Rickards: The Threat Of Contagion "Is Now More Dangerous Than Ever"

Authored by James Rickards via The Daily Reckoning,

Each crisis is bigger than the one before. In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses.

This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008.

Today, systemic risk is more dangerous than ever.

Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system and have much larger derivatives books.

To understand the risk of contagion, you can think of the marlin in Hemingway’s Old Man and the Sea. The marlin started out as a prize catch lashed to the side of the fisherman Santiago’s boat.

But, once there was blood in the water, every shark within miles descended on the marlin and devoured it. By the time Santiago got to shore, there was nothing left of the marlin but the bill, the tail and some bones.

An even greater danger for markets is when these two kinds of contagion converge. This happens when market losses spillover into broader markets, then those losses give rise to systematic trading against a particular instrument or hedge fund.

When the targeted instrument or fund is driven under, credit losses spread to a wider group of fund counterparts who then fall under suspicion themselves. Soon a market-wide liquidity panic emerges in which, “everybody wants his money back.”

This is exactly what happened during the Russia-Long Term Capital Management (LTCM) crisis in 1998. The month of August 1998 was a liquidity crisis involving broad classes of instruments. But, the month of September was systematically aimed at LTCM.

I was right in the middle of that crash. It was an international monetary crisis that started in Thailand in June of 1997, spread to Indonesia and Korea, and then finally Russia by August of ’98. It was exactly like dominoes falling.

LTCM wasn’t a country, although it was a hedge fund big as a country in terms of its financial footings.

I was the general counsel of that firm. I negotiated that bailout.  The importance of that role is that I had a front-row seat.

I’m in the conference room, in the deal room, at a big New York law firm. There were hundreds of lawyers. There were 14 banks in the LTCM bailout fund. There were 19 other banks in a one billion dollar unsecured credit facility. Included were Treasury officials, Federal Reserve officials, other government officials, Long-Term Capital, our partners.

It was a thundering herd of lawyers, but I was on point for one side of the deal and had to coordinate all that.

It was a 4 billion dollar all-cash deal, which we put together in 72 hours with no due diligence. Anyone who’s raised money for his or her company, or done deals can think about that and imagine how difficult it would be to get a group of banks to write you a check for 4 billion dollars in 3 days.

Systematic pressure on LTCM persisted until the fund was almost broke. As Wall Street attacked the fund, they missed the fact that they were the creditors of the fund. By breaking LTCM, they were breaking themselves. That’s when the Fed intervened and forced Wall Street to bail out the fund.

Those involved can say they bailed out Long-Term capital. But if Long-Term Capital had failed, and it was on the way to failure, 1.3 trillion dollars of derivatives would’ve been flipped back to Wall Street.

In reality, Wall Street bailed out itself.

The panic of 2008 was an even more extreme version of 1998. We were days, if not hours, from the sequential collapse of every major bank in the world. Of course, the 2008 panic had its roots in sub-prime mortgages, but quickly spread to debt obligations of all kinds especially money market funds and European bank commercial paper.

Think of the dominoes again. What had happened there? You had a banking crisis.

Except in 2008, Wall Street did not bail out a hedge fund; instead the central banks bailed out Wall Street.

And as I mentioned earlier, today systemic risk is more dangerous than ever. Each crisis is bigger than the one before.Too-big-to-fail banks are bigger than ever, have a larger percentage of the total assets of the banking system, and have much larger derivatives books.

The next crisis could well begin in the private bank debt market. The specific culprit is a kind of debt called “contingent convertible” debt or CoCos.

These bonds start out like ordinary debt, but a bank in distress could convert them to equity to improve its capital ratios. The problem is that bondholders know this and start dumping the bonds before the bank can pull the trigger on the conversion clause. This can cause a run on the bank and trigger cross default clauses in other bonds. Far from adding safety to bank capital structures, CoCos can make banks more unstable by igniting panics.

This is just one more example of capital market complexity and it signals the fact that the next crisis will be worse than the last.

Also. new automated trading algorithms like high-frequency trading techniques used in stock markets could add to liquidity in normal times, but the liquidity could disappear instantly in times of market stress. And when the catalyst is triggered and panic commences, impersonal dynamics take on a life of their own.

These kinds of sudden, unexpected crashes that seems to emerge from nowhere are entirely consistent with the predictions of complexity theory.

