If Lehman Had "No Idea," Who Else is Clueless?

Here’s a zinger of a news story:

Barclays Plc had no idea how big Lehman Brothers Holdings Inc.’s futures-and-options trading business was when it considered taking over the defunct bank’s derivatives trades at exchanges in 2008, a Barclays executive said.

“Lehman’s books were in such a mess that I don’t think they knew where they were,” Elizabeth James, a director of Barclays’s futures business, testified today in U.S. Bankruptcy Court in Manhattan. James worked on Barclays’s purchase of Lehman’s brokerage during the 2008 financial crisis.

Source: http://www.bloomberg.com/news/2010-08-30/lehman-derivatives-records-a-mess-barclays-executive-says.html

I’ve railed for months that the central issue surrounding the Financial Crisis (derivatives) was not only misunderstood but completely ignored by the mainstream financial media. Here we are, nearly two years after Lehman Brothers went bust, and they’re telling us that Lehman had “no idea” what its options and futures exposure was.

Let’s put this into perspective.

The notional value of the derivatives market at the time that Lehman went bust was somewhere between $600 trillion and $1 Quadrillion (1,000 trillions). It was a market of inter-linked paper contracts entangling virtually every financial institution (including some non-financials), country (Greece, Italy used derivatives to get into the European union), and county (Birmingham Alabama is one example) in the world. As a market it was at least 20 times larger than the world stock market and somewhere north of 10 times World GDP.

In other words, this was the giant white elephant in the living room.

And here’s Lehman brothers, one of Wall Streets’ finest, most respected financial institutions which had been in business for over 150 years announcing that it had “no idea” “if it had sold $2 billion more options than it had bought, or whether it owned $4 billion more than it had sold.”

In today’s world of trillion dollar bailouts, $2-4 billion doesn’t sound like much, so let’s give some perspective here… in its golden days, Lehman Brother’s market cap was roughly $47 billion. So you’re talking about bets equal to an amount between five and 10% of its market cap. Not exactly chump change.

And Lehman had no idea where it was or how much it really owed.

Mind you, we’re only addressing Lehman’s options and futures derivatives, we’re completely ignoring its mortgage backed securities, collateralized debt obligations (CDOs), and other Level 3 assets. Options and futures are literally the “tip of the iceberg,” the most visible portion of the behemoth that was Lehman’s off balance sheet derivative issues.  After all, these are regulated securities unlike most derivatives.

Now, if the above statement doesn’t send shivers down your spine, have a look at the notional value of derivatives exposure at the top five financial institutions in the US (mind you, this chart is denominated in TRILLIONS).

If Lehman had “no idea” what it owned even when it came to options and futures (regulated derivatives), what are the odds that these other firms, whose derivative exposure is tens if not hundreds of times larger than that of Lehman’s, might similarly be “in the dark’ regarding their risk?

Moreover, who on earth might be on the opposite end of these deals? Other US counties like Birmingham Alabama (which JP Morgan transformed into 3^rd world country status)? Other countries like Italy or Greece (who used Goldman’s financial engineering to get into the European Union)? My next-door neighbor’s house? Tim Geithner’s long-lost tax returns? WHO KNOWS?

The point is that the very same issues that nearly took the financial world under in 2008 still exist today. In fact, this time around the systemic risk is even more severe.

Consider that the Credit Default Swap (CDS) market which nearly took the financial system down in 2008 was roughly $50-60 trillion in size. In contrast, the interest rate based derivative market is in the ballpark of $500+ trillion.

Indeed, US commercial banks alone have $182 TRILLION in notional value of interest rate based derivatives outstanding right now. To put that ridiculous number in perspective it’s 13 times US GDP and roughly three times WORLD GDP.

Fed Chairman Ben Bernanke has promised to maintain Zero Interest Rate Policy (ZIRP) for as long as possible. Now you know why. But even this guarantees nothing because at some point the bond vigilantes that visited Greece, Hungary, and Ireland will set their sights on the US. When that happens, inevitably interest rates will rise and the financial system will once again begin to implode only on a scale TEN TIMES that of 2008.

I realize this may sound ridiculous now, but all warnings of doom sounded ridiculous in 2008 right up until the world imploded (I was warning as far back as April 2008 that a full-scale Crash was coming). Again, remember Lehman Brothers had “no idea” what its options and future positions were… again, these were for regulated derivatives… do you think this ignorance was somehow a special or unique?

Or do you think Lehman’s admission is just a taste of what’s to come?

If you’re leaning towards the latter and have yet to take steps to prepare yourself and your portfolio for what’s coming, you NEED to check out my paid newsletter Private Wealth Advisory, my specialized investment advisory detailing precisely what is occurring in the markets (and behind the scenes) and how to profit from it.

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Graham Summers’ Weekly Market Forecast

Last week I mentioned that barring any additional intervention (monetary or otherwise) stocks would roll over. That is precisely what happened with the S&P 500 falling to test MAJOR support around 1,040 twice.

