If, unknown to you, certain parties had bets totaling millions of dollars on the chance your $200 thousand house will burn down in the coming year, would you be upset? I suspect so. Some of those parties may need money, may send an arsonist over, maybe not even tell you in time to get your family out. Well… Welcome to the world of derivatives. Only, forget the $200,000 house, start thinking in the billions and trillions.
Now, sit down, these figures may shock you: The face (notional) value of derivatives held by US commercial banks is over $200 trillion dollars and the total derivative market over $700 trillion. Don’t believe me? Click here for the US government’s recently released fourth quarter OCC Report. Read the first two bullets. Remember, this is just derivatives held by US commercial banks, the total derivative market is, as mentioned above, over $700 trillion (see here).
How much is $700 trillion dollars? Temple University math professor John Allen Paulos says: “A million dollars a day for 2,000 years is only three-quarters of a trillion dollars” Well, think about it a minute or so, then go figure $700 trillion.
Okay, critics of this article's viewpoint will be quick to point out this is not new news and derivatives can be unwound, it is a zero sum game. Derivatives are useful for farmers, miners and many others, hedging future market commodity risks. They increase liquidity and facilitate transactions. Credit Default Swaps (CDSs) can be used to measure perceived risk of an asset. The purpose of this article is not to demonize all derivatives, rather it is to point out the danger in the speculative components, especially when the public dime (bit of an understatement that) is involved.
The question is: What are commercial banks doing with over $200 trillion of derivatives? This amount is over three times larger than world GNP , more than all the world's combined stock and bond markets.
You may wonder; what the hoot is going on here? Credit Default Swap (CDSs) didn’t even exist 14 years ago. Now they are a $62 trillion dollar market. Interest swaps started slowly in the 1980’s, the five banks above alone hold $162 trillion worth. Why is this rapidly growing market so huge? Is it necessary? A recent Newsweek article mentioned the derivative market may be in the quadrillions soon.
I can see only one explanation: large scale speculation. Another, perhaps more accurate term, would be gambling.
The OCC report tells us which banks are deeply involved in derivatives, it is five large commercial banks. They are JPMorgan Chase (JPM), Citigroup (C), Bank of America (BAC), HSBC Bank USA (HBC), and Goldman Sachs (GS). Some 82% of the holdings are interest rate swaps. Swaps are risky with winners and losers. Goldman Sachs is the most deeply involved.
Goldman recently reported much higher than expected first quarter earnings. How much of the earnings is due to AIG (taxpayer) CDS payments to Goldman? I don’t know. Don’t ask Goldman’s CFO David Viniar, even he is “mystified”. Mr Viniar says the trades “netted to zero”. Perhaps the reason the payments netted to zero is because taxpayers, via AIG, made good for AIG to Goldman's benefit. Now they want to repay TARP - a nice public relations move. If Mr Viniar is “mystified” by his own firms trading how much more so are taxpayers. Why does this remind me of Enron’s CFO statements of awhile back? Yes, Goldman Sachs can probably outsmart taxpayers. But taxpayers should never become counterparites to Goldman Sachs in the first place.
Glass-Steagal was repealed in 1999, allowing banks and others, equipped with sophisticated computer systems, to plunge into derivative trading. A worldwide, unlimited casino opened up. Hedge funds, banks, insurance companies all taking advantage.
Derivative trading is a huge, unregulated market, run around the world by the self-appointed elite. They use OPM (other people/countries money) skimming off profits. Forget lotteries, forget sports betting, forget Vegas. This stuff is the ultimate! Look at the sums involved. A powerful elixir those in power cannot resist playing with. Gambling at this level for personal accounts may be acceptable - what else can you do with sums that large? Holding the world economy as hostage and involving taxpayers as backups for losses, however, is criminal.
This high-stakes gambling, like all gambling, has winners and losers. Consider Bear Stearns, AIG and Lehman Brothers (LEHMQ.PK) as the losers. In a deleveraging world, we may be getting more and more losers. It doesn’t take much of a shift in a $700 trillion market to wipe out world class companies fast, look at AIG. Look at what may have happened to Citigroup without taxpayer money.
The large commercial banks are heavily into interest rate swaps, with a combined notional value of over $150 billion according to the OCC report. If these systemically important institutions start losing on their interest rate bets, which the OCC Report said happened in the fourth quarter, will we the taxpayers be on the hook to bail them out again? Remember the interest rate swap market is much bigger than the CDS market brought down AIG.
Forbes magazine, in their March 16, 2009 issue, has an article on how Lawrence Summers (currently heading the White House’s National Economic Council) entered into interest rate swaps at Harvard University which “burdened Harvard with a multibillion-dollar bet on interest rates that went against it”. The Forbes article goes on to say that bad derivative bets may have adversely affected universities and hospitals around the nation.
So, how dangerous are derivatives? Warren Buffett called Credit Default Swaps “financial weapons of mass destruction”. AIG proved him right. AIGFP insured CDS derivatives, lost their bets, didn’t have the money to make good, even all of AIG couldn’t make good. So the American taxpayer was told they must make good, to the tune of hundreds of billions of dollars. American taxpayers are the losers, financial institutions world wide are the winners. Now, after AIG, tell me how you can possibly think derivatives are not dangerous. And, doesn’t it strike you as strange: few are talking, even now, about reining in the derivative markets? Perhaps defenders of derivatives can explain to us who "don't understand" what possible good comes from this bloated market.
Systemically important institutions have no business being major players in this market. Certainly, taxpayers have not agreed to participate, much less bail out the losers. This is why US taxpayers are organizing "tea parties".
The US government has printed, borrowed or promised some $14 trillion so far. And guess what: It hasn’t worked! The London protesters suddenly don’t look so foolish, they at least aren’t bankrupting companies and countries. AIG, Fannie (FNM), Freddie (FRE), JPMorgan, Bank of America, Citigroup will soon want even more taxpayer money. Will we have the courage to say no to this insanity?