May 25, 2011; Debt, Derivatives and Dominoes

The McAlvany Weekly Commentary
with David McAlvany and Kevin Orrick

Kevin: David, gold has been going up in dollars for the last few years, but something that a lot of times people do not pay attention to, is what is happening in other currencies.  Right now, isn’t gold very, very reactive to, for instance, the British pound, or the euro?

David: Kevin, characteristic of this particular bull market is gold and silver appreciating in every currency around the world and we have talked about this a number of times, in which we have basically said the inflation that we experience here in the United States is a rather benign thing, whether it is the single digit, which the BLS confesses to, or using their older models, as high as low double-digit, 10.7%, using their 1980 methodology, and it still, relative to our national income, and the average income for the average American, is insignificant.  But what we see, globally, is inflation on steroids.

Kevin: Are we seeing gold reacting to the inflation that other people are feeling overseas right now?

David: That is exactly right.  We see increased physical demand for metals other places in the world.  If you look at the U.S. market, it is still a dominant paper trade, where people will trade contracts, people will trade options, but the physical metals are really not important to most people here in the United States.  Globally, because they are experiencing on-the-street inflation, you are dealing with individual investors who are saying, “I’ve got to do something to protect myself against inflation, and against the demise of my home currency, whether that is the rupee, whether that is the pound sterling, whether that is the euro.

In every currency, globally, gold is moving up, silver has been, too, factor in the correction, and they are both in a strong up-trend.  Today, you have gold higher, at the highest levels they have ever been in euro and British pound terms.  We have just broken out to new highs.  This is similar to the U.S. market.  We are fairly fixated on ourselves here in the U.S. and don’t realize that gold is in a correction here, and it is not in a correction in other parts of the world, namely, the second largest economic block on the planet, and then, Britain, as well, the previous heavyweight in the monetary world.  We are in a raging bull market, across the globe.

Kevin: Dave, you and I were talking just recently about how in the United States, the public here is so numbed right now with QE-II and this talk of possibly a recovery.  It is like morphine that has numbed the body, and we are not matching the tempo of the rest of the world.  The tempo of the rest of the world is to buy gold and hedge against, not future inflation, but actually, hedge against the inflation that they are experiencing right now.

David: It is always a forward-looking project, too.  It is real world in that they are experiencing something of a money panic today, but it is with the outlook not really changing.  When they look at their monetary authorities, they come to the same conclusion we should here in the United States.  It’s the same song, it’s just a different verse.

Kevin: David, today we were talking to Trader Roy before we came into the studio.  This is a man who has been directly involved in the precious metals business as far back as the 1980 bull market.  He put things in perspective.  Back during that 1980 period, gold, you would think, was trading in extremely high volume.  People understood gold quite a bit at that time.  Gold shot up to $850 an ounce.  But about 3½ billion dollars of gold was traded per day.  He put that in perspective.  He said, “If you want to see what is really going on right now, guys, 38 billion dollars worth of gold is trading on a daily basis right now.”  Yet America is asleep.  It is not this hyper-energized understanding of gold like it was in 1980 when it was sky-rocketing.

David: Kevin, that perspective is interesting.  We have basically seen a ten-fold increase, a little bit more, from 3½ to 38 billion in gold traded per day.  Two-thirds of that, consistently, from then until now, was paper, one-third, physical metals.  Then, as now, we were trading about two-thirds of all volume in gold on the paper side, with about one-third being physical metals.  What was 1 to 1.2 billion dollars traded in physical metals in 1980, is now 12 to 14 billion dollars of physical metals traded every day.  That is a big increase, but then, remember this, too.  The world’s monetary aggregates are not up ten-fold, as the trading in gold is up ten-fold.  They are up twelve-fold.  We have far more liquidity in the marketplace today, and I think we will continue to see higher volumes in the metals market traded.  The biggest transition ahead is when we see two-thirds traded in paper, to two-thirds traded in physicals instead.

