By: Lynette Zang

Overnight, the 10 year Italian bond interest rates went over 7%. For Portugal, Ireland and Greece, this was the tipping point that drove them to seek a “Bailout.” I had just written about this on Friday, but then those bonds were at 6.77%. It took Greece three months to go from 6% to 7%, it took Italy 8 days. Italy has the third largest bond market in the world behind Japan and the US.

There is more wealth in the bond market, than any other asset class and this is how they work. Hold a pencil in between your thumb and fore finger. Have the point facing to the left and the eraser pointing to the right. The point is the principal value, the eraser are interest rates. When a bond is issued, it comes out at par ($1,000) and has a stated interest rate (6%). The amount paid out in interest does not change, but the principal will move with the interest rate market. Push up on the eraser: When interest rates go up, principal values go down. Push down on the eraser: When interest rates go down, principal values go up. As you can see when you do this exercise, the farther away you go from your holding fingers, the greater the movement of the pencil, this distance is the maturity. Therefore, the longer the maturity, the greater the volatility when interest rates move.

As interest rates have gone up in Greece, Portugal, Ireland, Italy etc., anyone holding those government bonds lost money. If you are a large entity, like a bank or a hedge fund, and you buy bonds it is likely that you want to protect against that potential loss and therefore, you would likely buy a CDS (Credit Default Swap) which is a derivative. A credit default swap is derived from bonds and for hedging a position, is used like an insurance policy so that if there is a default, you do not get paid interest or principal, all or in part, the CDS pays out and makes you whole. According to the BIS (Bank of International Settlements) the first over the counter CDS was created the end of 2004.

A couple of weeks ago, with the proverbial guns to their heads, European banks and pension funds agreed to give up 50% of the principal, extend out the maturity and reduce interest payments on Greek government bonds. By any definition, a default of the original agreed upon terms. But what the ECB and EU are saying is that since the debt holders agreed, this would be a soft default and not trigger a CDS payout. If that is true, the entire almost $30 trillion CDS market falls apart, because even though you bought insurance, the government has the ability to cancel the contract; and since derivatives can be cut up into little pieces and commingled with other unrelated derivatives, it is possible to infect a much bigger derivative market. Here’s the breakdown from the BIS

Let’s say there is a default and CDS payout is triggered. Do you remember what happened to AIG in 2008? They had sold more mortgage derivatives than they could payout and our government jumped in and gave them your tax dollars so they could payout at 100%. They had to do this or we would have seen a domino effect throughout the banking system and more derivatives would have been triggered.

So I am afraid we are between a rock and a hard place. Let me remind you of the derivatives held by our top 25 FDIC insured banks.

OK, so now you have a foundation for what I am about to show you. There was an article in Bloomberg today, on the exposure to Italian debt from some US banks. I’m going to put it in a PDF and explain what you are reading in red (you will need to click on the link below & click it again on the next page).

Goldman Has $2.3B Funded Italy Credit Exposure

Because of the incestuous nature of the banking system, we are all vulnerable and the numbers are huge. This time around, it isn’t only the banks that need to be saved, but governments as well and with numbers in the quadrillions, I’m afraid what we are facing is a “Too Big to Fail and Too Big to Save.” Many think it was the implosion of the banking system that set off the Great Depression. Clearly, the current system is extremely vulnerable and the CDS derivative weapon is a relatively new beast. There isn’t anyone on the planet that knows exactly what will happen with this mess or how to handle it effectively and no one can even seem to agree on an approach. This makes me very nervous. I think we all should pray and convert those pieces of debt currency into gold and silver in our possession.