Why the Financial System is in Jeopardy(by ray_heritage)

Why are central banks around the world pouring massive amounts of fresh new cash into their markets? Is the global economy suddenly contracting? No. Are the world's largest banks suddenly going broke? No. So what's prompted these governments to pour out so much money so soon? Pureand simple, they're afraid the mortgage meltdown in the United Statescould trigger massive failures in the international financial system. Justlook at what almost happened back in 1998 when Russia defaulted on itsdebts and the hedge fund, Long Term Capital Management, collapsed.Banks recoiled in horror. Stock and bond markets nosedived. And theworld's financial system came perilously close to the brink. Inthe November 2006 issue of Weiss' Safe Money Report, he laid out ascenario of how this was likely to happen again and in a bigger way.Weiss explained how a mortgage market collapse would lead to a creditcrunch, and how a credit crunch could threaten the financial system. "Wepledged to monitor the situation and to alert you when we felt it wasbecoming an immediate danger. Now, that time has come." The dangers are undeniable Total"notional" value of all derivatives outstanding in the world is now amind-boggling $415 trillion, over eight times the GDP of the entireworld economy … twenty times the total value of all U.S. stocks … andfifty times all the Treasury debts of the United States Government. Anyunexpected disruption in this $415-trillion market could throw theworld's financial markets into turmoil … bankrupt hundreds of hedgefunds … wipe out the profits of big-name financial institutions …sabotage the investments of pension funds … and scramble the portfoliosof millions of average investors. In 1998, the last time thederivatives market nearly blew up, there were $80 trillion inderivatives outstanding worldwide, according to the BIS. Today,total derivatives outstanding have expanded to $415 trillion, which isover FIVE times more than in 1998. From 2005 to 2006 alone,outstandings surged by 39.5%, which was TEN times faster than thegrowth in the global economy. If the risks were spread amongthousands of institutions, each with plenty of capital to back up itsbets, this derivatives balloon might not be such a threat. But... - The U.S. Government's Office of the Comptroller of the Currency (OCC) reports that, in the United States … Just FIVE banks control 97.1% of the derivatives in the entire U.S. banking system. -Among these five banks, none has the capital to cover its net creditrisk, the primary measure the OCC uses to evaluate the risks thesebanks are taking in their derivatives trading. In 1998,JPMorgan Chase, the world's largest player in the derivatives market,had $3.80 in credit risk for each dollar of capital. Now, the OCCreports that JPMorgan Chase has a whopping $7.99 in credit risk perdollar of capital, more than double its 1998 risk level. JPM is thesingle largest player in the derivatives market, and is taking the mostrisk of all: EIGHT times its entire capital, according to the OCC'sdata. HSBC, was barely a player in the derivatives market back in 1998. Today, HSBC has $5.65 in credit risk per dollar of capital! Citibank had credit risk of $2.03 per dollar of capital in 1998; it's grown to $4.60 today. Bankof America, America's largest bank, is up to its eyeballs, risking overFOUR times its capital: 90 cents on the dollar in 1998; $2.88 today. Wachovia: Just 18 cents on the dollar in 1998; $1.56 today. That's more at stake than its entire capital. Scant Oversight or Control Basedon data compiled (but no longer published) by the OCC, less than 9% ofthe derivatives held by U.S. banks are traded on regulated exchanges. The remaining 91% are strictly one-on-one contracts, handled over the counter, outside the domain of regulated exchanges. Thismean that each party is ultimately responsible for monitoring thecredit and trustworthiness of each counterparty. They're on their own,which leads to the conclusion that … Even Some of the Biggest Winners Could Wind Up Among the Losers Right now, everyone is worried about the big losers: - Hedge funds that poured too much money into bad mortgages … - Banks that financed the hedge funds, and … - Investors that own the bank shares. There's no question that many of these are in grave danger as a result of the mortgage meltdown. Most people don't seem to realize that even some of the biggest winners could wind up among the losers Say,for example, that you're running a mortgage company and you've got abig stake in the subprime mortgage market. Say you're getting hammeredwith one massive loss after another. So one morning, you wake up in acold sweat and say: "I can't take this any more! If this continues,it's going to wipe me out! I've got to buy some protection. I've got toplace some bets on the opposite side!" Like thousands of othersin recent weeks, you rush to buy "credit default swaps" — in your case,special bets that are designed to go UP in value when your borrowersdefault. You figure it's good insurance. Plus, as is the usualpractice, in order to avoid putting up a lot of capital, you financemost of your new bets with short-term loans. Finally, you figureyou can sleep nights. If the mortgage market calms down, you anticipatethat your regular operations will stabilize. Conversely, if themortgage meltdown worsens, the profits likely on your new bets shouldhelp offset your losses. Either way, you're covered … or so you think. Now… here comes the hidden nightmare: Long before you start cashing inyour chips, you're shocked to learn that the other guy — the one on thelosing side of the bet, has run out of capital! He's broke. And hewon't pay you a single penny. Bottom line: - Even thoughyou're on the winning side of the trade, you still lose. You lose onyour regular mortgage operations. AND you lose on the new trade. Yourun out of capital just like the others caught in the mortgagemeltdown. And, just like the others, you default on your bank loans. The crux of the problem:- If you were trading on an established exchange, the other guy'sdefault would be primarily the exchange's problem — not yours. Itwould be their responsibility to make sure the market participants haveenough capital to back up their bets. It would be their job to go afteranyone who doesn't meet his obligations. But unfortunately, the exchange has very little to do with your transaction! Remember:91% of U.S. derivatives are strictly one-on-one contracts, handled overthe counter, outside the domain of regulated exchanges. In other words, it's between you and the other guy: If he pays up, fine. But if he stiffs you, tough luck! - Now you see why there's so much concern in high places about the credit risk America's five biggest banks are taking? - Now you see why central banks all over the world are dishing out such huge amounts of cash all of a sudden? Their great fears: 1. A chain reaction of defaults that no government or exchange authority could control. 2. Huge losses at major international banks. 3. Massive convulsions in the world economy. How to Protect Yourself - cont'd here.