Kevin: Right now, physical trading is probably about 3-4 times what the entire gold market was, paper and physical, before, on a daily basis.  When he was putting this in perspective, Trader Roy said that it is actually these large hedge funds, and some of these larger institutions that are buying physical, and moving away from margin.  They have been burned with the rule changes at the commodities exchanges.  The strut that we saw in the metals just a few weeks ago was actually precipitated by a man-made event.

David: Kevin, we are going to talk today about debt, derivatives, and dominos.  These three things – debt, derivatives, and dominos – relate very well to the gold market, because as we explore this morning, the growing interest in the physical metals by the commodity trading advisers and the hedge funds, is not on the paper side of the trade.  They have, in the post 2008 world, become suspicious of counter-parties.  They don’t want to borrow money and have to pay back on short notice.  They don’t want to be any part of a rigged game.  They know how well rigged games can be played, and if they are not the ones calling the shots, they are going to be the patsies.  They are going to be the ones taken advantage of.

The reason why people are moving into gold today is on the basis of an insurance policy being necessary in the context of a concerted, global, competitive devaluation in currencies – not just the dollar – but as we have seen even today, with the euro, gold price in euros, and gold price in British pounds.  This is a devaluation globally.  We are seeing that response in the marketplace, but people aren’t playing games any more.  People aren’t wanting there to be any added risk variables in the metals that they hold.

Kevin: When you say people, you are actually talking about sophisticated investors.  The people down on the lower levels of investment right now are being fueled by risk and speculation and shooting for higher returns.  It is the large hedge fund manager right now that is battening down the hatches, is it not?

David: In the late summer of 2008 we had an interesting conversation with Bill King up in Chicago.  He has been in the commodity pits.  He has been trading in the financial markets and has been a guest on our program a number of times, and off-air, he commented that he had paid off his house recently, and had added a few ounces to the gold stash, and the interesting thing was, these guys have good instincts, and we are seeing a growing number of commentators, writers, traders, looking at this period of June to October as absolutely treacherous, where we could see a turn in the stock market.  What is the precipitating event?  We don’t know.  Is it the end of QE-II?

Kevin: Or could it be the European situation – Greece?

David: It could be.  We are going to talk a little bit about the European situation today, because it is really critical.  There are some undercurrents that are worth taking an appraisal of, and that is where we are going to begin talking about debt, derivatives, and dominos.

Kevin: Before we get to that, David, let me ask you a question.  When you were in the Bahamas earlier this year, silver was really perking and starting to show quite a bit of potential, but when asked if you could only own one investment this year, your reply was gold.  Can you explain your reasoning?  There were people who had stocked up on silver and it had paid off, but you still said gold first, without detracting from silver.  Explain.

David: It was interesting, Kevin, several participants were visibly surprised, and they stood up out of their seats and said, “Well, what about silver?”  They wanted to know.  They had already placed their bets and wanted to know immediately.  My response was that while I like and continue to own significant amounts of silver, we are moving into a period of international financial dislocation, similar to 2008, with differences being that the governments who were there to bail out the financial markets don’t have the balance sheets that they had then.

Kevin: They’re out of bullets.

David: Exactly.  To step in and bail out the markets this time around will look quite a bit different.  Silver would be fine, and I think will be fine, eventually, but gold was, and is, and will be, more of a solid choice based on its appeal in the midst of crisis.  Real money moves to that particular metal, gold, when other assets are not providing real returns, and silver tends to follow that trend.  I had no idea silver would run as it did in the first quarter of the year, but I am confident that gold will be the standout for 2011.

Part of this does tie directly into what we are talking about with Europe.  We had Italy, who was put on negative watch.  When a company puts a firm or a country on negative watch, whether it is Standard and Poor’s, or Fitch, they are giving it a one-third probability that over the next two years, that entity will be downgraded, so Italy has been put on negative watch.  Last week we had Greece downgraded three notches.  We covered this in our weekly comments on Friday on the wrap-up.

This is what we think is happening.  Greece has been an issue within Europe, and the fear there is that contagion will spread within the banking community if there is a reduction in the value of the assets held by those banks that are, in fact, Greek paper.

