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The Bond Markets Are Primed For an Epic Crash Far Worse Than 2008
The single most important issue for understanding why the finacnial system is not healthy and why we’re set to have an even bigger crash than in 2008 has to do with one word…
Collateral.
Collateral is an underlying asset that is pledged when a party enters into a financial arrangement. It is essentially a promise that should things go awry, you have some “thing” that is of value, which the other party can get access to in order to compensate them for their losses.
You no doubt are familiar with this concept on a personal level: any time you take out a bank loan the bank wants something pledged as collateral should you fail to pay the money back. In the case of property, the property itself is usually the collateral posted on the mortgage. So if you fail to pay your mortage, the bank can seize the home and sell it to recoup the losses on the mortgage loan (at least in theory).
In this sense, collateral is a kind of “insurance” for any financial transaction; it is a way that the parties involved mitigate the risk of their deal not working out.
As many of you know, our entire global financial system is based on leverage or borrowed money. Collateral is what allows this to work. Without collateral, there is no trust between financial institutions. Without trust there is no borrowed money. And without borrowed money, money does not enter the financial system.
In this sense, collateral is the “reality” underlying the “imaginary” or “borrowed” component of leverage: the asset is real and can be used to back-stop a proposed deal/ trade that has yet to come to fruition.
On a consumer level, our bank deposits (cash), homes, and other assets are the collateral pledged when we borrow money from a bank to finance something. This applies to everyone in the US all the way up to the multi-billionaire bracket.
On a corporate level, companies pledge various assets as collateral for their corporate loans. For manufacturing firms, this might be the actual steel inventory they own. For property companies, it’s portions of their real estate portfolios.
And for finacial firms, at the top of the corporate food chain, it’s sovereign bonds.
Modern financial theory dictates that sovereign bonds are the most “risk free” assets in the financial system (equity, municipal bond, corporate bonds, and the like are all below sovereign bonds in terms of risk profile). The reason for this is because it is far more likely for a company to go belly up than a country.
Because of this, the entire Western financial system has sovereign bonds (US Treasuries, German Bunds, Japanese sovereign bonds, etc.) as the senior most asset pledged as collateral for hundreds of trillions of Dollars worth of trades.
Indeed, the global derivatives market is roughly $700 trillion in size. That’s over TEN TIMES the world’s GDP. And sovereign bonds… including even bonds from bankrupt countries such as Spain… are one of, if not the primary collateral underlying all of these trades.
How did the world get this way?
Back in 2004, the large banks (think Goldman, JP Morgan, etc.) lobbied the SEC to allow them to increase their leverage levels. In very simple terms, the banks wanted to use the same collateral to backstop much larger trades. So whereas before a bank might have $1 worth of collateral for every $10 worth of trades, under the new regulation, banks would be able to have $1 worth of collateral for every $20, $30, even $50 worth of trades.
Another component of the ruling was that the banks could abandon “mark to market” valuations for their securities. What this means is that the banks no longer had to value what they owned accurately, or based on what the “market” would pay for them.
Instead, the banks could value everything they owned, including their massive derivatives portfolios worth tens of trillions of Dollars using in-house models… or basically make believe.
This sounds completely ludicrous, but that is precisely the environment that banks operated in post-2004. As a result, today US banks alone are sitting on over $200 TRILLION worth of derivates trades. These are trades that the banks can value at whatever valuation they want.
Now, every large bank/ broker dealer knows that the other banks/dealers are overstating the value of their securities. As a result, these derivatives trades, like all financial instruments, require collateral to be pledged to insure that if the trades blow up, the other party has access to some asset to compensate it for the loss.
As a result, the ultimate backstop for the $700+ trillion derivatives market today is sovereign bonds.
However, there is one BIG problem with the Fed, Bank of Japan, and Bank of England’s QE programs… they’ve SHRUNKEN the global pool of high grade collateral.
By actively buying Treasuries, Japanese bonds, etc. central banks have soaked up over $10 trillion worth of high grade collateral from the system.
As Zero Hedge has done a great job of exploring, the results of this are already showing up in the bond market with fund managers admitting that there is little if any liquidity in the corporate bond market.
The same problem applies to the sovereign bond market with bond managers putting money into fixed income derivatives because they can’t get their hands on sovereign bonds themselves.
It is not coincidence that the first ever Interantioanl Conference on Sovereign Bond Markets took place this year… nor is it coincidence that “liquidity” was the first topic of focus.
This has the makings of a Crash that will be far worse than 2008. If you’ll recall, 2008 was primarily an investment banking crisis. However, when the next crisis hits, it will be a global bond crisis. And given that bond liquidity is already a trickle when bonds area rallying one can only imagine the selling panic that would ensue once the market turns.
If you’ve yet to take action to prepare for the second round of the financial crisis, we offer a FREE investment report Financial Crisis "Round Two" Survival Guide that outlines easy, simple to follow strategies you can use to not only protect your portfolio from a market downturn, but actually produce profits.
You can pick up a FREE copy at:
http://www.phoenixcapitalmarketing.com/roundtwo.html
Best Regards
Graham Summers
Phoenix Capital Research
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Paper Collateral should work for paper investment vehicles...
A crash is just where the banksters' frauds and theft become conspicuous.
An American, not US subject.
Great insights.
