December 6, 2012
Economy
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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