"Regulator-dealer informational [gaps] can be extraordinary — e.g., regulators may not even be aware of the existence of certain derivatives, much less how they are modeled or used."

Major threat #3. Too much in the hands of too few. In our 2006 "Global Vesuvius" report, we wrote:

"There are close to 9,000 commercial and savings banks in the U.S. But at midyear … 97% of the bank-held derivatives in the U.S. are concentrated in the hands of just five banks." (Page 3)

Today, virtually nothing has changed. The five largest commercial banks still hold 95 percent of the total! And if you include the recent shotgun mergers and restructurings, such as Bank of America’s acquisition of Merrill Lynch, the concentration of risk today is even greater.

In her recent testimony, the SEC Chairman puts it this way:

"The markets are concentrated and … one of a small number of major dealers is a party to almost all transactions, whether as a buyer or a seller. The customers of the dealers appear to be almost exclusively institutions. Many of these may be highly sophisticated, such as large hedge funds and other pooled short-term trading vehicles. As you know, many hedge funds have not been subject to direct regulation by the SEC and, accordingly, we have very little ability to obtain information concerning their trading activity … "

Also testifying before the Senate Banking Committee, Christopher Whalen, co-founder of Institutional Risk Analytics, points out that

"Perhaps the most important issue for the Committee to understand is that the structure of the OTC derivatives market today is a function of the flaws in the business models of the largest dealer banks, including JPMorgan Chase [JPM], Bank of America and Goldman Sachs [GS]. These flaws are structural, have been many decades in the making, and have been concealed from the Congress by the Fed and other financial regulators.

"Many cash and other capital markets operations in these banks are marginal in terms of return on invested capital, suggesting that banks beyond a certain size are not only too risky to manage — but are net destroyers of value for shareholders and society even while pretending to be profitable …

"No matter how good an operator of commercial banks JPM CEO Jamie Dimon may be, his bank is doomed without its near-monopoly in OTC derivatives — yet that same OTC business must eventually destroy JPM and the other large dealers. Seen from that perspective, the rescues of Bear Stearns and AIG were meant to protect not investors nor the global markets, but rather to protect JPM, GS and the small group of dealers who benefit from the continuance of their monopoly over the OTC derivatives market."

Major threat #4. Shenanigans in Credit Default Swaps (CDS). In our 2006 "Global Vesuvius" report, Mike Larson and I also wrote …

"The global market for these credit derivatives is absolutely exploding. It was just $180 billion in 1996. That grew to $893 billion in 2000 … $1.95 trillion in 2002 … and a stunning $20 trillion this year. It’s hard to believe. But that’s a 111-fold expansion in just a decade!

"The problem: Now, hedge funds and other investors are using these derivatives to spin the roulette wheel. In fact, the $1.2 trillion hedge fund industry now holds 32% of the credit default swaps, up from 15% two years ago. Think about that for a minute: Thinly capitalized, gun-slinging hedge funds are now essentially taking on the responsibility for insuring billions of dollars in bonds." (Page 5)

Now, in his Senate testimony, Institutional Risk Analytics’ Whalen explains it this way:

"In my view, CDS contracts and complex structured assets are deceptive by design and beg the question as to whether a certain level of complexity is so speculative and reckless as to violate US securities and anti-fraud laws. …

"Pretending to price CDS contracts or complex structured securities using ‘models’ is a ridiculous deception that should be rejected by the Congress and by regulators. And members of Congress should remember that federal regulators and the academic economists who populate agencies like the Fed are almost entirely captured by the largest dealer banks. Even today, the Fed and other regulatory agencies raise little or no questions as to the efficacy of OTC derivatives and the absurd quantitative models that Wall Street pretends to use to value these gaming instruments."

Major threat #5. Outstanding derivatives dwarf the trading in the underlying securities. In our "Global Vesuvius" report, Mike and I wrote:

"The sheer volume of derivatives outstanding … is dwarfing the amount of underlying debt securities. That’s causing major market distortions.

"Take last October. Auto supplier Delphia filed for bankruptcy. At the time, it had just $2 billion in outstanding bonds. But there were a mind-boggling $20 billion of default swaps on its debt!

"To settle those contracts, derivatives players had to scramble to buy underlying bonds. That drove their prices up substantially even as the company was going broke!

"Similar distortions occurred when Delta, Northwest, and Calpine defaulted on their debt.

"End result: The impact of bankruptcies, instead of being minimized by derivatives, can often be multiplied far beyond what you’d normally expect."

In his testimony, Whalen adds:

"What makes credit default swaps like betting on the temperature is that, in the case of many if not most of these contracts, the volume of swaps outstanding far exceeds the amount of debt the specified company owes."

And he sums up all the threats nicely with this concluding comment:

"Jefferson said that ‘commerce between master and slave is barbarism.’ All of the Founders were Greek scholars. They knew what made nations great and what pulled them down into ruins. And they knew that, above all else, how we treat ourselves, as individuals, customers, neighbors, traders and fellow citizens, matters more than just making a living. If we as a nation tolerate unfairness in our financial markets in the form of the current market for CDS and other complex derivatives, then how can we expect our financial institutions and markets to be safe and sound?"

Plus, I ask, how can any investor — whether a sophisticated money manager entrusted with billions of the public’s money or an average American seeking a respectable retirement — afford to believe the Great Lie of 2009?

Follow the recommendations we are giving you in our services. Then take all the needed steps to protect your money and convert surging volatility into profit opportunities.

Good luck and God bless!