We looked about ready to fall off a cliff until Friday when Fed Chairman Ben Bernanke stated in his speech that the Fed stands ready to do whatever is needed to fight the financial crisis. It wasn’t a direct monetary intervention, but in these desperate times verbal intervention is good enough, and traders gunned the S&P 500 higher back into the gap created by the Monday/Tuesday sell-off.

The Big Picture below shows just how crucial the 1,040 line is for stocks. If we had taken it out then the next stop would be 1,020, and then 1,000 or even sub 1,000 in short order:

I think we’ll be hitting those lines relatively soon. However, it may take some work to get there. As you can see, since breaking out of their bearish rising wedge pattern the week of August 9, stocks have entered a clear down trend channel. Friday’s late day rally brought stocks right up to the upper trend-line which has acted as resistance before.

Judging from this pattern I would expect stocks to roll over again this week and re-test 1,040 before ultimately heading lower. The upper trend line of this trading channel has acted as stiff resistance before. We’ve also got major overhead resistance at 1,070 and 1,080 (see the red lines below).

However, an alternative scenario would be for stocks to rally to break above the upper trend-line and test the 50-DMA (1,084), much as they did following the Flash Crash in early May.

Indeed, it is not uncommon to see stocks mount a final rally to “kiss” their 50-DMAs before rolling over to new lows. As I write this Sunday evening, the S&P 500 futures are rallying and look to have just broken the upper trend-line of the downward trend channel, which indicates this final rally and “kiss” scenario might be how we start out the week.

Regardless, the BIG PICTURE scenario is that stocks are heading downward and that this latest upward move is a dead cat bounce if anything. We have a clear Head and Shoulders pattern with a downside target of 975 on the S&P 500. As I write, stocks are literally on the neckline for this patter. A break down here would mean a new wave of heavy selling (similar to early May) bringing the S&P 500 down to 1,000 in a hurry.

Thus, in the intermediate and long-term, I believe stocks will be down sub 1,000 on the S&P 500 within a month or so. However, in the near term, for this week, I expect continued weakness with perhaps some choppy action between 1,070 to the upside and 1,040 to the downside. A break above or below either level would indicate something larger has begun.

In the case of a break above 1,070, then we will likely rally to “kiss” the 50-DMA at 1,084 before this dead cat bounce rolls over and we break the massive neckline on the H&S pattern.

In contrast, a break below 1,040 would give a clear cut of the neckline on the H&S pattern which would mean 1,020 then 1,000 on the S&P 500 in a hurry.

So be on the look out for either scenario this week.

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Today Bernanke Plays His Hand… Are You Ready?

Today, all eyes, or rather ears, are on Bernanke’s speech in Jackson Hole Wyoming.

The “Big Picture” thinkers already know that regardless of what Bernanke says or promises, the END GAME for Fed monetary intervention is at hand. If Bernanke DOES announce some new massive QE 2 program the subsequent spike in equities will only last a short time before stocks enter a free-fall (Europe’s $1 trillion bailout only bought a few days worth of gains back in June).

Moreover, the announcement of a massive QE 2 program would also kick the US Dollar off a cliff, sending a huge signal to international investors that the EXTREME moves Bernanke committed during the 2008-2009 Crisis are actually ALL he knows how to do and will remain the norm rather than the exceptional measures they were promised to be.

All of this would be HUGELY Dollar negative and ultimately stock negative though we might see a brief spike in equities for a few days.

In contrast, if the Fed DOESN’T announce a new QE 2 or some similar monetary intervention, we are very likely heading into another deflationary collapse similar to that of Autumn 2008. Looking at Treasuries, the bond market seems to be favoring this outcome. Indeed, if you only looked at US Treasuries you would think stocks were already in a free-fall akin to that of October-November 2008.

Thus, regardless of what the Fed does, stocks are likely to tank in the near future.

The question is WHEN?

Honestly, I cannot predict exactly what will be in Bernanke’s speech tomorrow. But looking at the charts for various asset classes, I think we can get a decent idea of what the market is predicting.

First off, Treasuries are obviously favoring a deflationary collapse now (no QE). They have already rallied to levels not see since the very DEPTH of the Autumn 2008 Crisis (see above).

Despite having rallied strongly for the last month, I think Gold is also favoring this scenario as well. Despite over $1.3 trillion in loose money being announced (Europe’s $1 trillion bailout and the Fed’s $340 billion QE Lite program), Gold has essentially traded sideways for the last several months. If the Fed were about to announce a massive QE 2 program you would think Gold would be exploding higher in anticipation of this. So again, I think Gold is predicting more deflation.

The same goes for the US Dollar.

As you can see, the Greenback has rallied strongly in the last month. It now looks to be taking a breather. But it is certainly not showing any indication that it is about to roll over and croak (the kind of action that would predict QE 2). In plain terms, the Dollar is in an uptrend, so once again, we have a major asset class predicting more deflation in the near future.