Kevin: There is a musical named Grease, and I keep hearing in the back of my head, “[Greece] is the word, is the word, is the word…” because really, that is all you see right now on television.  It seems to be the focus, not only of the Europeans, but it seems to be the focus here in America.  Those two don’t necessarily seem tied together.  But are they?

David: There are two things going on.  First of all, we have just the nuts and bolts of the way that a bank would buy different sovereign paper.  We had the opportunity to distribute mortgage-backed securities and agency paper for a number of years, and we have investors all over the world look at it and they said, “Okay, wait a minute.  I can buy treasuries that yield “x” percent, or I can buy agency paper, which has the implicit guarantee of the U.S. government, not explicit, like the treasuries, but the implicit guarantee, and I’ll earn an extra 150 basis points, 1 percent, 1½ percent more.”

Kevin: That sounds awfully familiar, David.  Let’s face it.  That has happened here in America a number of times, and it just blew up in 2008.

David: Right.  The same thing was done in the context of the European banking community.  You could buy euro-denominated German paper, or you could buy euro-denominated Spanish paper, or Greek paper, and earn a little bit more.  But one of the things that you were assuming was that Frankfurt had your back, and that the ECB would not allow failure.

Kevin: When you say Frankfurt had your back, you are talking about the European Central Bank?  That is where they are headquartered.

David: Correct.  This is the issue.  You had almost an implicit guarantee with these peripheral countries, where you may have made a little bit extra, and it made sense from a liquidity management standpoint.  For managing your float at the bank, you wanted to maximize the deposits.  So, to get paid a little more for really not taking any more risk, because, after all, the ECB had your back on that, it just made sense.  So you bought Greek paper, you bought Portuguese paper, you bought Spanish paper, you bought Irish paper, and that is what is chock full in these banks.

There are two tiers that we are going to discuss real quick.  One is an obvious exposure that these banks have, and that is, directly to this country-specific, euro-denominated paper.

Kevin: They bought paper that the country may not pay on.  That is considered a default.  That is the obvious risk.

David: Exactly.  When paper is marked down, if those banks have to take a loss on the paper, or it has to be marked to market because it is trading at a lower level than its original face value, it affects that banking institution’s leverage ratios, or “capital adequacy ratios,” as they like to call them.  Capital adequacy ratios are just tier-1 capital, plus tier-2 capital, divided by the risk-weighted assets on their balance sheets.

Kevin: But for the guy who doesn’t understand that equation, let’s face it.  Credit default swaps are here to help us.  We have insurance against these events, so this obvious default risk really shouldn’t be an obvious default risk, because there are credit default swaps.

David: Tier-1 capital, you are supposed to have a 4% cushion on, so if you want to put it in laymen’s terms, rather than CAR, and all the fancy names that go with it, you need to have a cash cushion, and if the bank doesn’t have an adequate cash cushion, they are in trouble.  What is considered an adequate cash cushion for tier-1 capital is 4% cash.

Kevin: That doesn’t sound like much.

David: Not much.  For tier-2 capital, 8%.  So what happens is, if you have a bunch of assets that you own, and they get marked down in value, all of sudden you don’t have as much in terms of your leverage ratios, or capital adequacy ratios.  They change in light of the impairment to the asset.

Kevin: So you have to raise liquidity somehow.

David: You have to raise liquidity, so what ends up happening is that you precipitate either a liquidity crisis, or a solvency crisis.  This is what they are trying to avoid in Europe.  They don’t want to see a replay of 2008 where they see one or the other, a liquidity crisis on the one hand, a solvency crisis on the other.

Kevin: Isn’t that what happened to AIG?

David: That is what happened to AIG, and this is where they are concerned about contagion.  If one institution is impaired, others with similar exposures can see that sort of classic run on the bank, so if the bank doesn’t have adequate liquidity, you could have depositors taking out more money than is actual available liquidity, and that causes a real problem for the bank.

Kevin, what you were alluding to earlier, credit default swaps, or CDSs, this is the second part of the problem.  The first problem is pretty nuts and bolts.

Kevin: It’s just a lack of liquidity.

