Wednesday, December 5, 2012

Findings & Forecasts 12/05/2012

The August Forecast & Review
December 6, 2012


Deriv­a­tives. After the near-total melt­down of the finan­cial sector in 2008, one might expect that big banks would cur­tail their exces­sive risk-taking behavior. Alas, not so. In fact, just the oppo­site has occurred: More risk exists in today’s banks than at any time in history.
The largest nine banks have an overall expo­sure to deriv­a­tives of over $200 tril­lion, a figure that is more than three times the size of the entire global economy. For all global banks, the total “notional” value of deriv­a­tives is well over $1,500 tril­lion; $1,000 tril­lion is $1 quadrillion.
There is no reg­u­la­tion in the deriv­a­tives mar­kets, where only the law of the jungle pre­sides. Preda­tors and prey jockey for sur­vival in dimly lit trading rooms. If a fellow predator gets “eaten,” the news of it is taken with sat­is­fac­tion that more is left over for the remaining survivors.
In sim­plest terms, a deriv­a­tive is a bet on the out­come of some future event. While a bookie takes a bet on the out­come of next week’s horse race, deriv­a­tive traders make bets on events months and years into the future.
A bet works like this. I pur­chase $1 mil­lion in low-rated cor­po­rate bonds that cur­rently yield 6 per­cent and are not due for repay­ment for another 10 years. I’m going for the higher income knowing that there is a higher risk of default. Thus, I seek to find a bettor that will bet against that risk for a tol­er­able fee. Banker X thinks my bonds will be paid off when due, and charges me $25,000 for the assur­ance that if the cor­po­ra­tion does default, the bank will make up any dif­fer­ence. My $25,000 pay­ment is pure income to the bank, and there is no off­set­ting lia­bility recorded.
How­ever, if my cor­po­ra­tion defaults five years down the road, and I lose $800,000 in the process, then banker X imme­di­ately owes me $800,000, which, by the way, is also the so-called “notional value” of the con­tract. Because of all the uncer­tainty, the cur­rent notional value of a deriv­a­tive con­tract can only be guessed at.
If you ask a bookie what his “expo­sure” is, he may say some­thing like $100,000, but he knows that he will not lose all of his bets. Some will cost and some will profit. If he is really good, he will take home a pay­check every week – fewer pay­outs than bets received. If the odds go against him and he cannot pay, then clients with crow­bars are chasing him down the street.
Bankers think the same way about deriv­a­tives. Of course they know that they will lose some bets, but given their mega­lo­ma­niac per­son­al­i­ties, they figure they will win more than they lose and hence, the more bets that they can make, the more money they can pocket. This is why the deriv­a­tives market con­tinues to expand.
Sellers of deriv­a­tives have cul­ti­vated (suck­ered) an industry of pur­chasers who wrongly believe that they can lower their actual risk by adding deriv­a­tives to their overly-risky invest­ments. Put another way, if there were no deriv­a­tive market, people would not make such risky invest­ments in the first place. The temp­ta­tion to take on too much risk because deriv­a­tives are avail­able is called “moral hazard.” In this writer’s opinion, the entire deriv­a­tives market is one big cesspool of moral hazard.
When things go wrong again, this market will destroy the entire global finan­cial system: Cen­tral banks, banks, insur­ance com­pa­nies, wealthy investors, pen­sion funds, sov­er­eign wealth funds, national trea­suries, etc.
How­ever, there is another moral hazard that is enabled by the deriv­a­tives market: That is, for those who long for the death of cap­i­talism, finan­cial armageddon may be per­ceived as only be a few trades away…

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