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Watching Glaciers Move

06/05/2013

The economy is clearly showing signs of recovery, albeit a weak one.  Investment pundits on Wall Street are mostly enthusiastic about a continued bull run.  Yes, the market over-reacts to any comments about quantitative easing (QE), forgetting that reduced QE means the economy is getting better.  But, of course, that’s what the market always does:  it over-reacts.

Against this generally bullish environment, I have feared a “Jim Fixx” moment or a derivatives blow-out, which could make the now-famous Flash Crash look pint-sized.  A financial advisor at Carey Financial said it best:  The difference between investing using a derivative versus investing in a business is comparable to the difference between starting a football team and betting on the outcome of the Super Bowl.  Nothing is produced with derivatives, nothing is built.  It is 10% prudent hedging and 90% Las Vegas.

Derivatives are like icebergs, i.e., you cannot see how big a threat they really are.  Here are the latest estimates from Bain & Company (yes, that Bain & Company).  In 2010, GDP was $63 trillion, while total real assets (public companies, private companies, real estate, etc.) totaled $210 trillion.  Total derivatives were estimated at $600 trillion — many times greater than GDP or total real assets.

By 2020, they estimate GDP will rise to $90 trillion, while total assets will rise to $300 trillion.  Total derivatives will rise to a whopping $900 trillion.

Here is the first problem — not even a highly sophisticated company like Bain knows how much exposure we  really have to derivatives.  This is just an estimate.  Nobody knows for sure!  Unlike stocks and bonds which are traded on the exchanges, such as the NYSE or the CME, derivatives are traded in the dark, despite the fact they can impact the nation immensely.

Knowing the problem is huge and seeing no action, I feared the Jim Fixx moment of a healthy economy running down the road when it suddenly has a heart attack.  But, some recent developments have given me a tiny bit more confidence.  One good thing that came out the Dodd-Frank legislation is that the Commodity Futures Trading Commission (CFTC) is attempting to regulate the type of derivatives known as swaps.  (An example of a swap is I will pay the floating interest rate on your debt if you will pay the fixed interest rate on my debt, because I think interest rates are going down and you think they are going up.)  This may be a tough sell as it would involve regulating branches of foreign banks in the U.S. and foreign branches of U.S. banks.  Foreign government might have a problem with this, but most of the huge multi-national banks would not.  But, the important thing to me is that, after five long years since the 2008 collapse, we are seeing some movement – at a glacial rate perhaps but still movement.

Also, the Financial Stability Oversight Council created by Dodd-Frank wants to increase their regulation of systemically important financial companies that are not banks, such as AIG, Prudential, and GE Capital.  (AIG alone nearly destroyed our financial markets.  Even though taxpayers have now been repaid, only a huge controversial bailout saved it and maybe saved the market too.)  The glacier just moved another inch.

Has the danger passed?  Absolutely not!  But, I think I can see which way the glacier is moving, and I’m happy about that. 

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