Operation Disclosure | By David Lifschultz, Contributing Writer
Submitted on May 18, 2021
THE US STRATEGIC INTEREST IN THE MIDDLE EAST
Compliments of the Lifschultz Organization founded in 1899
The invasion of Iraq in 2003 had as its purpose the strategic interest in securing the Middle Eastern oil for the US as it imported about 3/4 of the 20 million barrels a day of oil that it used. Since the shale developments have made the US energy independent both in natural gas and oil, the Middle East has no strategic interest to the US anymore. Nor is the nuclear issue of much meaning to the US as most countries have them either openly or secretly as they can be purchased from North Korea or Pakistan and Iran can easily buy them from North Korea if they have not already which sources say they have.
The Iran key is their ability to shut the Straits of Hormuz as indicated in the military analysis in footnote one. If Russia cuts off the natural gas and oil to Europe, and Iran shuts the Straits, then Europe collapses with the rest of the world based on 600 trillion to 1.5 quadrillion of derivatives which would implode the 87 trillion world GDP as Warren Buffett describes in a metaphorical sense as a financial weapon of mass destruction.
This CIA has never been in favour of supporting Israel. What they saw was in the balance of power we were jeopardizing our position with 1.8 billion members of Islam or 25% of the world’s population by supporting six million Israelis but Colonel Jake Arvey, who took over the supervision of Truman from Tom Pendergast, told Truman that he either supported the statehood for Israel or he would not be nominated for President at the Democratic National Convention of 1948. There is some question whether Roosevelt’s early demise was related to this issue.
Israel in the early years relied on western military help but the influx of a million Russians gave their internal advanced technology sections a giant push as the Russians were very advanced technologically. They graduate twice as many engineers as the US according to the Israeli military analyst Yakov Kedmi. He quotes Bismarck as saying that Prussia defeated Austria in 1866 based on their teachers. I say Russian immigrants from Russia to Israel as there is some question how many were Jewish as lots of Russians wanted to get out. When I was in Israel a good time ago I saw there beautiful 18 year old blondes laughing together who were in the Israeli military and went up to chat with them. The first thing I said was Russkie, and they laughed. Of course, they were not Jewish.
I quote from David Solomon’s article:
“Meanwhile, Russia, China’s de facto partner in a range of high-tech industries, graduated nearly twice as many engineers as the United States in 2015. Russian engineers are first rate, as the Israelis well know; mass immigration of Russian Jews brought about 150,000 scientists and engineers to Israel, and turned the small country into a pocket superpower. Together, China and Russia have an eight-to-one advantage over the United States in engineering graduates.
The US doesn’t have the engineers to make a smartphone. In fact, we don’t have enough engineers to expand US manufacturing output by any significant margin. As of 2015, China graduated six times as many engineers as the United States, according to the National Science Foundation. That was five years ago.
The solution for the US is very simple. All those who go to engineering school will have their tuition and costs paid for but no tuition will be paid for anyone else except those areas as physics, or other areas that have military significance. And we should repatriate all our industries as discussed in my recent article to furnish them jobs. See footnote two.
The future of Israel is very fragile. I was having dinner with Paul Nitze before he died and he said one nuclear bomb well placed finishes Israel off. These are obtainable from North Korea. If they were delivered by submarine via a missile launched beneath the water, there would be what the Israelis call in reverse nuclear ambiguity.
We possess several hundred atomic warheads and rockets and can launch them at targets in all directions, perhaps even at Rome. Most European capitals are targets for our air force…. We have the capability to take the world down with us. And I can assure you that that will happen before Israel goes under.
The main issue is that the Iran nuclear treaty has very little meaning as far as nuclear missiles are concerned as anyone who wants them who has the money can buy them.
THE STRAITS OF HORMUZ AS A TRIGGER TO WORLD DEPRESSION
July 1, 2018
There is a grave national interest that is threatened by the derivative and financial structure outlined below in the report below on the use of Stochastic Control Theory which I have explained in simple English. According to Warren Buffett, the 600 trillion to 1.2 quadrillion world derivative market constitutes a weapon of financial mass destruction. In the discussions outlined below, these derivatives are used to drain at least a trillion dollars a year out of the market in manipulated profits. Aside from this being parasitic and illegal, it is dangerous to the national security of the United States as the shutting of the Straits of Hormuz by Iran can trigger a world depression as these 1.2 trillion of derivatives implode. These profits are protected by the former Attorney General Eric Holder too big to prosecute doctrine.
The 1987 stock market crash was engineered by the manipulation of the stock market by the cash settlement derivative by a giant cartel on Wall St. as explained in the Stochastic piece. It was resolved by forcing all the major players in the cartel to use their massive profits from their manipulation to reverse the crash using the same technique that they crashed it with and this was successful. In the 2008 crash such efforts were not sufficient and we created about 400 years of credit to make sure the monetary aggregates such as M-3 did not implode. 2.7 trillion dollars of which were used as excess reserves to repair the balance sheets of the bankrupt banks by paying them interest above market so that they would not fractionalize for ten years. These excess reserves are now being unwound with a much more limited effect than if they had been fractionalized. This can be offset by lowering reserve requirements as the Chinese are doing. We had to make up for the destruction of credit and it could be handled by papering it over.
If the Straits of Hormuz are closed by the Iranians the shortage of 22% of the world oil supply could not be similarly papered over and it would detonate a collapse of the 1.2 quadrillion derivative market causing a market crash worse than 1933 Weimar Germany. The Bank for International Settlements calculates about 600 billion in total derivatives but Swiss sources say there are at least 1.2 quadrillion with some placing it at 2.5 quadrillion. This relates to an 88 trillion dollar World GDP or a derivative market 28 times the World GDP.
General Barry McCaffrey explained to me below at a lunch at the Harvard Club that the US fleet cannot keep the Straits of Hormuz open as it cannot project sufficient military power to do so and the fleet must leave immediately the entire area in the event of a war with Iran or face total annihilation.
“The Russians have delivered large quantities of Sunburn missiles to Iran designed to fly as low as nine feet at 1,500 miles an hour with dodging capacity. They can be fired from a flatbed truck which makes them mobile. It is perfect for flying into the Straits of Hormuz which is no more than forty miles wide while the actual transit space is about two miles at points. This missile fired from the Iranian shores will punch a hole the size of a room in any ship in the Straits in a fraction of a second. The SS-N-22 sunburn supersonic anti-ship missile has been described as the most lethal missile in the world today designed to defeat the Aegis radar defence system of the United States and subsequent renditions. The Russian SS-NX-26 Yakhont missile (speed Mach 2.9) line the Iranian northern shore. No declassified studies of the ability of these missile to penetrate an aircraft carrier defence have been issued, but it would appear that a large barrage of these missiles cannot be defended against by any known method but jamming equipment.
However, we have the example of the Russian missile (falsely attributed to China) designed with anti-jamming equipment hitting an Israeli frigate (INS Hanit, July 14, 2006) off the shore of Lebanon during the Israeli attack on the Hezbollah. It sailed through the most advanced US and Israeli jamming equipment. While the Israelis denied that they even had turned on their jamming equipment, this did not make any sense to have the INS Hanit jamming equipment turned off when that ship off Lebanon was in a war zone and that they were turned on was confirmed to me by the highest Israel authorities (Mossad) who said they issued this denial at the request of the Americans so that it might not be known that the system on American warships was worthless.”
Many more advanced offensive missiles than this have been since that conversation been acquired by the Iranians as well as advanced anti-missile missiles to deny access to their airspace from enemy aircraft.
