BLACK HOLE FOR DERIVATIVE MARKETS GETTING BIGGER

One of the financial sites I like to follow is Money Morning. Sure it's designed to attract investors. And, yes, they want to make money from you by placing investments on your behalf. Finally, there's no doubt that they can drift slightly towards political hackery with their criticism of President Obama and his policies. However, they also regularly provide good clean real time information, and offer good analysis of developing events. It's one of the reasons I cited several Money Morning articles in my book, and continue to read their newsletters over other market "news" sources.

This helps to explain why I've posted the article, "The Most Dangerous Financial Headline I've Seen Since 2008," below. It might be a bit long for some, but it's worth the read.

In a few words, the chief investment strategist for Money Morning, Keith Fitz-Gerald, explains how a small bank in Germany might just be our canary in the mine when it comes to warning us about derivatives, and the next market collapse (derivatives explained here). His argument? Derivatives are little more than market bets, and not really based on sound market principles.

Specifically, Fitz-Gerald writes, "Contrary to what Wall Street wants you to believe, derivatives aren't investments ... in anything. Not stocks, not bonds, not currencies." After running us through the many trillions of dollars in derivative bets that swirl around the banks and our financial sector, Fitz-Gerald makes it clear that the world's largest banks are in way too deep.

In a few words, the banks don't have enough to clear out the bets they've placed in our derivative markets when the next market collapse hits.

Fitz-Gerald ends by noting that the financial sector is not healthy, and that anyone who claims that derivatives are part of a healthy investment portfolio is nuts because they're only making our markets less healthy. I agree.

So, yeah, if you have the time, read the article, which I've posted below.

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The Most Dangerous Financial Headline I’ve Seen Since 2008
By KEITH FITZ-GERALD, Chief Investment Strategist, Money Morning

In my capacity as Chief Investment Strategist, I read news feeds from more than 100 sources every day. That helps me keep tabs on the Unstoppable Trends we follow here, what’s going on around the world, and, more importantly, discover opportunities for you that others don’t yet understand or even recognize.Given everything going on – ISIS, Russia, Washington, fabricated economic numbers, earnings… you name it – it takes a lot to surprise me. I’m pretty jaded.But a headline I recently came across stopped me in my tracks. Cold.

It was, by far, the single most dangerous story I’ve seen since the Financial Crisis began in 2008. Worse, it merited only a passing mention on Bloomberg. Not a single major U.S. network I’m aware of paid it any meaningful attention.

They should have.

What I am about to tell you is proof positive that big banks are not the bastions of stability and financial prowess many believe them to be at this stage of the “recovery.”

More to the point, big banks may harbor hidden risks and are not, as many analysts believe, the bright spot in this otherwise potentially disappointing earnings season.

Here’s that headline… and what it means for four bank stocks you may own.

This Small German Bank Just Put Up a Huge Red Flag

Last month, according to Bloomberg, the Association of German Banks (BdB for short) had to bail out German-based Duesseldorfer Hypothekenbank AG (DuessHyp).

Never heard of it? I hadn’t either… but here’s what you need to know.

Like many banks around the world that have made questionable investments, DuessHyp was facing write downs on debt it held. In this case, some €348 million (approximately $375 million) issued by Austria’s Heta Asset Resolution AG, which “blew up” – a banking term meaning failed – because of bad loans.

Theoretically, this isn’t a big deal. Every bank maintains reserves sufficient to deal with this kind of situation. Or at least they’re supposed to.

But, also like many banks, DuessHyp had been trading highly leveraged swaps, and that meant the Heta failure caused a hit to the bank’s reserves. Consequently, DuessHyp would have to post additional margin to maintain the highly leveraged trading positions on Eurex, Europe’s largest derivatives markets.

Only DuessHyp didn’t have it. So DuessHyp was forced to seek a rescue, lest the damage caused by Heta’s failure cause the bank to fail and the damage to spread throughout the European banking system.

I realize that all this can be hard to follow, so let me cut right to the chase:

1. A bank almost nobody’s ever heard of before with a total capitalization of under €15 billion in assets and just 52 employees is suddenly deemed “too big to fail” and has to be rescued when it’s unable to post additional collateral on a mere €348 million in bad debt.
2. The total notional value of derivatives exposure by U.S. banks was $240 trillion according to the Office of the Comptroller of the Currency (OCC) as of Q4/2014.

Contrary to what Wall Street wants you to believe, derivatives are not investments… in anything. Not stocks, not bonds, not currencies.

They are nothing more than legalized gambling, because they are wagers on the expected outcomes of specific events like the failure of Greece to secure sovereign financing and what happens to its national debt when that comes to pass.

It was the same thing for Ireland, Portugal, Italy, and several other countries during the depths of the Financial Crisis – bad debt and a lack of collateral to cover it when it went bad caused regulators and central banks to “rescue the system.”

So this begs the question. Why? Big banks make big bucks from trading this schlock. Meanwhile, everybody pretends like everything is okay.

Here’s where it matters to you and your money.

Derivatives Trading Is Not Only Still Happening… It’s Growing

Many analysts are expecting the “undervalued” financial sector to post positive profits this earnings season at a time when there will be otherwise disappointing earnings ahead.

Much of that will come from a “surprisingly robust mortgage business that bolsters earnings,” notes Paul Vigna of the Wall Street Journal. John Butters of FactSet observes that the financials may report positive earnings results reflecting as much as 8.4% growth.

At the same time, banks are planning billions in stock buybacks and raising dividends as a means of enticing skittish investors.