Of course, all of this could change in the next 24 hours. Indeed, tomorrow’s open is the most critical time for ascertaining if my “deflation now” scenario holds true. Remember, the Federal Reserve has a history of leaking vital information to key market participants before the public. So if tomorrow morning the US Dollar is nose-diving and Gold is soaring, then it’s likely QE 2 is on the way.

But for now, as I write this Thursday evening, the charts point to more deflation in the near-term. Personally I think Bernanke is hoping to refrain from implementing more QE before the November elections. The only thing that would catalyze him to act earlier would be a full-scale Systemic Crisis erupting.

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Graham Summers

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Are You Ready for the Fed “END GAME” ?

Graham’s note: The following is an excerpt from my paid newsletter Private Wealth Advisory, explaining in plain terms how we are rapidly approaching the “END GAME” for Fed monetary intervention in the markets.

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Throughout 2009, most stock market gains (80+%) occurred during unusual hours: in the nightly or weekend futures sessions.

Now, there is no concrete evidence that the Fed was the mystery buyer during these times (either directly or indirectly), but given how bizarre the action was, how heavily invested mutual funds were (they couldn’t buy more even if they wanted to), and how little real buying power there was, it’s fairly obvious who was pumping the market at these key times (the Fed or someone acting at its behest in one form or another).

Regardless of who was buying, one thing was clear: there were few REAL buyers in the market in 2009. This was clear in the market’s day-to-day action. Indeed, most days when the market rose it simply gapped higher overnight and then flat-lined throughout the regular trading session (9:30AM ET to 4PM ET).This was largely due to the fact that few real buyers were participating in the market. Instead, most market gains occurred in the “after hours” when someone (the Fed or its cronies) pumped the market higher. However, once normal market hours began, stocks simply flat-lined and didn’t go anywhere.

This is the kind of market you get from implementing “props” to hold stocks up. And it goes a long way towards explaining why the market action felt so “strange” in 2009: we simply did not have a healthy market with real buyers and sellers.

This pattern began to change in early to mid-2010, particularly after the May 6 Flash Crash. At that point, many individual investors said, “enough is enough” and began withdrawing their money from mutual funds. All told, we have seen 14 straight weeks of mutual fund redemptions equaling some $46 billion being pulled from stocks. That’s a HECK of a lot of capital fleeing the markets and it means financial institutions having even LESS buying power for stocks.

This is why the Fed’s money pumps no longer result in the market rallying and then flat-lining. Instead, we’re getting brief rallies, followed by actual reversals.

Things have now gotten to the point that the Fed is actively pumping money into the system via its new QE Lite program and stocks can only rally for a few hours:

In plain terms, we are reaching the “end game” for the Fed’s reflation/ money pump schemes. Financial systems that are built on excessive debt are like heroin addicts: giving them a fresh “hit” may create a brief new “high” but each time the addict uses the drug, the effects grow weaker.

In terms of the financial markets today, the Fed’s money “high” which propped up the market throughout 2009 is now beginning to lose its force. What used to push stocks up 2-3% and keep them there now only gives a brief 1-2% intraday rally that rolls over before the trading session ends.

We’re seeing this “monetary tolerance” play out on a larger scale in the financial markets as a whole in relation to Stimulus/ Bailout announcements from Central Banks.

In 2009, each announcement of bailouts or stimulus induced a strong market rally that lasted. Yet by May 2010 bailouts efforts no longer are having the same effect. Indeed, Europe’s $1 TRILLION (the all time record) bailout only held the market up for a few days.  A few months later the Fed’s announcement of its $340 billion QE Lite program only held the market up for ONE AFTERNOON.

I am telling you all of this so you have a sense of the “big picture” of what is taking place in the markets today. I’ve long stated that the next real crisis will be a “Crisis of Faith.” What I meant was that at some point the world markets will figure out that the Fed and other central bankers’ attempts to reflate the economy/ financial system have failed. At that point the markets will undergo a mass awakening that the Fed CANNOT fix the financial system. What follow this awakening will make 2008 look like a picnic.

For decades the financial markets have operated under the idea that the world central bankers, particularly the US Federal Reserve, can fix any problem.  The reason for this was that any time a serious market crisis emerged (Long Term Capital Management, the Asian Crisis, the Tech Bust, etc) the central bankers pumped the system full of easy money and credit to keep things afloat.

In the near-term, these tactics have averted some serious losses in the markets. However, the consequence of this is that the Fed has allowed the system to become so heavily indebted and so leveraged that we now must think in terms of systemic collapse rather than a mere stock Crash.

This is why it is absolutely critical to note that the Fed’s recent attempts to reflate the market have produced weaker, smaller effects. This is the kind of climate in which systemic risk a la 2008 can really take hold.

If you’re a regular passive investor and have not taken steps to prepare for what's coming, you need to do so right now. It’s not difficult to turn Crisis into times of profits. Indeed, subscribers of Private Wealth Advisory have recently opened seven CRISIS TRADES to profit from the coming collapse. They’re all already up between 2% and 8% this week alone.

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Good Investing!

Graham Summers