Derivatives - Weapons of financial Mass Destruction (Warren Buffet)

It was 10 years ago that I discussed my view of the precarious situation of German Banks at a seminar for an elite group of banker colleagues. My audience dubbed me as a pessimist because I cautioned against the existing high risk situation the German Banks were engaged in with their oversized derivative positions at the time. The banking community pared this point of discussion with the view that "we have hedged all our derivative positions and therefore we do not carry open positions - hence there is no risk"! My answer to this was that only a permanent "Triple A" credit rating (quality) of any counter-party in the total chain of a derivative contract could possibly guarantee immunity to risk. We all know, however, that a chain is only as strong as its weakest link.

In the meantime, my misgivings about the unbridled activities in piling up pyramids of derivative contracts have been proven correct; the German Banks have manoeuvred themselves into a structural crisis and have exponentially geared their derivative volumes to unsustainable heights. The total notional value of global derivatives is reported to have reached between 150 to 180 trillion dollars, an unimaginable number as it would mean 5 to 6 times the total global annual GNP of roughly 30 trillion dollars. The same, even in much higher denominations, holds true for the US banking sector where JPM is reported to hold a notional value of about 26 trillion dollars in derivatives alone. Where, one has to ask, do they find the counter-parties of sufficient credibility to cover this volume when giants like JPM are downgraded in their rating? … As an aside, the takeover of Chase, which already had an offer from Deutsche Bank on the table, was "rescued" within the hour by JPM. By that time, I would suggest, DB was sufficiently served with the Bankers Trust's derivative positions.

I herewith repeat and emphasise my position in 1992. After all, " ...one of the apocalyptic horsemen carries a banner with the insignia of the Derivative Monster".

Experiences from History

Even if I may have reduced my misgivings about the ever escalating intrinsics of derivative risks, studying the brilliant Model of Black-Scholes, because of its risk minimizing calculations, I was taught a lesson of reality, never the less. One of my former colleagues during my trader days at the Duesseldorf Stock Exchange was a Foreign Exchange trader for the well respected Private Bank of I.D. Herstatt of Colonia. The bank traded huge volumes of dollar futures and was priding itself as having "almost" total risk-control of its derivative positions. As one rogue trader took down Barings Bank, the risk controls I.D. Herstatt were insufficient and the bank inevitably had to resort to bankruptcy proceedings and was finally closed down.

The old stock exchange platitude was proven once more: The best concepts of risk management are obsolete as soon as "greed and fear" take over the minds of the actual decision makers. And no one is or ever will be immune to its allures.

The most sophisticated and tightest control mechanisms did not prevent the demise of LTCM (Long Term Capital Management), a hedge fund which not only used the Black-Scholes model but had one of the Nobel prize-winning authors on its management team right next to John Merriweather, the famed bond trader of Goldman Sachs. Underestimating the consequences of rogue waves or suddenly recurring unexpected volatilities have led to belated responses in a seemingly fool-proof system. If such 'unforeseeable, once in a lifetime' events happen, accentuated by over-gearing - in the case of LTCM it was a leverage of 1 to 300 on average - then this in and of itself may become the systemic risk of the Fiat dollar reserve currency. This issue was addressed under the lead of N.Y. FED in emergency meetings. Noteworthy to mention is that the clients of LTCM were, coincidentally, some of the largest and most prestigious financial institutions of the world, including the likes of Italy's Central Bank.

Still, it is fair to say that in a linear world these genial risk control models would serve their purpose. Unfortunately the world does not function on linear premises and ever so sophisticated models ultimately meet their Waterloo at one stage or another. In this case, the high leverage has added a toxic waste factor akin to a thermo-nuclear melt down of the globe's financial and currency system. The N.Y. FED would not likely organise a bail-out for anything less than a who's who client list or the risk of a total systemic currency collapse.

It was later understood that as a part of the LTCM huge derivative trading positions a short of about 300 tons of physical gold may have been the real and fundamental kicker to its ultimate demise. Until now the insinuation was neither confirmed nor denied. The practise of the Gold Carry-Trade at the time was a common and guaranteed trade of enormous profit potential. It is therefore almost a given that a prominent hedge fund like LTCM would participate with the ultimate gearing that the Bullion Banks were willing to extend to them to use this seemingly almost "risk-free and guaranteed" gold-hedging vehicle to enhance their profits.

Today it is becoming apparent, even to the uninitiated that the holding of physical gold is the only real protection of wealth. Inflation and the ever more rapidly recurring volatilities in the worlds currencies, floating against each other without any kind of "golden" anchor, are not only undermining confidence, but have cost the holders of the US dollar already more than 30% of buying power vis a vis the €. The CB's would have to do a lot explaining to do if it was discovered that this perceived wealth is actually squandered in the protection of a hegemonial reserve system based on the US-Fiat-Dollar, a system which is clearly now suffering from extreme overindulgence.