In complex dynamic systems such as capital markets, risk is an exponential function of system scale. Increasing market scale correlates with exponentially larger market collapses. This means that the larger size of the system implies a future global liquidity crisis and market panic far larger than the Panic of 2008.

The ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which despite some movement in that direction, still have not been normalized since the last crisis.

For now, it’s not clear which way things will break next. Markets are still in a precarious position and volatility has returned. Regardless of which direction markets go from here, yesterday’s threat of contagion is a scary reminder of the hidden linkages in modern capital markets.

Next time we may not be so lucky.

We’ve already had a correction this year. But the next correction could turn into a 30% or 40% crash.

The conditions are in place. But you can’t wait for the shock to occur because by then it will be too late. You won’t be able to get your money out of the market in time because it’ll be a mad rush to the exits.

The solution for investors is to have some assets outside the traditional markets and outside the banking system.


sixsigma cygnu… lester1 Thu, 05/31/2018 - 18:34 Permalink

"These bonds start out like ordinary debt, but a bank in distress could convert them to equity to improve its capital ratios."

In Canada, this process was written into law.  So after a crisis, creditors are wiped out but the banks remain standing. And your deposit is only insured to a $100K max. Insurance just means the first $100K won't be confiscated, everything else just gets redistributed to everyone else who lost money. See, the house never loses. Your money IS another depositor's insurance policy.


In the unlikely event of a fire...

Oh, and Fcuk islam.

In reply to by lester1

BigJim Lordflin Fri, 06/01/2018 - 10:42 Permalink

Indeed. And what about this?

The ability of central banks to deal with a new crisis is highly constrained by low interest rates and bloated balance sheets, which despite some movement in that direction, still have not been normalized since the last crisis.

Er, no, Rickards-m'-Boy, central banks are not "constrained" by bloated balance sheets; they own the fucking denominator! The next crisis comes they'll just do what "worked" before: buy bonds and stocks, and short PMs with their unlimited liquidity.

Gradually, more and more "private" and "public" assets will come to be owned by the central banks. There'll be no major crash (unless the CBs collude to enable one to happen to create economic turmoil for a government they dislike).

No, there won't be a crash; just increasing capital misallocation as zombie nations, states, municipalities and corporations get bailed out and what little remains of capitalism will become an even deeper festering swamp of fascism.

See Greece.

In reply to by Lordflin

HRH of Aquitaine 2.0 sixsigma cygnu… Thu, 05/31/2018 - 19:07 Permalink

"You won’t be able to get your money out of the market in time because it’ll be a mad rush to the exits."

The banks have already practiced two bail-ins and rewrote the rules here in the US. As a depositor to a bank that makes you a creditor and derivatives will be paid first. As for the FDIC insurance here in the US? Hahahaha. Yeah, right. It doesn't matter, most people don't have $400 let alone $250k. For anyone with that kind of cash, sitting in a bank, you have my sympathy.

In reply to by sixsigma cygnu…

Harry Lightning HRH of Aquitaine 2.0 Thu, 05/31/2018 - 21:12 Permalink

If they try to do a bail in in the US, there will  be a Civil War, the bankers against everyone else.

Guess who'll win.

That's probably what is needed, a few of these CEOs struck up on the gallows in vigilante justice. They won't have to worry about making risky investments to shore up the stock price so their stock options vest in a profit when that all happens. Would serve them right, especially since the government refuses to stop them or punish them.

And while all this is going on, while the country has one financial foot in the grave and the other on a banana peel because of a handful of greedy bankers, half the country is all amiss because of some comic calling a politician an ape. What the hell has happened to America ?

When I was in Nam, occasionally when we had time to breathe we would watch some piped in close circuit television of what was happening back in the States. The military tried to censor it so as to keep morale up, but the newbies would tell you what was going on when they arrived, and so the military had to let some things come through that they rather would not have allowed. Anyway, we knew about the hippies and the protests...and I remember this grizzled old Staff Sergeant say one night as we watched some protest of people who looked like they needed showers and haircuts...he said "the worst part of this is these jack-offs will be running the country someday." Well someday is here, and those protesters are now the Bill and Hillary Clintons of the US, and all their followers. That old Sarge was right, the grown up protesters are ripping up the States like they ripped up and burned their draft cards. I left after they elected obama, and it only seems to have gotten worse. You have a President who has not be given a day of rest from the opposition, because the losers still can't get over losing an election they thought was in the bag. You have problems on top of problems with even more problems as the interest being paid on the original problems, and all half the country wants to do is fight an ideological war. Its amazing the country still functions with all the division. 