David: Yes, and if you take a loss on assets, it can impair your management of the remaining assets, and in fact, your liquidity, or even solvency, in a worst case scenario.  Where there is further complexity in this instance, is with derivatives.  Derivatives feature prominently in this equation, as credit default swaps have become more popular over the last ten years, in particular.  They have served multiple purposes.  They have helped off-load risk.  They have helped hedge out certain parts of risk, and they have also allowed for speculators to come in and make what you might call unidirectional bets, where you are hoping that the market is going to work for you or against you.  It is basically a way of shorting a particular asset and profiting when that asset goes down in value.

Kevin: For the guys who are positive on derivatives, a lot of times they are positive on derivatives because it is supposed to bring safety to the market.  That’s why I brought it up earlier.  When these things happen, there should be some sort of insurance against that and that insurance, like any insurance type of product, needs to be spread out over a broad spectrum to reduce the impact in a single area.  We saw that go terribly wrong in 2008.  Are CDS-derivative types of products built into this European paper?

David: That is the issue, Kevin.  AIG covered, or insured, as a counter-party, a number of bets, which they were required to pay on in the event of insolvency or default.  This turned a low probability cash requirement at AIG into a real-time liquidity shock.  The sums were staggering, and the requirement to pay was immediate, which forced the demise of the institution.

This is the issue.  If we see a default, and the ECB is fighting against this, they don’t want to see any form of default restructuring.  They have a whole number of new names that they can call this, but any kind of default at all will trigger a credit default swap payment.  The question is:  Do those counter-parties have adequate liquidity?  Can they make payment on short notice?  Or are they invested such that they cannot actually get to the capital they need to make payment on that insurance policy?

Kevin: This is why they call it a contagion.  It spreads like the bird flu, or something like that.  It doesn’t just affect a single institution, or even a single country, or even a single euro-group like Euroland.  We are talking about a worldwide contagion that could be triggered by a single country going into default.

David: Sure.  What was the lesson learned from 2008 from AIG?  You have to pay attention to your counter-party risk.  Know who is making one-way or unidirectional speculative bets, as well as who is hedged, and with whom.  In other words, who has taken the other side of the bet?  You think the asset class that you are interested in, whether that is a Greek bond, or an ounce of gold, owning those things, to you, as an investor, for one reason or the other, may make sense.  Who is betting against you?  It is interesting to know who is betting against you, because you need to know how deep their pockets are.  They may be able to hold the trade longer than you are, and force you to close out the trade.  They win, you lose, because they had deeper pockets.

Kevin: This takes us back to the gold issue.  Actually, you eliminate counter-party risk when you buy an ounce of gold, because it carries with it, its actual buying power everywhere it goes, and you really don’t have to know who is betting against you.

David: It is no one else’s liability, and I guess that is the point of owning physical, versus paper, gold, in any form or fashion.  That is what I think is happening at the institutional level.  CTAs and hedge funds are realizing that counter-party risk is involved in virtually every asset class they touch, with one exception.

Kevin: And that is gold.

David: You could even look at a treasury bond and assume that there is counter-party risk in the sense that you are counting on the treasury to remain solvent and make payments on that investment.  If they are no longer around, or are impaired, or they restructure, as we are considering with Greece, as we are considering with Spain, Portugal, Italy, Ireland, and a number of other European countries, then your counter-party risk is there, as well.  There really is only one asset, physical metals, that has no counter-party risk.

Kevin: Since gold is not an IOU, and what we are talking about is the default, possibly, of IOUs, you would think that the banks would be out buying gold and trying to hedge themselves, but the banks are loaded, aren’t they, with this IOU counter-party risk?

David: This is what we see throughout Europe, where the retail franchise banks loaded up with this European paper.  It made sense, on the same basis that buying mortgage-backed securities and agency paper made sense, because it paid a little bit more, and the risk didn’t seem to really factor in.  Granted, we may look at that differently today, but throw on the lens of analysis that would have been used 3, 4, or 5 years ago, before sovereign debt crisis was even in the vernacular.

Kevin: We would buy something with the seal of approval of the European Central Bank.  Let’s face it, it was a completely new currency, it was a currency that finally unified the other currencies.  These guys basically gave the thumbs-up that they would be behind it.

