Credit Problems are Larger then Central Banks

The outstanding amounts of derivatives ($ trillion).

End-Dec 2006 End-June 2006 End-Dec 2005

Interest rates 292 262 212

Credit 29 20 14

Equity 7.5 6.8 5.8

Commodities 6.9 6.4 5.4

Foreign Exchange 40 38 31


(interest rate Derivatives were three hundred trillion over a year ago)

As I have predicted through various mediums in the last few years, we've seen some calm in the American capital markets regarding the credit crisis currently underway. Some would coin this the work of the "PPT" (actually it would be the The Financial Stability Forum (FSF) which convened in April 1999 to promote international financial stability through information exchange and international co-operation in financial supervision and surveillance.) working through mechanisms such as the BIS.

Although the market is anticipating as much as a 50 bps rate cut by the Fed, there are still many risks out there. The biggest toxin is the potential short term currency fluctuations that could jeopardize the entire global financial system. But the root cause, as I have been writing for some time, lies within the system itself. The inability of credit markets to properly hedge or liquidate has caused the short term panic. This panic was attributed the warm feeling that things such as Credit Default swaps could actually "insure" the almost 450 Trillion of derivatives tied to everything from weather to corn crops. Hyman Minsky famously stated that stability produces instability, and that the longer things are stable, the greater the instability that will result, precisely because we are unprepared for it.

In the Mortgage arena, the underwriting/securitization process as we know it has changed forever. How will end up is only answered in the process of time. But credibility has been shaken. And there is liquidity, but there is no certainty.

It seems that the Enron debacle around the turn of the century had one CLEAR outcome far beyond what would have seemed to be important at the time, but very important today. Asymmetric information, which
won economist Joseph Stiglitz a 2001 Nobel prize, was clearly apparent.

When the borrower involved fails to make timely payments of interest and principal, the buyer of the protection can exchange the debt it holds for cash from the seller of the swap. But when commercial banks are involved in the deals, the party on the other side has to worry that the lenders can profit from the use of information they have privately gleaned from borrowers in the course of assessing their creditworthiness.

Fans of swaps argue that they encourage bank lending, an assertion that isn't reflected in loan data. Critics contend that banks' reliance on credit default insurance and other forms of risk transfer leads to poorer credit oversight, as it shifts the responsibility from those with the most intimate knowledge of a borrower's financial position to those with less.

What is keeping me up is why banks exist if all they're going to do is transfer risk to someone else?

Warren Buffett was worried enough about the extensive portfolio of credit swaps and other derivatives held by Berkshire Hathaway's insurance subsidiary, General Re, to close down the company's derivatives operations years ago.

But where insurance companies stepped off, thrice the number of hedge funds stepped up to play.

Add to this element, the world of derivatives, which have actually played a stability role in many mini financial issues in the recent past.

Where this leads is into the equation of currency. The dollar has always been a store of value and liquidity worldwide. Today, because of the instability, it is quickly becoming a liability for those holding dollar denominated assets. For some this could be profitable, but for the American consumer in general, it is a hidden tax.

We can be certain of one thing; This will not turn out like most pundits or the MEDIA is spinning it to be. Somewhere, in the horizon - lays a greater iceberg. We've already hit something, but the largest piece of risk lays just beyond the fog.

-Oscar Toscano

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