I always felt it was better to get bad things over with as soon as possible. The waiting really is the hardest part, be it a game, a battle or a teeth cleaning. The sooner it starts the sooner it will be over. America is coming to a flashpoint, there is no way a country with that many people and that many problems can survive for long before the gasket breaks and the steam comes piping out, I sort of wish for the sake of the country that whatever is going to happen to end the divisiveness hurries up and happens. Because from what I see a couple of hundred miles off shore, the country is being subjected to Chinese water torture from every angle, politically, economically and socially. If its a secession or a dictatorship or an actual shooting war, get it over with already, because the longer it takes the more devastating will be the consequence. 

I have a child in America and  a child in Europe. I feel sorry for both. The world their generation is being left by their parents is totally unfair to them. I have always done everything I could for my kids, and still do. But I can't help make their world more fair, more peaceful, more humane, more law abiding. The forces working to do the opposite are too many for any one person to oppose, it will take a revolution of good versus evil. In the States they seemingly put all the criminals in jails during the last thirty years, but now the problem is not a criminal element but rather a country in which half the people don't even care about the law if it doesn't suit their purposes. Who in America ever would have thought that the FBI would deliberately get involved in a Presidential election to help one of the candidates by hurting the other ? Who ever thought that citizens of a country where so many receive schooling would not see the dangers of working to overturn their existing immigration laws ? Whoever thought that for the love of money that people can be thrown out of a career for what they say in their own time ? Its like a movie out of the Theater of the Absurd. 

The economy of a country often is a mirror of the values of the country, as people tend to use their passions and experiences and world view to decide where they will invest or how they will run their businesses. If that adage holds true, we can see what kind of country America is today from looking at the economy. With the stock market as artificially high as it is, doesn't this say that Americans cannot make reasonable judgments as to the value of principles ? And isn't this observation confirmed by what entertainers and sports stars are being paid to play kids' games ? With only conservative comics and public figures being punished for what they say, doesn't it tell us that the scales of justice cannot possibly be in balance any more ? Surely the FBI fiasco and the unwillingness of the government to investigate for good reasons the Clintons and their cohorts like Comey and Lynch and a whole litany of other rascals, while at the same time trying to nail Trump and his cohorts for made-up lies, makes the case that there is no justice at work in America any longer. Is there any greater sign of an irresponsible country than one whose populace allows their politicians to mortgage their country's future to a point where the debts and promises can never be paid ? Oh I could go on and on for a fortnight about this.

There is a very dark set of days, weeks months and years coming to the States, and because the world is so inter-connected in so many ways now, to the rest of the world will fall this darkness. I am not a pessimist by nature, nor am I a fan of dystopia, but it sure is hard not to look unkindly upon the corruption that permeates so much of America's thoughts and actions today. And I mean that for the body aggregate, not the government, for as the population is a reflection of its economy, the government is a reflection of its people. Someone needs to do something to water the grass, because its so vapid now that a small flash of fire will ignite a firestorm of discontent. 


In reply to by HRH of Aquitaine 2.0

HRH of Aquitaine 2.0 Harry Lightning Thu, 05/31/2018 - 22:54 Permalink

I agree with your conclusion about the future being filled with very dark days in the US. However, Europe is not going to ride through the coming financial, and cultural storm unaffected. If anyone had told me, when I was in West Germany, and when the Berlin Wall was extant and East Germany was still shooting its own citizens, dead, for making the attempt to be free, that I would wake up and find myself in the country country of my birth, and that country would be infested with communists and many who support communist ideas, I would have laughed and called you crazy.

This Islamic cult and the bullshit they have brought to the western world is another factor that isn't going to go away. I am a fan of dystopic fiction and have been reading such works all my life. I am a pessimist, by nature. Optimism is foreign to me. I have chosen my sides in this battle. If you are white, Christian, and a capitalist, I am with you. If you are a mulitculti koolaid-guzzling globablist / communist that thinks you deserve to take what I own and give it to the undeserving you are my enemy, now and forever. Oh, this is war. A cultural war, an economic war, a propoganda war, a religious war. If you think this is only an American problem, it is not. The communists / globalists have infected much of the world with their insanity. It isn't viable, of course. Not unless they kill off all the old people and intimidate and brainwash the young. That is still possible. Not highly probably but still possible.