David: And the interest rates on those loans were reflective, not of the individual country’s specific credit risks, but rather, of a collective obligation to pay, or a collectively assigned credit rating, an average, if you will, of the good, and the bad, to the benefit of the poorly rated countries.

Kevin: Did these banks add any of these credit default swaps to the list, partially to insure against problems, but then, partially to enhance the return?

David: Let’s say that I have 100 million dollars worth of Greek paper on my balance sheet.  I own the paper, I am getting paid by the Greek government regularly, and that is fine, but I do have some concern, so I decide to hedge that part of my portfolio, not completely, but I hedge a part of it.

Kevin: No different than a wheat farmer, who possibly will hedge his crop just in case something happens.

David: I can buy credit default swap on the Greek paper that I own, and in the case that they do default, I lose on one side of my investment portfolio, gain on the other, and suffer less by having the insurance policy in place.  That is the role that a credit default swap can play when used as a hedging instrument.

Kevin: If that was the only way the credit default swap market worked, it probably would work to a high degree of substance, but in reality, traders come in and start speculating on these credit default swaps, people who aren’t hedging against anything, they are just betting against something.  Don’t you need to know who took the other side of that bet, and how much control they have over the outcome?

David: I think that is where we are beginning to see a very interesting sub-story, if you will, within Europe.  We have the ECB, and they are not wanting to allow for any default, whatsoever.

Kevin: Why?  Let me ask you, because restructuring is something that we have seen many times before.  Why is there such a fear of restructuring this debt?

David: If you look at the Latin American debt restructuring in the 1980s, and the Brady plan that was put in place, it was very common to see debts restructured, and a 40-50% reduction in principle payments.

Kevin: Adding also to the maturities, or the length of time that it pays, right?

David: Sure, you could restructure a number of different ways, whether it was just a simple haircut, or changing the terms of the loan itself.  There are some interesting things happening in Europe.  I think the question remains, “Who has taken the other side of the bet?”  Not as a hedge, but as a speculative bet.

Kevin: Are we about to go cloak and dagger here, a little bit?

David: A little bit, because what we have found with Wall Street, and particularly, the financial gurus of our day – when you meet a child who is both bright and clever, you always keep your eye on him, because he is smart, but he may be too smart for his own good.

Kevin: Are you talking about the golden boy, or maybe the Goldman boy?

David: Or the Goldman boy. (laughter)  Kevin, the reason we bring up this concept of cleverness, is because what we have seen become more and more common in the financial arena is rigged games, where you are not just betting on the future appreciation of a particular asset class, or its decline, but you structure it in such a way that you can’t lose.  We watched a number of shenanigans occur and we mentioned this a few weeks ago on the commentary, back in 2001, with Goldman creating those 13 currency swaps, and covering over just how bad the Greek debt problem was then, as they were coming into the EU.  There has been some obfuscation and some subterfuge already put into the context of Europe, with Goldman being involved.

Kevin: Goldman-Sachs keeps coming up in non-financial press.  Rolling Stone Magazine has had multiple articles on Goldman-Sachs, how not only do they package an investment and sell it to somebody, then they bet against it, because they knew exactly what was going to happen, that it couldn’t possibly pay off.  That is criminal.

David: I guess what we are looking at is a kind of division of interests between the ECB and the euro-banks, on the one hand, worrying about their solvency, worrying about their capital adequacy ratios, and then London and New York, who have taken out bets on the demise of these peripheral European countries.

Kevin: They are betting against it and they are ready to rake in the winnings.

David: Pounding the drum – “Default, default, default, default.”

Kevin: David, let me get this clear.  The European Central Bank really would be the loser if there were defaults at this point.  They don’t want to see defaults.  They would like to see the thing with Greece work out – Spain, Italy, whoever.  But you have Wall Street, and you have London, not the entire market, but the people that we are talking about, would benefit dramatically, if there was a default?

