Derivatives -- the new 'ticking bomb'

The very complex financial instruments called derivatives (identified by Warren Buffet as financial weapons of mass destruction) are used by markets to hedge bets, and their use/popularity has exploded over the last 10 years.

Today, the world is awash with these weapons of mass destruction and hundreds of TRILLIONS (yes, that was not a typo) of these bets are so over-utilized and intertwined throughout the various financial markets, hedging one’s bets against losses, that no one really understands the true impact of any one loss against another and the daisy chain effect caused by simultaneous losses -- many with the same hedges/bets.

Problem is: we’re now starting to find out... As the housing bubble bursts, the financial world is swiftly realizing that their hedges/insurance bets on losses/gains (derivatives) were also used by everyone else and when the financial truth eventually gets out, the losses will be absolutely staggering -- there is absolutely no way anyone cand get paid.


Derivatives the new 'ticking bomb'

ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe Berkshire should be a fortress of financial strength" wrote Warren Buffett. That was five years before the subprime-credit meltdown.

"We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

That warning was in Buffett's 2002 letter to Berkshire shareholders. He saw a future that many others chose to ignore. The Iraq war build-up was at a fever-pitch. The imagery of WMDs and a mushroom cloud fresh in his mind.

Also fresh on Buffett's mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared with the hundreds of billions of dollars of subprime-credit write-offs now making Wall Street's big shots look like amateurs.

Buffett tried to sell off Gen Re's derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a "financial weapon of mass destruction." That was 2002.

Derivatives bubble explodes five times bigger in five years
Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

1. Sarbanes-Oxley increased corporate disclosures and government oversight
2. Federal Reserve's cheap money policies created the subprime-housing boom
3. War budgets burdened the U.S. Treasury and future entitlements programs
4. Trade deficits with China and others destroyed the value of the U.S. dollar
5. Oil and commodity rich nations demanding equity payments rather than debt

In short, despite Buffett's clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.

Data on the five-fold growth of derivatives to $516 trillion in five years comes from the most recent survey by the Bank of International Settlements, the world's clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier's window at a racetrack or casino, where you'd place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:

U.S. annual gross domestic product is about $15 trillion
U.S. money supply is also about $15 trillion
Current proposed U.S. federal budget is $3 trillion
U.S. government's maximum legal debt is $9 trillion
U.S. mutual fund companies manage about $12 trillion
World's GDPs for all nations is approximately $50 trillion
Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
Total value of the world's real estate is estimated at about $75 trillion
Total value of world's stock and bond markets is more than $100 trillion
BIS valuation of world's derivatives back in 2002 was about $100 trillion
BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes "transactions in which a major private dealer (bank) is involved on at least one side of the transaction," but doesn't include private deals between two "non-reporting entities." They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion "notional" value (maximum in case of a meltdown) of the deals is a good measure of the market's size, the 2007 BIS study notes that the $11 trillion "gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets."

Bubbles, domino effects and the 'bad 2%'

However, while that may be true as far as the parties to an individual deal, there are broader risks to the world's economies. Remember back in 1998 when LTCM's little $5 billion loss nearly brought down the world's banking system. That "domino effect" is now repeating many times over, straining the world's monetary, economic and political system as the subprime housing mess metastasizes, taking the U.S. stock market and the world economy down with it.

This cascading "domino effect" was brilliantly described in "The $300 Trillion Time Bomb: If Buffett can't figure out derivatives, can anybody?" published early last year in Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger's $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded:

"There's nothing intrinsically scary about derivatives, except when the bad 2% blow up." Unfortunately, that "bad 2%" did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was "contained."

Bottom line: Little things leverage a heck of a big wallop. It only takes a little spark from a "bad 2% deal" to ignite this $516 trillion weapon of mass destruction. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile. It's only a matter of time.

World's newest and biggest 'black market'

The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only 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 world's $516 trillion derivatives.

Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.

BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic "shadow banking system" that has become the world's biggest "black market."

That's crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don't. They're not "real money." They're paper promises closer to "Monopoly" money than real U.S. dollars.

And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.

Comments? Yes, we want to hear your thoughts. Tell us what you think about derivatives: as "financial weapons of mass destruction;" as a "shadow banking system;" as a "black market;" as the next big bubble dangerously exposing us to that unpredictable "bad 2%."


