Billy,
I fully agree that derivatives help hyper-leverage the whole financial system and that this is very dangerous. Because my software used to deliver real-time derivatives quotes from the major exchanges I spent time working inside the system. (My software was the first "direct from the exchange" web-based real-time quote delivery system for the Chicago Board of Trade.) I also worked with hedge fund managers. For good reasons, I could never get my head around the hyper-leveraged derivatives like options and swaps. How did they make any sense? It seemed like they were trading fictitious vapor. There are brilliant mathematicians working on and through the trading floors. They can think their ways into minuscule cracks in the system that they can exploit to make tons of money. Most of their angles are completely legal because the regulatory system has no idea what they are doing and there are no regulations to prevent their niche trading system. Chris From: [email protected] [mailto:[email protected]] On Behalf Of [email protected] Sent: Thursday, April 12, 2012 12:18 PM To: [email protected] Cc: [email protected] Subject: Re: [RC] Everything you wanted to know about derivatives but were afraid to ask Chris : Many thanks for your comments. But I am less skeptical about the author's conclusions since I have read similar stuff elsewhere about how derivatives help hyper-leverage the whole ( global ) financial system, Hence, as the article says about the value of financials, viz., most derivatives : -23 TIMES WORLD GDP. This has been the "prophet in the wilderness" cry of Kevin Phillips for about 20 years now, viz, finance capital is out of control, answers only to greed and the bottom line, and has little or no sense of morality or the national interest. This said, some healthy skepticism about the article --or others-- is a really good idea. It seems safe enough to say that as economists we are all amateurs. Skepticism helps keep us honest. Also, you pointed out some questionable assertions that otherwise I would not have realized, or not found out about for X amount of time. That is very helpful. Thanks again Billy ======================================= 4/12/2012 10:35:29 A.M. Pacific Daylight Time, [email protected] writes: This author is a bit dramatic. Derivatives are a primary cause of the severity of the financial crisis, but hardly the only cause as the author suggests. What about the grossly leveraged normal guy on Main Street who got that way with careless loans? Also when he says that there is no clearing house for derivatives he is ignoring exchanges like the Chicago Mercantile Exchange (that bought the Chicago Board of Trade), the Chicago Board Options Exchange (CBOE), etc. These organizations have lots of private clearing firms that work within the rules of the exchanges. Can the many exchanges and clearing firms keep track of and adequately regulate all of the derivatives? Heck no. As soon as a dangerous loophole gets closed, some very bright trader will figure out a way to invent another angle at working the system. These traders will always be a step ahead of the regulators. The derivatives market is a house of cards and it is dangerous, but this article over reaches. Chris From: [email protected] [mailto:[email protected]] On Behalf Of [email protected] Sent: Thursday, April 12, 2012 11:16 AM To: [email protected] Cc: [email protected] Subject: [RC] Everything you wanted to know about derivatives but were afraid to ask from the site : Seeking Alpha Why Derivatives Caused Financial Crisis April 12, 2010 As we celebrate year three of the Great Financial Crisis with the first official bailout of an entire country (Greece), I'm still astounded by the complete and utter lack of coverage the underlying cause of this Crisis has received. Tens of thousands, if not hundreds of thousands of articles and research reports have been written about the Crisis, and yet I would wager less than 1% of them actually bother talking about what caused it, let alone how the various efforts to stop it have in fact FAILED to address this key issue. Remember back in 2007? At that time we were told it was all about Subprime mortgages. Then in 2008, we were told it was the investment banks, specifically Lehman Brothers' (LEHMQ.PK <http://seekingalpha.com/symbol/lehmq.pk> ) failure and AIG <http://seekingalpha.com/symbol/aig> 's credit default swaps. In 2009, we were told it was poor accounting standards and bad bets made by Wall Street. And here we are in 2010, and we're still being told it was simply bad bets made by Wall Street. All of these answers are partially right, but none of them are totally 100% accurate. Why? Because they fail to address the one underlying issue that links ALL of these items. I'm talking about the Black Hole of Finance: a bottomless pit that no official or regulator bothers mentioning in public because acknowledging it would mean acknowledging that all of the efforts to stop the Crisis are truly paltry. What caused the Crisis? Derivatives. You've probably heard this term before, or have some vague understanding of what the term means. But the actual reality of derivatives and what they represent for the financial markets remains a topic no one in the mainstream media (or the regulators for that matter) wants to touch. Why? Let's do some quick math. If you add up the value of every stock on the planet, the