Great Depression Online Archive Issue:

Daisy Chain Finance

Great Depression Online
Long Beach, CA
August 05, 2008

Inside This Issue You Will Discover…

*** Preface
*** Financial Contrivances
*** Daisy Chain Finance
*** And More

Preface

A daisy chain is created by threading multiple daisies together to form a chain, or garland, for decoration.  The term daisy chain is also used to describe a chain of exploding devices that are linked together, so that when one device is set off, it trips a chain of explosions and causes a wider area of destruction.

Financial Contrivances

In modern finance there are market instruments called derivatives.  These abstract securities do not imply a claim to part of a company’s assets and earnings like shares of stock would, but rather they derive their price from the underlying asset they represent.  In this respect, the derivative itself is merely a contract that’s value is determined by fluctuations in the underlying asset.

While the underlying assets they derive their value from often include stocks, bonds, commodities, currencies, interest rates and market indexes, derivatives commonly take the form of futures contracts, forward contracts, options, and swaps.

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Fundamentally, derivatives are used to reduce financial risk…  Each year a wheat farmer and a wheat miller would enter into a futures contract to exchange money for wheat at a predetermined price and date.  The wheat farmer then knows in advance the price he will receive and the wheat miller is guaranteed the availability of the wheat.  Using this knowledge they can make prudent financial and business decisions.

Speculators, however, through the practice of arbitrage, seek to exploit the price differentials in derivative contracts by simultaneously buying and selling a combination of such contracts.  The price differentials are often minute, but with massive amounts of leverage, the profits become enormous.

For example, two gas stations on opposite corners have their gas priced at $4.18 per gallon and $4.21 per gallon, respectively.  Note the $0.03 price differential.  Theoretically you could buy the gas at the first station for $4.18 per gallon and sell it to the customers of the second gas station for the sale price of $4.20 per gallon.  They’d be saving $0.01 and you’d have arbitraged $0.02 per gallon.

All that work for a whole $0.02 seems like a waste of time.  But if you could rapidly do it over and over again on a massive scale, you’d be talking real money.  In essence, this is what futures speculators do…they trade contracts.  They could care less about actually taking delivery of the gas, or the wheat, or the copper, or whatever else.

Similarly, the price differentials show up in currency exchange rates, interest rates on government and municipal bonds, and credit spreads on corporate bonds.  Hedge funds and speculators find these price differentials and exploit them on an immense scale.

Daisy Chain Finance

Commercial banks and investment banks also buy and sell credit derivatives to spread the risk of possible default or downgrade in their client’s credit rating.  This broad extension of risk, it is thought, can insulate banks and soften the impact of an economic downturn. 

Carl Schuman, managing director for credit derivatives at Westdeutsche Landesban, explains…

“The new impetus for us as investors is to be balance-sheet suppliers.  We’ve detected a rise in the pricing of total-return swaps in which we provide a balance-sheet rental.  The trade is simple: We buy an asset and then transfer all of the credit risk of the asset back to the bank that sold us the asset.  For the counterparty, it’s a way for it to take the risk of an asset but not have to fund it.”

Just reading that made our brain hurt…and our brain’s much too soft to understand what it means.  However we do understand that by spreading risk across the financial system many times over, a financial daisy chain has been constructed where the failure of several large banks could lead to a breakdown of the system’s workings and the collapse of the credit market.

The Bank for International Settlements (BIS) tracks the derivatives market, and, as of December 2007, the valuation of the world’s derivatives is now at an exasperating $596 trillion.

To put this crazy number in perspective: the U.S. annual gross domestic product is about $15 trillion; the current proposed U.S. federal budget is $3 trillion; U.S. mutual fund companies manage about $12 trillion; the total value of the world’s real estate is estimated at about $75 trillion; and the BIS valuation of world's derivatives back in 2002 was about $100 trillion – a 596% increase in just five years.

Legendary investor Warren Buffett has warned that derivatives are “…financial weapons of mass destruction.”

Columnist Jesse Eisinger said, “There's nothing intrinsically scary about derivatives, except when the bad 2% blow up.”

Since these warnings were made, the pricing models of collateralized debt obligations (CDO), which are a form of credit derivative, failed due to their composition of subprime loans.  Suddenly, with home prices dropping and foreclosures rising, the collateral backing the CDOs buckled…and no one could tell their value.  Hence, the beginning of the current credit crisis.

But for every big mistake it’s possible to make an even bigger mistake to solve it.

Following the credit market’s seizure, the Federal Reserve’s instituted both the Term Auction Facility and the Term Securities Lending Facility to promote liquidity in financial markets…and stem the cascading daisy chain of credit derivatives.  In the Federal Reserve’s 95 year history, they’ve never engaged in this type of market intervention before now.

While this may temporarily keep the financial system from coming completely unglued.  All this liquidity – money created out of thin air – is not without consequence. 

We believe the colossal waves of inflation poised to crash on the U.S. economy, and by extension the world economy, will be far more destructive than the natural cleansing of mistakes that’s vital to restoring a fundamentally healthy financial system.

Not only will the economy collapse…currencies – led by the dollar – will too.

Sincerely,

M.N. Gordon
Great Depression Online

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