“The United States does not have the military power to keep the Straits of Hormuz open and its carrier task forces must flee if they are within range of Russian and Chinese anti-ship missiles lining the coast of Iran which are the most advanced in the world.” General Barry McCaffrey, former Assistant to the Chairman, Joint Chiefs of Staff (JCS); and Director of Strategic Plans and Policy, Joint Chiefs of Staff, in a conversation with David Lifschultz at lunch at the Harvard Club.” In addition, in a conversation with David Lifschultz the chief derivative trader in oil for Goldman Sachs said if the Straits were cut off oil would rise to $500.00 to a $1,000.00 a barrel and then crash the derivative market taking down the world economy as Warren Buffett has pointed out.
Here is a brief summary of the military analysis of General Barry McCaffrey at the Harvard Club lunch with me in which he discusses the strategic inability of the United States to keep the Straits of Hormuz open:
The aircraft carrier became the new weapon of naval war replacing the battleship as the premier weapon for the simple reason that the planes were able to destroy the battleships before the battleships came near enough to destroy the aircraft carriers. This made battleships, cruisers and destroyers obsolete.
The United States ended the World War Two essentially in control of the all the seas and their main instrument of control were these aircraft carrier task forces. The US took this control from the exhausted and bankrupt British Empire and inherited their long built Empire with the empires of Japan, Germany, France and the Netherlands. The control mechanism was the US control of the world financial system established at Bretton Woods constructed around the CHIPS and Swift clearing systems where 88% of world financial transactions has a dollar on one side. The UN and World Court were merely parts of the control mechanism where the small nations rights were really imaginary as we see in the case of Iran.
When the Korean war broke out with the surprise invasion of South Korea in June, 1950, the other key component of the United States winning World War Two of land based air power was quickly nullified as most of the friendly air bases in South Korea were overrun. (Tanks armies were the third component of World War Two military power now nullified by advanced Kornet missiles. Submarines were the third.) The United States Seventh Fleet quickly arrived at the scene to provide that air power to the US and South Korean armies stranded defending at the Pusan Perimeter which saved the day. It was from that moment to the present that air power projection against land targets, rather than the fleet battles in the deep blue water, would be the main justification for aircraft carrier task forces. Naval aircrews from the Seventh Fleet’s Task Force 77 flew 275,000 sorties amounting to 53% of the close air support and 40% of the interdictions sorties in Korea.
Air power was a major factor in World War Two. Field Marshall Fritz Erich von Manstein outnumbered troops defeated the Russians at the Crimea saved by Baron Wolfram von Richthohen Fliegerkorps VIII whose air force annihilated half the Russian forces. There Fritz earned his Marshall’s Baton. In a reversal at Normandy, Field Marshall Rommel in his famous message to Hitler predicting an allied breakthrough stated that allied air supremacy was smashing their best trained troops and the situation was hopeless. As we shall discuss later, the United States is banking on air power to stop the Russian Army in Europe today in the event of an attack but there will be no airports whether military or commercial within ten minutes of the commencement of war as Russian Iskander missiles carrying tactical nuclear warheads or conventional will knock them all out nullifying NATO’s air power. Tank warfare is similarly obsolete based on the improved Kornet missile and advanced silent submarines and their advanced missiles will control the seas eliminating the aircraft carriers the other major component of World War Two power. The problem is that the western armies are preparing for World War Two and not World War Three. As such, a look at NATO and its dilapidated German force demonstrates that this deterrent is but a figment of the imagination and would be wiped out within two to three weeks according to German generals we have discussed this with. In other words, in a war in Europe the three components of World War Two military power power the aircraft carrier nullified by submarines, tanks nullified by the Kornet missile and air power nullified by the destruction of the air fields would not stand in the way of a Russian Army that could reach the English Channel in two weeks.
During the Vietnam War the US Navy similarly projected air power in the newly reconstituted Task Force 77 participating in the sustained air campaigns such as Rolling Thunder and Linebacker. From 1964 to 1973 Task Force 77 flew hundreds of thousands of attack sorties against targets in North and South Vietnam. In Operation Desert Storm in Iraq the United States Navy gathered six aircraft carriers with over 400 aircraft into the Red and Arabian Seas as part of the coalition air campaign. The aircraft carriers remained in the region participating in the Iraq and Afghanistan conflict.
During the period from World War Two until recently the Navy operated close to shore with little to fear. The Russians and Chinese have developed anti-ship missiles that line the coast of China creating a 2,000 kilometer fire zone where no aircraft carrier is safe according to open sources. We understand that the range is much further than this from informed sources. If we go just by the 2,000 kilometer line it includes a large part Japan, the Philippines, Indonesia, Malaysia, etc.. And if we go according current informed estimates 3,000 to 4,000 kilometers, it will include all of these countries as well as the waterways. It would jeopardize our bases in countries as Japan, the Philippines, etc. which would be targeted in a war.
The Chinese anti-navy missile and airpower is dispersed, mobile, and designed either to be hidden or sheltered in hardened and underground facilities. For example, China’s DF-21D anti-ship missile is based on a medium-range missile that is moved about and launched from a transporter-erector-launcher (TEL). Most of China’s land-based anti-ship land attack cruise missiles are also launched from a TEL. China’s maritime strike airpower, which includes most of its fleet of Flanker fighter aircraft, can be based at scores of air bases, most of which are hardened against attack, some to a very high extent. These are the forces that can reach out 2,000 kilometers if not more.
It is important to note that our new F-35C strike fighter for our aircraft carriers has a maximum combat radius 1,100 kilometers which is about the same as the older F/A 18 EF. Even when armed with standoff missiles, these combat radii won’t be adequate to keep the aircraft carriers out of range of land-based threats to aircraft carriers. In addition, most of our bases are vulnerable within the 2,000 kilometer range and all of them except in Australia would be within Chinese missile defensive range at 4,000 kilometers.
We recently watched the Tomahawk missiles strike Syria but their range is only 1,600 kilometers which are carried by our cruisers and destroyers which makes them worthless against a land opponent with longer distance missile capacity as China presently has lining their shore.
In other words, the nearer bases are vulnerable and the farther bases are too far out for our short range designed strike aircraft. This means our entire offensive capacity in Asia is geared to short-range conflict that we are hopelessly outmatched in that almost all our short range bases stand to be immediately wiped out by Chinese defensive missiles and our long range bases do not have sufficient long range strike aircraft. We must consider all our aircraft carriers as short range as they are limited by the range of their aircraft and therefore useless in future ground support operations, And as far as their use for patrolling the seas the aircraft carriers are vulnerable to advanced Russian and Chinese silent submarines with anti-ship missiles. In other words, the United States has lost control of the seas and all of its commerce is in jeopardy in the event of a major war. Its military industrial complex that depends on parts from Asia could be shut down within two weeks for those that rely on just in time inventory control.
The cost of a Gerald R. Ford-call aircraft carrier is 15.1 billion dollars which breaks down to 11.8 billion for the carrier and 3.3 billion for 24 F-35C strike fighters. We could buy for that some 27 of the new long-range strike aircraft at a planned cost of 550 million each. The United States has to immediately shift its procurement budgets to try to remedy this mismatch.
Thus far General McCaffrey analysis and it continues.
The Russians have delivered large quantities of Sunburn missiles to Iran designed to fly as low as nine feet at 1,500 miles an hour with dodging capacity. They can be fired from a flatbed truck which makes them mobile. It is perfect for flying into the Straits of Hormuz which is no more than forty miles wide while the actual transit space is about two miles at points. This missile fired from the Iranian shores will punch a hole the size of a room in any ship in the Straits in a fraction of a second. The SS-N-22 sunburn supersonic anti-ship missile has been described as the most lethal missile in the world today designed to defeat the Aegis radar defence system of the United States and subsequent renditions. The Russian SS-NX-26 Yakhont missile (speed Mach 2.9) line the Iranian northern shore. No declassified studies of the ability of these missile to penetrate an aircraft carrier defence have been issued, but it would appear that a large barrage of these missiles cannot be defended against by any known method but jamming equipment. However, we have the example of the Russian missile designed with anti-jamming equipment hitting an Israeli frigate (INS Hanit, July 14, 2006) off the shore of Lebanon during the Israeli attack on the Hezbollah. It sailed through the most advanced US and Israeli jamming equipment. The Chinese have these missiles.
