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Gold v. the Dollar, Bernanke's Liquidity Trap, and Our $700 Trillion Derivatives Monster

by
August 11, 2011 3:13 pm
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In this episode of Attention, Benzinga Radio chats with Brian Rogers of Fator Securities. Rogers has some great insights on the price of gold, the Federal Reserve’s dwindling policy options, and the nature of the term “Too Big To Fail,” which boils down to the derivatives exposure of systemically-important banks.

Rogers sees the value of gold rising as the dollar weakens. The devaluation of the dollar puts pressure on the many countries and institutions with large dollar holdings to find alternative reserve currencies as their dollar holdings become less valuable. According to Rogers, gold would fill this gap nicely:

“Gold ends up being the world’s most useful currency because it’s not controlled by any government. There are a lot of reasons to believe that the central banks of the world, who won’t necessarily want to keep receiving dollars over time, will switch into gold in a big way at some point in time in the future.”

As Rogers explains, the Federal Reserve has a clear 100-year track record of devaluing the dollar, making this a likely scenario. Now it seems the bank is running out of options to quell inflation while fostering growth in the struggling US economy. Rogers:

“The [Fed’s] policies, particularly quantitative easing, are causing inflation levels to rise. As prices rise, the Fed finds itself in a situation that is not dissimilar to the late 70’s, where we had low growth, high and rising unemployment, and the dollar’s reserve standard called into question, which is exactly what we have today.

At the same time you have a Fed who, if we go into a downward spiral where inflation starts to rise, will have a gun to its head to raise rates in order to quell the growing inflation as the American consumer gets painted into a box with inflationary prices. The problem is, with our fiscal debt at around $15 trillion, any significant rise in interest rate is literally going to bankrupt the United States.”

We can’t wait to see what the Fed does next.

Rogers also discussed the root of “TBTF” banks: $700 trillion in notional value derivatives. Here’s his summary:

“The derivatives market really gets to the heart of what “Too Big To Fail” means. At $700 trillion in size, we basically have this monster where some big bank enters into a derivatives transaction of, say, $100 million. They enter into it with a counterparty, so the other side also has $100 million of exposure. In the derivatives world, they’ll say ‘Don’t worry worry about the size of this transaction, even though it seems big.’ This is because the parties agree on the notional size, but what they pay each other is actually just the gain or loss on the notional size over time.

This analysis is correct – as long as counterparty risk doesn’t come into question. But if the existence of the counterparty comes into question, margin on that trade is going to rise because risk goes up, and that creates a cash crunch in the system immediately. Plus, as soon as [the idea of] counterparty risk steps onto the scene, no one wants to lend money to anyone else. So all the big banks start pulling in their lending. And if it gets to the point where a bank has to write down all of those outstanding derivative contracts, you’re talking about huge exposure. I believe JP Morgan has exposure to the derivatives market of total notional size of something like $90 trillion. So the size of the numbers here is just massive.”

“The real risk is that the notional sizes of these derivatives trades could be marked down to zero because the counterparties are no good. This kind of a writeoff affects every financial institution, every corporation on the planet. This is the sort of global systemic risk that scares Hank Paulson into corralling Congress into a room and threatening them with end-of-days should he not be given a blank check to bail out his buddies. This is essentially Too Big To Fail.”

Now that $700 trillion is starting to look like a powder keg of epic proportions. It’s too bad we didn’t reign in this sector when we had the chance. Rogers:

“This story is going to continue. And we didn’t get here by accident – Brooksley Born was out in front of this issue years ago when she was head of the CFTC, talking about regulating the derivatives markets. Warren Buffet called these things weapons of mass destruction and he was right. And look at what happened to Brooksley Born: she was completely squashed by Larry Summers, Ben Bernanke, Robert Rubin – the architects of the current system that is breaking down in front of us. It smells to high heaven from start to finish.”

Be sure to check out the full audio of our discussion for more on these topics.

Fator Securities LLC, Member FINRA/SIPC, is a U.S. entity and a member of the Fator group of companies in Brazil. The comments above are from Brian Rogers, who is employed by Fator Securities (Brian’s opinions are his own and do not constitute the opinions of Fator Securities or the Fator group of companies).

Brian’s notes from this week are posted on Zerohedge.
Macro Commentary: The Cost of Fiat Money and Gold
Macro Commentary: The endgame of TBTF banks and rising rates

Be sure to check out the audio of the interview in its entirety: Fator Securities’ Brian Rogers on Gold, Bernanke’s Liquidity Trap, and Our $700 Trillion Derivatives Monster

Subscribe to the Benzinga Attention podcast feed in iTunes: Benzinga Strategies

Find us on Twitter: @lukelavanway @matthewboesler @benzingaradio @benzinga

And for our full range of podcast content, visit the Benzinga Radio homepage.


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