Another fantastic article sums up the derivatives issue quite well:

Empire of Debt I: The Great Unraveling Begins

Here is an analogy. Let's say you are offered a chance to play roulette, a very risky game of chance, but with an option for insurance which guarantees you will suffer no more than a tiny loss.

Let's say you place a $10 bet, in the hopes of winning $100. Your "insurance"--what we call a hedge, as in "hedging your bets"--costs only $1. Thus you can gamble $10, with a chance of winning as much as $100, and your loss is limited to a mere $1--the cost of your hedge. If you lose the $10, the other side of the hedge trade--whoever took your $1--will give you $10. Life is good, n'est pas?

Note what this hedge does: it makes you believe a high-risk game can be played at almost no risk. But alas, the game is inherently risky, and the reduction of risk is ultimately illusory: you can't change roulette into a low-risk gamble.

Since this is such a low-risk bet, you are soon gambling, say $100 billion. And why not? The hedges are so cheap! Abd everything goes swimmingly until the day you lose the $100 billion. Ah, bad luck, Mate; but no worries, you turn to the other side of your hedge and politely request your $100 billion.

Oops--that guy just lost his bets, too, and can't pay you. Now the risk of the underlying game is fully revealed; the entire hedge which made it all so "safe" is revealed as a house of cards which depends on all the other players being able to pay off their bets. Once they can't, well, as the saying goes, all bets are off.

To hide your immense losses, you continue to claim your bet is still worth $100 billion. Since you aren't required to "mark to market," i.e. reveal the market value of your bet, you stash the $100 billion loss in "Level 3" of your assets--a dark place where you can temporarily hide your worthless bets.

In other words, you bought an insurance policy to protect your risky bet on mortgage-backed securities and derivatives and now you find the insurer is belly-up and can't pay you.

If their bad bets were marked to market, Citicorp and Merrill Lynch would be declared insolvent. Why? Because they are insolvent--right now. The meaning of insolvency is straightforward: their losses exceed their capital. Recall that these firms list assets of $100 billion (or whatever) but their actual net capital is on the order of 2.5% - 5% --a mere sliver of their stated assets. In other words: a 5% loss of their stated assets wipes them out.

And once those leviathans fall, what other dominoes will they strike down?

Inherently risky bets were encouraged because they were "hedged." That's what Hedge funds do: place bets on both sides so they collect gains whether the markets go up or down. But the risks of the gamble didn't really change; the introduction of low risk to a high-risk bet was an illusion.

The whole risk-management model depends on somebody being able to pay off the hedge. If they can't-- the game is over. the game is now over, and the players shuffling losses can only last a few more days or weeks.

The game is over for other fundamental reasons, too. The U.S. "prosperity" of the past five years has depended on one thing and one thing alone: cheap, easy borrowing, by consumers, home buyers, businesses, gamblers/bankers and government--cheap easy credit for everyone.

This was funded by capital inflows of billions each and every day. Foreigners poured trillions into U.S. markets, buying up risky mortgage-backed securities, supposedly "safe" U.S. Treasuries, and U.S. stocks, bonds and derivatives.

Now as the Fed and the Treasury destroy the dollar's value, foreign owners of dollar-denominated assets are seeing their wealth decimated. That "safe" Treasury you bought in 2002? It's down 30% as the dollar has been depreciated. You're underwater so deep you'll never make that money back.

And how about all those Yankee CDOs, MBS, interest-swaps and other exotic derivatives which Yankee ingenuity invented and sold to you as low-risk, high yield investments? They're mostly worthless now. You lost most of your money in a "safe investment." How anxious are you now to buy more Yankee "investments" denominated in the sinking dollar?

There goes the capital inflows which have funded our profligacy. They're gone, and not coming back. Mr. Bernanke and Mr. Paulson are busy destroying the dollar with interest-rate cuts, fueling runaway inflation as they flail mightily to save their banking buddies--but they can't succeed. Making more debt available to bankrupt entities, be they investment bankers or homeowners, solves nothing. It's called "putting good money after bad," and it simply guarantees ever-larger losses.

Allow me to sum it up: the money's lost, folks. You can't borrow more and pretend you made the money back. All those trillions in bad debt and derivatives are already lost. The Ministry of Propaganda is in a tizzy, trying to mask the meltdown and offer up a facade of normalcy. But the money's already lost.

Will it be contained to the U.S.? Why should it? The bad debt is everywhere. And the spending spree all that borrowing unleashed washed over the entire globe. Now that Americans can't borrow any more, the spending dries up--and so does the global "prosperity" built on an Empire of Debt.