make phantom bonds available to buy, and
phantom gold available to sell, for the benefit of speculators. It is no
problem to make speculators want to buy phantom bonds. They have the
incentives. They know that the Federal Reserve is going to buy, rain or
shine. This offers a risk-free opportunity for profits. All the speculators
have to do is to pre-empt Federal Reserve purchases, that is, to buy
beforehand. So let them.
The tricky part is how to make speculators
want to sell phantom gold. This problem is solved by setting up a gold mine
as a front, beefing it up as the world's largest
gold-mining concern, and letting it introduce a phony hedge plan. Let's call
it Sarrick Gold. The hedge plan of Sarrick calls for selling but never buying gold
forward. The plan is then promoted as an essential 'risk-management'
tool for the company, which is supposed to 'stabilize revenues' and even
enhance them. It is alleged that forward selling also serves 'to satisfy the
banks that finance Sarrick's mining operations'.
Other hare-brained gold mining companies chime in: "Me too! Me
But since no forward purchases complement
forward sales (as they should if it were an honest-to-goodness hedging
program), speculators abandon their traditional spot on long side of the
market, and make the short side their haunt. They now have a risk-free
opportunity for profits in short-selling gold. Speculators know that Sarrick is going to sell whenever the gold price is
itching to rise. All they have to do is to pre-empt Sarrick's
sales, that is, to sell beforehand. So let them.
The lore of
You don't have to go any further than that to
explain the inordinate size of the derivatives markets in bonds and gold, and
their cancerous growth. It is uninhibited pyramiding, pure and simple.
Speculators pyramid on the long side of the bond derivatives market; and they
pyramid on the short side of the gold derivatives market. In Part 2 we shall
see that, far from supporting one another, the two activities tilt the
imbalance more and more away from equilibrium so that, eventually, the
pyramids will topple.
The gold standard rules out risk-free profits
and unlimited pyramiding. That is its main excellence. The regime of
irredeemable currency makes risk-free profits and unlimited pyramiding
possible. That is the main reason that it will self-destruct in due course
through the crash of the Derivatives Tower of Babel.***
To recapitulate, apologists suggest that the
derivatives market is largely due to prudent risk-management, in the form of
swaps between fixed and floating-rate payment-streams. Other contributing
factors can be neglected. At any rate, there is nothing to worry about:
payments streams are netted out and will stay manageable.
I emphatically disagree. I argue that the bulk
of the derivatives market is due to positions motivated by the lure of
risk-free profits. The lure is planted by the Treasury and the Federal
Reserve. In particular, there is no limit to pyramiding for bonds on the long
and for gold on the short side of the market, since there is no limit to
human greed and thirst for power. This is not a condemnation of the individual
speculator who, like everyone else, is trying to eke out a living. He is not
responsible for bringing about false incentives. The responsibility for that
rests squarely with the government.
In the second and concluding part I shall draw
attention to the fact that the bond and gold derivatives markets are
interdependent: the former is subordinate to the latter. Gold plays a pivotal
role in the operation of the bond market in terms of 'Gibson's Paradox'.
Default in gold derivatives will bring about the collapse of bond
derivatives, with incalculable consequences to human welfare.
* With apologies to Ayn
Rand, author of Atlas Shrugged.
** Schadenfreude is German, meaning the pleasure felt over other's
*** Derivatives per se are not necessarily evil. Futures markets
functioned quite well during the gold standard. It is conceivable that a
sophisticated derivatives market would function optimally again in a world
with a working gold standard. Agents may partake in derivatives for insurance
against risks created by nature. Also, speculators may use derivatives to
offer liquidity services against such natural risks.
Gene Callahan, Greg Kaza,
In Defense of Derivatives, February, 2004
Michael S. Rozeff, Derivatives:
Facts and Fallacies, August 12, 2006
Antal E. Fekete, To
Barrick or to Be Barricked,
That Is the Question,
www.gold-eagle.com , August 12, 2006
DISCLAIMER AND CONFLICTS
THE PUBLICATION OF THIS LETTER IS FOR YOUR
INFORMATION AND AMUSEMENT ONLY. THE AUTHOR IS NOT SOLICITING ANY ACTION BASED
UPON IT, NOR IS HE SUGGESTING THAT IT REPRESENTS, UNDER ANY CIRCUMSTANCES, A
RECOMMENDATION TO BUY OR SELL ANY SECURITY. THE CONTENT OF THIS LETTER IS
DERIVED FROM INFORMATION AND SOURCES BELIEVED TO BE RELIABLE, BUT THE AUTHOR
MAKES NO REPRESENTATION THAT IT IS COMPLETE OR ERROR-FREE, AND IT SHOULD NOT
BE RELIED UPON AS SUCH. IT IS TO BE TAKEN AS THE AUTHOR'S OPINION AS SHAPED
BY HIS EXPERIENCE, RATHER THAN A STATEMENT OF FACTS. THE AUTHOR MAY HAVE
INVESTMENT POSITIONS, LONG OR SHORT, IN ANY SECURITIES MENTIONED, WHICH MAY
BE CHANGED AT ANY TIME FOR ANY REASON.
August 24, 2006