Value Microcaps Junior Energy

[Bobwins]

It's not just the TSX. What Rule is saying is that the smarty pants bankers invented derivatives to supposedly hedge risk. The derivatives are supposed to enable market participants to reduce risk, if they so choose, by buying insurance. However, they base the pricing and the ultimate profitability of the hedges on computer projections of what the markets and the derivatives will do under varying conditions.

What took down LTCM was that the real world didn't do what their computer projections said it would. So when there was a deviation from the model, they bet more money that it would eventually fall back in line. Never happened. They were just like the Blackjack player in Vegas who keeps doubling down after each loss, expecting the make a profit eventually. But they ran out of money first, partly because they were operating on other people's money anyway and they just couldn't borrow anymore.

Today, many years after the LTCM debacle, the bankers haven't learned from their mistakes. They think they can accurately predict how the markets and the human market participants will react to any given situation. Just because something happens a certain way 20 times in a row, doesn't mean it will happen on #21. But I bet the JPMorgan guys thought it would. So instead of being hedged and minimizing risk, they end up with an open ended risk situation in huge markets with billions on the table and their model ain't working anymore so how can they be sure it will work on #22 and #23, etc. So they admit they goofed and try to work their way out.

The banking system is highly leveraged. Most banks have 5 to 10% equity. That's all. So if you have a 10 billion dollar bank, they will be lucky to have 500 million to 1 billion in equity. Most banks will not lend to a business that has more than 5 to 1 equity while they, themselves are levered 20 to 1. Why?

Because when the banking system was created, banks didn't take huge risks. They were prudent, had stable, low cost of funds and were loaning to people they knew for businesses they could understand.

So they could be leveraged because the chances of them making a bonehead mistake that could wipe out their equity was slim to none. Bank examiners would come by, examine their financials, their loans and slap their hands if they strayed too far outside prudent risks.

If they had made too many mistakes in their loans, they would be told to raise more capital or risk being merged with a bigger, more capitalized bank.

Today, banks lobbied for and got way more discretion with their revenue generating activities. Instead of relying mostly on loan income, they craved fees. They wanted to be more like the glamorous stock brokers who could syndicate deals and put together fancy paper instruments and sell them for big bucks. Once they got the power, they created derivatives. This expanded their already highly leveraged balance sheets to an exponential degree.

These derivatives started out as pooling loans together so that institutions could buy them easier. FNMA and FMAC provided investment products for pensions by pooling individual mortgage loans together. It made a lot of sense and created liquidity in the mortgage markets. Banks could sell their individual loans to FNMA immediately and recover almost all their principal. Pension funds, who could never investigate something as small as individual mortgage loans could buy pieces of the mortgage pool in small to enormous amounts, without worrying about the individual loans. They relied on FNMA to do that part of the dirty work. By strictly regulating the quality, they could ensure the pension fund buyer that they were buying a standard product that had a proven track record of deliquencies and default.

You know what happened. FNMA and FMAC got bored with standard mortgage pools. They were encouraged to develop new products. So they developed the derivative mortgage pools that poisoned the entire world's financial system.

These new pools relied on computer models to predict what these substandard loans would do under stress. The models didn't work and the system fell apart because the base component(low to no down payment loans) were faulty and predictably didn't pay. Rather than ban derivatives altogether, legislators simply tightened existing rules. But the derivatives are still out there and more were invented to slice and dice risk in all areas of finance.

So the derivatives are mostly unregulated AND the local bank examiners can look at the loans all they want but they can't figure out the ultimate risk of a Big Bank like JPM because JPM doesn't know. So they can't force them to adequately capitalize because they don't know the risk. Bank examiners and most regulators are not equipped to judge the safety and risk of today's derivatives. They're too complicated. The big banks involved play in world markets that are gigantic. Trillions are swapped back and forth daily.

Remember it's only the really big banks that can play in this arena. So what happens now if they goof? The too big to fail syndrome comes into play and the only answer is the country's government. But as we all know, most of the world's government are serial money printers and they are bankrupt on paper. So the government steps up and guarantees the stupid bank's mistakes. The bank stays in business instead of being forced to closed due to stupidity and greed. The officers get rewarded with continued stock bonuses for their stupidity.

So Rule and others are saying that the entire financial system is hanging by a thread. The risks are immense and the derivatives can turn negative in hours and turn a solidly financed bank into a bankrupt shell. Since almost all the world's governments are playing the same printing game, they are all vulnerable because they and their tax paying citizens do not have enough savings to guarantee anywhere close to a fraction of the total risk in the derivatives markets.

Governments assure you they can handle the situation but they don't know if they can maneuver their way out. Bernanke is playing a hypothetical game. He thinks the Fed and US Government made certain errors in the way they handled the Depression. So he is using the Fed to experiment and see if his ideas are right. He has no assurance they are. We have no assurance they are.

Against this backdrop, the derivatives crisis has been ongoing for several years and is responsible for many of the problems we are now seeing in Europe. The US exported and sold most of the derivatives overseas. The defaults that followed drained the capital from overseas banks and governments.

So the ugly fragility of the total world financial system has investors on edge. They are risk averse. They are not currently willing to finance all the Venture companies who have a mine to build or an oil field to drill. As companies proceed forward, they need constant infusions of capital to keep drilling out their project. If they can't keep selling stock, they will go out of business. Just like they did in 2007-9. Legitimate companies with good assets will shut the doors or end up selling out for pennies on the dollar if they can't keep moving forward by selling paper. Arguably there are too many Venture stocks that claim to have the latest graphite or rare earth deposit. They have been issuing paper at a mad pace and now some of them will go away.

So there are still companies that have legit projects. Institutions know that some companies are big enough to finance good projects and if they are going to shun the smaller companies, they have to get in on the limited number of high quality projects. They are eliminating opportunities for individual investors. The high quality projects and companies are going to be able to call the shots because the competition to get in on their high quality investments will be high.

Is it the end of the world for us? Probably not. The world has stumbled and bumbled it's way for thousands of years. There will be a tomorrow but it may not be exactly the way it's been before. The specter of a financial disaster is still out there lurking.

There is no right answer to the current situation. As we know, gold and silver stocks didn't perform that well in the 2007-9 crisis. Junior stocks in general got hammered. Cash was ok because it didn't lose 75% of it's value. Most everything else was down big. Will we go thru that again, so soon? Don't know.

Can you hide in the Dow Stocks? Some did ok but most were down big also.

By issuing paper to cover the bad loans and the bad banks, governments are delaying the inevitable. You have to pay for mistakes one way or another. The US is hoping that by delaying the punishment, they can buy time and the economy will bounce back and government revs and taxes will climb. But as Japan found out, papering over mistakes just elongates the recession and spreads it out for decades instead of years.

Because it's my birthday, I don't want to focus on this ugly topic anymore. Good luck, Bobwins