Look around the world and big risks abound. One or more countries may drop out of the eurozone. Violence may spread across the Middle East. The US Congress may yet drive the country off its fiscal cliff and into recession. An island dispute between China and its neighbours may flare up, provoking the US to intervene in the Pacific. But in my view, the single greatest risk is that one of these events or some other throws the world into another global financial crisis, a “GFC II”….
1000x Systemic Leverage: $600 Trillion In Derivatives “Backed” By $600 Billion In Collateral
There is much debate whether when it comes to the total notional size of outstanding derivatives, it is the gross notional that matters (roughly $600 trillion), or the amount which takes out biletaral netting and other offsetting positions (much lower). We explained previously how gross is irrelevant… until it is, i.e. until there is a breach in the counterparty chain and suddenly all net becomes gross (as in the case of the Lehman bankruptcy), such as during a financial crisis, i.e., the only time when gross derivative exposure becomes material. But a bigger question is what is the actual collateralbacking this gargantuan market which is about 10 times greater than the world’s combined GDP, because as the “derivative” name implies all this exposure is backed on some dedicated, real assets, somewhere. Luckily, the IMF recently released a discussion note titled “Shadow Banking: Economics and Policy” where quietly hidden in one of the appendices it answers precisely this critical question. The bottom line: $600 trillion in gross notional derivatives backed by a tiny $600 billion in real assets: a whopping 0.1% margin requirement! Surely nothing can possibly go wrong with this amount of unprecedented 1000x systemic leverage.
From the IMF:
Over-the-counter (OTC) derivatives markets straddle regulated systemically important financial institutions and the shadow banking world. Recent regulatory efforts focus on moving OTC derivatives contracts to central counterparties (CCPs). A CCP will be collecting collateral and netting bilateral positions. While CCPs do not have explicit taxpayer backing, they may be supported in times of stress. For example, the U.S. Dodd-Frank Act allows the Federal Reserve to lend to key financial market infrastructures during times of crises. Incentives to move OTC contracts could come from increasing bank capital charges on OTC positions that are not moved to CCP (BCBS, 2012).
The notional value of OTC contracts is about $600 trillion, but while much cited, that number overstates the still very sizable risks. A better estimate may be based on adding “in-the-money” (or gross positive value) and “out-of-the money” (or gross negative value) derivative positions (to obtain total exposures), further reduced by the “netting” of related positions. Once these are taken into account, the resulting exposures are currently about $3 trillion, down from $5 trillion (see table below; see also BIS, 2012, and Singh, 2010).
Another important metric is the under-collateralization of the OTC market. The Bank for International Settlements estimates that the volume of collateral supporting the OTC market is about $1.8 trillion, thus roughly only half of exposures. Assuming a collateral reuse rate between 2.5-3.0, the dedicated collateral is some $600 – $700 billion. Some counterparties (e.g., sovereigns, quasi-sovereigns, large pension funds and insurers, and AAA corporations) are often not required to post collateral. The remaining exposures will have to be collateralized when moved to CCP to avoid creating puts to the safety net. As such, there is likely to an increased demand for collateral worldwide.
There’s been a major reversal of sentiment.
“For the week that ended last Friday, this sell-to-buy ratio for NYSE-listed shares listed stood at 6.67-to-1. That means insiders, on average, were selling nearly seven shares of their companies’ stock for every one that they were buying. One month ago, in contrast, the comparable ratio stood at 1.54-to-1.
|Sell-to-buy ratio for NYSE-listed stocks|
|Early May high, just before May-June correction||7.11-to-1|
|Early October high, just before October-November correction||5.13-to-1|
|Average over last 20 years||3.41-to-1|
|Early June low||2.01-to-1|
As you can see from the accompanying table, the latest reading is both far above the long-term average and right in line with levels seen at the market’s intermediate tops earlier this year.” Read more here
Just a standard selloff could kill two years worth of profits.
In his latest weekly note, John Hussman is very bearish and he blasts the Fed for not correctly fixing the economy.
This is very standard for him.
One interesting observation regards the fragility of investor gains:
The stock market is only a few percent from its 6-month high at present, and even an overextended move to about 1490 would put the S&P 500 at its upper Bollinger band (two standard deviations above the 20-period moving average) on daily, weekly and monthly resolutions. That’s something that we saw back in early 2011 (see Extreme Conditions and Typical Outcomes), when the S&P 500 Index was only about 5% below where it is today, and again in September 2012 (see Low Water Mark) when the S&P 500 was above where it is today. Overextended moves like that, coupled with other features of an overvalued, overbought, overbullish syndrome, are typically associated with awful outcomes over the following 6-18 months, though not always immediately.
Aside from the early 2011 instance, which was followed by a nearly 20% plunge before Bernanke launched QE2, and the September 2012 instance, the outcome of which remains to be seen, other points where the S&P 500 has reached its upper Bollinger band on a monthly resolution, an overvalued Shiller P/E above 18 (S&P 500 divided by the 10-year average of inflation-adjusted earnings), a 20-point spread between advisory bulls and bears, and an overbought S&P 500, 8% above the 52-week average and at least 50% above its 4-year low include: early 2007 and late 1999 – both just before separate 50% market losses, mid-1998 before the market plunge associated with the Asian crisis, August 1987 before the October 1987 crash, and late 1972 as the market rolled over into a 50% market plunge. Notably, one instance – the span from mid-1996 to early 1997 during the late-1990’s market bubble – was followed by strong continued gains. While the 2009 market decline wiped out the entire total return that the S&P 500 had achieved in excess of Treasury bills, all the way back to June 1995, it’s fair to note that overextended market conditions did not produce losses in short-order in the midst of that bubble.
Following each market setback of the past few years, the kick-the-can rebounds back to overvalued, overbought, overbullish conditions have made the market seem like it is boundlessly running away. The reality is that the S&P 500 Index is presently within 5% of its level of April 2011 – more than 18 months ago – and even a few weeks ago the index was within about 11% of its April 2010 level. A correction comparable to the ones we observed separately in 2010 and in 2011, and not even qualifying as a bear market, would wipe out the total return of the S&P 500 since early 2010 (the point that our present ensembles would have moved away from a significant and sustained exposure to market risk). Since then, the market has been a chronicle of shakeouts from overbought highs and rescues at the first sign of material weakness. What has changed over the past few years, relative to history, is the enormous effort by the Federal Reserve to short-circuit not only ordinary corrections, but also the deeper and more typical resolution of the market cycle.
Lawmakers: We’re Likely to Go Over the ‘Fiscal Cliff’
REUTERS: Top U.S. lawmakers voiced rising fear on Sunday that the country would go over “the fiscal cliff” in nine days, triggering harsh spending cuts and tax hikes, and some Republicans charged that was President Barack Obama’s goal.
“It’s the first time that I feel it’s more likely that we will go over the cliff than not,” Senator Joe Lieberman, an independent from Connecticut, said on CNN’s “State of the Union.”
MUST-WATCH: There Will Be NO Deal On The Fiscal Cliff-Karl Denninger
Equities took a significant overnight drop on Thursday when talks of a fiscal cliff breakdown hit the wires. The drop only served the purpose of keeping this 100 point 1st Daily Cycle from getting to far ahead of itself. The decline has only taken the S&P right back to its rising 10dma where I expect the next rally to a DC Top will begin. With a good 10 days left before a normal DC Top is expected I believe we will first see another drop on Monday the 24th that is followed by a rally starting from the 26th. The top of this Daily Cycle will likely be a failed challenge of the cyclical bull market highs (1,472 area). In all likelihood this Daily Cycle will top right in that area and will be the cue for a chorus of double top callers.
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