Warren Buffett believes derivatives are ‘weapons of mass destruction’.
Of course, the Oracle of Omaha says one thing and does another. Berkshire Hathaway has billions of dollars’ worth of derivatives on its balance sheet.
At some point in the future, these ticking time bonds are likely to erupt.
When financial markets close — like they did for five months during the First World War — or see huge volatility — for example, the Global Financial Crisis of 2008/09 — huge problems arise.
In my view, the global derivatives game will wreak havoc on the world in the near future. Fortunately, there is a way to survive and prosper.
A European financial storm is near
With the mainstream media focused on global growth concerns after the Brexit vote, let’s face reality. The Brexit should prove itself to be a major turning point in history. As I explained in Money Morning on Tuesday, Europe is heading towards a major contagion event.
The European Commission (EC), believing it’s an elitist hierarchy, has over stepped the line. The undemocratic and unelected bureaucracy has tried to federalise Europe by sheer political agenda. For example, roughly two thirds of all the laws that apply in the UK — most of them unfavourable — are linked to the EU. The Financial Times reported on 23 January 2014,
‘Britain suffered a serious defeat in its campaign to limit the power of EU financial watchdogs after Europe’s highest court dismissed London’s attempt to prevent Brussels from winning powers to ban short selling.
‘In a keenly awaited ruling with broad implications for how the EU regulates financial services, the European Court of Justice threw out a legal argument Britain has relied on for decades to prevent Brussels from extending its powers.
‘The judges rejected all four of Britain’s pleas in a finding that will cast a shadow over the UK Treasury’s recent strategy of asking courts to overturn unwanted rules it failed to block during the EU legislative process.’
If the UK had voted to remain in the EU, when the sovereign debt crisis hits, this law would have destroyed London — the financial capital of Europe. Without short selling, institutions, hedge funds, investment banks, corporates and pension funds wanting to — at the very least — hedge their positions, would have done business elsewhere.
Fortunately for the UK, it voted to get out of this dictatorship. Despite the scaremongering by the global elitists in recent months, London should be able to survive and prosper.
The EU has neglected the will of the European people for far too long. It’s why the majority of Europeans have turned against Brussels.
By voting out of the European Union, Britain regained its sovereignty. Now eight more countries — who have also had enough — want to hold referendums to exit the EU. France, Holland, Italy, Austria, Finland, Hungary, Portugal, and Slovakia could all leave. This spells a disaster for the European Union.
With the writing on the wall for Europe, a huge amount of capital will want to escape its borders. When this happens, the US dollar — the world reserve currency — should become a beneficiary and scream higher.
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The European banking collapse is next
The International Monetary Fund (IMF) knows a major financial meltdown is looming. Of course, it will never tell you that. In a report it published yesterday and titled ‘Financial System Stability Assessment’, the IMF wrote (with my emphasis):
‘Domestically, the largest German banks and insurance companies are highly interconnected. The highest degree of interconnectedness can be found between Allianz, Munich Re, Hannover Re, Deutsche Bank, Commerzbank and Aareal bank, with Allianz being the largest contributor to systemic risks among the publicly-traded German financials. Both Deutsche Bank and Commerzbank are the source of outward spillovers to most other publicly-listed banks and insurers. Given the likelihood of distress spillovers between banks and life insurers, close monitoring and continued systemic risk analysis by authorities is warranted.’
In other words, if Deutsche Bank — Europe’s largest bank — goes bankrupt, it would trigger a contagion event across the banks and life insurers. This isn’t great news, considering that the bank failed a US banking stress test yesterday. The BBC reported,
‘While all 31 large US banks passed the test, Morgan Stanley only got conditional approval and has to submit a new capital plan by the end of the year.
‘For Germany’s Deutsche Bank it was the second year that the subsidiary of the German lender failed the test while for Spain’s Santander it was the third time.
‘While the Fed noted improvements for the two banks, the regulator said there were continued substantial weaknesses.’
It’s hardly a shock…
Deutsche Bank boasted a notional derivatives exposure of €41.9 trillion (US$46.53 trillion) in its 2015 annual report. This is about 10% of the total global derivatives market, stands at roughly US$493 trillion. In comparison, the current market cap of Deutsche Bank is worth €17.46 billion. In other words, Deutsche Bank is leveraged 2,399 times. Imagine promising to buy a house for $2,399 with assets of $1!
While a fair chunk of these derivatives are hedged (i.e. there’s a buyer and seller for each contract), what happens if one side can’t pay up during the coming times of chaos? This is exactly what happened during the US sub-prime crisis of 2008. For this reason, the IMF notes that Deutsche Bank ‘appears to be the most important net contributor to systemic risks’.
Indeed, the bank is connected to everything. Will it be the first domino to fall?
The end of Deutsche Bank is near
When Deutsche Bank goes under, which is likely to happen once the European contagion takes off, I expect massive bloodshed across financial markets. More than when Lehmann Brothers collapsed in September 2008.
Looking at the globally connected game of counterparty derivative contracts, if Deutsche Bank fails, everyone else should follow. The IMF reported (my emphasis added):
‘Notwithstanding moderate cross-border exposures on aggregate, the banking sector is a potential source of outward spillovers. Network analysis suggests a higher degree of outward spillovers from the German banking sector than inward spillovers. In particular, Germany, France, the U.K. and the U.S. have the highest degree of outward spillovers as measured by the average percentage of capital loss of other banking systems due to banking sector shock in the source country.’
For more detail, check out the IMF’s chart. It shows the key linkages of the world’s riskiest bank:
When the European banking crisis hits, it will unleash a sea of mayhem across the financial world. Unlike the Global Financial Crisis of 2008/09, global central banks are out of ammunition. In this case, we should expect a global contagion event to unfold.
On this note, check out the IMF chart below showing the riskiest banks in the world. If Deutsche goes under, HSBC should be next.
Unfortunately, the next financial meltdown will tear the financial world apart. If history’s a good road map, the banking crisis should transition into a global sovereign debt meltdown. I wrote about this at length in late February/early March to Resource Speculator readers. If you want to read those reports, click here.
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Resources Analyst, Money Morning