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Derivatives Time-Bomb Update
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Tuesday, October 10, 2006
Vol. 8 No. 202 |
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In Today's Letter:
Comment: Derivatives Time-Bomb Update
Offshore: Mexico - Canadian Tax Haven
Wealth: Why I Like T-Bonds
Privacy: More Ways They Control You
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Derivatives Time-Bomb Update: Regulators Match 80% of Credit-Derivatives in Late 2006
Today's comment is by Eric Roseman, The Sovereign Society's Investment Director and editor of Commodity Trend Alert.
Dear A-Letter Reader:
One of the greatest mysteries on Wall Street isn't about market timing or which investment strategy will lead to the next big stock market rally. Rather, the greatest challenge facing America's largest investment banks is how to control the credit-derivatives market, now home to a massive $26 trillion (with a "T") dollars - which more than doubled in size over the last 12 months.
I've written and warned about credit derivatives many times over the last several months and I remain committed to keeping you informed of the massive risks inherent to the global financial system. The pace of derivatives growth, a market often viewed with deep suspicion because of its complexity and lack of transparency, has raised concerns that investors may not understand the inherent risks associated with these products.
It's truly amazing that many of the banks and hedge funds which use derivatives don't always understand these securities. (Imagine - the brokers not understanding the investments they trade!) Sometimes, these trades are placed without identifying the other counterparty to the trade (i.e. the person they're trading with). Credit default swaps trade away from exchanges in the over-the-counter market, and tend to be negotiated privately and over the phone between traders. That's what makes them very risky because nobody is policing these trades, which start at $5 million dollars.
The credit protection industry has mushroomed over the last few years. Credit default swaps offer protection against the possibility of default by a debt issuer. By using these swaps, traders, including hedge funds, can offset potential losses from risky fixed-income positions. In many ways, credit derivatives almost encourage traders to assume greater risk, and the amazing outcome of this pseudo-bond market protection is the outstanding number of unmatched trades still unsettled by Wall Street's largest banks.
Over 12 months ago, fourteen high profile Wall Street investment banks, including a former Federal Reserve regional board member, gathered in New York to tackle the growing monster of unmatched credit-derivative trades. Indeed, progress has been made in just over a year as 80% of all unmatched trades have now been identified. That's the good news.
But just in case this whole mess blows-up in our faces, I would seriously recommend holding chaos investment insurance - gold bullion. Let's not forget that over 20% of all credit derivatives trades have yet to be matched. That's a formidable $5.3 trillion dollars - approximately half the size of the American economy.
Wall Street might ultimately fix the derivatives time-bomb before it explodes. Lower long-term interest rates since July and a slowing housing market almost guarantee the Federal Reserve's next move will be to lower short-term rates early next year. Lower rates ease pressure on the financial system, especially one that is marked by huge amounts of leverage. This is the first credit-tightening cycle in over thirty years where more risk, not less, has been accumulated since June 2004 when the Fed began raising its benchmark lending rate. Higher rates squeeze global markets, including credit markets, which historically have collapsed under the weight of tighter credit conditions. Remember Orange County in 1994 and Long Term Capital Management in 1998?
With short-term interest rates heading lower next year, I think the worst of this credit cycle has already passed. But just in case, I've got gold and some cash reserves in my portfolio.
ERIC ROSEMAN, InvestmentDirector
on behalf of The Sovereign Society
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Mexico, a Canadian Tax Haven
Unlike Americans, lucky Canadians can escape most income taxes if they move outside their home country. That's because, unlike the U.S., Canada has territorial tax law with most taxes imposed on residents. This allows many Canadians to retire to sunny climates such as Florida, or now, Mexico, which is a newly popular destination. Reg Cyr, a Toronto-based financial planner, points out that by retiring in Mexico Canadians not only live in a warmer climate, they can also reduce their cost of living and taxes. "Mexico is one destination where this works for many Canadians because Mexico can be called a tax haven," he says. "By moving to Mexico you can eliminate or mitigate most taxes while still collecting Canadian social security and other pensions."
Even better, while Canada will withhold 15% from these government payments as a non-resident tax, Canadians on a long term Mexican resident FM3 visa are not required to fill out tax forms in Mexico.
BOB BAUMAN, Editor
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Why I Like T-Bonds
Let's get something straight. I'm not bullish on bonds because I think we're going to suffer an economic recession. And it's not because I see inflation plunging from current levels, commodities crashing even further or geopolitical trends worsening.
It's the real estate market and the possibility of a major mortgage backed disaster that frightens me. A major financial debacle has occurred at the end of every monetary tightening cycle since the early 1970s. Banks failed in the mid-1970s. Businesses collapsed in 1980-81. The Savings & Loans crisis erupted in 1990-91. Stock market crashed in 1987 and 1989. Orange County declared bankruptcy in 1994. The Asian economic crisis hit in 1997 and Long Term Capital Management exploded in 1998. This all resulted because the Fed tightened the monetary screws too tightly.
This time, in late 2006, we've got the biggest real estate bull market on its knees, pleading with the ferocious bear as data since July point to a serious decline in housing.
Throughout the country, statistics on existing and new home sales have tanked into the double-digits. Not one region has logged a single-digit decline through August. Considering the amount of leverage tied to real estate, mainly mortgage-backed securities and bank loans, it's a disaster waiting to happen. Though I doubt it'll sink the economy, it can potentially destabilize global markets, not unlike the painful events that occurred in August 1998 when the MSCI World Index plunged 15.5% and the S&P 500 Index crashed 17%.
The way I see it, inflation has peaked, residential real estate is coming undone and the economy is slowing. If unemployment trends deteriorate, then we will suffer an economic recession. But thus far, companies remain financially strong and are still hiring -- a trend I don't see changing any time soon. But the threat of some sort of mortgage-backed disaster looms. In the event of a real estate fallout-- a growing possibility -- high quality Treasury bonds will rank as one of the few top-performing assets in a very dark environment.
ERIC ROSEMAN, Investment Director
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And the Government Keeps Stealing Privacy
As I said yesterday...quietly, very quietly, governments throughout the world are constructing a global surveillance infrastructure. Here are few more ways Big Brother will soon be able to control you... as quietly as possible.
- In the EU, and most likely in the U.S. as well, any business offering Internet access will need to comply with the data retention requirements-hotels, Internet cafés, public libraries, wireless hotspot operators, etc. Private companies with in-house networks area also are covered.
- For call data, phone companies will need to store the name of the registered owner of each phone, the numbers dialed, the length of a call and, for mobile phones, the location of the caller. For e-mail the information required includes the registered owner of the e-mail address and the e-mail addresses of their correspondents.
- Police investigating terrorism and serious crime will have access to the commercial traffic logs of all phone calls, text messages, emails and instances of internet use by suspects. Because this data offers historic information, it allows your calling and e-mail patterns to be tracked over long periods of time. Regular numbers called and your network of contacts will be in plain sight.
- E-mail providers that don't require proof of identity, such as Yahoo! or Hotmail, would presumably have to begin requiring such proof in order to open an account. Pre-paid mobile phone services would presumably be banned as well unless proof of identity is provided. It's not at all clear about exactly who will be able to access this information, but if you look at the situation in the one country where similar laws are in effect-the UK-the record isn't encouraging.
What can you do to protect yourself from this web of surveillance being constructed around you? As long as it's legal to do so, use telecom services that don't require proof of identity: e-mail services like Yahoo! (although Hushmail is better), pre-paid telephone services, and encryption programs like PGP. Another service that offers significant protection to your online communications is Armorware. You can read more about it at in the further resource section below.
MARK NESTMANN, Privacy Expert & President of The Nestmann Group
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