We now believe that continued high levels of notional values of derivatives equate to continued high systemic risk, cautions Alan Newman, editor of CrossCurrents.
We can remember decades ago when only $0.70 in new debt had the ability to increase GDP by $1. It was a truly golden age and it was no wonder that debt increased sharply.
By 1997, it took $2.50 to grow GDP by a dollar and shortly thereafter, we experienced the greatest stock market mania since the Roaring Twenties.
By 2007, it took $3.50 to grow GDP by a dollar and months later; we experienced the peak of yet another bubble, in stocks and in housing. And now? It is estimated to it takes $4.47 in new debt to increase GDP by $1.
Thus, we continue on a path to disaster. There is no point in adding even one dollar of debt since it cannot accomplish enough.
While it has seemingly been possible to accommodate more debt in recent years as rates have trended down, there is no room remaining for more debt. We have reached the end of the line.
The nine major commercial banks account for virtually all-outstanding notional values in derivatives.
Before its collapse, Bear Stearns had a portfolio of notional contracts amounting to $13.4 trillion, which were more than 38 times total assets.
Today, Goldman Sachs (GS) has derivatives contracts that total $46.2 billion, which is 340 times its total assets, nearly nine times as high as Bear Stearns.
We are certainly not forecasting the Goldman will experience a similar outcome, but we are strongly suggesting that derivatives exposure continues to be enormous in comparison to the total assets of these players.
The nine major commercial banks account for virtually all-outstanding notional values in derivatives.
Total assets of just three "too big to fail" banks — JP Morgan (JPM), Citigroup (C) and Goldman Sachs — while 4.2% lower than in 2008, are still 16.1% higher than in 2007.
As a result, there is no essential difference between today's environment and that of the bubble in 2007-2008.
The huge exposure we see are based to a large degree on the concept of netting benefits. Theoretically, if gross negative fair values are balanced by gross positive fair values the risks of derivatives of minimized — ideally to zero.
However, this balance can only be based on assumptions and when assumptions go horrible wrong as they did in 2007 and 2008, anything can and typically does happen.
History has shown that the more money that is in play, the more risk rises. If the assumptions used to balance derivative exposure are out of whack by only 5%, the imbalance adds up to half the total assets of JP Morgan, Citigroup, Goldman and Bank of America (BAC).
As a result, merely a fraction of "fair values" assumed in derivatives contract need be corrupted by unexpected circumstances to catalyze another crisis. In our view it will occur.
Meanwhile, the quick rebound in stocks and the return of the VIX Volatility index to the lowest levels since last October bears witness to an extreme episode of complacency and optimism. Episodes such as this are typically countered by opposite extremes.
We expect any short to intermediate term rally to prove futile. Seasonal factors — the historically unfavorable months of May through October — will soon come into play.
We see no reason for the pattern to change this year. The confluence of potential negative catalysts include a significant slow down in economic growth and great concern about where the country might be headed for the next four years based on the political climate.
Our "most likely" downside target is a 16% decline, or a drop to Dow 14,719. Our worst-case bear market target is a decline of 21% to 27%, or a decline in the Dow to between 12,846 and 13,763.
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By Alan Newman, Editor of CrossCurrents
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