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The Fatal Flaw

Bob Moriarty
Dec 4, 2008

I must be getting old. I keep thinking about things I used to think about 40 years ago and can't remember the name of the person I met two minutes ago or what I had for dinner yesterday. It's ok; there are alternatives to getting old and they are all bad.

I remember the paradox of the "irresistible force" and "immovable object." We used to study logic. I don't think anyone does that any longer. It could well have something to do with so many people doing so many illogical things today. No background in logic.

An irresistible force is a force so strong that nothing can stop it. An immovable object is an object so fixed that no force can move it. So what do you get when you have an irresistible force meet an immovable object? I think the answer was supposed to be "immeasurable energy." It's a paradox.

I have harped for years about the problem with derivatives. Not that derivatives in and of themselves are a problem. A call on gold is a derivative. Similar derivatives have existed for hundreds, perhaps thousands of years. My very first stock market transaction was buying an over-the-counter call on Great Western Finance in May of 1970. I made money on it but it was something like a call on 5,000 shares at $10.85 expiring exactly 91 days later. The only person I could sell to was the person I had bought from. You might want to think of it as illiquid as hell.

But then computers came along with giant hard drives with 30 megabytes of data with an access time of 30 milliseconds. That was the old Winchester drive, the 30-30. The computer combined with unimaginable storage space allowed the creation of tens of thousands of derivatives. Around 1973 the CBOE was founded and derivatives began to explode.

Derivatives can be almost anything. We are familiar with derivatives on gold or silver. And everyone knows about puts and calls on shares and stock indexes. You can write or buy derivatives on the possibility of the dollar crashing or temperature futures in Houston 23 years in the future. You can bet on the odds of Lehman Brothers going out of business. Yeah right. They have been in business for 168 years, what kind of fool thinks they are going to go out of business? These are all derivatives.

The Bank for International Settlements [BIS] tracks most derivatives, not all, but most. They just released the most current numbers recently. OTC derivatives are now up to an incredible $684 trillion dollars. They increased some $88.384 trillion from December of 2007 to June of 2008. World GDP probably increased about $27 trillion during the same period. Derivatives are increasing three times faster than the world economy and in fact, now dwarf the world economy.

That sets up something I will call Moriarty's paradox.

The mark-to-market paper losses in derivatives are far greater than the value of all the financial assets in the world.

How do I know this is true? No one can know the real total of losses in derivatives until they fail. It's pretty simple. We know the total value of OTC derivatives; $684 trillion and we can compare that figure with known derivatives losses.

But what exactly does the figure $684 trillion mean, because it's a number called a "notional" figure. Here's how it works. If someone sells you a call on Dec gold at $800, it represents the right but not the obligation to buy 100 ounces of gold at $800 anytime between now and when the option expires. The notional value of one Dec $800 gold call is $80,000, the same as the value of 100 ounces of gold at $800.

Here's where it gets interesting. What is the potential loss on an $800 gold call? There are two sides to the equation. If you are a buyer of the gold call, you can and often do, lose 100% of your investment. That's bad. But not that bad. You may have paid $1,000 for the call. If you lose 100% of the $1,000 invested on a derivative with a notional value of $80,000, that doesn't sound serious.

It might be if you were the seller of the call. Your risk is unlimited. In theory, gold could go from $800 to some magic number like $1,650. In this case, the seller of a call with a notional value of $80,000 has suffered a loss of $85,000. But maybe not, he may have owned the gold and all he has lost is opportunity cost of owning the gold. So to him it might not be serious. But if he sold a naked called with a notional value of $80,000 he easily could lose even more than the notional value of the original derivative.

Let's look at other derivatives where we know what the losses were when they blew up. When Lehman Brothers collapsed in September (Who could imagine a 168 year-old company going under?) some hedge funds had been writing Credit Default Swaps on their bonds. (CDS) Those are a form of derivative and the theory was that if you wanted to protect a position in the bonds, you bought the CDS. Let's say the CDS was written two years ago. I think you could have gone to any economist and the most pessimistic might have said there was a 5% chance over 5 years of the bonds crashing. But Lehman did go bankrupt and the payout on the bonds was about 8%. So the writers of CDS on Lehman bonds lost 92% of the notional value of the CDS and may have taken in 2-3% in income. Easy income, yeah right.

Mr. Anti-Derivative Financial Weapons of Mass Destruction himself, Warren Buffett, had Berkshire Hathaway write $37.04 billion dollars worth of naked puts on the S&P 500 and three other indexes. We know the notional value, it's pennies over $37 billion. We know what he believed the risk might be. Berkshire took in $4.85 billion in income premium. And now we calculate that they faced a $15 billion dollar margin call. Almost 40% loss.

I'm trying to make a simple point no one else has figured out yet. It's the Fatal Flaw. With $684 trillion in notional value in derivatives, the real risk may well be in the $300 trillion dollar area.

The Fatal Flaw or Moriarty's Paradox is that there isn't that much in financial assets in the world. I've seen estimates that $50 trillion has been lost already. Clearly we are only in the first inning; there will be many more losses to follow.

You can take the value of all the stocks, all the bonds, all the gold, all the silver, all the banks, all the homes and businesses in the world and can't pay off the losses in derivatives. Derivatives got too big, they introduced a new element of risk, that of counterparty risk and now they are collapsing even as they were growing 6 months ago.

The only way out is to print money until you run out of trees and ink. That's what we are doing now. You are transferring all the losses of a monopoly money casino onto the backs of the American people.

Our great grandchildren will be paying it off doing laundry for the Chinese. Of course there will be riots in the streets and revolution very soon. They will be living under a totally different form of government after the US defaults on a debt far too large to ever be paid off.

Dec 3, 2008
President: 321gold

321gold Ltd