Derivatives: Lethal Financial Instruments of Mass Destruction

By Navin Doshi, June 19th, 2010

Warren E. Buffett has warned over the past decade that derivatives are the fiscal equivalent of a weapon of mass destruction (WMD). The consequences of an explosion of such a weapon could make the recent global economic crisis seem insignificant. But lobbyists, on behalf of big banks, plead for keeping the over-the-counter derivative market unchanged with no restrictions and no supervision.

Derivatives essentially are bets that come in different forms. Examples include a bet for or against the house in a casino, or against the weather in situations in which the weather is critical. Forwards, futures, options, and swaps are different forms of derivatives. Credit derivatives are based on loans, bonds or other forms of credit. Over-the-counter (OTC) derivatives are contracts that are traded and privately negotiated directly between two parties, outside of a regular exchange. Just as the velocity is a time-dependent derivative of distance, so are the financial derivatives time dependent. What happens between two parties, notably hedge funds, is like what happens between two individuals who bet on the final score of a football or baseball game. Congressional committees have been informed about “ticking time bombs” to no avail, demonstrating that both the U.S. government and the U.S. Congress are dysfunctional and out of sync.

On May 16, 2006, for example, Richard T. McCormack, Vice Chairman of Merrill Lynch and former undersecretary of state for economic and agricultural affairs, spoke at a Senate banking hearing on derivatives and hedge funds in 2006, when the derivatives industry was in the $300 trillion range. He is quoted as saying “the increasing internationalization of finance and investment suggests the need for an ever-more-global approach to monitoring and controlling potentially dangerous problems.” Derivatives played a key role in camouflaging the multibillion-dollar Enron scam in 2001. The Long-Term Capital Management (LTCM) hedge fund debacle of 1998 almost destroyed the global monetary system. Even though its trading losses were a mere $5 billion, it still threatened the soundness of the financial markets.

When the Russian ruble suddenly nose-dived without warning, LTCM found itself exposed with more than $1 trillion in foreign-exchange derivatives it couldn’t pay. The New York Federal Reserve Bank organized a consortium of companies to buy out LTCM and cover its debts. LTCM shareholders were wiped out, but none of the creditors took losses. LTCM was a hedge fund with just 200 employees, but without the New York Fed’s intervention, it would have caused a crash felt around the world. Mr. McCormack pleaded with congressional banking experts to correct any structural or technical problems that could increase the likelihood of systemic risk in the event of future shock to the financial system. There was no response from all the parties concerned, inside and outside the government. The 2007 U.S. subprime mortgage global disaster was also derivatives-driven, and provoked the biggest financial and economic disaster since the Great Depression.

Mr. McCormack, then a senior fellow at the Center for Strategic Studies, explained to the Banking Committee how Italy had secured entrance into the Euro by purchasing exotic derivatives that obscured the true financial condition of the country, until after they were admitted to the new European common currency. The same thing happened with Japan when some banks purchased derivative instruments, which disguised the actual catastrophic state of their balance sheets at the time. Today’s massive new derivative bubble is driving the domestic and global economies, far outstripping the subprime-credit meltdown. Currently very few, “too big to fail” banks, control the derivative markets and earn much more trading derivatives, employing their proprietary trading software, than from regular banking business. However as more banks and hedge funds learn the same trick, it could culminate into generating more unpredictable and catastrophic “Black Swan” events. This is reminiscent of the morphic field described by Rupert Sheldrake in his book The Presence of the Past. He hypothesizes that the rats in Europe learn the same trick, discovered by the rats in Asia, caused by this natural field analagous to an electromagnetic field. Please note that there is no interaction or communication in any form between these two groups of rats. Intuitively, we know that any trading system, no matter how advanced it may be, degrades in time as more players do the same.

While banks all over the world were imploding and some $50 trillion vanished in global stock markets, the derivatives market grew by an estimated 65 percent, according to the Bank for International Settlements (BIS). The BIS convenes the world’s 57 most powerful central bankers in Basel, Switzerland for periodic secret meetings. Occasionally, they issue a cry of alarm. In this particular instance, derivatives had soared from $415 trillion at the end of 2006 to $684 trillion in mid-2008. The derivative market is now estimated at $700 trillion (notional, or face, value, not market value). The world’s gross domestic product in 2009 is about $70 trillion and America’s is $14 trillion. The total market cap of all major global stock markets is a mere $30 trillion, and the total amount of dollar bills in circulation, most of them abroad, is estimated to be about $830 billion.

Cautious bankers around the world concede that, even after listening to experts, they still do not understand derivatives and therefore don’t trust them and won’t have anything to do with them. And when that weapon of mass destruction explodes, they explain, “Our bank’s customers, from all over the world, will be saved from the disaster.” George Soros thinks of the current state of the world economy to be in Act two of a three Act play. The melt down of 2008-2009 was Act one. He believes that entering into a double deep recession is Act two. Apparently the total collapse of the economy will be act three.

Congress is considering legislation to curb the use of derivatives and other methods that artificially boost returns. One measure proposed by Sen. Blanche Lincoln of Arkansas would bar banks from trading in derivatives. This, in turn, would push almost $300 trillion beyond the reach of regulators. Derivatives would become still more opaque. Some say abolish derivatives trading in the U.S. and push it offshore.

The Greek tragedy over its debt crisis is echoing around the world and certainly in the halls of Congress. Greece’s public debt is around 100 percent of its economy, about the same as for the United States. If you add unfunded U.S. liabilities for Social Security, Medicare, and Medicaid, the long-term shortfall is $62 trillion, or about the same as the total world GDP, or about $200,000 for each and every American. Fed’s current posture is to add liquidity (print money) when markets go down substantially (S/P 500 support at 1040), or stay on the side line if the mood of the market is positive. Please refer to articles like, Economics 101…, Butterfly Effect…, posted at http://www.nalandainternational.org, for detailed explanation.

When the Dow Jones went into a 1,000-point tailspin and back up in 16 minutes on May 6th of this year, economic and financial prognostication made astrology look respectable. Barron’s round table analyst Marc Faber, hedge-fund manager Jim Chanos and Harvard’s Kenneth Rogoff told Bloomberg that China’s economy will slow and possibly “crash” within a year or two as the nation’s property bubble is set to burst. Another Barron’s round table analyst Felix Zulauf anticipates the secular bear market bottom should occur at around the market book value. If it happens, then the S/P 500 would have to fall from the current level of about 1100 to the S/P book value of about 500. If I were to consider the forecast of UBS technician Peter Lee, it should happen sometime in 2012. However, in the mean time in coming months, S/P 500 could go over 1150 depending upon what the Fed does in matters of money supply. Market technicians in general believe the market is in a bullish territory if the index is over 200 days moving average and in bearish territory if it is below the same.

Needless to say that no one can predict the future accurately unless one happens to be Sahdeva of Mahabharata, or Cassandra of Greek mythology.

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