In fact, it is our view that this unprecedented proliferation of derivatives has set the stage for a serious crisis, with a not insignificant possibility of a major financial accident. In this regard, it is definitely no coincidence that derivatives have proliferated simultaneously with historys greatest period of credit excess. Instead of reducing risk, derivatives have been a close accomplice with unprecedented credit growth, creating an historic financial and economic bubble.

And there is no better illustration of the tight interaction between derivatives, credit excesses and the bubble economy than in the workings of mortgage behemoths Fannie Mae and Freddie Mac. As we have mentioned previously, these institutions have aggressively expanded their balance sheets, largely holdings of residential mortgages, from $379 billion at the end of 1994, to almost $870 billion at the end of June. These massive holdings are supported by shareholders equity of about $27 billion. Much of this growth was during last years mortgage refinancing boom, where American homeowners were offered an incredible opportunity to refinance mortgages at very low rates. For all of 1998, Fannie and Freddie total assets increased $220 billion. To finance these ballooning balance sheets of mortgage holdings, Fannie and Freddie borrowed aggressively from the money markets, and actually ended 1998 with about $400 billion combined short-term debt. One may, understandably, question the wisdom of accepting the interest rate risk inherent with using short-term funding sources for leveraging long-term mortgages. Actually, this is where it gets interesting. Both Fannie and Freddie use derivatives extensively to hedge interest rate risk, and in this regard are likely Wall Streets best customers. In fact, they are apparently so proficient at "hedging" that Wall Street takes it for granted that they have little interest rate exposure. At the end of last year, Fannie had $170 billion of derivative positions and Freddie Mac had $313 billion, including $220 billion of futures and options, and $42 billion in interest rate swaps.

Looking at how much interest rates have risen since last year when Fannie and Freddie bought all those low-yielding mortgages, they had better hope that they were properly hedged. And, just as important, they better hope that they are able to collect on their winning derivative contracts. In this regard, we cant help but to remember, and continue to ponder, last years fiasco in Russia where many speculators had entered into hedging contracts with Russian banks to protect against a fall in the ruble. Much to everyones dismay, however, the ruble was hit with devaluation and the Russian banks were quickly and completely wiped out, defaulting on their derivative contractual obligations. Russia was a textbook case of a derivative market meltdown and counter-party fiasco that should have provided a wakeup call as to the overwhelming systemic risk that is associated with the proliferation of derivatives. This is particularly the case when the derivatives market is dominated by speculators and highly leveraged players. We will certainly place this high on our long list of "lessons that should have been learned." Increasingly, we fear that something quite similar is unfolding in the derivative markets in the US and likely in Europe. Both, clearly, have been hotbeds for the use of derivatives for leveraged speculating.

But lets get back to Fannie and Freddie. Look at it this way: Since last fall, mortgage-backed securities have lost about 7% of their value. Fannie and Freddie 10-year debt securities have dropped about 10%. So, without hedges, Fannie and Freddie would have suffered huge losses as the value of their mortgage portfolios have dropped significantly. So lets be conservative and assume that they made 5% on upwards of $400 billion of derivative hedges that offset losses on their mortgages. Well, this means their counterparties owe them $20 billion. Now, if interest rates continue to rise, it is not unrealistic to assume that counterparty obligations could grow, to say $40 billion, and so forth. The problem, remembering back to the Russian bank example, is that Fannie and Freddie have most of their contracts with securities firms. Yet, these firms are themselves acutely vulnerable in todays environment, with highly leveraged balance sheets and huge exposure to higher rates and a generally tumultuous financial environment. Taking a quick look, and combining five of the major Wall Street firms, Goldman Sachs, Merrill Lynch, Morgan Stanley Dean Witter, Lehman Brothers, and Bear Stearns, we see that they have total assets of $1.3 trillion supported by equity of about $50 billion. And this, importantly, does not include massive off-balance sheet derivative exposure.

The story line here is that sharply rising interest rates very much surprised the Street. Derivative players, with great faith in Greenspan and confidence in models that saw little chance of higher rates, bet wrong and now are potentially on the hook to pay tens of billions, and this just to Fannie and Freddie. If rates rise dramatically from here, these scantly capitalized firms will be hard-pressed to compensate Fannie and Freddie for making all those low-yielding mortgages that will be increasingly underwater. Here, we will use the analogy that Wall Street derivatives dealers have for years acted, and profited handsomely, much as if they were writing flood insurance during a long, and seemingly, endless drought; pocketing premiums that were about as close as it gets to free money. In what must be a harsh reality for many, the drought ended. Now it is raining cats and dogs and the insurers are scurrying around in a near panic at the thought of actually having to pay damage claims. The rocket scientists, armed with the most sophisticated software, always assumed that when the storm clouds formed, they would go out and find some reinsurance and do some hedging. Additionally, such a strategy would also call for major hedging, or purchases of reinsurance, if ever heavy rain began to fall. And, under the worst case scenario, at the first sign of raising river levels, the computer would have the insurer fully reinsured and completely protected against loss. At least this was how it is suppose to work.