I think they ought to have their heads examined because the highly leveraged derivatives trading that got them into this mess is still out there… and growing.

Goldman Sachs, JPMorgan Chase, and Morgan Stanley had to alter their dividend payouts to pass the Fed’s (questionable) “stress tests.” Bank of America passed only provisionally.

Any big bank, no matter how tempting, is truly a case of “buyer beware.” Especially now.

Ironically, only one man on Wall Street seems to get this, and it’s somebody you’d least expect to raise the flag of caution. None other than JPMorgan’s CEO Jamie Dimon.

In a March 2015 letter to shareholders, he noted that the U.S. Treasury market’s freakish behavior last fall – which included a decline of 40 basis points, which is so many standard deviations from the norm that it should happen approximately once every three billion years – was the result of a foreseeable liquidity crunch. “We need to be mindful,” he wrote, “of the consequences of the myriad new regulations and current monetary policy on the money markets and liquidity in the marketplace – particularly if we enter a highly stressed environment.”

Many people think Dimon is the financial equivalent of Darth Vader. But I believe he may be the ONLY banker on Wall Street who fully understands the big picture. As such, he gives JPMorgan a decisive edge over the other big banks, many of which could be brought to the brink of collapse when the next bubble bursts.

Here are four banks that will learn the hard way – perhaps not tomorrow, or even next quarter, but sooner than most people think.

Banking Stock to Drop #1:

Deutsche Bank (NYSE:DB)

In the 2008-2009 crisis, Deutsche Bank stock lost 64% of its value. It’s seen an explosion of toxic derivatives since, becoming the most overleveraged holder of these “financial weapons of mass destruction” in late 2013. The bank’s total derivatives exposure is now greater than €52 trillion – or five times greater than the GDP of Europe, according to the company’s 2014 Annual Report, published March 2015.

Despite this massive undertaking of risk and exposure, DB ended 2014 without a lot to show for it. The company reported net revenues of €31.94 billion in 2014, up just 0.07% from the €31.91 billion achieved in 2013.

Banking Stock to Drop #2:

The Goldman Sachs Group Inc. (NYSE:GS)

A lot of people feel comfortable investing in Goldman because of the (not unfounded) perception that that the bank has U.S. legislators wrapped around its trading finger. After all, Goldman received $10 billion from taxpayers in the last crisis.

But GS shares still fell by 55% in that time period, despite the cash infusion. You may remember that its slide was arrested by none other than Warren Buffett, who pledged a $5 billion infusion in GS stock in return for a hefty 10% dividend yield on his preferred shares. Despite that big vote of confidence, it took the stock more than six years (until September 2014) to recover from the crash and reach its old July 2008 price.

Goldman Sachs has been secretive about the exact extent of its derivatives holdings, but the bank was reported to have derivatives exposure of $48 trillion by late 2013, and Bloomberg Businessweek reported that the bank plans to acquire derivatives even more aggressively going forward.

With its enormous derivatives exposure and extremely anemic stock performance in the midst of a historic bull market, Goldman Sachs is a banking stock to avoid.

Banking Stock to Drop #3:

HSBC Holdings plc (NYSE:HSBC)

Research shows that HSBC has $4.75 trillion in derivatives exposure as of December 31, 2014, according to the OCC. For a bank with $170 billion in market capitalization, that’s a staggering amount.

And the company’s leadership doesn’t inspire confidence, either. The London-based bank was ordered by French authorities yesterday to pay $1.07 billion in restitution following the investigation of alleged tax evasion in Switzerland.

The bank is appealing the ruling – and shares rallied 1.5% in the wake of the news. That’s a short-sighted rally, considering that the bank’s stock has shown itself to be especially vulnerable to crises that are becoming inevitable in the wake of the derivatives explosion. HSBC stock lost 65% of its value between September 2008 and March 2009 – and next time could be even more painful.

Banking Stock to Drop #4:

Citigroup Inc. (NYSE:C)

If you thought that the other three banks proved themselves to be vulnerable in the last financial crisis, just look at how the bubble ravaged Citigroup.

From July 2008 to January 2009, Citigroup lost 87% of its value, going from $205.10/share on July 1, 2008, to $25.30/share on January 1, 2009. In the six years since, it’s more than doubled from its 2009 nadir, but it’s still underperformed the gains of the markets.

This underperformance might be a key reason that Citigroup was ranked dead last in a comprehensive investing report released yesterday. The J.D. Power 2015 U.S. Full Service Investor Satisfaction Study surveyed 5,300 investors who have relied on guidance of advisory firms, ranking their satisfaction levels on a 1,000-point scale. The industry score average was 807; Citigroup came in last at 738.

Besides scoring low in its advisory service department, Citigroup comes up short in returning capital to investors, even compared with its notorious colleagues. Its 0.10% dividend yield is paltry compared to HSBC’s (9.90%) and even Goldman Sachs’ (1.30%).

One thing the company does have in spades is risk. With just under $2 trillion in assets, Citigroup has approximately $59 trillion in derivatives exposure, according to the OCC report.

In closing, I realize that I am bucking Wall Street here. But I’m okay with that because we’ve had a terrific run together making calls that they can’t fathom.

Remember, the banks, the regulators, our leaders, and the world’s central bankers want you to believe the financial sector is in good health because they want you to buy their shares and, by implication, reward their risky behavior. They hope that you will sign off on the fact that you can “safely” have a derivatives portfolio that’s hundreds of times bigger than actual total assets.

Fat chance.

Best regards for great investing,

Keith Fitz-Gerald

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- Mark