You have a theoretical contagion. By that I mean the big boy markets....I do not mean the small fry nations. No one cares about them (except to manipulate and exploit with hot money flows).
The fed has a printing press and a complicit media/propaganda network, and a very well-established put on stocks and RE.
Who will win that one?
Of course we know that economy is being slowly eviscerated, but the sheeple cannot connect the dots.
Lacking collateral? Absolutely no problem! Just order a few hundred of these:
http://www.amazon.com/Collateral-Two-Disc-Special-Edition-Cruise/dp/B000...
When you don't have a lot of assets deflation is great. Prices go down, housing, food, health care, college fees and almost everything else costs less.
Deflation is worse for the rich than the poor and that is why they are panicking. They can take the gain but not the pain.
Deflationary episodes inevitably destroy the greediest individuals of societies (since they are always the most over-extended), and inevitably expose insolvent governments. This is why no bankers or politicians ever tell the truth about deflation
http://www.minyanville.com/businessmarkets/articles/inflation-deflation-...
http://www.financialsamurai.com/benefits-of-deflation/
the rich may already be amply stocked with Au and Ag. that's the part they don't tell u.
The more and more I study derivatives it now appears the main goal of QE may have been to hold up the underlying value of assets that feed into and support the massive derivative market more than help the economy.
QE has up to now stopped an implosion of derivatives and the resulting contagion and shock that would have spread throughout the financial system. In postponing this collapse the Fed has created a whole slew of new problems. More on this subject in the article below.
http://brucewilds.blogspot.com/2014/03/derivatives-house-of-cards.html
I've been worried about the finacnial system
Don't worry the Interantioanl conferences will solve it.
OK, send Phoenix Capital 10% of your stuff. They know what they are doing.
When I first read the advertisement, I climbed under the bed and started sucking my thumb, but on reflection, Phoenix still accepts dollars, so how bad can it be?
And I will be more than happy with big deflation......most others not so much.
and Aussie govt bonds I wonder....
Dont know....lack of liquidity rates rise, assets fall.
Offloading assets where low liquidity you would have to drop your price to sell... would be a race to the bottom. Or if a market flooded with one type asset prices fall.
They would have to extra print to soak it all up.....deflation to high inflation to hyperinflation...
Printing on that level would collapse the system. I think that is where they are heading as the final straw.
This artcile is incomplete. When there is a lack of liquidity, price rises. How does lack of collateral cause of crisis?
HaiPaiMai,
Lack of collateral becomes a trust issue, and trust is the grease that lubricates the money machine. I'm hearing squealing sounds from every part of the machine...
Just like the collateral issue, I think you're barking up the wrong tree. Trust is only an issue if the preponderance of the system is based on an honest foundation. I don't think that's the case. When all is lost, then priorities change. In this case, everyone knows everyone else can't pony up. Everyone knows the collateral is non-existent. Everyone knnows everyone else is lying about solvency, and that the TRUTH is that everyone is broke.
When everything is a lie, then liars all know the truth is that everyone is lying to everyone else. That means everyone in the game is in on the lie. So, the fraud isn't being perpetrated within the Circle, ie with some honest (but sucker) players and some dishonest- it's the Circle vs Everyone Else.
And in that case, trust is a non-issue, because "Everyone else" does not have the means to levy sanctions against the Circle in case of default.
I'm taking too long to explain, but there is no trust issues at the highest levels. They all know the game is rigged against us and for them.
[but there is no trust issues at the highest levels.]
I agree, finance has become a blood sport just the same as politics. The financial elites suffer the same set of dangers that the politicians suffer. Their status is maintained by holding the trust of the people that are feedstock for the system. When these people for whatever reason cannot or will not participate, the pedestal that the elites like so much crumbles and they fall into the pit where the wolves tear them to shreds.
It was a full moon last night. How many ZHers were out howling???
1. sovereign bonds are now ridiculously expensive
2. they are used to back the derivatives trade
3. investors are finding it harder to own these bonds
4. the great unwinding is therefore near
5. when the great unwinding begins, these sovereigns (and everything else for that matter) will be marked down heavily
6. there will be margin calls everywhere
7. i will sit back, relax and watch the show unfold by tuning in to zh
I suggest it has to do with lack of collateral leading to more contagion.
A great deal of our economic system is about debt. It is important to remember not all debt is created equal. A mirage is a naturally occurring optical phenomenon in which light rays are bent to produce a displaced image of distant objects. Joining the idea of a mirage and contagion with the reality of collapsing debt forms an interesting subject.
It is important to remember all debts and obligations do not come due at the same time. Also, it must be noted when a bill is not paid or defaults it often starts a long and drawn out legal battle, this collection process that may extend years without harsh consequences. This my friends is the reality of modern life in America and much of the world. More on this subject in the article below.
http://brucewilds.blogspot.com/2014/05/debt-mirage-always-moving-into-di...
What lack of collateral?
I mean, I bought a giant McMansion with a ninja loan, and THEN used that house as collateral for loans on cars, boats, and RV's. I then used those toys as collateral for more loans, etc, etc. I don't have any problems finding collateral!
So, if lil ol me can do it, why not the Big Boys? Seems to me that a multi-trillion dollar derivatives portfolio would make excellent collateral for more loans, esp. from your buds at the CB.
I just don't see the problem here.