In reply to by Harry Lightning

BigJim Harry Lightning Fri, 06/01/2018 - 10:58 Permalink

If they try to do a bail in in the US, there will  be a Civil War, the bankers against everyone else.

Guess who'll win.

Lulz. Who'll win? The banks, obviously.

The FDIC covers up to what, USD$250k? You think the average American is going to take up arms against "his" government and

put his life on the line because anyone rich enough to have more than $250k sitting around in a bank account lost money over that amount?

You are truly delusional.

As for the rest of your post, yes, the US is falling apart, as is every other country in the developed world, and the biggest reason is that cultural marxism and immigration will kill off the cultural values that made the US' success possible.

Mind you, most US governments throughout history have been genocidal and corrupt, but the citizenry's work ethic and belief in "America" kept the wheels on. How much longer that will continue to be the case is anyone's guess. The petrodollar is the US biggest prop, and that's only slowly losing its grip. The fact that the US has almost complete control of politicians throughout the West (thanks to the NSA spying and resultant "control files") means that Europe and the 5 eyes will probably continue to be in the US' pocket for the foreseeable future.

In reply to by Harry Lightning

Sonny Brakes sixsigma cygnu… Thu, 05/31/2018 - 19:22 Permalink

This is why you shouldn't spend your life collecting imaginary money in the form of Fiat currency, but you already knew that and if you didn't, you do now. The government is the public relations department of the fleet of banks in any and all countries, and you knew that too, and if you didn't, you do now.

Money is debt, and debt is money. You wipe out debt and you wipeout money. It's a simple as that. The real value is found in the vigorish that is drawn from productive labour in the form of accrued interest payments to the banks, and the taxes, which are confiscated by the government to simply pay themselves and those that produce nothing. These are the same people who pretend to have jobs where they can afford to be away from the office, while they spend their summers at the cottage. You're paying for that too.

In reply to by sixsigma cygnu…

Kendle C lester1 Thu, 05/31/2018 - 19:15 Permalink

It's a good bet on the Tesla because some black ops hedge fund is paying remote control hackers to crash the cars. Just today one, empty, started itself and drove into a building. The media driven by payola or shadenfruede makes sure each occurrence is pumped on all channels. This punishment has been steady but has increased right after the shorts were pestering Musk on that conference call. This is vulture capital at its best. Deutsche is a very simple play, they're the "sacrifice" for the slaughter, and Bitcoin is people paying the electric company for a string of numbers puked out of a computer, no way to get that real money back. 

In reply to by lester1

Clock Crasher Thu, 05/31/2018 - 18:32 Permalink

There is no shortage of sheep to sheer.  This circus is going on for a long time.  Ever sit through 4 quarters of NHL playoff overtime?  On top of regulation?  

Clock Crasher Thu, 05/31/2018 - 18:42 Permalink

When realize that it's actually 2018 and take a look around you at what is actually happening there is no reason to panic.  

Stocks are +300% off their 2009 low

Gold n shit are -40% off their highs

I'll let you decide

If there were manipulation someone would have exploited that flaw for their own gain by now considering the world is run on the pursuit of worldly material goodies

It's funny, you don't check in on ZH for days/weeks/months... and its the same headlines.  

Parrotile shankster Thu, 05/31/2018 - 19:15 Permalink

Actually quite a realistic film if I remember correctly - especially the closing sequences with the "next instalment" arriving via migratory geese!

Personally, I'm betting on "Disease X" - nice catchy title, and such a reputable source for this article ( :-D ) 


I'd mention that fungi seem regarded as a low threat risk. The reality is that systemic fungal disease kills very easily, and is both difficult (and costly) to manage. We are seeing an increase in systemic Candidiasis in tour poorly controlled diabetics, and this week one customer checked out despite pretty high cost treatment (liposomal amphotericin and flucytosine).