But as you can see, the rocket scientist, with his sophisticated flood insurance hedging program, makes some major assumptions, ones that had better be right or there is a big problem. These assumptions include that there will always be a liquid market for reinsurance and that the reinsurers will have the resources to pay in the event of catastrophe. If either of these prove not to be the case, come the flood, the insurance is useless and everyone involved is wiped out. Such erroneous assumptions certainly led to the portfolio insurance debacle during the crash of 1987.

We tend to think that the problem today in the credit markets is that the unfathomable amount of 10s of trillions of dollars of interest rate insurance has been written and the rain has begun to come down. And actually, it is now coming down real hard and most remain in disbelief that it is really happening, not appreciating that the drought has ended. Certainly, the Wall Street firms that have written hundreds of billions of interest rate contracts to Fannie and Freddie didnt expect rates to rise like they have. The computer had this as a low probability event. Now, however, these firms are forced to protect themselves, to rush to locate reinsurance. In this event, the computer and sophisticated hedging software called for heavy shorting of Treasury bonds, or better yet, buying derivative protection from one of the other derivative players. To make this all work, the computer had to assume there would always be liquidity to execute these protective hedges. But today, this assumption looks dubious. With rates rising and huge losses for the leveraged speculating community, few, understandably, are interested in jumping in and taking the other side of these types of protective trades. Not only is this not appealing in a faltering marketplace, they already have enough problems of their own to deal with. So, lets face it, if you have written flood insurance and it is now raining buckets and the river is rising rapidly, it is going to be awfully difficult to find someone to relieve you of your flood insurance risk.

So our financial system has a big problem. Institutions such as Fannie and Freddie, banks, security firms, money managers, pension funds, and corporations throughout our country and throughout the world have purchased trillions of dollars of derivative contracts as insurance against rising rates. They are now going to have claims and expect to get paid. For many, and certainly the case for Fannie and Freddie, if they dont get paid they will be severely impaired. Yet, we simply can not comprehend who will have the resources to pay if rates continue to rise and losses mount. Certainly, not from the equity of Wall Street firms; they today have big leveraged balance sheets replete with sinking asset values. And as rates rise, the larger the required shorting of securities for hedging, or reinsuring, and the greater the losses for the system as a whole. With liquidity rapidly disappearing, rising rates only leads to greater dislocation and a greater probability of a Russian-style derivative collapse.

We believe todays higher rates are much the result of derivative hedging programs. Furthermore, it is our belief that sharply widening spreads are the consequence of a lack of liquidity in the securities markets, forcing the panicked derivative players to move to the swaps market for hedges. Market dislocation is further compounded by the heavy losses being suffered by the leveraged speculating community. Certainly, some liquidation has taken place but we are likely approaching the point of heavy forced security sales. And if that wasnt enough, the booming economy continues to generate incredible demands for borrowings, with a long line of companies waiting to issue debt and a plethora of securitizers with a seemingly endless inventory of loans to bundle and sell. So, the makings for trouble are clear as day: A mountain of securities to be sold and an increasingly illiquid and dislocated financial market environment. The stage is set.

Sure, the bulls just assume that if a problem does develop the Fed will simply lower rates, flood the system with liquidity and let the derivative players off the hook, again. Well, this did work splendidly last fall, but this is anything but a sure thing this time around. There are two critical differences today. First, there is the recognition that the economy is overheated and creating dangerous imbalances. And second, the dollar is in trouble. Importantly, this now leaves the Fed in a quandary and we are not quite sure how they get out of this one. They have certainly created quite a mess. All the same, we would not be surprised by a forceful intervention to support the dollar. This could provide some short-term shock treatment and provide a fleeting boost to both the equity and credit markets. Certainly, the bulls will hope to get through option expiration two weeks from today. With all the equity derivatives that now exist in the marketplace, if we have a serious break next week, the financial markets will have an additional derivative problem to deal with.

David W. Tice

August 9, 1999

DAVID W. TICE manages the Prudent Bear mutual fund. His Dallas-based research firm advises more than 150 institutional investors.

Prudent Bear Fund: http://www.prudentbear.com

-- Andy (2000EOD@prodigy.net), August 07, 1999

Answers

This guy Tice gives me the Willies!

-- K. Stevens (kstevens@It's ALL giong away in January.com), August 07, 1999.

I didn't think Al.com and company (thanks Fleckenstein) could pull it off last fall, but they did. I won't count them out so early this year.

Jeff

-- Jeffrey G. Bane (thebanezoo@apex2000.net), August 07, 1999.