Today, we appreciate the risks of the FED and even the Government guaranteed Gold Carry Trade. The metal has been regarded as having both intrinsic and tradable value since time memorial. The old acronym for the US dollar "as good as gold" has been effectively replaced by the printing press of the FED. The forward selling, shorting or leasing of gold is not going to be replaced by printing in form of paper FRN's, as the FED's Mr. Bernanke stipulated, bonds or even shares. Gold must be located, extracted and refined to its pure tradable form of .999 proof. I can assure you that gold mining is a nerve wracking and mostly futile experience of risking substantial venture capital for a minimal success ratio. As some pre-eminent analysts of the gold market assume that probably half of the 33 thousand tons of the suggested physical hoard of the western CB's is already encumbered by either forward sales, leases and other not so plain vanilla derivative constructs. Further suppression of the POG will meet rising appetites for eastern CB's to exchange their huge dollar balances for real money, gold. Astute and contrarian thinking investors are accumulating by stealth. After all, the POG overcame any resistance level from a long-term low of 250 $/oz to trade now above 360 $/oz, a level which again seems to be fiercely defended. This level, which will eventually be overcome as the remaining physical gold in the vaults of CB's and others won't be disposable to the whims of hedgers.

The introduction may highlight the overall risks of derivative trading in general terms. Derivative gold trading, known as gold carry trade, is intrinsically more risky as the bulk of trading is commenced by futures contracts, whereby both parties don't expect more than a few percentage points being settled in physical delivery. Just see the LBMA - a secretive London based paper gold trading organization, while losing market share over recent years, prides itself in annual trading of 140 MOZ, more than 4 times the total volume of all gold reserves the CB's claim to hold. What a clever market, valuing the futures paper price of any commodity not only in today's diminishing real value by paper substitutes. By the way, this is also at the very foundation of affecting the CPI with delusional disinformation the BLS regularly spins to the detriment of reality.

Thanks to the enlightening findings of some astute analysts over the past several years, investors have been made aware to beware of (over-) hedged gold miners. The strategy of profiting by expectations of eternally and -for some guaranteed erosion of prices of their product, is now starting to backfire for the extreme hedgers. Investors in the gold mining sector have clearly learned to differentiate between companies which have left the options open to the believers of a major bull market in gold and its proxies, or the alternate route of securing some profits in a market adverse to gold.

There are no free lunches - Somebody has to ultimately shoulder the risks involved!

I'd probably be better off investing in the popular heralded "new bull market" of Wall Street - after all you could have made a 100% gain in popular hi-tech stocks as Adobe, Amazon and consorts in no time - though at a second glance I may see the astronomical valuations and ask myself what kind of future earnings would support today's valuations? A futile question perhaps - as futile as what future earnings could lift the price of Barrick as it seemed to be totally unaffected by the 40% plus advance of the POG. It just may be the horrendous hedge book of Barrick, which is sinking below the utilitarian level with any uptick in physical POG.

Fascinated by the conditions Barrick's hedge book seems to elevate it over its peers, which have seemingly been secured by its pre-eminent banker, JPM, as I've been led to believe, have furthered my determination to scrutinize the reality behind the company's offered statement of its "premium hedge program". A statement, which won't pass today's smell test, as no-one with his right senses would and could afford such singularly, and as Barrick pronounces lopsided conditions. In this case I will have to resort to the (unthinkable…) hypothesis that a deal of this potential magnitude of inherent risk would have to be initiated by guarantees from party's of (in-) finite powers. The composition of Barrick's hedge book begs the question as to these definable counter-party credit ratings - as the main derivative, can you say ruling or defining party, was downgraded from Triple A to single A+ … The weakest link again becomes the determining force in the game of pyramiding credit … BTW, another obscuring misnomer of debt.

Returning to Barrick for a moment, just imagine the unbelievable hassles even a well-financed German entrepreneur would face in attempting to effect a 2-year interest swap with his regular bank. How much more collateral or insurance would even a first tier gold producer have to deliver for a 15 year flexible (as in spot deferred…) forward sales contract in order to achieve absolute immunity for potential losses by the bullion bankers?