For real "nightmare scenario" fungal infections (of insects, mind you) - Cordyceps. https://www.youtube.com/watch?v=XuKjBIBBAL8 (Cordyceps: attack of the killer fungi - Planet Earth Attenborough BBC wildlife)

In reply to by shankster

Harry Lightning Thu, 05/31/2018 - 18:58 Permalink

In the last crisis of 2008, the US equity markets dropped a bit more than 50% from peak to trough. If this author is correct about the size of a crisis being exponentially determined by the size of the market, this next crisis would have to be much larger than 50%. There probably isn't a pension fund that could survive that kind of capital destruction, especially since so many pensions remain underfunded with the stock market near record highs. Which means that a large swath of baby boomer retirees will not be able to retire as the income they were promised never materializes. How will they survive, will they seek vengeance through the voting booth or the shotgun ? Will some big shot bankers finally go to prison this time for malfeasance ? Will Congress wake up in time to finally change the laws that give rise to the excessive risk taking of investment banks, notably the granting of stock options based on short term company performance, and the writing of credit default swaps without posting of adequate capital to underwrite potential losses ?

No one on Wall Street ever learns, they think that if enough time passes the regulators and the public will forget about the stupid things the bankers did to cause each last crisis. Its been that way for over a hundred years. And their paid for puppets in Washington keep allowing those bankers to make the same mistakes over and again. That stupidity feedback loop needs to end, and maybe there will be a crisis so large at some point that real change is forced upon the imbeciles. 

Let's hope that when that crisis comes, the blame and the expense to fix the damage will be placed on the backs of the people who caused it instead of the working class taxpayers who always seem to get stuck paying for the mistakes of the wealthy.

GreatUncle Thu, 05/31/2018 - 19:15 Permalink

So the bankers own near 100% of everything in all the over valued assets.

But if nobody can afford them lol they may as well be worthless.

Demand creates value so ... I got some tulips to sell anybody want them ... there were worth lots of money once upon a time.

Nope worthless no demand.

Herdee Thu, 05/31/2018 - 19:46 Permalink

At least here we've learned that you should be prepared. The world right now is very dangerous, especially most politicians that are psychopaths. Even the IMF used the word fragile.

CrytpoFTW Thu, 05/31/2018 - 21:24 Permalink

The one and only long term solution to this problem (big government getting bigger and fiat funny money) is anarcho-capitalism and crypto-currencies.

Let it Go Thu, 05/31/2018 - 23:01 Permalink

Little has been done to reduce leverage. On occasion, it is important to revisit issues that have been swept under the rug or simply overlooked. For most people, the derivatives market falls into this category, partly because they don't understand exactly what derivatives are or why this market is so important.

Everyone paying attention knows that the size of the derivatives market dwarfs the global economy. Paul Wilmott who holds a doctorate in applied mathematics from Oxford University has written several books on derivatives. Wilmott estimates the derivatives market at $1.2 quadrillion, to put that in perspective it is about 20 times the size of the world economy.


Phillyguy Thu, 05/31/2018 - 23:09 Permalink

The problem is Capitalism. By their very nature, Capitalists are greedy and always seek the highest rate of return. In 2008, the US experienced the largest financial collapse since the Great Depression, a direct result of: 1) multiple tax cuts for the wealthy, 2) attacks on labor and job outsourcing, 3) financial deregulation, 4) lack of investment in new plants and equipment- business spending, and 5) spending astronomical amounts of taxpayer money on the Pentagon and strategic debacles in Afghanistan, Iraq, Libya, Yemen and Syria. Unfortunately, none of the structural financial problems giving rise to the 2008 crash have been resolved. Indeed, since that time equity markets and [still] insolvent banks have been propped up with almost unlimited amounts of ultra-cheap money from large Central Banks- US FED (circa $4 trillion), BOJ (largest holder of shares on the Nikkei) and ECB (massive bond buying program, which continues). The end result of these policies has been a debt orgy which has inflated bond and equity markets via share buybacks and MA deals, as you point out, and also inflated trendy real estate in Boston, NYC, SF, Portland, Seattle, etc. Meanwhile, government debt has exploded- US government debt is $21 Trillion (does not include municipal, corporate or consumer debt). This figure is only going to grow, following enactment of Trump's military appropriation and his large tax cuts, primarily benefiting wealthy Americans. I am not aware of any country that has been able to sustain their economy for an extended period by issuing unlimited debt and printing money. This is going to end very badly.