Irrational Exuberance Goes Global

The World According to Derivatives: Part 1 of 7

On Sunday September 7, 2008 — in a dramatic move reminiscent of the announcement of the Bear Stearns takeover a few months earlier — Treasury Secretary Hank Paulson told the world that the giant “government sponsored enterprises” Freddie Mac and Fannie Mae would be placed under the conservatorship of the U.S. Government. Under the new plan, implied U.S. government backing now became explicit government backing. This, it was hoped, would be enough to persuade foreign sovereign wealth fund investors to keep purchasing U.S. Securities.

As early as Monday, reports began circulating that “The government’s takeover of Fannie Mae and Freddie Mac may lead to one of the largest ever payments in the credit default swap market … Losses to protection sellers, however, are expected to be minimal because of the high trading levels of the $1.6 trillion of outstanding Fannie Mae and Freddie Mac debt.”1

A Bloomberg report put another twist on this latest derivatives blow-up story when it related that “Thirteen “major” dealers of credit-default swaps agreed “unanimously” that the rescue constitutes a credit event triggering payment or delivery of the companies’ bonds, the International Swaps and Derivatives Association …”2

No one can say they weren’t warned about long-standing “Enron-style” accounting problems with Fannie Mae and Freddie Mac. For example, in 2003 testimony to Congress, Peter Wallison asserts that “From press accounts, it appears that Freddie attempted over many years to manage its earnings by manipulating the valuation of its derivatives…”3

Reading between the lines, one analysts tells the reader to “imagine betting on a default, getting it, and losing your ass. It seems to me that is what happened.” Among the betting winners in this latest debacle are the thirteen “major” dealers of credit-default swaps… and PIMCO. The losers? U.S. Taxpayers and small banks and investors holding F(annie)& F(reddie) preferreds and/or F(annie) &F(reddie) common.4

Freddie Mac and Fannie Mae are not alone. Threats of implosion permeate the entire banking industry, due to the derivatives markets. Thus it was that market guru Warren Buffet explicitly warned in a 2002 letter to Berkshire Hathaway shareholders that “derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal”. Yet despite clarion warnings from Mr. Buffet and many others before and since, the growth of the global derivatives markets over the last five years has escalated beyond comprehension or belief.

Mind-numbing numbers tell the tale. For example, when Buffet penned those extraordinary words in 2002, the derivatives trade had grown worldwide to an estimated $100 trillion, from an estimated $40 trillion a little over a year earlier. As of June 2007, a mere five years later, they totaled an estimated $516 trillion according to the Bank of International Settlements, or BIS.5 Even more eye-popping third quarter figures were given in an article appearing in Bloomberg last December, which began with “Derivatives traded on exchanges surged 27 percent to a record $681 trillion in the third quarter, the biggest increase in three years, the Bank For International Settlements said.”6

Located in Basel, Switzerland, the BIS officially acts as the world’s “clearinghouse” for central banks. However, a somewhat more apt description is provided by analyst Paul B. Farrell, who likened the BIS to “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.”7

How can we comprehend such staggering numbers and the kinds of activities that may be associated with them? We can start by looking at what the real economy is producing versus what is taking place in the newly burgeoning “global casino”. As of June of last year, total world GDP stood at $52 trillion whereas worldwide derivatives contracts amounted to some $516 trillion — which means that gambling out-paced the production of real goods and services by a factor of ten to one. Today the ratio may well be too outrageous to mention in polite circles.

What accounts for such incendiary and disproportionate growth in the global derivatives trade? How might it be contributing to our economic and social woes? And, lastly, can the current monetary system be saved from the imminent collapse that such numbers portend?

The answers to these questions are immediately important, for the course we take now will set us on a path toward peace and abundance for all, or propel us ever faster toward certain global economic meltdown and, to borrow Mr. Buffet’s phrase, mass destruction.

Derivatives may seem to have sprung up out of nowhere. However, senior economist and policy adviser at the Federal Reserve Bank of Dallas Thomas F. Siems points out that Aristotle’s writings provide an example of the world’s first options contract — a type of derivative — occurring some 2500 years ago. This type of derivatives contract was developed as a method by which a farmer could protect himself from downward fluctuations in the value of his crops.

These contracts, offered by the farmer for a fee, allowed him to secure buyers for his crops months before the crops were even planted — so long as the farmer agreed in advance to sell his crops for a set price. If the price of crops at time of harvest were significantly higher than the contract price, the buyer got his goods at a bargain price and the farmer got the contract fee to help make up the difference. If, on the other hand, crop prices were significantly lower at harvest time, the buyer could walk, but the farmer had the contract fee as a hedge against his loss. These were relatively straightforward contracts, particularly when compared to the far more complex financial instruments derivatives have evolved into today.

What are derivatives? Former merchant banker-turned-novelist Linda Davies provides the wonderfully succinct description of derivatives as “bookie transactions once removed, taking a bet on a bet”. More pedagogically speaking, derivatives are complex financial instruments that are merely a promise to convey ownership at some later date. Their value is derived from fluctuations in the value of an asset, rather than from the asset itself. Thus they themselves do not constitute ownership of an asset and so have no intrinsic value. Rarely is the asset in question ever exchanged, since the primary objective of these contracts is to realize profits or hedge against losses.

