Monday, June 30, 2008

Ratcheting Mechanism: How Speculators Are Financing Bad Debt in the USA

NVDL: If I understand the contents of the letter below correctly, it means that speculators in the US are using oil futures markets (virtually the only long term growth market that remains) to finance bad debts. Unfortunately, oil markets are cyclical, and while long term they are climbing, they tend to dip slightly in August/September/October (after the US holiday driving season ends) and then dip again in February/March/April (as the US winter becomes spring). The speculators thus (also because of tuition payments made in July/August) will not be able to continue to win their bets during these months, meaning banks will go bankrupt and markets will face drastic drops during these periods.

It is possible that we will see world stock markets eviscerated by as soon as next month (August 2008).


You may recall that a few weeks ago I wrote regarding my theory that a substantial chunk of the increase in the price of oil was due to speculation to offset bad debt portfolios by the larger east coast investment houses. What puzzled me was how this worked: because once the futures are bid up and the margins made, then the price of crude at the head assumes the previous month’s futures price! The short answer is that a kind of ratcheting mechanism is at work: once the price is bid up, it stays there until it is bid up again the following month.

It’s reported that the level of oil futures market activity by these investment houses is significant, with at least 10 percent of the futures market controlled in any one month. With each market manipulation, their margin per barrel is probably around $5.00. So if you take 10 percent of 85,000,000 barrels a day times 30 days in an average month times $5.00 you get a total of $1,275,000,000 in margin. With each month of these shenanigans, these banks can offset upwards of 12,000 subprime mortgages. Not a lot given that there may be upwards of 2,000,000 of these ticking time bombs, and considerably more if the banks fail to walk the razor’s edge they’ve defined for themselves. At this rate, it will take over ten years to offset the bad debt portfolios and only if few of those who have investment accounts make withdrawals. At the rate of +$5.00 a month, the price for a barrel of oil in 2018 would probably be over $900. It will never get there!

So each month, the investment houses pay out cash to those with account holders who demand it, offset bad paper and then go back to work the futures market with what’s left and what they borrow for 30 days from the Fed. As long as they work quickly, they can keep ahead of the game, at least until the price of oil destroys the underlying economic base. It’s reported that with Americans now paying around 11 percent of their income on energy, we are getting pretty darn close to the end of these shenanigans: in the 1973-74 time frame, the tipping point was reached when Americans had to pay more than 12 percent of their income for energy. When oil gets to $150/barrel in two to three months we’ll be past that point.

Another thing to note: a fair amount of funds in the investment accounts are withdrawn annually in the July-August time frame so that middle class parents can pay college tuition. This is one of the reasons why the market always drops in value in the late summer.

If you consider the combined effects of both the limits to oil futures manipulation and the annual July-August tuition dip and you have some of the makings of a perfect storm.
I think that we very well could be witness the effects of gravity on some very big shoes within the next two months.

It is a pity that potatoes do not have planting instructions written on them like Burpee seed packets do.

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