Derivatives: A Nuclear Bubble Waiting to Burst

The Dodd-Frank financial reform bill has opened the door to the greatest danger the world’s financial markets have ever faced: derivatives. It’s worthy to note that no prices or fees are available to the general public, government regulators or financial observers. In theory, the derivatives allow investors to hedge against excessive risk but they have no value in their own right they are just financial products derived from another asset: stocks, bonds, commodities, a market index or credit-default swaps.
Not only did the Dodd-Frank bill not reform any of the practices of the major banks, it provided an opportunity for new lenders to enter the high casino risk game of financial gambling. New clearing houses have already been established for the trading of these new financial instruments. The Chicago Mercantile Exchange and the InterContinental Exchange have invited many major banks into their risk committees. Several critics have warned of the dangers of derivatives.

Warren Buffett has called the derivatives
“financial weapons of mass destruction.”

 

Today, the worldwide derivatives market is approximately 20 times the size of the entire global economy! Some place the risks in the quadrillion-dollar range. Unfortunately, the average citizen, much less most of our elected Congress, doesn’t even know what a derivative is!

Derivatives are so highly levered that
all the money in the world
could not cover the potential losses.

Michael Snyder has said that the hedge fund and derivatives markets are so complex and technical that even many top economists and investment banking professionals don’t fully understand them. Over $18 billion of losses were incurred by AIG on their investments in derivatives before the bailout by the American taxpayer.
Webster Tarplay said that financial derivatives have come to represent the principal business of Wall Street, London, Frankfurt and other money centers.

He further notes that a concerted effort has been made by politicians and the news media to hide and camouflage the central role played by derivative speculation in the economic disasters of recent years. Journalists and public relations types have done everything possible to avoid even mentioning derivatives, instead coining phrases like “toxic assets” and the most obvious: “troubled assets,” as in the Troubled Asset Relief Program, aka TARP, the monstrous $800 billion bailout of Wall Street speculators which was enacted in October of 2008.

To illustrate the secrecy and profits that underlie the derivatives market, refer to Louise Story’s article in The New York Times where she points out that there is a meeting once a month of nine members of a select fraternity. Their goal is to protect the interests of the big banks in the vast market for derivatives, one of the most profitable—and controversial—fields in finance.

These meetings are always held in secret.

It is believed that JPMorgan Chase, Goldman Sachs and Morgan Stanley are among the guiding members. They fight to prevent other banks from entering the market, and are doing everything they can to stop any regulations which would make the prices and fees available to others. The current derivatives market is believed to generate many billions in fees each year for the major banks. The customers, or investors, for derivatives include pension funds, state governments and city governments all in an attempt to hedge their investments and to hold down borrowing costs.

The Department of Justice is investigating the whole derivatives market but most observers are of the opinion that the DOJ will do nothing to offend the big banks. They post on their web sites how important they are in the entire derivative community. For example, JPMorgan touts their awards as “Derivatives House of the Year” for 2010 and “#1 Overall Derivatives Dealer” also in 2010.

It is getting a little sticky though, as Citibank has just sued for breach of contract in a credit default swap case saying that many hedge funds are elbowing in on the derivatives market without really knowing what they are doing or the risks involved.

Leslie Rahl, founder and president of Capital Market Risk Advisors, says “Risk management is all about thinking about two or three standard deviations from the mean. No one ever expects events to fall beyond that. Once in a lifetime events that fall outside that parameter have exponential, not arithmetic, consequences. There is no doubt that the less liquid and more exotic the derivatives position, the more subjective the estimate of value is.”

On December 20, Bloomberg News reported that the Chinese are setting up a market in credit default swaps to enter the derivatives marketplace in a big way. 23 separate agreements covering a total of 1.99 billion Yuan have already been sold since they set up their credit derivatives market.

Congress, having passed the ineffectual Dodd-Frank Act has left it to the regulators to write the rules that will be in effect once they are established. The Commodity Futures Trading Commission has asked for 30 areas that require new rules as they apply to derivatives. But the big banks want their control undisturbed and are an active voice at the conference table. It is estimated that 90% of all swaps are traded through the ten largest banks generating an estimated $60 billion a year in fees.

There is no question that Wall Street will do everything in their power to protect this last opportunity to harvest extraordinary profits but we must remember that if there is an event beyond their expectations, there isn’t enough money in the world to cover the losses, especially when the risk is twenty times bigger than the entire global economy.