FedUpUSA

Gee, who’s been talking about uncollateralized lending and the inherent fraud that is created by such transactions in that they are effectively a naked short on the currency involved? 

Swaps that will be allowed to remain outside clearinghouses when new rules take effect in 2013 will require traders to post $1.7 trillion to $10.2 trillion in margin, according to a report by an industry group.

The analysis from the International Swaps and Derivatives Association, using data sent in anonymously by banks, says the trillions of dollars in cash or securities will be needed in the form of so-called “initial margin.” Margin is the collateral that traders need to put up to back their positions, and initial margin is money backing trades on day one, as opposed to variation margin posted over the life of a trade as it fluctuates in value.

This, my friends, is the amount of margin in the amount of actual hard funds that is supposed to be tied up in the form of collateral to back these bets but currently is not.

Oh, and if you’re wondering how that compares against the actual amount of “un-cleared” swaps?  That’s “estimated” at $127 trillion, which means that the ISDA thinks it’s perfectly reasonable for people to have somewhere between 12 and 75 times leverage in these things.

That’s utter and complete crap but it is what passes for an alleged “cleanup” of this “market.”

Bernie!  Oh Bernie!  Is that you Made-Off?

Such has been the siren song for the last few months on commodities in general.

Despite my repeated warnings that markets aren’t that simple, and that it has all been leverage – that is, cheap debt – that has powered them higher, nobody wanted to hear it.  “Gold is money.”  “Silver is money.”

Uh huh.

So are you going to tell me, my friends, that there has been an inflation and then deflation of roughly 20% – on the upward side in the last month or so, and on the downside in the last couple of days?

Gold is getting hit pretty good too:

Then, of course, there’s oil.

How about “Dr. Copper”?  What’s he saying about the economy?

“Cheap money” – that is, unlimited leverage – will drive markets higher.  For a while.  It creates speculative manias.  It creates the feeling of wealth.  It creates a “high”, much like an addictive drug.

But it is not wealth.  It is not prosperity.  And it is not sustainable.

The real economy, on the other hand, continues to suck.  Gas prices have reached the point of demand destruction.  It’s $3.96 for regular here today, although I’m sure with oil off $9 it’ll come in over the next few days.

GDP was soft as well.  And the jobless claims numbers today?  Horrible.  Then there’s all the “great news” over in Europe – Ireland, Greece, German production number misses and Trichet claiming “We have this guys.  Really, we have this.”  Uh huh.

Are markets going higher?  Based on what?  Expectations on a forward basis and general bullishness are ridiculously high.  Profit projections are for $100 on the SPX for the year.  Really?  With all the input cost pressures already in the cake and unable to come back out for six to nine months?

This was exactly what I was warning about last August when this pattern began to be evident – that those who chased and continued to pile in would eventually get their heads cut off.

Sure, if you just bought with cash back then you’re doing fine.  But far too many people did not.  They kept adding off their paper “profits” – margin debt is at extremely high levels, as people piled in more and more as prices rose.

Well, now there’s a problem and it’s especially bad if you’re in a levered instrument such as the futures markets.

You buy a contract that controls $50,000 of the underlying with a margin of $5,000.  The contract’s value goes up 10%.  You now have a 100% profit against your margin.  You take that and buy another contract.

What happens if the price goes back to the original level?  You’re in trouble, that’s what.

Not only is your original $5,000 margin “profit” gone but so is another $5,000, even though price just round-tripped up and then down!  That is, you’re now broke as your entire original stake has evaporated into the ether, even though prices are right back to where they were.

If you think this isn’t common, you’re very wrong.  It is.  Traders blow up in this fashion all the time.  It’s idiotic, but it happens on virtually every prolonged move where leverage becomes the gist of the action.  It happened to real estate speculators during the real estate bubble, it happened to tech speculators during the 1990s and now it’s happening again.

Might this “stop” at some point before the market really unwinds?  It might.  But there’s no guarantee that it will.  In fact, there’s plenty of reason to believe it won’t – that margin calls will in fact beget more margin calls.

In 2008, these sorts of margin-unwind trades are what fostered the instability that ultimately blew up in everyone’s face.  The systemic imbalances in the system are worse now than they were in early 2008, and the policy response available to attempt to stop a collapse are nearly all spent.

Go ahead folks, buy the dip.  It’s been a good trade for the last year or so, especially from August onward.

Just be aware that you’re buying into a margin liquidation, and if the “Cheap Money” disappears, you’re going to be dealing with a lot of sleepless nights.

The Market-Ticker