Jim Sinclair: 13 reasons to be terrified of OTC derivatives


By Jim Sinclair
Thursday, July 5, 2007

Conde Nast's magazine, "Portfolio -- Business Intelligence," recently carried a story that is shocking even to me. I do not know where they got their numbers but I suspect that they fact-check their articles. The title is "$300 Trillion Time Bomb."

The article starts with an interesting question. "If Warren Buffett can't figure out derivatives, can anybody?" The answer requires an understanding of the question.

Certainly Mr. Buffett can dissect the transaction and understand the specific performance required and the lack of financing to guarantee the financial capability of the item. What Mr. Buffet was saying with this question is: How can so many people be that stupid and reckless?

If, as Conde Nast's magazine claims, the derivatives figures are at or above $300 trillion, then gold will go much higher than even I suspect. The authority on the size of the derivative pile is the Bank for International Settlements and the International Monetary Fund.

The article takes the standard tack of saying, "There is nothing intrinsically scary about derivatives, except when the bad 2 percent blow up." I disagree with the first part of that statement but wholeheartedly agree with the second.

Nothing intrinsically scary about derivatives? Then what would you call the following about over-the-counter derivatives?

1) They have no regulation.

2) They have no standards.

3) Without standards there can be no viable market.

4) They are unlisted.

5) They are traded by private treaty negotiation.

6) They are valued by "mark to model," which is a total cartoon.

7) They have no financial guarantee such as a clearing house.

8) They are unfunded special performance contracts floating in cyberspace. All funds in OTC derivatives are taken out as spreads and commissions.

9) More than 50 percent of the earnings of major international investment banks come from granting in the private treaty negotiation of these instruments of mass financial destruction.

10) Financial performance of OTC derivatives depends on the financial capacity of the loser in the transaction.

11) Control has been loose in interest-sensitive OTC derivatives because of multiple dealings outside of the initiating two parties until no one knows who has what.

12) The replacement value of these instruments is in the multi-trillions of dollars.

13) The massive expansion of these instruments has come in interest-sensitive and debt-guarantee instruments. Those are the most vulnerable.

From this point the character of over-the-counter derivatives only gets worse. If that does not scare you, you can see "Poltergeist" and "The Exorcist" and consider them musical comedies.

This situation guarantees an expansion of international liquidity, making one wonder if this is not what the equity markets lately have been taking their lead from. This tells me that "three strikes and you are out" is the rule for the U.S. dollar, and we now have two strikes at the .8050 to .8150 mark on the USDX.

This also tells me that funds operating against gold shares will have to cover once momentum and regression fail to support further moves on the downside. That is, IF the shorts can MAKE cover, since in most cases now the only stockholders left are those without margin and true believers in their situations.

The way to beat the shorts in anything is to do nothing. Shorts can push price but they must trust that by pushing the price lower they will panic the remaining holders to help them make their cover on a high-volume down day. If the shorts fail to get this to occur, then the covering will happen in a panic by the shorts themselves and therefore be of a different order.

As almost always, gold today mirrored trading in the dollar but multiplied the dimension of the move. Remember that in the United States this is the week of the July 4 holiday, even as it is summer in Europe, where no true European works. Asia never makes price but only takes advantage of it by buying breaks and selling strength.

Crude oil, which was never supposed to go over $70, reached up to $72 but reacted when the inventory reports came out. The downward pressure in energy pressured gold down. This is all noise and fury with no meaning. Gold is headed for $761, $887.50, and over $1,000. The dollar is headed to .7200 after the three strikes and then will be out of the game.

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