The United States has tested successfully in 2013 the X-47B experimental unmanned aircraft though the trouble with them is that its range is only 1,900 kilometers versus about 1,100 for manned jets, but that greater range is insufficient to operate outside even the 2,000 kilometer missile defensive wall of Russian and Chinese missiles and these anti-ship missiles are said to have a much greater distance capability. There was a phenomenal exhibition of Russian military advances when their equipment downed a Stealth Drone and effected its landing in Iran enabling the Russians to put their hands on this advanced technology. The implications of this military coup could be dire for any adversary in that a nuclear tipped missile fired at Iran could be diverted and returned to its source. Nor have we discussed here how the Russians have sealed their airspace with defensive missiles (S-500) ending MAD. Nor their tens of millions of nuclear bomb shelters for their people.
This ends the General’s analysis summed by saying in a war the US fleet must flee away from the Straits of Hormuz or be annihilated, and the US cannot keep the Straits open.
If the Iranians shut down the Straits of Hormuz, 22% of the world oil supply will be cut off. The consequences will be that the oil price will rise to over $500.00 to $1000.00 a barrel and the world economy will start to implode with all the financial markets crashing as in 1929 as the 2.5 quadrillion of derivatives start a chain reaction of destruction as a financial weapon of mass destruction. In this case, the shortage of oil unlike the shortage of credit in 2008 destroyed as it was cannot be made up by a fiat instruments. The oil is not there. Therefore, this derivative market is a national security issue. The manipulations of markets is also a serious issue as it is illegal but no one seems to care about it. Until these derivatives are wound down, Iran controls the entire world whether the US Carthaginian Congress wants to recognize it or not. This is the reason the US wants to oust the present leadership in Iran and not nuclear weapons that are available on the black market from Pakistan and North Korea as the Straits closing would collapse the US economy.
I had proposed a solution to this problem to the then Secretary of Energy Samuel Bodman that the company named Genoil can tap the 900 billion barrels of world heavy oil reserves creating a 25 million barrel a day reserve production capacity at a cost of 165 billion dollars as an insurance policy for the now 88 trillion dollar world GDP and Sam thought it was a great idea. However, it was blocked by the major oil companies as the Genoil technology is highly disruptive to the value of their light oil reserves whose value would collapse as Genoil can convert heavy, high sulfured oil to light unsulfured oil at a much cheaper price that WTI and Brent which make up their reserves.
We recommend that the Department of State together with the Department of Defense and Treasury Departments move to unwind the 2.5 trillion derivative market for national security reasons on an emergency basis and adopt the Genoil technology.
Stochastic Control Theory, Dynamic Programming and Numerical Analysis of PDE’s Stopping Theory Used in the Market Rigging By Cash Settlement In 1987 and Today
David K. Lifschultz
Today these cash settlement manipulations are much more coordinated by the many trillions of dollars of managed money by the remaining Wall Street firms and their private equity fund cousins in a form of a cartel than in 1987 and represent 50% of the trading on the New York Stock Exchange otherwise identified as systemic trading which is a euphemism. The key to draining a trillion dollars a year out of the market is to manipulate the direction of the market. The power of these manipulations are described by Lord Bertrand Russell as follows quoted from page 144 from his “ABC of Relativity”:
“Abstraction, difficult at it is, is the source of practical power. A financier, whose dealings with the world are more abstract than any other practical man, is also more powerful than any other practical man. He can deal in wheat or cotton without needing ever to have seen either: all he needs to know is whether they will go up or down.”
We point out in our piece below entitled “Goethe, Faust and the Euro” how these hypothecated abstractions have been used to take over the whole world over two and fifty hundred years ago through the the financial use of currency hypothecations, or abstractions, as Goethe showed in his “Faust” in the early part of Part Two. Mephistopheles represented Mayer Amshel Rothschild. This can be read in footnote three. This is what Lord Russell was telling us.
Now see this Barron’s ad appearing a short time before the 1987 rigged cash settlement crash should have intrigued our regulators and see how it corresponds with Lord Russell’s comments:
Securities firm employing sophisticated arbitrage strategies and proprietary valuation models for the investment of private funds in the convertible securities and options markets seeks Ph D. level mathematician to join its research staff. EXPERIENCE IN SECURITIES ANALYSIS IS NOT NECESSARY. Academic specializations of interest are stochastic control theory, dynamic programming, numerical analysis of PDE’s stopping theory.
Box S-687, BARRON’S
The key here is to know which way the market will go. The private equity funds and the Wall Street Houses manage their investment accounts with complete autonomy from their clients and will not accept funds on any other basis. What they do with these funds in association with their other members of the cartel is to directionally move the Standard And Poor Index using their trillions to do that while having earlier laid out their “abstract” cash settlement positions that will settle for cash so that when they move the market down their cash settlement short settles for cash eliminating the self-correcting mechanism of having to buy back their position and vice versa. That is the basic principle which is quite easy to understand and we show below for our Wall Street friends how they do it.
I personally was involved in supervising the rescue of the United States from this cash settlement manipulation discussed below. A significant number of participants called here a cartel coordinated among themselves the raising of the market prices through the manipulation of the Standard and Poor’s Index via cash settlement earlier, and then lowering it laying out their cash settlement positions below the market. It was not their intention to destroy the whole market in a massive crash but it did happen. They were reluctant to risk their own capital much of it made through these manipulations to save the system that they had crashed and we, of course, ordered them to do so making them an offer that they could not refuse. Therefore, though this essay is written as a form of request for an investigation at the time, none was really required as the we knew what happened when it was written. When it was written we could not have written otherwise but such a distance has now ensued that now the truth can be told. The crash was a rig gone wrong. There was a whitewash later by Professor Glauber who headed the Brady Commission who subpoenaed the wrong data on purpose to cover it up.
We have been alarmed by the recent behaviour of our financial markets. Our concern is not so much with market volatility but rather with market combustibility. It is not random wildness that troubles us but the markets susceptibility to specific stimuli which are controlling the short and intermediate pricing of equities, futures and options.
We are concerned that the regulators have allowed the development of a market mechanism that they neither understand nor can control. More, we contend that the US equity markets are now sullied by an extensive on-going manipulation of unprecedented proportion.
Our securities industry takes space travel and genetic engineering for granted yet continually succumbs to the rhetoric of “random walk” and “no one is bigger than the market.”
In the wake of the 1987 market break, regulators and scholars have been asking the “right” wrong questions. Leading us astray they raise the classic moot issues, like margin requirements and market limits, which evoke fervent debate simply because those elements, though debatably irrelevant, are easy to understand. Moreover, the brute-force actions of trembling margins and imposing 50 point limits are sure to have some noticeable impact.
Many of the academics/ rhetoricians consulted following the October ‘87 crash are or have been in the paid service of interested parties. They have massaged data to show that what we see is just illusion and that our markets are not being controlled.
At the root of the current confusion is an often ignored, little-understood feature of the new derivative instruments. It is called “cash settlement,” and it functions to undermine fair markets.
What is “cash settlement”? It is the feature of certain options and futures which specify that they be settled only in cash at (or sometimes before) maturity at the existing price of the underlying security.
“Cash settlement” instruments are synthetic devices. They have no other purpose than to transfer cash from one entity to another by manipulating an underlying index number from one moment to the next, one month to the next.
Nothing REAL is produced, created or even traded. On expiration, money is just transferred automatically into or out of accounts of those who have placed their bets. No more, no less.