In addition and as Mr. Buffet so richly put it: “Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values… The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen)… [So] say you want to write a contract speculating on the number of twins to be born in Nebraska in 2020. No problem — at a price, you will easily find an obliging counterparty.”8

The primary purpose of modern day derivatives is ostensibly to reduce risk for one party (such as a farmer) or group (such as tulip growers), although a cascading web of interconnected “counterparties to risk” may be, and increasingly are connected to these transactions. The secondary purpose for investing in derivatives is, of course, to gamble that your bet on a future asset valuation will win — and bring in “fast money” for you with no investment in the asset, and at minimal upfront cost.

Common derivative contract categories include options, swaps, forwards and futures. Although some argue that the lines have been blurred in recent years, there are two main methods for trading in derivatives: over-the-counter or OTC and exchange traded.

Futures for example are typically exchange-traded. Because they must go through a clearinghouse, the parties to exchange-traded futures contracts are required to maintain deposits whose size depends on the contracts, similar in nature to the role that capital requirements play for banks. And unlike over-the-counter trades which are privately negotiated agreements between two parties, buyers and sellers of exchange-traded securities must make a contract with the clearing house. This means these contracts must be standardized in such a way as to allow buyers and sellers the ability to know what it is they are buying and selling – thus creating a level of transparency that is non-existent in OTC trades.

As part of the “secondary” market, over-the-counter trades also include stocks, bonds, and commodities, and it is in this market that the bulk of derivatives are traded. In contrast to traditional trading floor operations, OTC trades take place in a decentralized global marketplace, where geographically disconnected dealers conduct business electronically via faxes, telephones, and computers. The scale and speed with which these transactions occur further reduces transparency and significantly impairs regulatory oversight.

The SEC has deemed OTC traded stocks to be “extremely risky”. The Morningstar group takes this assessment a step further when it says that “Trading in OTC stocks is a lot like gambling, and it is not something we recommend for beginners.”

Not surprisingly, a certain exclusivity is built into OTC markets in particular, with trading taking place among brokers — who arrange transactions between buyers and sellers — and dealers, who are people and firms within the securities business that own securities and trade for their own accounts. In truth this is the domain of heavy rollers who play a high stakes game with pricey entrance fees. This fact creates a series of related problems because, as Mr. Buffet details,

Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant [author's note: read “privatized”] power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems.

The recent growth of the OTC derivatives trade has been nothing short of phenomenal. For example, analyst Kevin McFarland relates in an article for Advanced Trading that “Since 2002, the outstanding notional value of all OTC interest rate, currency, credit and equity derivatives has grown nearly 30 percent a year. Additionally, between 2006 and 2007 that growth rate rose to over 40 percent… As of mid-2007 (the latest available data), there was over $400 trillion ” with a T ” of notional value in outstanding OTC derivative contracts.”

Leveraging is a major fault line embedded within various derivatives products, including futures, options, swaps, margin and other financial instruments. While the “effect” of borrowing is implicitly built into the cost of purchasing the derivative contract itself, derivatives allow considerable leverage without any actual borrowing — or for that matter investment in an asset.

Opportunity for profit is of course maximized considerably by leveraging. However risky derivatives may be, the lure of potentially huge profits and “fast money” makes these kinds of “bets on bets” as irresistible as they are deadly.

  1. Reuters, September 9, 2008, International Herald Tribune. []
  2. Fannie, Freddie Credit-Default Swaps May Be Settled by Oliver Biggadike and Shannon D. Harrington. []
  3. TESTIMONY on Fannie Mae and Freddie Mac by Peter J. Wallison before the House Subcommittee on Commerce, Trade and Consumer Protection: July 22, 2003. []
  4. Big Non-Event In Fannie, Freddie Credit Default Swaps, Mike Shedlock. []
  5. Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity in 2007 – Final results press release, December 19, 2007. []
  6. Derivative Trades Jump 27% to Record $681 Trillion by Hamish Risk. []
  7. Derivatives Are the New Ticking Time Bomb, Paul B. Farrell. []
  8. Berkshire Hathaway 2002 Annual Report []

Geraldine Perry is co-author of The Two Faces of Money and creator of its related website which includes recent reviews. This website also has an abundance of related material and links, along with a free, down loadable slide presentation describing the two forms of money creation and the Constitutional solution, which is not the gold-backed dollar as popularly believed. As a means of imparting accurate information on health and nutrition to as broad an audience as possible she developed the web site The Health Advantage. Read other articles by Geraldine, or visit Geraldine's website.

4 comments on this article so far ...

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  1. Dissident Voice : A Faustian Bargain said on October 2nd, 2008 at 6:47pm #

    [...] Part 1. “Deciphering the 2007-08 Liquidity and Credit Crunch”, Markus K. Brunnermeier, Princeton [...]

  2. Dissident Voice : History Repeats as the Off-Balance Sheet Money Supply Explodes, Then Contracts said on October 8th, 2008 at 5:43pm #

    [...] Part 1, Part 2, and Part 3. Derivatives Are the New Ticking Time Bomb, Paul B. Farrell. [↩]Testimony [...]

  3. Peter L. Griffiths said on October 3rd, 2009 at 6:22am #

    Credit Default Swaps can be highly complicated instruments. Nevertheless there are three simple properties of every Credit Default agreement, the identity of the losers, the identity of the winners, and the credit event. Disclosure of these three properties should be a legal requirement.

  4. Peter L. Griffiths said on November 4th, 2009 at 10:44am #

    Further to my comments of 3 October 2009, the collapse in September 2008 of AIG, Lehman Brothers and Merrill Lynch occurred because they all lost Credit Default Swap bets on the conservatorship of Fannie Mae and Freddie Mac who had been encouraged into entering such agreements by the US Treasury who wanted assurance that Government loans would be repaid.