Bridgewater Associates: 4 years into 15-20 of Deleveraging

[jpatter666]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Does anyone really talk about the bond vigilantes anymore?

This was such crap - where are the 'bond vigilantes' for the gigantic US fiscal fiasco? Japan? the UK?

Shrug. Didn't say I believed it, just said in the end, that seems to be the basis of the argument (given fiat currencies). Automatic Earth very much takes this tone still and I still hear weak echoes of it from Mish-mash.

[coolhand]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Does anyone really talk about the bond vigilantes anymore?

This was such crap - where are the 'bond vigilantes' for the gigantic US fiscal fiasco? Japan? the UK?

They were neutered by interest rate derivatives. Initiating an interest rate derivative position requires putting up no capital. Initiating an interest rate derivative position also often creates artificial demand for real bonds (such as 10-year Treasuries), b/c taking on the derivative & bond together lock you into a truly risk free position, regardless of which way interest rates move. If you can lever up 10 to 1 & guarantee yourself 2% no matter what, then you get 20% of the profits every year as at a hedge fund, voila!

So the question is are interest rates derivatives big enough to have done that? Taking a look at the IR derivative books at the big banks, they are measured in the hundreds of trillions. The answer is absolutely.

It has always been my assertion that THIS is why Larry Summers called Brooksley Born at the CFTC (I believe) in the late 1990's, as she was trying to regulate interest rate & bond derivatives, & threatened her by saying "I have 13 Bankers in my office that say that you will destroy the financial system if you regulate derivatives." Since then, Simon Johnson has written a book entitled "13 Bankers" that in part details how we got here. I haven't finished it yet, but it's pretty good.

[coolhand]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

The essence of the deflation argument to me is: bond markets are king, they will eventually bring a printing central bank to heel
The essence of the inflation argument to me is: bond markets be damned -- they don't vote in elections. We have a printing press and we are going to use it.

Then you get the weird "I can't decide what I am" character like Europe and the Euro.....

You got it - the Fed can keep rates wherever they want them, but in doing so, they will lose control of their balance sheet size, & by extension, inflation rates of food & energy. And the Fed has history...they did this EXACT thing from 1942-1951...pinned 10-yr rates at 2.5%. The US could afford the war that way, but inflation went bonkers...there were several years, even after WW2, where inflation was double digits.

[ProdigyofZen]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Coolhand, You have very cool hand posts

[coolhand]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Thank you, you are too kind!

[c1ue]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

So the question is are interest rates derivatives big enough to have done that? Taking a look at the IR derivative books at the big banks, they are measured in the hundreds of trillions. The answer is absolutely.

I thought some part of the AIG problems were interest rate derivatives.

If so, it would seem that said derivatives are hardly much more than vehicles by which to siphon bailout money out of the federal government and Federal Reserve.

That, or just another bs way by which exposure can be hedged in order to pump up bonuses.

[jk]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Coolhand, You have very cool hand posts

+1

[coolhand]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

I thought some part of the AIG problems were interest rate derivatives.

If so, it would seem that said derivatives are hardly much more than vehicles by which to siphon bailout money out of the federal government and Federal Reserve.

That, or just another bs way by which exposure can be hedged in order to pump up bonuses.

Absolutely that was the problem. We just saw this problem in Europe, a real life example. What happened to rates on PIIGS debt immediately after it was ruled that the 50% haircut on Greek bonds was NOT a default event b/c it was voluntary, & as such, did NOT trigger CDS contracts? Interest rates on PIIGS debt shot up, as investors that owned debt & CDS protection (just a type of interest rate/debt derivative) on that debt realized that they were NOT protected as they thought, & so they dumped their debt holdings...or in other words, acted as bond vigilantes, once they learned their interest rate derivatives were NOT protecting them.

In the case of AIG, the gov't had to step in b/c if AIG wouldn't have paid out 100% on those IR derivatives to GS & others, then GS & others would've been forced to act as bond vigilantes & dump debt, & you would've collapsed the bond market, you would've had an Argentinian Ka-Poom moment in the US, complete with 20%-50% interest rates, whatever the right % rate is, I don't know...the US economy obviously would've collapsed, as would've the US dollar, b/c any interest rate over roughly 20% on externally held US Treasury debt (~$10T worth) would mean the interest expense would surpass tax receipts.