While the mechanics of “cash settlement” index options and futures are simplicity itself (a bookkeeper’s dream), these insidious instruments impact the market with great complexity.
To begin with, disposal of these instruments exerts no buying or selling pressure on the market.
It is difficult to imagine any legitimate product on security where buying and selling in massive quantity doesn’t impact price. With “cash settlement” that is what we have. There is no balancing mechanism as there is with any normal product, commodity, stock, bond or standard option and future.
In normal markets, unwinding positions will stabilize rather than destabilize by precisely counteracting the initiating transactions and returning the market to external supply- demand equilibrium.
On a typical option expiration, those who exercise the usual 150,000 (plus or minus) in-the-money “cash settlement” index options do not dispose of the $ 5 billion worth of stocks which ostensibly underlies these options. NOTHING really underlies these options; only cash changes hands; the game is repeated the following month.
The buyer of a “cash settlement” index future is NOT buying an underlying basket of stocks for future delivery, no matter what the “efficient market” rhetoricians claim. The “cash settlement” future is mathematically different from every other future in that it is really a hybrid OPTION, not a future.
At expiration, the so-called index future affords the holder no ownership, but an OPTION to take or not to take delivery of the underlying stock basket. This fundamental aspect of “cash settlement”, and how it impacts the market, is little understood.
To illustrate, consider the holder of 10,000 standard futures contracts on silver at maturity. If this holder does not choose to own the metal, the equivalent of 50 million ounces must be sold into the open market. This order to sell, taken by itself, is likely to depress the market price for the metal. The seller has an incentive to sell as carefully as possible as the more the price is depressed, the less the proceeds will be. Such a seller is likely to begin the process of liquidation well before maturity; he has a disincentive to disrupt market price.
In contrast, the holder of 10,000 S&P futures owns contracts which settle for cash. Disposing of these contracts puts no downward pressure on the market whatever. They just turn to cash. Where the holder of these contracts chooses to take delivery of the underlying stock baskets, it may be done without market risk, as follows: At expiration, stock baskets are purchased “at the market.” Any higher cost which results from this buying pressure is exactly offset by the higher “cash settlement” proceeds from the expiring futures.
This “cash settlement” futures holder has no incentive to tread carefully on the market.
Quite the contrary; there is an incentive to cause as much disruption as possible.
Consider the operator who is long the futures and short stock baskets against them. Knowing in advance that he and his associates will cover short stocks aggressively at predetermined moments (and thus drive the market upwards), they all buy “cash settlement” call options (and/or sell puts) in advance to profit from upward movement that they THEMSELVES will generate. Note that the simple act of covering short stocks at or near expiration is all that is necessary to create the profit and close ALL positions. Various labels, including “front-running,” have been applied to this strategy.
The key to a successful “cash settlement” manipulation is power and organization. The market must be overwhelmed at distinct points in time. Profit without risk can be achieved so long as domination can be achieved. If no greater opposing force appears or, if none exists, the market can be controlled.
We must recall the Hunt Brothers’ failed attempt to corner the silver market in 1980. What doomed that organized scheme from the out-set was that the Hunts actually OWNED something that they themselves would not consume, a physical commodity, which would have to be sold to complete the transaction to create the profit.
Thus, as in all fair markets, the simple round-trip action of one non-consuming group counteracted itself. As the Hunts were unable to convince or coerce others to take them out of their positions in the physical silver, the futures or options, the price of silver wound up where it started.
Now, consider the logical outcome had the Hunts been holders of “cash settlement” calls and futures on silver (which did not exist at the time). If they would have timed their buying of the physical to achieve the desired price rise through hypothetical “cash settlement” expiration dates (or “triple witching hours” as the press calls it), they would have been cashed out of option and futures positions automatically, for cash, without selling silver and depressing its price. They may have become masters of the financial world, using the EXACT mechanism which others are currently using to dominate today’s equity markets.
In theory, “cash settlement” was created to facilitate operations and to allow participants of any size to move easily in and out of the marketplace. As October, 1987 demonstrated, precious few were able to find liquidity when it was needed most.
We believe that a PROPER analysis of the existing marketplace will demonstrate that a group, a Cartel, now exists and that it has been using the “cash settlement” mechanism to profit from its ongoing manipulation of the New York Stock Exchange. We likewise believe that there is no other group substantial enough to oppose this Cartel and unless it is dismantled, fair capital markets will cease to exist altogether in this country.
It is folly that regulators who do not fully understand or appreciate the key and subtle features of “cash settlement” futures and options are judging the viability of a marketplace driven and controlled by this instruments.
In our discussions of “cash settlement” with various regulators, we have yet to encounter a single one who begins to understand the mathematics of the mechanism which now dominates our markets.
Our regulators must first acknowledge that they require the input of impartial scholars who can explain that the owner of a “cash settlement” index option or future holds a highly complex instrument the market impact of which they have yet to determine.
Advertisements, such as the following, five years old, from BARRON’S, should also intrigue our regulators:
Securities firm employing sophisticated arbitrage strategies and proprietary valuation models for the investment of private funds in the convertible securities and options markets seeks Ph D. level mathematician to join its research staff.
Experience in securities analysis is not necessary.
Academic specializations of interest are stochastic control theory, dynamic programming, numerical analysis of PDE’s stopping theory.
Box S-687, BARRON’S
This ad says a lot. What it doesn’t say is that stochastic control theory, optimal stopping theory, superb organization and a few $ Billion may be sufficient to corner our “cash settlement” markets. It is possible that some operators have transformed the US equity markets into a well-oiled machine. Push a button for a specific, predetermined response; stop the market in its track, turn it on a dime once option positions are established, then race it the other way.
Our deregulating SEC and CFTC have allowed the complexities of “cash settlement” to be foisted on an unsuspecting public. It is remarkable that in the wake of a global market panic precipitated by the “cash settlement” mechanism, the Commissions do not appreciate what has happened, and do not know where to look.
Despite all rhetoric, there is no evidence that the existing market is any more efficient now than ever before. Much of the heavy volume does not reflect any genuine change of ownership. Baskets of stock traded back and forth without risk against futures and options add nothing to the economy or to the equity markets. Such positions are established and subsequently unwound strategically to EXCITE the market to profit of “cash settlement” options. The premise that derivative instruments add liquidity is a myth.
The formal studies of the October crash, notably that of The Brady Commission, contend that market volatility has not increased. To quote that prejudiced report: “recent volatility is not particularly high when viewed in a broad historical context.”
For calendar year 1987, that analysis fails the sanity test and the flaw is obvious: only day-to-day closing prices were used. The wild INTRA-day swings, so characteristic of the pre- crash environment, were ignored. DAYS where the market traveled THREE HUNDRED Dow Jones points, in violent fifty point swings, to close up or down only ten points just don’t show up. The Brady analysis concerns itself only with NET daily price changes.
Curiously, the Brady Commission did not acknowledge what every professional trader knows: the venerable New York Stock Exchange is being dragged around daily by a new mysterious force.
While 60% of those polled by the Brady Commission agreed that the three “cash settlement” trading strategies (portfolio insurance, index arbitrage and program trading) were “principal factors” contributing to the October, 1987 world market panic, Brady doesn’t follow its own nose to explore how these strategies INTERACT as a mechanism to manage markets.
We have not seen a single published analysis of the crash which has broached even the POSSIBILITY that a market control mechanism exists. Market studies which have received attention have been directly or indirectly sponsored and we cannot ignore the singularity of interest between those who are manipulating and those who have been called on to “analyze” it.
With key data available to the regulators and with scholarly effort, the market control mechanism can be laid bare. It will be possible to demonstrate how the “cash settlement” index option is utilized as the primary profit generator in a rigged marketplace driven by highly managed tape painting. Institutional money is used to move the markets to achieve portfolio managers’ specific personal short-term trading objectives in the form of “cash settlement” index option profits.
