Filling the derivative hole

Developments surrounding sovereign debt and their off-balance sheet liabilities in the form of derivatives such as currency swaps pose serious inflationary risks over the next five years. Below an excerpt from Bloomberg article:

“As details of the coverup [of AIG bailout by NY Fed under Tim Geithner] emerge, so does anger at the perceived conflicts. Philip Angelides, chairman of the Financial Crisis Inquiry Commission, at a hearing held by his panel on Jan. 13, questioned how banks could underwrite poisonous securities and then bet against them. “It sounds to me a little bit like selling a car with faulty brakes and then buying an insurance policy on the buyer of those cars,” he said.”
[Human Action emphasis]

Big money was made in shorting the mortgage market (or simply underwriting an increasing amount of MBS’, CDOs, CMOs, etc) while at the same time holding insurance on these securities through credit default swaps in 2006-08. The next trend are bear raids on sovereign debt. The play is to go short a sovereign nation’s debt, while at the same time owning credit default swaps on the debt and being short the currency. The focus of bear raids have shifted from companies to sovereign states (think Greece). This is where trillions in profit will be made compared to the billions of breaking companies. Consider the following from BusinessInsider:

“Goldman Sachs arranged swaps that effectively allowed Greece to borrow 1 billion Euros without adding to its official public debt. While it arranged the swaps, Goldman also sought to buy insurance on Greek debt and engage in other trades to protect itself against the risk of a default on those swaps. Eventually, Goldman sold the swaps to the national bank of Greece.”

These EU states (and shortly US states) will be bailed out or back-stopped by their central bank in some way or form. Greece just got bailed out with implicit guarantees, and politicians have now shifted their focus to controlling these speculators. The fact remains that it is too late — the damage has been done as these instruments have been written and aren’t on an exchange. Pandora is out the box.

Why do people trust the government’s ability to continuously backstop the entire economy to the tune of billions or even trillions of dollars? The only means they have to fulfill their promises is by taxing its people. How much more can the people be squeezed? To be sure, government has the ability to borrow the difference – yet, there aren’t sufficient surpluses in the world to finance the increase in debt issuance. This leaves governments of the West with only one tool to finance deficits caused by profligate spending and shady losses on off-balance sheet derivatives, and that is the printing press. The result is a global co-ordinated inflation through individual sovereign inflationary policies, the IMF (think SDR disbursement to over 100 countries in 2009), and other means such as currency swaps from the Fed.

We expect a result of this will be a sharp rise in inflation in Western economies over the coming five years, an inevitable result of governments competing to take their currencies lower. 

If you’re interested to learn more on use of derivatives in masking sovereign debt, here is a good short analysis by Satyajit Das on FT.com.