As a practical matter, it wouldn't even take a move that dramatic - at rates equal to just the average of the last 50 years, the interest expense on US debt would be $500B higher, & the deficit would then be $500B higher.

Once you realize this, you realize why Bernanke said he hated bailing out these bankers but he had to. And that they aren't just a way for bankers to get rich (although that is a nifty by-product for the bankers.) The fact is that without the unregulated derivatives, the bond market would've revolted long ago...and since we didn't let markets function normally, we have now piled on so much debt that the slightest rise in interest rates will collapse the system...so interest rate derivatives are the US gov'ts best friend. This has nothing to do with getting bankers rich. It has everything to do with keeping the dollar from collapsing.

As a side note, I suspect that THIS is also why there have been exactly zero prosecutions of anyone in the TBTF banks. You don't want to start asking too many questions, esp to the senior level execs. Washington DC knows that the TBTF banks are the only reason the Ponzi game has been kept alive this long. And quite frankly, since there is no capital charge for these IR derivatives, it can be kept going a lot longer, with bigger & bigger debt levels. The only thing that can trip it up is the physical world - ie when food & energy prices get too high.

This is also why, IMO, shorting US treasury debt, & Japanese debt for that matter, is a sucker's game. You will be right, eventually, but when it happens, the only thing that matters will be how much food you have, how many bullets you have, & how good your gardening skills & aim is!! The better way so far, & the likely continued better way to "short Treasuries" is the old fashioned way - borrow as much money as you can at these IR derivative-manipulated rates, & buy productive assets that have a food & energy inflation bent to them - farmland is my favorite, but there are others. The other way to do it is buying gold. Gold's price has tracked fairly nicely with the size of the derivative market over the past 10 years.

This won't end happily, but it can go on a lot longer than people think...the physical world will determine how long.

[jpatter666]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Wow coolhand, thanks for that very interesting note.

Wonder what EJ, bart and finster might have to say to this. Might bart have a chart for that?

[coolhand]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Wow coolhand, thanks for that very interesting note.

Wonder what EJ, bart and finster might have to say to this. Might bart have a chart for that?

You're welcome! There are some parts in there that might be off slightly, but directionally I think its pretty solid. I will tell you that in a meeting with a hedge fund exec a few years ago, they told me "Be afraid of interest rate derivatives. Very afraid." You can see from both the example above & what we saw in 2008, I think the net of the interest rate derivatives market is that they will force the central bankers to have to print every last dollar b/c my guess is the derivative stuff probably scares the crap out of them too...b/c remember that while on the front end, there is no capital charge, making it really easy to write interest rate derivatives "insurance", the "back end" gets really, really messy b/c no one has any reserves to backstop any of the stuff...they are written with the implicit understanding they'll be backstopped by the gov't.

As I understand it, insurance companies are highly regulated in terms of how much capital they must hold back in reserves to cover existing policies, yet the interest rate derivatives market is a multiple-hundred-trillion dollar market & it is completely unregulated, & for all intents & purposes, has no capital or reserves standing behind it, only the "premiums" the TBTF banks take in upon initiation of the contract...so when they were for example writing AIG CDS' at 2bps over US gov't CDS rates, they weren't getting very much money, they sure didn't have the money to pay out on those bets when it was needed. So if the TBTF's don't have the money, the gov'ts globally are effectively underwriting this market by backstopping the TBTF's.

When you look at it that way, you can see a couple things:

1. The global financial system is an enormous Ponzi, where gov'ts issue debt at below market rates b/c the TBTF banks write incomprehensibly large amounts of these massively undercapitalized insurance contracts on that debt, then the gov'ts effectively backstop those TBTF's with as much taxpayer $ as it takes to keep the TBTF's alive & to keep the game going.

2. Why the gov'ts of the world have moved heaven & earth twice now (once in 08, again in 11 in the Greek CDS situation I described above) to avoid having CDS' go off when by all rights they should've. IMO, when you consider my point #1 above, there's only 2 reasons they would've done that:

a) they know that they, gov'ts collectively, would have to backstop every last dollar of interest rate derivatives/CDS' that goes off, &

b) the CDS/IR derivative market, by virtue of the nearly infinite leverage contained in it (when you write a $100mm interest rate derivative on something with no capital behind it & just the small premium/fee against it, you are basically leveraged infinitely if you are ever forced to pay out on that contract), is like an ammo dump - if one explosive goes off, forget about it - the whole thing will go up, & you will need to get away ASAP and just wait for however long it takes for the ammo dump to completely cook off ever last round, till all that is left is a smoldering crater.