Today’s investors must navigate within a marketplace which includes an odd array of players, some of whom are familiar while others are new, unusual and confusing:
A) THE NAIVE GAMBLER: Speculators who try to profit on short-term market moves. Known collectively as “the public”, then often buy “cash settlement” OEX puts and calls. These players and their brokers are substantial net losers but are drawn back to the market repeatedly by the lure of quick “unlimited profit with limited risk”.
As public players become increasingly experienced they realize, much the way casino gamblers do, that the game is not “fair”. Unlike roulette, blackjack and craps however, the OEX game odds are not yet regulated and the house is still unknown.
B) THE NAIVE HEDGER: Institutions and individuals with large portfolios which try to use futures and options to hedge volatile markets and even participate in “index arbitrage.”
If they do not rely on “pros” to manage their hedging programs, they do not succeed. The “pro” is given total control over the short-term trading of these portfolios (with which to help move markets) in exchange for a share of incremental performance.
As an example, Wells Fargo Bank handles the daily index trading for such august entities as the Rockefeller Foundation and the General Motors Pension Fund (source: Futures Magazine, WSJ).
While Wells Fargo clients were major sellers during the panic of 1987, we have seen no analysis which lays to rest the burning possibility that Wells Fargo or key personnel held short positions in “cash settlement” instruments in personal accounts and were using institutional money to drive the market down.
We have seen no attempt to analyze personal trading patterns of fiduciaries who surrender control of institutional portfolios used to create specific market combustibility.
C) MAJOR TRADING FIRMS: Experts who handle the enormous wave of stock “buy and sell programs” which rock the market. These players act both as agent and as principal and enter into quasi-legal profit sharing agreements with institutional clients (source: WSJ) to orchestrate buy and sell orders.
While there is little evidence to indicate that all of these major firms act independently, regulators have sufficient data to determine the level at which they DO act in concert.
To date, apparently, the regulators have chosen not to perform this analysis although some interesting tidbits are emerging. It seems that at least Salomon Brothers and Morgan Stanley (two key contributors to the Brady Commission, no less) were subsequently identified by the SEC as illegal short-sellers into the 1987 panic.
Initially, the trading firms used program trading to manipulate the market only in the moments immediately preceding option expirations.
The level of short-term market control has since developed extensively as the Cartel has reaped $ Billions of profits both on and offshore. Program trading is now the single dominant market mover on a day-to- day basis and is understood only as a system where “the computers make the buy and sell decisions.”
Regulators, by their inaction, are entrenching this mysterious system and are forcing the public to compete against informed traders who “run ahead” with stock, futures and option orders just prior to their own organized prearranged short-term market moves.
Buried away (Appendix 3, figure 12) in its report, without any cross- reference, the Brady Report discloses that the twenty largest trading firms’ principal accounts were net SHORT $200 million of stocks coming into the crash.
This is simply the tip of the iceberg as it does NOT include the short futures and long put positions of either the firms OR their partners’ and principals’ personal accounts, onshore and offshore.
Too, nowhere does Brady mention that the normal long “core” investment positions for these firms is many $ billions.
This is to say that during the weeks prior to the October crash, the 20 major firms were indeed very heavy sellers of stocks for their own accounts.
We believe that certain trading firms helped orchestrate the crash and profited handsomely from it. This is not the impression one gets from either the industry or these sponsored studies.
D) PORTFOLIO INSURANCE OPERATORS: These groups decided when participating institutions would buy or sell $ Billions in waves. Again we are told that the “computers” made the decisions. We are told to believe this handful of portfolio managers had no personal short positions in derivative instruments prior to pulling the plug on the market, selling stocks, as fiduciaries, mindlessly at ANY price.
E) LOCALS AND MARKETMAKERS: These participants make money by watching “body language” of brokers filling large orders for savvy institutional and upstairs accounts. They go WITH the smart money, not counter to it and are the distributors for the Cartel.
The Cartel buys options and futures, in prearranged trades, from key locals and market makers who then hedge against the public in smaller transactions. When all participants are properly positioned, and only then, the market is moved.
The Chicago Merc (CME), through its leadership and paid academicians, has done much to create public confusion and misinformation about how derivative instruments markets function.
While the CME Report claims the locals added liquidity and absorbed selling pressure during the October market panic, The Brady Commission specifically refutes that contention and shows that locals actually contributed to market instability.
It is very important to realize that as the market crash began, key locals and the Cartel members were short and got shorter as they all sold- not bought- the falling market. Savvy traders with short positions do not try to stabilize a panicky market, and this was not to be their finest patriotic moment as the nation shuddered.
F) INDEX ARBITRAGEURS: These are so-called “messengers” who everyone knows are to blame yet don’t know why; these are the darlings of the “efficient market” rhetoricians. There really is nothing wrong with index arbitrage per se. However, there is usually very little real arbitrage going on here.
“Arbitrage” STRICTLY means simultaneous equal positioning. Where a side (or “leg”) is lifted OR where there is a concurrent option position, there is no longer arbitrage.
Consider an arb who owns “cash settlement” calls and is short a stock basket which is offset by long “cash settlement” futures. If this short stock position is covered aggressively on expiration to enhance the value of the “cash settled” long call and long futures, this unwinding may be manipulation but it is certainly NOT arbitrage.
This powerful industry segment INCLUDES the major trading firms and, as such, has many friends in the press and in government. It is shrouded in mystery, lauded for financial artistry and granted significant trading and positioning exemptions.
Index arbs would have us believe that they are in business to make a few percentage points over the riskless rate. They claim marginal profitability from hedging and unwinding stock vs. futures positions.
Nothing is further from the truth. Careful analysis of trading patterns will tell another story. The major source of profit for the dominant index arbs is the tandem “cash settlement” index put and call option positions. Profits from these options are not mentioned when the arb explains market behavior or gives a raison d’etre to the press.
This group also thrives on public confusion and seems to have been a primary formulator and organizer of the Brady Commission Report presentation strategy.
How did an organization, this Cartel, gain the ability to manipulate the New York Stock Exchange? As an overview, we believe that individual Cartel members have had a long history of cooperation and information-sharing throughout their investment banking research, arbitrage and other trading activities.
More specifically, the origination of the Cartel’s present form apparently began in 1981 when the SEC and the CTFC were somehow motivated to introduce “cash settlement” in the “Accord.” This sham (which later emerged in the Futures Trading Act of 1982) included three criteria that a securities index future or option needed to satisfy to be eligible for trading.
The first criterion was that it be “cash settled”. Amazingly, the second criterion was that “it must not be READILY susceptible to manipulation.” What exactly does this mean and what is the intent?
It appears that the Commissions, aware of the susceptibility of “cash settlement” instruments to manipulation, were nonetheless motivated to let the scheme slip through. How, one wonders?
Taking control over the market did not then happen overnight. The first visible action occurred on the April, 1984 option expiration closing bell when small market-to-buy-on-close orders were entered on over 500 stocks, reportedly by a little known firm, Miller Tabak. The OEX index moved two points (equal to about 15 Dow Jones points), a very dramatic run-off move for the 1984 market. Those lucky or smart enough to own index call options profited by $75 for each $6.25 of market value existing only moments earlier. The unregulated OEX casino had made its debut.
The SEC announced an investigation of that manipulation but found nothing wrong with what had occurred thus giving its formal go-ahead to the high-jinks that have plagued the markets ever since.
Perhaps it is telling that in a subsequent 1986 “round-table” hosted by the SEC and convened to discuss the impact of program trading, Miller Tabak was one of ONLY four firms invited to participate. The other three were Goldman Sachs, Salomon Brothers and Harvard Management, all aggressive program traders. One thing is certain; the SEC had hardly selected a representative sample from the investment community for its “round-table.”
