Monday, October 03, 2005

The Latest 2 Point Spin on OTC Derivatives


General Editorial

Sunday, October 02, 2005, 7:56:00 PM EST

Higher Interest Rates and a Lower US Dollar

Author: Jim Sinclair

Now there is a piece of heresy in today’s world of OTC derivative trading kids, market maven brats, wunderkinds and seers.

The rub is that this piece of heresy is going to take place due to unusual circumstance with an undeniable scenario. This conclusion is supported by eons of monetary history when such an evil gathering of economic fact takes place.

1. The US Federal Budget deficit as a result of really bad weather and worse contingency planning is not going to be as advertised - under $360 billion - but rather over $550 billion. The idea that you can fight multiple wars, rebuild decimated cities and lower taxes is madness of world-class proportions. Lets' also not forget that cities and states as good little children are following the example of their Federal Daddy and deficit spending their tiny rear ends off as well.

2. The Trade balance thanks to ever escalating energy prices is also going off the scales on the deficit side.

3. The mad, mad, mad, world of US conspicuous consumption has landed US saving rates at below zero.

So how can all this be financed? Don't look at China as China bashing has finally bashed the dickens out of the theory that because Asia has so much US paper it has to buy as much as the US can print. Not so! Asia may not be functionally able to sell what they have but their continued consumption in order to allow the US to offend them is simply not going to happen. Asia will off-load their US paper by massive international corporate acquisitions outside of the US.

It happened again as the US put pressure on China for a more vigorous revaluation of their currency at the recent Washington get together. This is like a person (the financial management of the US) slitting their own throat and demanding a sharper knife so they can cut a few other necessities off as well.

So as currently presented, US financial managers intend to peddle US federal paper to people who are fed up financing the US, producing a backlash that no one really expects. More federal paper means more dollars. More dollars mean more supply on the market as interest rates rise as a direct result of smaller and smaller purchases by non-US interests of the much bigger supply of US Treasuries for sale.

The classical result that will happen by mid 2006 is:

1. A sharply lower US dollar.

2. Sharply higher interest rates.

3. Former Chairman Volcker's prediction that we would have a financial crisis within the next five years (one more year to go) could actually unfold tomorrow.

Want another reason for gold at $529 and $1650. Well, here it is!

* Credit Derivatives Go Wild
* New Total is a Notional Value of 12.4 Trillion
* Concern Grows over 3rd Party Deals

The spin on this is two fold: First, the notional value is simply notional while real value is determined by slices. Second, the problem is simply a back office situation of keeping track of the transactions.

The geeks can slip and slice, cut and dice, but when derivatives hit the fan they will hit for all the performances required. Therefore, the notion of slicing is nothing more than mad mathematicians who are out of touch with real world markets. When the fat lady finally sings, notional value will be real value.

The so-called back office problem is somewhat true but not in manner that it is presented. This is not a log jam of paperwork as much as it is the presence of third parties implied lifting of legs of the derivative spreads randomly which simply cannot be done without a disaster of mammoth proportions.

God help the world when interest rates really get out of hand. There are 12.4 trillion dollars and what side do you think they are betting on?

I have long held that there is not a single thing basically different between the derivative schemes of today and the old London commodity straddles and T-Bill spreads of the late 1970s. The spread transactions for instance on the COMEX where in the old days put on after the close at any level you desired in the range of the trading day. They were not put on as a purchase and then sale but sold as a completed long and short in different months.

I for instance purchased a 6000 contract silver spread in this manner. These spreads were usually taken off in the same manner, having more tax implications then than any other motivation. The difference between the old COMEX spread and today's over-the-counter derivative is that you could drop on side of the spread if you wanted to produce a mountain of money. I know this because the biggest money my old firm made was when my former partner Vincent went into our arbitrage department when gold broke above $400 and took off every short they had on their spread trading. This could be done because these trades were clearing house guaranteed.

This is not the case with the over-the-counter derivative markets where I maintain the pillar transactions are total frauds. The reason why there is panic in Mudville is because these transactions have been offset by many who really don't understand the inside game of a derivative, leaving the potential of selective leg lifting which simply cannot occur with such disruption you might as well be standing in a line in Baghdad to apply for a job with the police force.

Don't you think it slightly strange that when Enron blew up, all the firms that had formed to trade in supposed markets in OTC derivatives on electricity closed up shop? The answer is simple. There was no such market. The entire thing was a fraud.

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