JP Morgan Mauled by Derivatives

There are news reports that now suggest that JP Morgan’s derivatives losses are not $2 billion, they are likely to be $8 billion or perhaps as high as $9 billion http://dealbook.nytimes.com/2012/06/28/jpmorgan-trading-loss-may-reach-9-billion/.

The JP Morgan losses resulted from derivatives called Credit Default Swaps.

But the danger to the global economy isn’t Credit Default Swaps, it is a world mired in a vast interconnected Ponzi scheme of more than a $1.1 Quadrillion dollars of derivatives, more than half of which are bets on the direction of interest rates. These are called interest rate swaps.

In fact, an estimated six hundred trillion dollars of these derivatives are interest rate swaps – a casino that is so vast, even the people who built it have lost control.

Interest rate swaps are bets on whether interest will rise or fall. An investment bank thinks rates will go up. Another bank thinks they will go down.

And they bet.

Here’s an example: the City of Houston raises $100,000,000 by selling municipal bonds to build a new sports stadium.

The bonds are sold with a floating interest rate, which is tied to a rate controlled by the Fed called the federal funds rate (FFR) – say, FFR + 2% – and is at the closing of the bond issue, let’s say, 4%.

But the city’s budget is extraordinarily upside down and if rates go up, they’ll never be able to handle the interest payments. What to do?

In the distance we hear a bugle signaling a cavalry charge. This is followed by the sound of screeching tires as a Humvee stretch-limo the size of the Hindenburg squeals around the corner, roars up the street and pulls to a stop in front of the mayor’s office.

The chauffeur exits the driver’s side and walks briskly around the car and opens the rear door. The first person out is a Julia Roberts look-alike in a Valentino pantsuit. She is wearing designer shades and is carrying a Prada briefcase. She is followed by an unusually tall man wearing a midnight blue Armani suit with teal pinstripes. He is ostrich egg bald, is wearing granny glasses and has a Tumi laptop bag slung over his shoulder. He is furiously working the keys of a Blackberry while talking on a Bluetooth headset.

Goldman Sachs has arrived.

The City of Houston and Goldman strike a deal.

The City will pay Goldman a fixed rate of 4% so their interest expense is guaranteed not to rise. Goldman, in turn will pay the city the floating rate – the fed funds rate +2%, so they can pay their bondholders per the terms of the bond purchases.

That is an interest rate swap: the city “swaps” its floating rate for a fixed rate. If the Fed Funds Rate goes up, Goldman loses; if it goes down, they win.

But that transaction doesn’t end there. There are bets on this swap and bets on those bets and then bets on the bets of the bets and… stay with me …a $600,000,000,000 – six hundred TRILLION house of cards.

This is a colossal global casino, built on hot air and greed.

Which brings us back to what is truly driving the actions of the Fed, the International Monetary Fund and the Bank for International Settlements.

Perhaps you have noticed that the Federal Reserve (which we remind you, is owned by Goldman Sachs and other major New York banks, not the U.S. government) has kept interest rates at zero for the last three and a half years.

What happened to the banks that bet on low interest rates using interest rate swaps? They made billions in profit. Why? Because they arranged to receive fixed rates from borrowers (cities, states, universities) in exchange for floating rates. The floating rates were tied to the Federal Reserve’s Fed Funds rate, which was lowered to zero during to the “financial crisis” by Helicopter Ben and have remained there.

Consider the fact that the financial crisis seems to have missed JPMorgan, who made about $5 billion in profit on interest rate swaps during the first 9 months of 2008, the very heart of the crisis.

Goldman Sachs made similar profits on these swaps, as did Wells Fargo, to name a few. Of course, the cities, counties and states that took the other side of these bets on the advice of investment bankers to protect their bonds, got slaughtered. But let’s not be too harsh on them. According to Goldman Sachs’ CEO, Lloyd Blankfein, following his testimony before Congress, he’s just a banker “doing God’s work.”

We love you, Lloyd.

But here’s the problem.

The majority of the more than a half quadrillion dollars in interest rate swaps are held mainly by banks. As we documented above, the 9 biggest U.S. banks hold a quarter of a quadrillion in derivatives. An estimated $136 trillion are interest rate swaps (the U.S. Gross Domestic Product, basically the value of our annual production of goods and services is $15 trillion).

Stay with me here.

With rates at zero, what’s the only way they can go?

That’s right, up.

And what will happen to those banks with trillions of dollars of interest rate swaps in their portfolios when rates start to climb?

The planet is drowning in a multi-trillion dollar game of interest rate roulette, whose players will suffer massive losses when rates reverse.

And at this point, this isn’t entirely up to Bennie and the Jets. The U.S. Government went $1.4 trillion in debt last year and recorded a $1.3 trillion deficit this year.

Which means?

Which means that, at some point for China, Japan or the tooth fairy to buy our Treasury Bills, rates will have to rise. China is not drinking Tim Geithner’s Kool Aid. And the U.S. government will have to raise rates at some point to entice others to buy our fiscal waste. If we don’t raise them, the market will force them up.

Not, says Helicopter Ben, on my watch. The Bald One bought $600 billion dollar’s worth of U.S. Treasury last year. Ben calls the Alice in Wonderland money injection, “Quantitative Easing.” That was the second round of quantitative easing – the first one was an unqualified disaster – this one has been the same. According to reports, QE 3 is being discussed.

Ben is nothing if not brilliant. If he takes to the presses and buys Timmy Geithner’s debt he doesn’t have to rely on his comrades in the People’s Republic of China to buy it. Rates will stay low. And the trillions of dollars of interest rate swaps – which are owned by the same people who own his bank – will be safe.

Ben could be up for a Nobel Prize.

Except that’s not what happen as a result of QE 2. Finance ministers from around world issued statements implying that Ben was smoking something. And as noted by Mike Larson, of Money and Markets, some of the key U.S. government bond yields not only didn’t go down, they soared.

And what did our lenders, the Chinese, do? The Chinese credit rating agency, Dagong Global, downgraded the debt of the United States citing, “…the detrimental effects of the QE2 plan and the U.S.’s sizable debt load.”

Oops.

What will happen when someone sticks a pin in the derivatives balloon? Not a $2-$9 billion dollar JP Morgan sneeze. No, not even the flu. It will be double bronchial pneumonia.

What would you rather be holding when that happens, pieces of paper or gold and silver?

John Truman Wolfe, author of America the Litigious, Mind Games, and The Gift has released his latest stunning bestseller – Crisis By Design: The Untold Story of the Global Financial Coup and What You Can Do About It. Wolfe draws on experience as a senior credit officer in two banks, and co-founder of a prestigious Los Angeles based business management company, where as a registered investment adviser he oversaw the financial and investment matters of some of the biggest names in Hollywood.