Allowed to run the market at will at each subsequent expiration, the Cartel has grown richer, more powerful, creative and confident with each successful monthly manipulation. The SEC has continued to display unusually benign behaviour towards major cartel members, even in the face of overwhelming evidence of wrong-doing. One must ask, who is pulling the strings at the SEC?
In its simplest form, a meaningful upward market movement begins in Chicago where the Cartel establishes a large long “cash settlement” index call position. The S&P futures and selected visible NYSE issues are then simultaneously overwhelmed with large coordinated buy orders, much of which is self-dealing (i.e. tape painting among several cooperating entities who, by pooling, are avoiding real market risk).
Where are the real sellers during this hypothetical rally? Many are either on or urged to the sidelines by Cartel advisors. It is important to recognize that, for the most part institutional-sized orders to buy and sell must be routed through the major firms. Thus Cartel block trading desks are aware of supply and demands vacuums before the markets react to them.
The Cartel’s major profit does not come from stock vs. futures but rather from large concurrent “cash settlement” option positions. Theses positions are established at the beginning of and during major market moves and are often later settled for cash.
This mechanism, or one very much like it, fuelled the bulk of the rally of 1987. With cash constantly flowing into the institutions’ coffers, their prosperity to “index”, and a limited supply of blue chips, there were few meaningful sellers of the big capitalization stocks prior to the crash. In the frenzied takeover environment, the Cartel’s tape painting moved the markets to their outer limits.
The Cartel established a larger short position in index options and futures, hedged core investments, and the market was ready for the very rapid and effectively orchestrated descent. Led by the major trading firms and a handful of participating institutions, the market was crashed.
There has been and continues to be an attempt to mask and downplay the key role played by the “cash settlement” option in the existing complex market mechanism. The Brady Commission Report and The CME Report do not even broach the potential for abuse from option front-running.
THE OPTION MARKET ACTIVITY AND PRE-CRASH OPEN-INTEREST WERE NOT ANALYZED. It is there where information can easily be found to identify manipulating operators and provide needed insight into the art of “cash settlement” abuse.
It is no surprise that so little about the market mechanism is understood with this key piece of the puzzle intentionally shrouded. We have a better understanding when the true motive behind program trading and portfolio insurance becomes clear:
PROGRAM TRADING AND PORTFOLIO INSURANCE ARE TWO SCHEMES USED BY OPERATORS TO MANIPULATE THE MARKET TO PROFIT FROM CONCURRENT POSITIONS IN INDEX OPTIONS.
Certain aspects of market manipulation should be addressed and included in any thorough analysis:
A) Is there a consensus by regulators that front-running coupled with market manipulation is undesirable?
B) Can we assume that a fair zero-sum market does not allow for consistent material winning by the same group of major participants?
C) Is it fair to presume that entities which have held essentially identical options and futures positions repeatedly throughout a wide variety of major market condition are “acting in concert”? Why haven’t the Exchanges enforced position limits?
D) Should operators who are actively involved in buying or selling stocks and futures in massive market-moving waves have strictly enforced guidelines with respect to their transacting in the related “cash settlement” index options market?
E) Do front-running and manipulation usually occur together? Who were the major owners of puts when the market crashed? Were they coincidentally also involved as major sellers of stocks?
Brady hasn’t asked. Neither have the SEC and CFTC. The data is certainly available and the analysis is straightforward.
Why haven’t tandem analyses of index option trading patterns of major market operators been performed? Why not analyze how independently the major program trading firms (coincidentally important contributors to the Brady Report) were positioned in index puts and futures just prior to the crash and how they behaved during the debacle?
F) How much of the daily stock and index futures trading is to simply “paint the tape” and move the market in desired directions without any legitimate change of ownership? How are the program trading volume numbers determined and have strict enough guidelines been established to monitor the markets?
G) How much credibility should be given to market studies prepared by employees of interested parties? Academicians, like other professionals, are for hire. To blindly rely upon them is folly.
How much have Professors Miller, Malkiel and Scholes been paid by the CME in the past 5 years? Their report is hardly the objective study which their credentials merit. Rather, it is a stunning example of omission and obfuscation. It is no more than a marketing effort to absolve the CME and index futures.
The Brady Commission report is a description of selected details of the crash. That study was most careful not to implicate the Wall Street firms and generally avoided pointing fingers altogether. They treat the crash as a natural phenomenon rather than an intentional, profit- motivated act of organized manipulators.
The Brady Commission relies largely on input from the very firms and individuals who might otherwise be targeted for examination themselves. The director of the commission, Robert Glauber of the Harvard Business School, now an Assistant Secretary of the Treasury, has special expertise in mathematical models for portfolio management. He has had some involvement with the management of Harvard’s endowment, itself identified (by the SEC) as the sixth largest seller during the crash. Glauber has apparently also had a long standing consulting affiliation with Morgan Stanley and possibly other major trading firms which may be actively involved in program trading.
H) How do “cash settlement” instruments impact the market? Just as standard listed options and conventional futures do increase liquidity and reduce volatility, their “cash settlement” counterparts do the opposite. Yet the same arguments which support the legitimate options and futures markets are used incorrectly to promote the scheme.
Our regulators must arm themselves with unbiased mathematical analysis capable of understanding the new market instruments sufficiently to debunk the rhetoric.
I) How do index options originate and how are they distributed? To what extent is pre-arranged trading involved? We believe that any serious attempt to understand the manipulative market mechanism cannot ignore that the Cartel has developed techniques to originate as well as distinct arms with which to distribute “cash settlement” options into the market and with which to take them back.
J) If nothing underlies the “cash-settlement” derivative instruments, aren’t they simply a gambling vehicle utilized to promote volatility and control market behavior? What is their real as opposed to their alleged value or purpose? Specifically, who has benefited from them?
K) Why are “cash settlement” futures treated as futures when they are mathematically options?
L) Why should institutions, especially those with tax-free status, be encouraged to transact in a zero-sum market game that probably has no redeeming value and is clearly destabilizing? Why were funds, earmarked for long-term investment, used to actively trade the markets?
M) What of the world’s other “cash settlement” markets? To date we count 26 exchanges around the world which have begun experimenting with the new instruments. There is evidence that every one beyond the initial developmental stage is experiencing unusual behavior (see, for example, reports on the Sydney Financial Exchange’s 10-year T-Bond Contract).
Our regulators should be monitoring the development of aboriginal cartels with their U.S. international investment banker/arbitrageur partners.
N) What kind of numbers are involved? Our preliminary estimates indicate that more that $20 Billion has been reaped by the Cartel in illicit trading since 1984. We believe this money is traceable and recoverable and can be used to fund needed legitimate regulation of the capital markets through the next decade.
O) But have any laws been broken? Yes, many. The markets have been manipulated continuously since 1984 (with a brief respite during 1988 while the enormous profits of the 1987 crash were digested and invested). The Cartel has exceeded position limits and relied upon pre- arranged trading on an on-going basis to defraud public investors.
P) What is the long-term impact of surrendering control of the nation’s capital markets to a Cartel which has probably become the most powerful financial entity in the world?
The capital markets are under the control of a Cartel which has upwards of $ 50 Billion of trading capital with which to move markets. The markets will be subject to this control so long as the key “cash settlement” instruments (index futures and options) exist.
The casino volatility aura will prevail until our regulators understand, then put an end to what is a rigged zero-sum game.
There are two approaches to dismantling the control mechanism. “Cash settlement” instruments can be abolished altogether or “baskets” of real securities can be used to settle all positions IN EXCESS of some preset threshold.
Those studies prepared by the Brady Commission, The Chicago Merc and the SEC to address the true issues:
The regulators and the general public do not understand “cash settlement”.
“Cash settlement” instruments are being used effectively to manipulate the major equity markets on a day-to-day basis.