David: I guess the person to ask about who would benefit the most might be Mario Draghi.  Mario is an interesting character.  If you look at his CV, he is eminently qualified to be in the financial spheres within Europe, and he is being considered the likely European Central Bank presidential replacement for Jean-Claude Trichet.  Trichet’s term ends in October of 2011.  So we have an interesting changing of the guard.  Whoever is on the selection committee is hard at work now putting together the short list of candidates to be approved to become the head of the ECB.

Kevin: Help me on this, though, David.  Isn’t Mario Draghi an MIT-educated Ph.D. in economics, brilliant guy?  But he is also Goldman.

David: He has a lot of real-world experience, a lot of academic experience, but some of his real-world experience, the sign of approval, or the seal of approval, if you will, came from his tenure running Goldman-Sachs as a managing director in Europe between 2002 and 2005.

Kevin: This sounds to me like putting the Fox in the hen house.  If the ECB doesn’t want to see default, and Goldman and the guys in London and New York are betting against it, why would you put a Goldman man in the ECB?

David: Right.  And would Goldman take proprietary positions that benefit from the demise or the impairment of a client?  We need to go back and ask John Paulson this.  When he made his cool 3½ billion dollars on a single bet, was it genius, or was it a rigged game?  Again, signs of the times, but Wall Street has become a collection point for the particularly clever, not the particularly trustworthy, and that is an unfortunate state of affairs.  But you find people who are setting up bets that they can’t lose on, and certainly Paulson is one case in point, with Goldman being complicit in that case.  The genius of what these men are doing is that they are structuring them legally.  That is where, if you can skirt the legal issues, although you might consider it criminal, although from the common sense level you would consider it fraudulent, all the I’s are being dotted, and the T’s crossed, to be considered above-board, on a technical basis.

Kevin: This reminds me of the late 1980s, when you had these guys coming in, like Carl Icahn, these hostile take-over guys coming in, tearing apart single companies, large companies, and selling off the assets, and actually, you would think the take-over was to save the company, but in reality, it was just to put money in the pocket of the guy who took it over.  It seems to me like this has been transferred from a company scale to a country scale, or even a continental scale.

David: I guess that is what is in play here.  If you wanted to draw the lines between the interests in Frankfurt, and Frankfurt representing the European Union and the European banks, and those interests being very different than what you would find in New York and London, wherein it doesn’t matter the way the market goes – we don’t live there, it’s not our country, it’s not our currency, it’s not our way of life.  It’s simply this year’s way to make profits, whether that is profiting on the up-side or profiting on the down-side.  It appears that the London interests and the New York interests are deeply opposed to the Frankfurt interests and the ECB.  The ECB is arguing against any sort of default or restructuring.  What is interesting is that they are now calling it, not restructuring, but re-profiling.

Kevin: That’s the latest euphemism, isn’t it?

David: As you said, Kevin, the ECB and the European banking community are the ones that lose in a scenario of default.

Kevin: But for every loser, there is always a winner.

David: You are right, and the winner is clearly not Frankfurt.  It’s not the ECB.  It’s not the German, Italian and French retail banks that hold that sovereign paper on their balance sheets and whose books are currently under pressure.  The winner is the person, or the financial organizations, that have bet against the peripheral countries, making this unidirectional speculative bet on a soft restructure, or as they are now calling it, the re-profiling, or whatever kind of default.  It has to be categorically a default, sufficient to trigger payment, as legally required by the credit default swap contract.

Kevin: In a way, we actually have a war going on right now between Europe, Britain, and America.  It seems to be very similar, but this is just being played out in the financial scheme.

David: Right.  Continental Europe versus everyone else.  And everyone else really doesn’t care about continental Europe, unless you are talking about a currency alternative, in which case Asia certainly cares about the direction of Europe, and on that basis, I think the harder you see the European banks pressed, and the ECB pressed, to bring about a default with the sovereign paper, you may see China just step in and spend 100 billion.  You may see them come in and spend 500 billion.  They certainly have the money to do it.  The Chinese wanting to see the dollar decline over a longer period of time would imply that they don’t want to see the euro crater, and will act as something of a backstop.  They may be the knight on the white horse, stepping in to save continental Europe from a debt or default restructure.