My guess is that this is also why Buffett famously referred to interest rate derivatives as "financial WMD's."

My bottom line - once you understand this, you begin to think about the money supply a lot differently - so vis a vis gold, when you look at gold as a multiple of money supply to arrive at a gold price target, one can very easily make a case that you need to factor the size & undercapitalization of the interest rate derivative market into that calculation...ie likely upside to gold price targets v. what you would arrive at by simply looking at gold's value v. say US M1, M2 or M3 money supply. I don't know how much you'd add to a gold price target b/c of IR derivatives, but IMO, I think you should add a bit.

[AxelB]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Coolhand,

This was truly an excellent expose, and went quite a ways in providing a working theory on the overarching constraint on the financial oligarchy's ability to pursue what could be viewed as its interest in deflation over inflation. It appears that everyone's hands are to an extent tied by the bets that keep being made.

The question that comes to mind is whether with sufficient inflation over time there is a way to reduce this derivate liability. For example, does each new bond issuance necessarily result in a fresh round of IR derivatives? I dont think i'm asking the question properly, but a lot of discussion has been posted about the ability of the government to inflate away the debt overhang -- similar to what happened post WWII as written by Reinhard in the article on financial repression. Do the IR derivates effectively nullify this process?

anyway, just some thoughts, but really a very interesting read. Thank you again.

[coolhand]

Re: Bridgewater Associates: 4 years into 15-20 of Deleveraging

Coolhand,

This was truly an excellent expose, and went quite a ways in providing a working theory on the overarching constraint on the financial oligarchy's ability to pursue what could be viewed as its interest in deflation over inflation. It appears that everyone's hands are to an extent tied by the bets that keep being made.

The question that comes to mind is whether with sufficient inflation over time there is a way to reduce this derivate liability. For example, does each new bond issuance necessarily result in a fresh round of IR derivatives? I dont think i'm asking the question properly, but a lot of discussion has been posted about the ability of the government to inflate away the debt overhang -- similar to what happened post WWII as written by Reinhard in the article on financial repression. Do the IR derivates effectively nullify this process?

anyway, just some thoughts, but really a very interesting read. Thank you again.

Thank you Axel, & you are welcome. You rightfully call it a theory, based upon a mixture of fact, intuition & supposition. But it makes a lot of sense IMO.

As far as your question - I'll turn it around & pose it to you: Would you buy a 10-year US Treasury at 1.9% per yr, knowing that you would lose a substantial portion of your money if interest rates only went back to their long-term averages of say 5%? I know I wouldn't.

I absolutely think Reinhard, Rickards & others that have written about or discussed financial repression are right. I can see it in my own life, where the costs to raise my young children are rising at somewhere b/t a 7-10% annual clip, yet I am getting 0% interest anywhere relatively safe (short term CDs, Treasuries, etc. By safe, I mean little/no risk of capital loss on rising interest rates.)

Thinking it through, I think IR derivatives aid the process of financial repression immensely, b/c there is no ability of "bond vigilantes" to hold a gov'ts feet to the fire. This does reveal a gap in my logic to some degree, which is that if anyone can use these derivatives to neuter bond vigilantes, why couldn't the EU or ECB use them to keep EU sovereign interest rates in check...and the answer is 'I don't know.'

If I really wanted to put my tinfoil hat on, and I think Jesse at Jesse's Cafe Americain has alluded to this, I would guess that what is going on in Europe could be a battle in the ongoing "Currency Wars" as Rickards calls it in his excellent book...but I don't know.

To answer your question directly - I think these IR derivatives aid the authorities in their goal of financial repression...as to whether it will be successful, I am less certain. It seems to be a race b/t how long it takes to inflate away the debt levels v. how long before the process of inflating away the debt also inflates food & energy prices (in a peak cheap oil world) to levels that create negative economic feedback loops, or worse yet, negative geopolitical/social unrest implications in western nations.

I hope they can do it. Of course hope is a great thing, but a lousy strategy. Given where we are currently on food & energy prices relative to median incomes, & given the debt levels involved, which are likely to rise given US demographics (Soc security, Medicare, etc.), I am not very optimistic.