The inherently unstable, fundamentally unsound and immoral worldwide financial system organized out of intrinsically worthless debt has exploded into derivatives and imploded into a greater depression.  Several of the stronger voices in the financial press evade the D word which hangs over the world economy like the Sword of Damocles.

But Yahoo Finance! reports, “The Obama administration is asking Congress to extend its oversight of the financial system to include the shadowy market of derivatives, the kind of complex financial instruments that helped bring down the giant insurer AIG. … The global business world holds a staggering $600 trillion of these [over-the-counter] contracts.”

The Obama administration is already doing everything they possibly can to intentionally exacerbate the greater depression.  The use of political debt-based currency is destined to either implode in a deflationary depression or explode in hyperinflation.  As the Treasury bubble predictably bursts interest rates will rise.  The bond market is trembling as recognition that a 30-year bull market is coming to an end.

DERIVATIVES

Wikipedia gives a fairly clear definition of a derivative.  ”Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else. … Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.”

Wealth can be either a tangible or financial asset.  Tangible assets have intrinsic value and can never become worthless while financial assets can.  Often times financial assets are subject to counter-party risk.  Counter-party risk is the risk of loss due to a counter-party’s non-performance and is contingent upon their financial ability to pay.

In the shadowy world of derivatives there are many counter-parties potentially liable for hundreds of trillions of dollars.  These derivative assets infect the balance sheets of many public and private corporations, local and state governments and other institutions.  Through the use of fair-value lying the value of the derivative assets is hugely overstated while the value of the derivative liabilities is hugely understated.  Even worse is that the contingent liabilities have no basis in reality because they are based on nominal market value and not notional value.

Credit default swaps insure against a counter-party failing to make their payment.  Currently premiums for credit default swaps are twice as high on British sovereign debt as Cadbury.  In other words, a company that makes chocolate eggs is a better credit risk than a major western government.

APPLICATION TO PENSIONS

A good example of a derivative is a pension.  For example, an individual works for Chrysler for 40 years and retires.  Chrysler agrees to pay $2,000 per month for the rest of the retiree’s life.  The value of the pension is derived from the value of the underlying (Chrysler).

Chrysler will use actuarial methods under GAAP, which can now be based on fair-value lying, to calculate the estimated pension liability.  We will assume it is exactly 15 years or $360,000 which would then be adjusted to the net present value which we will assume is $150,000.  This nominal market value would then be carried on Chrysler’s balance sheet as a liability.

On the other hand, the individual uses their own method of fair-value lying to calculate the value of the pension.  They may be optimistic and overstate their expected remaining life span at 40 years and use a more friendly discount rate to arrive at a net present value of $450,000, or three times as much as Chrysler’s valuation.

Viewing the balance sheets systemically there is an asset of $450,000 with a corresponding liability of $150,000.  But the value of that $450,000 asset is also contingent upon Chrysler’s ability to pay and therefore subject to counter-party risk.

If Chrysler goes bankrupt then there is potentially at least $300,000 of illusory capital in the financial system that evaporates.  Of course, some creative investment bank who has loaned currency to Chrysler may actually profit from their bankruptcy and the greater the disparity of illusory capital and real capital then the greater their profit.

GOVERNMENT HELPLESSNESS

During the great inflationary credit expansion the use of illusions, irredeemable government or central bank tickets, as currency in ordinary daily transactions has become universal.  Their legal tender status, which is in complete conflict with the United States Constitution, is massive government regulation and the chief cause of all the current financial problems.  By violating the supreme law of the land Congress has created this massive mess.

Now the Obama administration wants Congress to engage in more regulation and intervention.  But why would these costumed officials be able to fix the problem they created?  Indeed, the only real tools they have are either their little intrinsically worthless tickets, which function like their common stock, or their guns.

Indeed, if the Obama administration sincerely wanted to fix this mess then they would remove the 28% tax on gold and then repeal the legal tender status of the FRN$.

The common stock of America’s owner has recently declined to around 82 and is looking increasingly unattractive.  As Vladimir Putin observed “The only problem:  your results were poor and this will always be the case because the work you do is unfair and immoral.  In the long run immoral policies always lose.”

But the truth of the matter is that the little tickets are subject to an incredible amount of counter-party risk.  Federal government liabilities are estimated to be around $100T.  When the tax eaters and soldiers no longer get paid with currency that will purchase anything and the purchasing power in their pensions are gone then things will get particularly interesting.

CONCLUSION

The golden Sword of Damocles has begun moving because the great deflationary credit contraction has begun.  As the common stock of nations continues evaporating civil unrest will increase.  The greater depression will make servicing debt increasingly difficult and many derivatives will continue to trigger and decimate entities during this deflationary crash.  Confidence, already slightly eroded, will be completely destroyed as counter-party risk continues materializing.  Corporations and governments will DEFAULT resulting in complete worthlessness of those assets.  But who needs the dangerous costumed Washington clowns anyway?

Through all of this chaos and change there will be at least one brilliant asset.  At all times and in all circumstances gold is money.  Gold is the only major currency not subject to counter-party risk.  Gold cannot default.  Therefore, during deflation if the like-cash FRN$ is king then the real form of cash, gold, is emperor.

Disclosures:  Long physical gold and silver with no position in TLT.