Major portfolio operators profited personally from index put positions when they pulled the plug on the market in 1987. This same group owned the index calls when they wildly bought stocks at dizzying levels with institutional money throughout pre-crash 1987. We are seeing a repeat performance in 1989.
The same groups which lobbied to introduce “cash settlement” options and futures are also actively protecting them from meaningful regulation by obscuring their central role in market manipulation and control.
Regulators are not mathematicians and, unlike traders in the financial industry, don’t know where to find them. The one-to-one correlation “cash settlement” and manipulation has yet to be made but it will be. The well-being of our capital markets depend on it.
Before you discount this analysis, ask yourself if you truly understand program trading, portfolio insurance and index arbitrage. Ask yourself if you know anyone who does or who has benefited from the new “cash settlement” instruments.
Do you truly believe the market has become a fairer one over the past few years since their introduction or is there a reasonable chance that they are being used for manipulative purposes? Are you comfortable with the trend toward deregulation of the securities industry?
Cash-Settled Derivatives Drive Market Turmoil
The Financial Times reported on 11-19-06 that, based on the Bank for International Settlements data, the notional value of the world derivative positions was 370 trillion dollars, where four times the number of derivatives were unregulated versus regulated. They also reported that exposures or market risk where there was no matching of the naked positions with a counter-party was ten trillion dollars. This relates to a World GDP of 48.244 trillion in 2006, and ten trillion dollars exposure could change in the event of a disruption of the oil flowing through the Straits of Hormuz. The largest single factor in this derivative market was the direction of interest rates, whose nominal value grew 24% to 262 trillion. Foreign exchange derivatives or those betting on direction of the currencies, such as in the yen carry trade, amounted to 38 trillion.
The yen carry trade is one of the largest derivative positions in the currency section, where yen credit is borrowed at low interest rates and then converted into dollar credits to purchase bonds at much higher interest rates. As long as the yen continues to fall or stays the same against the dollar, there is a huge profit with leveraged gains through derivatives that magnify or multiply the gain percentage wise. The yen today is valued, based on simple purchasing power parity analysis, at about 30% too low below the dollar. This is killing the United States car industry as Japan subsidizes their exports to the US. The Japanese ability to destroy General Motors was achieved over nearly 50 years of dirty float, or the accumulation of nearly one trillion dollars by the Japanese Central Bank. Each of these dollars was an instrument used to raise the value of the dollar, thereby making it more attractive for Americans to buy Japanese cars. This advantage, which was considerable, went a long way to enabling Japan to get the jump on GM, Ford and Chrysler and to give them the extra profits to improve their product against their competition in the United States, which had the greatest industrial complex in the world. One industry after another fell victim to this currency rigging, such as electronics, television, radios, etc.
The United States, which has faced an enormous de-industrialization, has been waking up too late and bills are moving in the Congress to stop the currency rigging. In the meantime, Japan is heading to an account surplus of six to eight percent by 2009, and the United States to the reciprocal of that. Ultimately, these currencies will have to go back to alignment, and when this starts to unwind, as it did much earlier this year and then reversed, and now is unwinding again, it will inflict huge losses on the market participants making the turbulence in the sub-prime market look like a picnic. The sub- prime market is about 10% of the entire mortgage market, at 1.3 trillion dollars, and 20% of that 10% (or 2% of the whole market) is estimated to be under water.
The trouble in the yen carry trade is far more severe than the sub-prime mortgage market highlighted in the media Greek Chorus. What is more significant in the mortgage market is the damage of borrowers who are personally on 90% mortgages than bank exposure, with their valuations in some parts of the countries dropping below the borrowed level. The inflation of values stemming from the carry trade and these current account deficits, which return to the United States in the form of investments in government bonds, and thus lower interest rates, have created over ten trillion in additional US nominal personal wealth from inflated values, despite very low savings in the United States.
This situation has caused housing and stock securities to soar based on artificially low interest rates. In the event of a recycling of much of this carry trade, the losses from market participants could be huge, and it would trigger a drop of net worth in the United States to the long run averages as housing and stock markets fall.
This also could be aided by any cessation of the rigging of the currencies against the United States, which would cause interest rates to rise, thereby causing markets in bonds, housing and stocks to fall. Then, as the dollar falls, re-industrialization of the US would take place, forcing the hordes of Wall Street to return to doing real work as they lose their Wall Street jobs.
Warren Buffett again discussed derivative exposures at his annual meeting. He repeated his discussion on the dangers of these instruments, saying that excessive borrowing by traders, investors and corporations will eventually lead to significant dislocations in the financial markets.
Going back a few paragraphs if, for example, the long run average of personal net worth to United State’s GDP went back to its average having been inflated by currency rigging, the carry trade and the coordination of the central banks which foster these trading mechanisms and thus artificial asset inflation (and more on this later), then the fall in personal net worth in the United States could be ten trillion dollars. Remember that world GDP is 48.244 trillion dollars in 2006.
That ten trillion dollar surge in the last ten years created the so-called wealth effect which translates in the United States into the psychological framework of consumerism, providing a great deal of world demand through United States demand. This demand would dramatically fall in the event of a considerable drop in personal net worth from its inflated values.
In fielding questions, Mr. Buffett told shareholders that he expects derivatives, which he once described as financial weapons of mass destruction, and borrowing or leverage, to inevitably end in huge losses for many financial participants. “The introduction of derivatives has totally made any regulation of margin requirements a joke”, said Mr. Buffett, referring to federal rules limiting the amount of borrowed money an investor can apply to in each trade. “I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don’t know when it will end precisely, but … at some point some very unpleasant things will happen in the markets.”
Those unpleasant things could well be started by a closing of the Straits of Hormuz, which our sources tell us the Russian missiles now held by Iran are capable of doing. When the Israeli ship off the Lebanese coast was struck by a Russian missile during last year’s Lebanon war, it demonstrated the electronic jamming equipment used by the United States fleet could not neutralize the Russian missile – more on this in the next military report – thereby making the United States armada presently in the Gulf area sitting ducks.
Since interest rate derivatives are the major component of the derivative exposure, a shutting of the Straits of Hormuz would cut off 20% of the world’s oil supply, or 17 out of 85 million barrels a day, and that would adversely affect world growth from which interest rates are largely derived. The ten trillion dollar market risk that the Bank for International Settlements refers to is the netting out of the notional and covered risks, and is based on a static analysis.
In the event of a catastrophe such as a United States attack on Iran that could lead to the Straits being closed, the market risk would be magnified gigantically, as in the case of Long Term Capital Management, whereby a trillion dollar derivative position backed by the LTCM net worth of five billion dollars would have created massive counter-party risk when they reneged on their obligations, thereby shaking the houses on Wall Street.
Since four times the amount of derivatives are unregulated versus regulated, it draws into question the philosophy of regulation, and the issue of free markets versus regulated markets. First of all, the thought that the markets are free is an illusion. There are a variety of monetary monopolies in existence, and we can start first with the central bank of each country. The Federal Reserve of the United States regulates the credit in the system, as a monopoly, when creating money by buying treasuries through the creation of a credit in the private banking system. At one time it required gold reserves to back that creation, but that was dispensed with a long time ago and there are no reserves other than a small amount of foreign currency and the vestigial remains of gold at Fort Knox and the Federal Reserve in New York City. That banking system, in turn, through its fractionalized reserves, expands that credit further, based on reserve requirements that are very low percentage-wise now, but to demonstrate the mathematical principle, if the reserves were 20%, then each dollar could expand in the banking system until it reached five times that amount as an accordian takes in air.