Kevin: What an amazing complexity that has been added to this spectrum.  It really is.  If you go back and study the makings of a World War I, or a World War II, from a military or political standpoint, it is very complicated.  We like to simplify it and say Hitler was a bad guy, and he was, but it was far more complex than that, being played out in the financial markets, and especially the derivatives market, which, when you add it all up, is the greater part of all the money markets out there.  We have talked over a quadrillion, when you count all the money.  We have Asia working in their best interests, possibly.  That would be a surprise if they come in on a white horse.  It certainly would shock the markets.  We have Goldman-Sachs working their way into the very thing that could be their pay-off, which is Mario Draghi.  How do you hedge against these things, David?  I guess it brings us back to gold, right?

David: I think you do want to look at your counter-party risks and realize that every asset class that you own, whether it is a stock portfolio, a currency portfolio, a managed futures portfolio – whatever it is, you’re dealing with institutions, and if you haven’t adequately hedged that institutional risk, or counter-party risk, you don’t know the context that we are in.

Kevin, you are right.  We have Europe fighting New York and London.  Europe is fighting what appears, more and more, to be a rigged game, one in which the Goldman-Sachs boys, along with other global financial speculators, are playing for keeps, again, in an already-rigged game.  They know how bad the numbers are because they came in with these sovereign entities and helped obscure, originally, just how bad it was 3, 4, 5, 6, 7 years ago, so they know exactly what they are betting.  They have put together the portfolios which they can now short, and profit from.

Kevin: And now they are sending their man in, Draghi.

David: This is if – if and when Draghi comes to the helm of the ECB, you will have your default delivered over to London and New York hedge funds.  Goldman will make a killing.  Goldman may play for keeps, and this is what will be interesting.  They stand to benefit in two ways – one, certainly, financially.  If Draghi comes in, as a former Goldman man, you know that the EBC’s hard stance on a default or restructuring goes away, and the logic of default, the logic of restructuring, all of a sudden, becomes a part of the ECB tune.

Kevin: Are they doing this all for profit, David, or is there more?

David: No, because frankly, London and New York benefit more significantly by translating that money and profit into power within the Eurozone.  Certainly, money means something, but it means less when you are making billions a quarter.  Power is the next best thing, frankly, to being God in a kingdom of your own making, and that is what Goldman has a vision of.  And we are not just picking on one firm.  There are other firms involved in this particular game.

Kevin: Sure.  J.P. Morgan, Morgan Stanley.

David: And there are tons of hedge funds that are on board as well.  It is not difficult to see that we have mismanaged our own books here in the United States.

Kevin: Let’s go mismanage the ones in Europe.

David: Right.  What you have is the new form of financial wizardry – setting up a package of securitized products that you can’t lose when you bet against.  That is amazing.  That is absolutely amazing, and something that will ultimately change, as there is a public uproar against it.  This was never meant to be.  If you go back to Greenspan’s speech in the 1990s about how wonderful derivatives were, he envisioned derivatives for the financial market being, as you described, Kevin, a way that someone who brings in corn, or wheat, or soy, is able to hedge their current production and lock in today’s price so that they don’t have to experience the vicissitudes of the market – the ups and downs and volatility of the commodity trading pits.  They were essentially hedging.  That is what derivatives were intended to be.  They have become, truly, financial weapons of mass destruction, and the war that is being waged is continental.

Kevin: David, one of the ways that the average guy can actually measure risk, like the risk of default, is by watching interest rates.  Don’t the credit default swaps, in some way, let us know what the likelihood for these various countries is, for some sort of default or other kind of non-paying event?

David: This is why we are talking today about debt, why we are talking today about dominos, and the falling of one domino leading to the fall of another, why we are talking about derivatives, and derivatives being central to this fall of the dominos within the debt markets in Europe.  It is because we already have credit default swaps, the insurance that you pay against default, at higher rates than we had a year ago, when the ECB was bringing out their 1.1 trillion-dollar or 750 billion-euro bailout.  This was the giant shock and awe – “We are going to change Europe, we are going to backstop every country, there will be no defaults, we are going to implement austerity, and here is all the money the world could ever want to fix the problem,” and yet, 12 months on, the situation is worse, and the probabilities of default, as indicated by credit default swap pricing, is even higher.

