'A derivative is a legal bet (contract) that derives its value from another asset, such as the future or current value of oil, government bonds or anything else. Ex- A derivative buys you the option (but not obligation) to buy oil in 6 months for today's price/any agreed price, hoping that oil will cost more in future. (I'll bet you it'll cost more in 6 months). Derivative can also be used as insurance, betting that a loan will or won't default before a given date. So its a big betting system, like a Casino, but instead of betting on cards and roulette, you bet on future values and performance of practically anything that holds value. The system is not regulated what-so-ever, and you can buy a derivative on an existing derivative.' (Source)
The nine largest banks have in excess of $220 trillion in derivative exposure. This is more than three times the size of the global economy. Bank of New York Mellon (NYSE:BK) has an exposure of $1.375 trillion, State Street Financial (NYSE:STT) has an exposure of $1.390 trillion, Morgan Stanley (NYSE:MS) has an exposure of $1.722 trillion, Wells Fargo (NYSE:WFC) has an exposure of $3.332 trillion, and HSBC (HBC) has an exposure of $4.321 trillion. These five banks pale in comparison to the other four banks. Goldman Sachs (NYSE:GS) has an exposure of $44.192 trillion, Bank of America (NYSE:BAC) has an exposure of $50.135 trillion, Citibank (NYSE:C) has an exposure of $52.102 trillion, and JP Morgan Chase (NYSE:JPM) has an exposure of $70.151 trillion. Five of the most trusted banks account for over 95% of the risky bets that are known as derivatives.
So, what does this mean in layman's terms? Many of the top banks are far too overexposed in the bets they have made. The top banks seem to be addicted to gambling and the bets they are making are increasingly risky. Derivatives have come under public scrutiny recently with JPMorgan's $2 billion trading loss on a derivatives trade. Jamie Dimon was forced to apologize and several people left over the trade. This trade has been called a colossal error, however, it was practically nothing of the true exposure banks like JPMorgan have to the derivative markets. It is a very dangerous game that these five banks are playing, and if everything goes wrong, they do not have the money to pay for the derivative bets they are making.
These banks hedge their derivative bets against each other so supposedly they cannot lose. This creates the perception that what they are doing is safe. However, the recent trading loss for JPMorgan shows that this is in fact not the case. If there is a sudden change that they do not expect, then the banks do lose on derivative trades. Especially during these uncertain times, the management of these banks should realize that there is the potential for the market to be very surprising. Therefore, these derivative bets are very risky bets. Depending on the derivative bets, if the market tanks or improves rapidly, these banks might have too much exposure in derivatives to be saved. Imagine having to repay $1 trillion, the fact is it would simply not be possible. The worst thing is that the banks have taken too many liberties because they realize they are so big that the taxpayer will intervene to bail them out.
This recent terrible bet by JPMorgan has proved that even the 'best' banks are capable of gigantic blunders. These banks, led by the 'infallible' Jamie Dimon, are trying to put an end to the Dodd-Frank Act. The Dodd-Frank Act has forced standardized derivatives to be traded on open platforms as well as implementing other regulations to curtail derivatives. However, there are now at least five bills before Congress, several of which are spearheaded by Jamie Dimon, which seek to weaken derivatives regulation and put an end to some of the Dodd-Frank Act. Jamie Dimon has also attacked the wisdom of the Volcker rule, which restricts proprietary trading by banks unless the client requests proprietary trading. Regulators in Washington, should have enough ammunition to pass the Volcker rule after JPMorgan's recent slip-up.
All in all, the banks have not learned their lessons from the 2007/2008 financial crisis. They continue to make risky bets, arguably far more risky than before. In 2006 and 2007, it was sub-prime mortgages; now derivatives are spiraling out of control. It is hard not to wonder, if the big banks, which handle our money, truly have our best interests at heart at all. If they blunder on a large scale again, like they did in 2007, they will be too overexposed to be saved.
The derivatives information is from demonocracy.info and I have confirmed it using a variety of reliable web sources.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.