Derivatives: Gambling at Public Expense

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?

Disclosures: none

Comments

[rds333:]

Gee. And to think Congress, the Senate, Greenspan all talked
about this years ago and did nothing. Who do we blame?

Apr 16 11:55 AM

[infp:]

Bullish stock analysts who proclaim "the worst is over, financial stocks and the market are going up," never explain how exactly the derivatives debacle has been suddenly resolved. I can only infer that they believe that as long as the government agrees to take over most of the derivatives liability through TARP/PPIP type programs that the problem will simply fade away. I suspect that the derivatives debt is simply too large to be solved in this manner so I remain bearish.

Apr 16 12:32 PM

[discov:]

The derivatives debacle is definitely unsolved and getting hidden under more and more Governmental meddling. Still, it hasn't paid to be early shorting this market wait until this concisetrading.blogspo...
trend line breaks

Apr 16 01:18 PM

[DonFurio:]

Look there will be more transparency in derivitives over time, but a large notional value doesn't necessarily mean anything, it all depends on what the underlying position is and how much it has to move for the derivitive to gain/lose value. Some of the "gambling at public expense" as this idiot author calls it are merely curreny or interest rate derivitives that the banks hold for their clients who wish to hedge out certain aspects of their business. Is there a risk, sure but let's not pretend that all derivitives are a major issue.

Apr 16 03:07 PM

[Tom Armistead:]

In the wake of the financial meltdown, this country is going to be taking a close look at stregthening regulation. When that occurs, there are two basic ways to end the gambling:

The first would be to repeal CFMA, which exempted CDS from state bucket shop or anti-gambling laws that had been in effect for nearly a century. As early as 1907 it was clearly understood that gambling in financial markets can destroy the economy and credit system.

As an alternative, Geithner's proposed central systemic risk regulator could be required to examine every type of financial transaction, to be sure that those that serve no useful purpose or are primarily for gambling and speculation are banned. As citizens and investors we all need to press our congressmen for solutions along these lines.

Apr 16 03:12 PM

[Repsonsible...:]

Look back in my comments this is what Ive been ranting about the last 2 months . Goldman got paid $180 billion on its Bad CDS s thru the back door using the AIG bailout money.
Dont Be sucked into this latest rally , cause its ALL built on more BS . The Economys terrible getting worst , Big Banks still have $100s of Billions in loses coming this Rally is nothing more then a Huge PR campaign by Wall Street and the Obama administartion hoping that maybe if they say things are getting better , they will SORRY printing money , spending 14 Trillion wont make The economy come back , all its going to do is Inflate the Dollar and make your money worthless , Buy some gold and protect yourself , sit back and watch the Madness!

Apr 16 03:29 PM

[cholmley:]

Not again, again.

Look try this on for size, it is simple enough that you might understand it.

Suppose a customer, yes a real customer, say IBM wants to hedge its interest rate exposure for 10 years and calls up Goldman Sachs and asks them a ten year interest rate swap in 500 million dollars. Goldman Sachs does the trade and does not want 500 million sitting on its books so it goes to Bank Of America to hedge its new risk, BoA then trades with GS in another 500 million to cover GS' risk but now has its own risk.

Now lets say it cover its 500 million risk with an equivalent exposure in US ten year note futures, BOA sells them to someone who has funds to invest, so at this stage we have a notional exposure of 2 billion USD in interest rate swaps and 1 billion of US Treasuries, the initial 500 million IBM wanted to hedge has turned into a notional exposure of 3 billion, YET THE RISK TO THE PARTIES INVOLVED HAS GONE DOWN!

Certainly there are still residual risks involved, basis between Swaps and Notes for example, and credit implications, but only on the net positions, but the one thing you can draw absolutely no inference from is the notional value of the outstandings. A company with 500 million unhedged is far more exposed than a company with a trillion which is hedged for rates exposures and netting agreements.

That is not to say all is well, but without drilling down into the positions you are being alarmist for its own sake.

