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What Are Derivatives and Why Do They Imperil the U.S. Economy?

By   Follow Me on Twitter     Message Richard Clark     Permalink
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(Article changed on April 19, 2013 at 20:54)

(Article changed on April 19, 2013 at 13:27)

The claim is that when financial markets in the United States next crash, so will the U.S. economy.   Remember what happened back in 2008:   The financial markets crashed, the credit markets froze up, and suddenly the economy went into cardiac arrest.   And there are very few things that could cause the financial markets to crash harder or farther than a derivatives panic.  

Sadly, however, most Americans don't yet understand what derivatives are.   Unlike stocks and bonds, a derivative is not an investment in anything tangible.   Rather, a derivative is a bet on the future value or performance of something else.   Just like you can go to Las Vegas and bet on who will win the football games this weekend, bankers on Wall Street make trillions of dollars of bets about how interest rates will perform in the future and about what credit instruments are likely to default.   And they do it in secret, in that no public record is kept of their bets.

In other words, without most people even knowing it, Wall Street has been transformed into a gigantic casino where people are betting on just about anything you can imagine.   This works fine as long as a) there are not any wild swings in the economy, and b) risk is managed with strict discipline.   But as we have seen, there have been times in recent years when derivatives have caused massive problems.   For example, recall why the largest insurance company in the world, AIG, crashed back in 2008, requiring a huge government bailout.   It was because huge numbers of their derivatives went bad.   To be specific, a great many banks and other institutions purchased, from AIG, a kind of insurance policy called a credit default swap, which is essentially an agreement or contract that guarantees that if a particular investment of these banks went belly up -- in this case a mortgage backed security -- AIG would compensate these banks for their loss.   In other words, AIG was betting that these mortgaged backed securities (MBSs) would hold up just fine while they collected thousands of payments each month, from these banks, while the banks that purchased this insurance from AIG were betting that the MBSs might very well not hold their value, and they wanted to be covered just in case they actually did not.   The problem that then arose was that the housing bubble popped and housing values began to plummet nationwide.   This meant that mortgage backed securities, which (once again) were essentially packages of mortgages that people, institutions and especially banks, had invested in, were rapidly losing value, with many of them soon becoming worthless, assuming the status of junk bonds.

When this happened, all the banks that had purchased this special insurance from AIG, wanted to collect on the "policies' they had purchased, i.e. they wanted to collect on these (derivative) bets.   But AIG had nowhere near the funds necessary to pay off all these claims, and so the US government, i.e. we taxpayers, had to bail them out. 

Why not just let AIG and the big banks fail?   You know the answer:   They were "too big to fail."   Which means that these banks, and AIG, were so completely integrated, invested in, and otherwise mixed in, with the larger economy, that if they failed, so would the larger economy. 

Bad derivative trades (i.e. betting) also caused the failure of MF Global, as well as the $6-billion loss that JPMorgan Chase recently suffered because of derivatives betting that went bad, and it made headlines all over the world.  

And now the claim is that all of those incidents were just warm-up acts for the inevitable derivatives panic that will destroy global financial markets.   It is said that this largest casino in history is going to go "bust" and that the economic fallout from the resulting financial crash will be absolutely horrific.   This is the reason why Warren Buffett refers to derivatives as "financial weapons of mass destruction."  

Nobody really knows the total value of all the derivatives (bets) that are floating around out there, but estimates place their total value at anywhere from 600 trillion dollars all the way up to several thousand trillion dollars.   By comparison, the global GDP is somewhere around 70 trillion dollars (for an entire year).   So we are talking about an amount of money, invested in bets that might very well go bad, that is absolutely mind blowing.  

The obvious question, then, is:   Can banks and other financial institutions really survive such gambling and investment losses without severely damaging the rest of the economy?   And considering that America's five biggest banks have almost $9 trillion in assets, which is more than half the size of the U.S. economy, with much of it bet on (or invested in) derivatives, one would have to guess that the answer is no, i.e. that the larger economy could not survive such massive gambling losses by the biggest banks.   For, according to the federal government, the four largest U.S. banks account for 93% of the total banking industry notional amounts of derivatives, and 81% of the derivatives industry's net current credit exposure.   ("Credit exposure" means, of course, that if the bets go bad, the banks will take it in the shorts.)    Therefore, if a widespread derivatives crisis were to cause these top banks to crash and burn, it would almost certainly cause the entire U.S. economy to crash and burn as well.   So just remember what we saw back in 2008.   What is coming could very well be far worse.

It would have been really nice if we had not allowed these banks to get so large and if we had not allowed them to use our depositor's money to make trillions of dollars of reckless bets.   But we essentially stood by and let it happen.   Our legislators are virtually owned by the big banks and so they were afraid to bite the hand that feeds them.   Now these banks have grown to be so important to, and integrated within, our overall economic system, that their dissolution or insolvency would also destroy the U.S. economy.   It's kind of like when cancer becomes so advanced that killing the cancer would also kill the patient.   That is essentially the situation that we are facing with these banks.

It would be hard to overstate the recklessness of these banks, so let's present some numbers that are absolutely jaw-dropping.  According to the Comptroller of the Currency, four of our largest U.S. banks are walking a tightrope of risk, leverage and debt when it comes to their gambling with derivatives.   Just check out how "exposed" they are.   (One example is provided below.   Click here to see more, and read the rest of the article from which the above synopsis was taken.)

JPMorgan Chase:   Total Assets: $1,812,837,000,000 (just over 1.8 trillion dollars) 

Total Exposure To Derivatives: $69,238,349,000,000 (more than 69 trillion dollars)

===================

Economics professor and former Wall Street insider Michael Hudson says that banking since World War I has been more and more focused on loading down the economy with debt rather than what he thinks should be the business of banks, which is financing economic growth and production.   Hudson says that banks should be public, government-run enterprises lending money only on economic merit, and that derivatives betting should remain private in separate institutions.   Watch the video at this site by clicking on the second video link there, if the first one doesn't work. 

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Several years after receiving my M.A. in social science (interdisciplinary studies) I was an instructor at S.F. State University for a year, but then went back to designing automated machinery, and then tech writing, in Silicon Valley. I've (more...)
 

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