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The Derivatives Market is Unwinding!
George
Washington's Blog
Thursday, June 5, 2008
A couple of months ago, a financial analyst who sells derivatives told
me that fears about a meltdown in the derivatives market were unfounded.
Yesterday, he told me - with a very
worried look - "THE DERIVATIVES MARKET IS UNWINDING!"
What does this mean? What are derivatives and why should you care if the
market is unwinding?
Well, it turns out that the reason that Bear Stearns was about to go belly-up
before JP Morgan bought it is that it had held trillions of dollars in
derivatives, which were about to go south. (The
reason that JP Morgan was so eager to buy Bear Stearns is that it was
on the other side of these derivative contracts -- if Bear Stearns had
gone under, JP Morgan would have taken a huge
hit. But the way the derivative
agreements were drafted, a purchase by JP Morgan canceled the derivative
contracts, so that JP Morgan didn't experience huge losses. That
is probably why the Fed was so eager to broker - and fund - the shotgun
marriage. JP Morgan is a much larger player, and if Bear's failure
had caused the derivatives hit to JP Morgan, it probably would have rippled
out to the whole financial system and potentially caused an instant depression).
In addition, the subprime prime loan crisis is intimately connected
to the unwinding of the derivatives market. Specifically, loans were repackaged
into derivatives called collateralized debt obligations (or "CDO's") and
sold to both big and regional banks and investment companies worldwide.
The CDO's were highly-leveraged -- many times the amount of the actual
loans. When the subprime loan crisis hit, the high leverage magnified
the fallout, and huge sums of CDO derivatives became essentially worthless.
Do you remember when wealthy Orange County, California, went bankrupt
in 1994? Yup, that was because it had invested
in bad derivatives.
And, according
to a recent article by one of the world's top derivative insiders,
the market for credit default swap ("CDS") derivatives is also unraveling.
And reported just today, Lehman
Brothers is now on the edge, due to exposure to derivatives.
Derivatives are the Elephant in the Living Room
The subprime mortgage crisis is bad, and is hurting many people, and slowing
the economy. High oil and food prices are bad, and are hurting many people,
and bringing down the economy. But -- according to top insiders -- derivatives
are the elephant in the room . . . the single largest threat to the U.S.
and world economy.
One reason is that, according
to Paul Volcker, the former chairman of the Federal Reserve, the entire
modern financial system is based upon derivatives, and the financial system
today is entirely different from the traditional American or global financial
system because derivatives - a relatively new concept - now underly the
entire fabric of the financial
system. In short, many of the people who know the most about derivatives
say that the current system is a house of cards built upon derivatives.
Moreover, as mentioned above, the subprime and derivatives crises are
closely linked. Similarly, Britian's New
Statesman newspaper links
derivatives and rising food and commodity prices:
"This latest food emergency has developed in an incredibly short space
of time - essentially over the past 18 months. The
reason for food "shortages" is speculation
in commodity futures following the collapse of the financial derivatives
markets. Desperate for quick returns, dealers are taking
trillions of dollars out of equities and mortgage bonds and ploughing
them into food and raw materials. It's called the "commodities super-cycle"
on Wall Street, and it is likely to cause starvation on an epic scale.
The rocketing price of wheat, soybeans, sugar, coffee - you name it
- is a direct result of debt defaults that have caused financial panic
in the west and encouraged investors to seek "stores of value". These
range from gold and oil at one end to corn, cocoa and cattle at the
other; speculators are even placing bets on water prices."
Hiding the Ball
And yet banks and financial houses have hidden their derivatives exposure
off
the balance sheets. No wonder almost no one understands derivatives:
"Not
only [world's richest man] Warren Buffett, but Bond King Bill Gross, our
Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the
rest of America's leaders can't 'figure out'" the derivatives market.
Indeed, the government may have actively helped to hide the the derivatives
mess since at least 2006. For example, according
to Business Week:
"President George W. Bush has bestowed on his intelligence czar,
John Negroponte, broad authority, in the name of national security, to
excuse publicly traded companies from their usual
accounting and securities-disclosure obligations."
Former fed chairman Alan Greenspan has been a huge
booster for and defender of derivatives since 1999 or before (and see
this).
Did you know that the same guy that pushed subprime loans has also aggressively
pushed derivatives for many years?
And the other regulatory agencies and Congress have taken a totally hands-off
approach towards derivatives.
How Big a Problem?
How big is the derivatives market? Worldwide, it is $596
TRILLION dollars *. The derivatives market dwarfs
the real market for goods and services, and acts likes an unregulated black
market.
As one writer put it:
"It’s
all smoke and mirrors. The financial system has decoupled from the productive
elements of the economy and is now beginning to show disturbing signs
of instability."
And its not just the U.S. Derivatives salesmen have sold these babies all
over the world. Because banks, financial institutions and governments world-wide
have bought significant derivatives, the fall out will not be limited solely
to the U.S. See this
and this.
If the derivatives market is truly unwinding, as my investment advisor friend
and some of the top industry insiders say, we could be in for a very
bumpy ride.
For further information
on derivatives, see these articles:
http://en.wikipedia.org/wiki/Derivative_%28finance%29
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