Why rising interest rates could be ‘potentially lethal’

From Justin Spittler, Editor, Casey Daily Dispatch:

Interest rates are soaring…

The yield on the U.S. 10-year Treasury note has jumped from 1.37% to 2.3% in just four months.

The yield on the Italian 10-year government bond has more than doubled since August.

Libor, one of the world’s most important benchmark rates, has jumped from 0.61% at the start of the year to 0.91%. It’s now at its highest level since 2009.

Most people wouldn’t think much of this. Some folks might even start dozing if you rattled off these facts. But Dispatch readers know these kinds of moves have a huge impact on the global financial system.

That’s because interest rates are the price of money. When they move a lot, they affect stocks…bonds…property…even the cash in our wallets.

Big moves in interest rates also have a huge impact on derivatives…

Derivatives are securities that derive their value from another security, like a stock or bond.

If the term sounds familiar, it’s because they played a major role in the last financial crisis.

During the last housing boom, banks created derivatives tied to mortgages. These complex instruments were supposed to protect banks from big losses if housing prices fell.

Instead, they blew up when housing prices crashed.

Derivatives helped turn the U.S. housing meltdown into a full-blown global financial crisis…

To prevent a repeat of the 2008–2009 financial crisis, the government started heavily regulating banks.

They put in new rules to curb excessive risk-taking. They required banks to hold more capital. But they didn’t stop banks from using derivatives.

E.B. Tucker, editor of The Casey Report, says the five biggest U.S. banks — JPMorgan Chase, Citigroup, Goldman Sachs, Bank of America, and Wells Fargo — have $179 trillion worth of derivatives sitting on their books.

That’s a gigantic number. To help you wrap your head around this figure, we put together the following chart.

It compares the value of derivatives held by these banks with their combined market value. You can see their derivative exposure far exceeds their combined worth.

Now, executives at one of these banks would probably tell you to not worry about this…  

They might even say derivatives make the financial system safer.

That’s because derivatives were created as a form of financial insurance. They’re supposed to keep a bank from losing money when the price of assets moves against them.

But E.B. says most banks don’t use derivatives for protection anymore. They use them to make money. They’re a huge source of profit for these institutions.

Derivatives aren’t just a problem for the U.S. banking system…

They’re a threat to the entire global banking system. You can see why in the chart below.

As you can see, the total value of outstanding derivatives is nearly seven times higher than the annual output of the global economy.

You don’t have to work on Wall Street to realize the global economy would be in serious trouble if the derivatives market started to unravel.

Legendary investor Warren Buffett thinks derivatives are “potentially lethal”…

In a letter Buffett sent to his shareholders in 2003, he warned:

Derivatives… create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counter-parties tend to build up over time. A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. However, under certain circumstances, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z.

In other words, Buffett says it’s hard to assess the risks of derivatives. Because of this, companies often take on more risk than they realize when they use derivatives.

What’s more, Buffett says derivatives can cause problems to “daisy chain” from one company to the next. This can turn one industry’s problems into a problem for the entire economy.

Despite their significant risks, Buffett feared that the use of derivatives would only grow:

The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.

Buffett is still worried…  

At Berkshire Hathaway’s annual meeting earlier this year, he said, “Some of these things get so complicated that they’re very hard to evaluate… The auditors, I don’t think, are necessarily capable of holding that behavior in check,” Bloomberg reported.

This is a powerful statement considering Buffet made a fortune in the insurance business.

Now, we didn’t write this issue to scare you…

We wrote it because most people don’t know anything about derivatives. Other people assume banks stopped using them after the last global financial crisis.

But, as you’ve seen, derivatives are still a huge threat to the financial system, especially with bond rates now climbing.

E.B. wrote in last month’s issue of The Casey Report:

Most of the nearly $500 trillion in outstanding derivatives are contracts based on movements in interest rates. With interest rates artificially fixed near 0%, they say there’s little danger of those contracts becoming a problem.

According to E.B. and his team, “the slightest unexpected change in interest rates or an unexpected bond default could trigger a complete collapse on a scale that dwarfs what we experienced in 2008.”

E.B. added in this month’s Casey Report:

[A] majority of the outstanding derivatives we’ve studied are bets on interest rates. The banks generally get paid premiums to sell their clients insurance against rates rising. If rates stay low, the bank keeps the premium, booking it as profit. But if rates rise, over $300 trillion of derivative contracts could come due.

In short, rising rates could eventually “break” the global derivatives market and trigger a financial crisis far worse than what we saw in 2008–2009.

To protect yourself, E.B. encourages you to avoid major bank stocks…

But he doesn’t think you should short (or bet against) these stocks yet.

If the banking system starts to unravel, the world’s central bankers will rescue these “too big to fail” institutions…even if that means making taxpayers foot the bailout.

E.B. also encourages you to own physical gold. If Deutsche Bank runs into trouble, its problems will quickly cascade across the globe. Investors from Tokyo to New York could sell stocks and bonds as fast as they can while buying gold hand over fist.

Owning even just a little gold could save you from big losses if this happens. That’s because gold is the ultimate safe-haven asset.

If you’ve been thinking about buying gold, we encourage you to watch this video first. It explains how to take advantage of a “loophole” in the global gold market. In short, E.B. may have found what could be the cheapest way in America to buy physical gold. Click here to learn more.

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