It is therefore clear that contrary to assertions by the parties involved in gold forwards, leases, swaps or other purely financial constructs based on gold yet to be produced - which in itself carries the risk of changing economies, political, environmental and a host of other imponderables - do carry an exponential risk factor. If, for any above reasons Barrick cannot service its delivery obligation to JPM, then JPM would be facing an insurmountable obligation to re-deliver the physical gold to the lender/lessor of last resort. An explosive short squeeze would probably tear apart the fabric of today's monetary system, as would have been experienced by the LTCM fiasco in 1999. It was only averted by the N.Y. FED blackmailing involved counterparties into a costly bailout of the renegade hedge fund. In the final review, one can only speculate that JPM may be held incommunicado by the PTB … and Barrick, too?

Meantime JPM may have learned a few more lessons in the context of gold forward sales. The recent case of the Yandal hedge-book, an Australian mine Newmont inherited by taking over Normandy, had sold about 3.7Moz forward. Yandal's "proven, mine-able reserves" had been anticipated at 6Moz and had to be revised to 3Moz. Remember, we're still talking un-mined gold and yet the actual reserves are short the forwards and hedges the great bullion bankers committed to - well, only by a mere 700.000 oz's. Newmont offered 50 cents on the dollar, or walk and leave the bankers to mine their own gold obligations, a fair deal as some close to the situation opine and so 94% of the counter-parties accepted. One bullion bank, allegedly GS, did not accept as it seemingly holds out for a better deal than its peers. The conclusion to this drama is still unsolved, though the consequences may fundamentally led to a sea-change of the perception of risk free "gold derivative banking", known also as gold carry trade.

In Barrick's case, probably the largest net hedger amongst the tier one global gold producers reality has set in. They fired their CEO Oliphant who may have been instrumental in blowing their "premium hedging" activities to disproportionate levels. The real risks may now be dawning, after the Yandal experience, to all parties involved. And it may prove totally inconclusive and of even less consequence if the major parties in these deals, namely JPM and Barrick, are guaranteed immunity by higher up "official?" powers. If and when the proverbial matter hits the fan, would you expect the established politicos not to act as the also proverbial cornered rat?

At this point I would like to list some of the main risks as perceived by this former German banker:

• It would be rather inconclusive to accept the notion that either contract partners were not aware of the inherent risks of their hedge contracts; the lagging price performance of overly hedged gold producers vis-a-vis their un-hedged peers, as well as the downgrades of ratings of the bullion bank counterparty (JPM) seem to assert this evaluation.



• How did the counter-parties arrive at the valuation of their forward sale contracts? How can Barrick arrive at a forward price of 345$/oz, when the prevailing market price is, say 280 $/oz or lower? Is it as simple as applying the expected interest differential between the gold lease rate and the (possible leveraged) higher rate of return in the actual investment of the proceeds, including the usual contango and option time factor and thus arriving at these screamingly high premiums for the gold forwards? These profit expectations, derived from future interest rate margins over the life of the contract have been fattening the earnings and balance sheet, similar to the now widely practised , though fraudulent "pro forma" accounting.



• It seems a bit daring to adopt these methods of accounting and fully expect the mathematical models for both the lease rate and the expected rate of return on the interest rate differential and, of course, the future gold price will not affect the bottom line. Even small changes of the assumed parameters could lead to dramatic effects which multiply potential losses, while positive effects due to the fixed gold price of the contract seem limited. The last few years have uncovered a number of assumed risk free derivative hedge constructs which are the exact opposite of hedges, or as Warren Buffets so aptly describes it, weapons of financial mass destruction.



• The recurring question is really, which of the counterparties have hedged their risk effectively? If it is Barrick, then they still carry the 'risk' of under-performance as the gold price appreciates way above their average forward sale price, thus denying the investor any upside. If it is JPM, then we just may experience another Enron type melt-down. In the financial world, there is absolutely nothing to be gained without some risk, but everything lost by not controlling risk parameters.

The accounting standards in the US have been deteriorating over the years, particularly as GAAP has proven to being wide open for interpretation. The practise of pro-forma earnings, originally, and probably legitimately used in quantifying future merger or take-over effects, were abused to excess in financial statements. The demise of Enron, World Com, et al, together with their pre-eminent accounting firm Arthur Andersen has highlighted a paradigm change which is still ongoing and was seemingly also adopted by the likes of Barrick and its counter-parties. It also allows the abuse of pro-forma profits of the now vastly under-funded company pension plans - it seems that the government is now facing similar problems with unfunded Medicare and pension accounts - while intrinsically bearing the mark of eventual default. The overall derivative mess of the global financial sector, and in particular in the US, are not just protected by Allan Greenspan for fun. He surely knows that any regulation would mean outright and present danger to the system. I therefore fully subscribe to Warren Buffet's view that the "over-load" of derivative instrumentation is the equivalent of the most destructive WMD's to the global monetary system. The hegemonial reserve currency - the US Dollar - is backed by the full faith and credit of the US government. There is not much to add, only that credit and debit now seem to have the same meaning in some parts of the world.