One of the closest measurements to this credit expansion was reflected by M-3, which showed 10 trillion dollars in 2005 (M-3 represented paper currency, coin and credit, less an estimate for non-depository instruments, but this rather good measure has been dispensed with by the Federal Reserve). It is to be remembered that this credit was once backed by gold, or at least the dollar, to the tune of one ounce per $20.00. That gold in the gold certificate account represents 11.037 billion dollars at $42.22 an ounce, or in other words, 261 million ounces underpinning on the old basis of the 1920s ten trillion dollars. To give some idea of the inflation above the gold reserve since the 1920s, it would take $38,000.00 of credit to be backed by each ounce of gold. Most of these statistics were taken from the Statistical Supplement to the Federal Reserve Bulletin of June 2007. Thus, intrinsically there was no real value to the currency and credit, once it lost its gold backing, and the value attributed to it stems from a form of secular transubstantiation, and really constitutes a secular, societal control mechanism.
Now, when the central banks expand credit it is very important what that credit is used for. If it is for building factories, then the domestic production of goods can offset the inflationary effect of the expansion by increasing the production of those goods. This is what is taught in modern economics. I am dispensing with the instabilities of floating exchange rates, assuming for a moment that the monopolists in currency that sit once a month at the Bank for International Settlements representing the key central banks, will coordinate or regulate the exchange rates with discipline.
If the United States central bank issues such credit to 1.6 trillion dollars in hedge funds, which own 40% of the derivatives as part of their gambling casino operations, then that credit creates an inflation of valuations in the instruments that the hedge funds buy, and there is not a concomitant increase in production to validate the credit expansion. This casino is reflected in 370 trillion in derivatives in relation to the real GDP of the world of 48.244 trillion dollars.
This, then, is what you call speculative finance or finance capital in relation to productive capital such as building car assembly lines. In a sense, these hedge funds skim money off the top and produce nothing of real value to the society.
Now, if this was not bad enough, they endanger the system with their speculations, as Mr. Buffett describes, and was seen in the LTCM debacle, and thus their effect in total is parasitic. It is interesting that these same speculators have historically played the same destructive role as they are playing out here in the United States. Let’s look at history.
The wreckage of the German economy through inflation was largely induced by the failure of the German Central Bank monopoly to act properly, at least in relation to the stated purposes of these monopolies, which is to produce credit for financing productive investment. In 1923 the German Central Bank was financing the speculative financiers in the currency markets as the Federal Reserve today through their credit creation and their supervised banking expanders of credit. These financiers borrowed from the German Central Bank credit in marks and then sold them on the foreign exchange markets for dollar credits. After that, when they wished to cover their position, they bought the German credit from the German Central Bank with appreciated dollar credits paying back the shorted amounts. As the currency was destroyed by this mechanism, extreme economic dislocations developed in the hyperinflated market, not dissimilar to that which can happen in the United States as these chickens come home to roost.
The speculators did no real work as our hedge funds got rich, and the savings of the masses of the German population were wiped out. Here the process has been slower. As the uproar in the nation grew, Dr. Hjalmar Horace Greely Schacht was brought in as Commissioner for National Currency, and his first major step was to stop issuing credit to the speculators so they would have to go on the open market to buy back the marks, creating the traditional self-correcting mechanism of the short vehicle. A great bloodbath followed among the speculators who tried to use all their influence to oust Dr. Schacht – and they had great influence as our hedge funds and Wall Street firms who hire former Federal Reserve officials right out of their jobs, or staff the key positions in Washington anyway – but they failed, and the currency stabilized.
Later, in 1929 Dr. Schacht resigned over the prosperity of the German economy being subsidized by foreign credit, as the United States is now, and predicted a collapse. In 1933, after the collapse brought German unemployment to 40%, Dr. Schacht was again brought back as Reichbank President on the basis that credit creation would be solely used for productive investment. Financed as Germany was by the British Central Bank in 1933, an economic miracle followed and unemployment in Germany was wiped out with almost the entire population doing productive work.
The largest derivative of the Chicago Board of Options Exchange is the cash settlement derivative based on the Standard and Poor’s index that settles for cash. Roughly 600,000 contracts trade a day at a value of $16,000.00 each, or 9.6 billion a day. If you multiply this by 252 days, the yearly turnover in the contract is 2.419 trillion. There is one major player here.
“The S&P futures that trade on the Comex are also cash settled and have a far bigger dollar value than the options. Each contract is for $1,500.00 and the volume is astronomical. There is a smaller contract called the e-mini which trades like raindrops. Additionally, the index trades as a stock, the “spy”, which also has cash-settled options, as these would affect the market in a meltdown. But the riggers are making so much money in these zero sum games that I’m not sure they would want to kill the golden goose by having people react and examine as nearly happened in 1987 (more on this later). Maybe they’d figure the government is getting too nosy and tax-concerned. So blow it up, make a ton, and go play with their yachts and jets. The major player at the Chicago Board would probably not want it to blow up to avoid a bloodbath. The new villains, of course, will be the alumni of the 1987 crash, and their later students at these major firms, who went on to make their billions through this rigging at their hedge funds.”
The instrument, the cash settlement derivative, is essentially a gambling casino vehicle which is rigged. If a major hedge fund shorts the Standards and Poor’s index, under an ordinary shorting mechanism you would have to buy back the index, which would have a self-correcting effect on the market. This we showed earlier was Dr. Schacht’s approach in stabilizing the German mark, in that he forced the buying back of marks rather than allowing the financiers to borrow the marks from the banking system through the central bank to cover their short disrupting, as the cash settlement derivative does the self-correcting nature of the traditional short. This gambling casino vehicle, once established, can be used in the following manner to rig the market.
First, you accumulate the stocks in the Standard and Poor’s index to a mathematically established quantity that can be used at pressure points to drive the market down. To some extent this causes the market to rise, and at the same time you establish a gigantic short position in the cash settlement derivative based on the Standard and Poor’s index that will settle for cash below these levels.
Then, when these derivatives get very close to maturity, you hit the market with your purchased securities, all at once, and drive the market down prior to cash settlement, so when the synthetic derivative expires you derive the cash profit from the decline in the market without forcing the market up against your position. Your short position will be far in excess of your long position. You need only do this continuously to make a great fortune out of the market.
If you wish to push the market up during other periods, as before the crash in 1987, you simply reverse the procedure. In this gain of profitability you do no useful work as a card dealer in the casino, and derive great profits. Now, this rigging technique went out of control when it was being done by five major firms in October 1987 and the entire world financial system nearly collapsed. Since these five firms cooperated in a counter-rig organized by the Federal Reserve at that time, which caused the mysterious move in the futures cash settlement derivative going upward and reversing the crash, the Brady Commission head did not subpoena the appropriate records that could have demonstrated the rigging. The Commission was a whitewash and everyone knew it.
It is asinine to argue that a credit system that is created by a government regulated Federal Reserve, though actually controlled by the private bankers, and a banking system that carries forward the creation of credit through the fractional reserve system, and thereby is supposed to be creating this credit theoretically to create industries to produce goods, well it is asinine to argue that the utilization of this credit by hedge funds to finance the greatest and most dangerous casino in history shouldn’t be regulated. Actually, the cash settlement derivative should be abolished.
The very structure of this system is so attenuated and fragile, and is such an upside down pyramid of credit and gambling, that any major event such as a disruption of the oil flowing through such Straits could bring the entire system down and create a depression of monumental proportions that could very well lead to political consequences as were seen in Germany in 1933. It is therefore ironic that the very players who have constructed this system cannot see beyond their own short-term greed, in that they are jeopardizing themselves no differently than the speculators in Germany in 1923 and 1929 who brought the entire Weimar system, with all its monumental corruption, down on their heads – as they will do here if permitted.
And so, again, in August 2007, nearly twenty years after the 1987 debacle, the grave market turmoil is once again attributable to the maneuvers in the cash settlement derivative, though as we predicted about three weeks ago, the August 17th option expiry date was picked by these folks to engineer the reversal.
THE LIFSCHULTZ ORGANIZATION
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