From an Arch Crawford post on Silicon Investor: Major Instability by Arch Crawford Editor, Crawford Perspectives The world will get a strong dose of Millennial Madness during the coming eclipse series. Political, military and social unrest at maximum with economic and financial repercussions aplenty! There may be surprise attacks across national borders, possibly involving Israel, and assassination attempts on world leaders, possibly including the U.S. We do not say these things lightly. This sequence of T-squares and Grand Crosses among the "wandering stars' is unprecedented in our lifetimes, and maybe for Millennia! Do you think we are alarmist? Can we frighten you into taking some modicum of defensive measures, personally and financially? If you're waiting for greater proximity to Y2K before tightening up, don't! Whatever you might be coerced to do for your own safetydo it now! Remember that we have a long history of predicting dates of astronomic moments which have often coincided with monstrous world events! Not all of these predicted events affected our markets. Many did. Among the greatest planetary alignments we brought to readers' attention were: Top day before the "October Massacre" of 1979, biggest point decline in history (to that date) in 1986, exact date of the Challenger explosion, exact high day before 1987 crash, exact day of Kobe earthquake, Lunar Eclipse conjunct Pluto 2 days before Chernobyl explosion, Lunar Eclipse forming Grand Cross when Saddam Hussein attacked Kuwait, Saturn square Neptune date of "Hunt Debacle" Saturn square Pluto date of Chiapas Uprising, Saturn semi-square Neptune date of Peso devaluation, Saturn/Neptune conjunction opposed Jupiter 2-3 days before Berlin Wall came down, exact date of drowning of 900 in ferry accident, date of Diana's deathand many more! The next 60 days will make all these look like a walk in the park! Never, ever, have we observed combination after deadly combination culminating one after another in a truly apocalyptic sequence. To those among the spiritual or religious communities, some of whom are planning gatherings for the Solar Eclipse, I give this advice: "Start sooner and pray harder!" To those who believe in nothing, I give this advice: "If there's something you have really wanted to do and haven't done yetdo it now!" If there is someone you haven't told "I love you!" best to do that now, as well. Although the sequence has already begun building, it can be observed openly by July 18, and even the dull- witted will become aware by July 21 that something is amiss. The biggest events will most likely occur Monday, July 26 when the first T-square forms involving Sun/Mercury conjunction opposing Neptune, all square Jupiter! This is extremely inflationary and will disrupt currencies and financial markets. Possibility of chemical spills, deception, germ warfare and tragedies at sea. Then comes the Lunar eclipse on the 28th conjunct Neptune and square Jupiter = more of the same! The third T-square reaches maximum energy on Saturday, August 7th. This combination of Sun opposing Uranus, both squaring Mars symbolizes open, In Your Face Confrontation, Warfare, Explosive Tempers, Explosive Hardware! August 11, 1999! This is The Big One, the MOTHER of all Solar Eclipses about which the 16th century seer, Nostradamus wrote: "A King Of Terror will come from the skies" Ebertin's Combination of Stellar Influences says of Mars/Saturn = Uranus: "The ability to give as well as to take under provocation, the inclination to apply brute force, a test of nervous strength, the intervening by higher power, separation, death. Dell Horoscope magazine opines: "This eclipse might augur a paradigm shift of global proportions." Richard Giles, writing for Gordon Michael Scallion's Earth Changes Report writes: "What's at stake hereis the basic stability and strength of the free market system. Struggles for control of the world economy and issues of ownership of the world's resources are in balance. War over land and rights to resources are very likely. Neptune in Aquarius will foster a mystical and humanitarian revival of the world at a mass level, offering many people their first transcendental glimpse of the planetin late July expect people claiming to be a messiah to emerge. This energy also favors sudden reversals of fortune in the markets." The greatest after-shocks are triggered with the formation of a second Grand Cross on August 16-17, involving Jupiter, Neptune, Mercury and Moon. How many thousands of years since we have encountered a Double Grand Cross? The Pluto station on the 18th will aggravate underground movement and, likewise, the realignment of power structures, physical and social. Further powerful astronomic hits on August 24, 26 and 29 add to the general chaos of this intense period. Editor's Note: Arch Crawford is editor of Crawford Perspectives, 6890 E Sunrise Dr., Ste. #120-70, Tucson, AZ 85750, 1 year, 12 issues, $250. Published since 1977, Crawford provides quinessential market timing by planetary cycles and technical analysis. A 900 Hotline service is available at 10 a.m. and 2 p.m. EDT for $4.30 total per 2-3 minute call 1-900-776- 3449.

-- Andy (2000EOD@prodigy.net), August 07, 1999.

Andy, et al: The post from the astrologist predicts a bunch of things happening in July, such as everyone becoming aware of problems-yet I dont see anything that would apply. What does he mean by this, and if he's way off the mark there, .... what kind of accuracy does this guy have so far? have you seen any of his predictions come true? Just curious, he sounds like he's a bit inflammatory, and I wonder about it. Thanks

-- LauraA (laadedah@aol.com), August 07, 1999.

Contacted regarding the Timebomb 2000 Forum question, Mr. Deano Beano had this to say:

"Duhh. Surf's up."

-- King of Spain (madrid@aol.com), August 08, 1999.

LauraA,

don't know much about him BUT...

from another thread...

"I've followed Arch Crawford for a long time, even got his News Letter for a while. He's right some times, and wrong more times, not some one to make financial decisions with. Many of his dates in the article just above have already passed with no apparent disruptions, at least not the type he was talking about. July 18, July21, July 26, July 28, and today Saturday, Aug 7.

-- thinkIcan (thinkIcan@make.it), August 07, 1999."

i tend to agree...

-- Andy (2000EOD@prodigy.net), August 08, 1999.

Huh?

-- Carol (glear@usa.net), August 08, 1999.