Should my interpretation of Barrick's presentation of gold forward sales contracts in its balance sheet prove correct, and combined with the risk-management mechanism's described in the Black-Scholes model, a gold price over 370 $/oz would trigger conclusive action. In the case at hand, massive short covering of the physical metal would be the only measure to counter the risk of saving a huge part of the hedge book from going under water and trigger margin calls by its counterparties. The largest gold hedgers among North America's producers are Barrick and Placer Dome, both of whose hedge-books are assumed to become toxic at a gold-price level above 370$/oz. If that assumption proves correct, is anybody still wondering why this POG level is defended so vigorously?

A falling US dollar will further accelerate dehedging.

Additional pressure is wielded by the rapidly depreciating US dollar. While the dollar weakness has little affected the purchasing power for gold in other major currencies, it has made gold purchases in dollars massively more expensive. As the main gold hedgers have committed their contracts in US dollars, the pressure towards the risk-management programs, according to the Black-Scholes model, becomes exponentially more severe as the contract currency depreciates. Even without much change in the gold price for competing currencies, a weaker dollar has to set the risk-management controls into motion on both sides of the equation, id est, the bullion banks and the forward sellers of gold (hedgers). One may be able to ignore these forces for a while longer, though the pressures of the market fundamentals will eventually re-adjust these excesses to equilibrium.

In my view, both, the contract partners are highly vulnerable. The "premium hedge program" Barrick was touting for so long can't have a neutral effect on either counter-party. The risks become inherently more appreciated as Ashanti and now Newmont's Yandal deal clearly demonstrates. Still both sides claim immunity to any risk based on their gold short contracts. I've got to admit, you have to admire this kind of ambiguity.

What's left is the question as to where and in what manner these contractual risks are accounted for in the respective balance sheets of the counter-parties. Is it an unknown (or assumed) entity having an interest in the perception of ongoing gold forward sales - and therefore cultivating the perception of unlimited supply of physical gold?

Summary and Conclusion

The undeniable profitability the Gold Carry-Trade bestowed on a small but powerful group has led to extreme over-indulgence and the volume of forward-sales climbed to astronomical proportions. The quality, or credit rating of the parties involved in gold futures trading, has decreased in direct proportion to the growth of the contract volumes. The long perception of a perpetual one-way street of lower trending gold prices is finally giving way to the reality of changing and positive fundamentals for gold. The accumulated huge piles of US dollars in the SE-Asian economies may be exchanged for gold at an increasing pace, accentuated by recent political and imperial "insinuations" Washington is exhibiting to the world.

It is becoming increasingly evident that the gold carry game cannot be unwound by delivering physical gold in sufficient quantity into the forward contracts, given the annual supply deficit of more than 1,000 tons. Nor can the paper futures gold game be rolled over forever, as the Yandal example proves.

Furthermore, the Blanchard court proceedings against Barrick and JPM may prove that JPM has a substantial interest in Barrick, again via offshore, or better known as "special purpose" companies. Uh, did I hear someone mentioning Enron in the background? And finally, Barrick's and JPM's motion to dismiss was founded on the allegation by Barrick's lawyers that involved parties are simply too powerful to sue - just how positively dumb and blatantly arrogant can you get?

One thing is for sure - the immediate future will be interesting as either the market is allowed to regulate this enormous pyramid of derivative risk, still being denied as such from all parties involved or further accidents are bound to happen down the road.

The Facts

The ongoing accumulation of physical gold in the Eastern hemisphere leads to a factual re-distribution of real gold holdings from West to East. He who has the gold makes the rules…

The extremely low interest rate environment has all but destroyed the advantages of the gold carry trade.

The delivery and cover obligations in kind are still binding for the hedgers and shorting hedge funds.

weak US dollar will lead to forced short-covering according to risk management rule without gold necessarily rising against competing currencies. In the longer run, however, it may be expected that gold will appreciate against all currencies as competitive de-valuations, known as beggar thy neighbour policies, will be adopted.

The Blanchard vs JPM/Barrick suit may well shed some light onto the risk distribution between the 2 parties on their mutual forward sales contracts.

The new Maginot line for gold at 370$/oz, defended as it seems in the moment, will give way rather sooner than later. If the Blanchard suit proceeds to discovery and the Yandal deal becomes known in its gory details, it may be sooner than many think.

Derived from musings by a former German investment banker, Dietmar Siebholz and a former Austrian investment banker Florian Riedl-Riedenstein - late June 2003.