Saturday, February 18, 2012

Jim Rickards on wealth preservation

Jim Rickards is the author of Currency Wars. His book provides a historical basis of money and past currency wars and how they affect various economies. He has "war gamed" financial warfare for the US government and explains well, where we have been and where we are currently going.

Listen to his podcast here.

Rickards begins the discussion by describing the role of Credit Default Swaps in the Greece crisis. To understand how these agreements may bring down the global financial system I'll give an example.

Let's say you were an institutional investor who bought $100 million of Greek bonds several years ago. You would probably want to hedge your position knowing that Greece had a high level of debt. So you go to an American bank, let's just say JP Morgan for example. They sell you a contract that does not trade like normal securities. Its essentially an insurance contract that says if Greece defaults on their debt, JP Morgan will pay you a specified dollar amount which would offset your losses on the bonds you own. For this insurance JP Morgan makes a substantial amount of money. They do not believe they will have to pay off the insurance. So unlikely they believe, that they sell huge amounts of the same insurance to everyone else who owns Greek bonds.

Now we find ourselves in 2012, and it looks like Greece has no chance to pay off their debts. Their GDP is declining along with their tax revenues and the market is demanding higher rates of returns to hold their bonds. The bonds you bought for 1,000 Euros now are worth 300 Euros. Their next payment is coming up in March 2012. They are negotiating with you and other holders of the bonds to devalue the worth of each bond to 30-40 cents on the dollar. Most would consider this a default sine the buyers of the bonds will not get all their money back and you would expect to get paid from JP Morgan from those Credit Default Swaps that you paid so much money for.

But there's a problem. In this example JP Morgan and other banks sold so much of these CDS' that if they ever had to pay them off they would no longer be solvent. This is exactly what happened in 2008 to AIG who sold more CDS than they could pay at once when Lehman went under. As a result they were bailed out by the US government saving banks like Goldman Sachs who otherwise might have gone under.

This time though, they can see the trouble coming and its no surprise. If Greece is declared in default, these big banks that sold the CDS' will have to pay up. But who decides whether Greece's devaluation of the bond is a default? Well that's determined by the ISDA (International Securities Deal Association). So the ISDA has a lot of influence in the solvency of the big banks (JP Morgan in this example). So just who is in charge of the ISDA who will determine if many of these banks stay solvent or go bust? Well, just take a look for yourself.

I'll save you the suspense. Its the banks themselves. If Greece defaults, the big banks will have to decide if they commit suicide by declaring the default or call it something else and save their hides. What do you think the banksters will do?

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