Kevin, takes these countries in Europe as the primary example.  In Greece, if you have a million dollars that you want to insure, it is going to cost you 147,000 per year to insure it.  That’s almost 15% to insure something that pays 16.7%.  You are eking out a marginal profit, but you have to insure against default.  It is costing you almost 15% to insure against default.  In Portugal it is better.  It is only $67,000 for every million dollars, or 6.7%.  In Ireland it is 6.6%.  In Spain it is 2.68%.  In Italy it is 1.69%.  So you can see where the concern is most concentrated, Greece, Portugal, then Ireland, ultimately Spain, the real revolution will be over the next few months as we see things materialize, particularly in Spain, and it goes from the bottom of the list to being near the top of the list.

Kevin: Let me ask you about that, because some people that I have read and we have talked about, Greek debt isn’t necessarily the big issue.  Even Portugal debt is not really the big issue.

David: It is because they don’t have that much, to speak of.

Kevin: But Spain is a different issue, isn’t it?

David: Spain and Italy are two borrowing giants.  There are tons of paper, and that is the issue.  Again, on the basis of contagion, it is not that you have to worry about Greek debt default.

Kevin: That wouldn’t take the ECB down, or the Euroland down.

David: It wouldn’t.  It doesn’t destroy the euro project.  Portugal, if you face default or a restructuring in Portuguese paper, again, it doesn’t impair the EU project.

Kevin: But these are the dominos that you are talking about, one domino leading to another.

David: Exactly, and the big one that you can’t recover from, because there is too much debt, is Spain, and then Italy, even more so.  But with Spain, since 2008, you have 17 autonomous regions, like our states, practically, which have doubled their debt, to 160 billion dollars.  You have municipal debt, so the cities within those states, which have debt that is right around 50 billion – 47 or 48 billion – and then central government debt, which in dollar terms, is pushing 700 billion dollars.  This is in addition to about 37 billion dollars worth of debt that hasn’t been factored in because it is being considered as unpaid bills and things of that nature, so they haven’t actually added an extra 37 billion to the negative side of their balance sheet.  Spain is a far bigger problem than Greece, Portugal, and Ireland.  Contagion, spreading to Spain, would be terminal for the EU project, as we know it.

Kevin: David, since we are on the subject of musicals, we talked about Grease, but I think maybe [Greece] isn’t the word.  It’s the rain in Spain, but we just don’t want it to fall, do we?

David: Unless it’s mainly on the plain.

Kevin: That’s right.

David: I think, Kevin, when you look at the debt that is in Europe, this is not a European problem only.  We have that clearly in the United States, too.  Our balance sheet is just as impaired as many of these European countries.  We have what they don’t have, which is an exorbitant privilege, as Barry Eichengreen has described it – that of world reserve currency status.  As that gets chipped away at, we are in the same boats as these folks are, too.  We have the Chinese Central Bank advisor saying just this last week again that he eventually expects to see a default of U.S. paper.  That may be a far-fetched notion for U.S. investors today, and maybe that is something that will only happen on a 5, 10, or 15-year time frame, but when you see a revolution in interest rates, when you see a revolution in the bond market, these things never happen gradually.

Kevin: David, I think probably one of the greatest signs of seeing that our sovereign debt is going to be defaulted on is watching the Goldman guys.  If we knew that Goldman started betting against the dollar ever paying up, we probably should run for the hills, shouldn’t we?

David: We already have the PIMCO guys saying, “We don’t want any part of the U.S. treasury market, which is a first strong indicator that short positions will be building over the next few years.  I think as we look at modern finance as a truly rigged game, this is where the smart money begins to figure out who their counter-parties are, and how they can insure against default, whether it is domestically, whether it is with their own currency, whether it is with a particular financial institution, that is where individuals and institutions and hedge funds, and even central banks, are all turning to gold as that insurance.