entire market capitalization would be about $36 trillion. If you do the same process for bonds, you'd get a market capitalization of roughly $72 trillion. The notional value of the derivative market is roughly $1.4 QUADRILLION. I realize that number sounds like something out of Looney tunes, so I'll try to put it into perspective. $1.4 Quadrillion is roughly: -40 TIMES THE WORLD'S STOCK MARKET. -10 TIMES the value of EVERY STOCK & EVERY BOND ON THE PLANET. -23 TIMES WORLD GDP. What's a derivative? As their name implies, derivatives are securities whose value is "derived" from an underlying asset (a mortgage, credit card debt, etc). A lot of smart people have tried to explain what these things are, but they usually miss the forest for the trees. A derivative is NOT an asset. It's, in reality, nothing, just an imaginary security of no tangible value that banks/ financial institutions trade as a kind of "gentleman's bet" on the value of future risk or securities. Let me give you an example. Let's say you and I want to bet on whether our neighbor Joe will default on his mortgage. Is the bet an asset? Does it have any real value? Both counts register a definite "no." That's the rough equivalent of a derivative. There are dozens of different types of these things based on just about everything under the sun. Some derivatives are actually derived off the value of other derivatives, a fact that makes my head hurt every time I think about it. The other thing you need to know about derivatives is that they are totally unregulated. There is no derivative clearing house. No official report explains the risk or actual value of these things (the notional value of the derivatives market is not the same thing as the actual "at risk" money underlying these securities: I'll detail all of this in tomorrow's essay). Regardless, to claim that these things have any real tangible value or perform any kind of wealth generation (for anyone other than Wall Street) is pure fiction (perpetuated by another fiction: that Wall Street is able to value these things or price them accurately). But thanks to Wall Street's lobbying power, they've become the centerpiece of the financial markets. If these numbers scare you, you're not alone. As early as 1998, soon to be chairperson of the Commodity Futures Trading Commission (CFTC), Brooksley Born, approached Alan Greenspan, Bob Rubin, and Larry Summers (the three heads of economic policy) about derivatives. She said she thought derivatives should be reined in and regulated because they were getting too out of control. The response from Greenspan and company was that if she pushed for regulation, the market would implode. Remember, this was back in 1998: a full DECADE before the Crisis hit. And already, the guys in charge of the markets knew that derivatives were such a big problem that trying to regulate them or increase their transparency would destroy the market. If you think I'm exaggerating, you can read the actual Washington Post story here. <http://www.washingtonpost.com/wp-dyn/content/article/2009/05/25/AR200905250 2108.html> So why are these items so accepted? Well, for one thing Wall Street makes roughly $35 billion+ per year from trading them, so it has a powerful incentive to keep them untouched. Also, it's kind of difficult for Ben Bernanke and the world's central bankers to claim they saved the financial world from destruction when you realize that even the most liberal estimate of the bailout costs ($24 trillion) is equal to less than 2% of the notional value of the derivatives market. Indeed, even saying the number ($1+ QUADRILLION) sounds ridiculous. Every time I've mentioned it at a dinner party I get nothing but blank stares or snickers. Can you imagine if someone in a position of power actually bothered explaining this on TV? The entire financial media would respond with, "well, that's great, now we.. wait a minute. what did you just say?" And yet, you simply cannot discuss the Financial Crisis without mentioning derivatives. What do you think subprime mortgage backed securities were? Derivatives. What about Credit Default Swaps? Yep, derivatives again. Heck, even the Greece crisis involved that country using derivatives to hide its true liabilities in order to join the European Union. In plain terms, derivatives are THE cause of the Financial Crisis. They are behind EVERY failure/ default that has occurred thus far. The fact that virtually no one is willing to address this issue or include it in the discussion of how to insure we don't have a Second Round of the Crisis only confirms the fact that no one has a clue how to resolve this situation. -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: http://groups.google.com/group/RadicalCentrism Radical Centrism website and blog: http://RadicalCentrism.org <http://radicalcentrism.org/> -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: http://groups.google.com/group/RadicalCentrism Radical Centrism website and blog: http://RadicalCentrism.org <http://radicalcentrism.org/> -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: http://groups.google.com/group/RadicalCentrism Radical Centrism website and blog: http://RadicalCentrism.org -- Centroids: The Center of the Radical Centrist Community <[email protected]> Google Group: http://groups.google.com/group/RadicalCentrism Radical Centrism website and blog: http://RadicalCentrism.org