Apr 16 05:08 PM

[Wide Moat I...:]

On Apr 16 11:55 AM rds333 wrote:

> Gee. And to think Congress, the Senate, Greenspan all talked
> about this years ago and did nothing. Who do we blame?

I'll carry a torch and pitchfork--first Greenspan, then the Senate, and maybe a couple Treasury Secretaries.

Apr 16 09:34 PM

[Bruce Vande...:]

Thank you Cholmley for providing an overview of how interest rate swaps can work and why notional values can be so high. Your comment clarifies how these swaps work. I'm wondering thoug, if we are seeing the forest because of the trees.

Two questions: 1) If a counterparty (AIG?) fails wouldn't the effect cascade through the system? Extensive counterparty swapping may decreases individual risk but increases systemic risk. 2) Also, you didn't mention why the US taxpayer. If all these banks are so well protected by hedging why do they need billions in public support?


On Apr 16 05:08 PM cholmley wrote:

> Not again, again.
>
> Look try this on for size, it is simple enough that you might understand
> it.
>
> Suppose a customer, yes a real customer, say IBM wants to hedge its
> interest rate exposure for 10 years and calls up Goldman Sachs and
> asks them a ten year interest rate swap in 500 million dollars. Goldman
> Sachs does the trade and does not want 500 million sitting on its
> books so it goes to Bank Of America to hedge its new risk, BoA then
> trades with GS in another 500 million to cover GS' risk but now has
> its own risk.
>
> Now lets say it cover its 500 million risk with an equivalent exposure
> in US ten year note futures, BOA sells them to someone who has funds
> to invest, so at this stage we have a notional exposure of 2 billion
> USD in interest rate swaps and 1 billion of US Treasuries, the initial
> 500 million IBM wanted to hedge has turned into a notional exposure
> of 3 billion, YET THE RISK TO THE PARTIES INVOLVED HAS GONE DOWN!
>
>
> Certainly there are still residual risks involved, basis between
> Swaps and Notes for example, and credit implications, but only on
> the net positions, but the one thing you can draw absolutely no inference
> from is the notional value of the outstandings. A company with 500
> million unhedged is far more exposed than a company with a trillion
> which is hedged for rates exposures and netting agreements.
>
> That is not to say all is well, but without drilling down into the
> positions you are being alarmist for its own sake.

Apr 17 08:05 AM

[JoeSixPack:]

Bernie Madoff and his Ponzi scheme was a distraction for the masses, diverting attention from the $1/2-1 QUADRILLION derivatives Ponzi scheme. This is a house of cards waiting to collapse.

DerivativesCollapse.com

Apr 17 12:50 PM

[cholmley:]

Bruce,

Thanks for coming back, appreciated.

Yes there are still risks involved due to credit but again the notional outstandings still offer nothing in the way of understanding of where the net risks lie. A bank such as BoA is a big trading bank and is likely to have as many buys as sells with a counterparty like AIG, the notionals net down to very little and the mark to market even less (remember with derivatives no principal changes hands), however a smaller bank might just have one trade on with AIG and might be set to lose the whole mark to market on that one trade if AIG failed, a potential catastrophe.

Sure there are systemic risks but they affect different banks very differently, a bank such as JPM for example will have pretty sophisticated risk systems and will demand margin and mark to market calls for all its trading, a failure at AIG would not be great but wouldn't impact the bottom line all that much. The hypothetical smaller bank with far fewer trades but less taken in margin and greater exposure to one name would be in trouble.

The problems at Citi and BoA were less to do with derivatives per se but just bad investment decisions, holding too much junk masquerading as AAA.

There are certainly questions to be asked about the systemic risks involved but they are more to do with the size of risks taken rather than how they are expressed and how good risk systems in each bank are and all banks need to be able to answer those questions. However notional outstandings of derivatives are really just a red herring signifying nothing in of themselves.

Apr 17 05:37 PM

[esaunders:]

o wow.. that's a hell of amount..

Aug 29 09:25 PM