Derivatives
It has taken me some time to come to terms with what derivatives really are. Ask seven people and you'll get seven different responses. Check out Wikipedia and you will be left feeling inadequate. Listen to any top government official or finance guy talking and the thing you will not hear them talk about is the derivative. Warren Buffet, a famous investor, is on record as saying that derivatives are "Financial Instruments of Mass Destruction".
A derivative is any security whose price is determined by the value of another asset, or, the 'underlying security'. The important thing to remember is that any price change in the 'underlying' affects price change in the derivative. Indeed, the very name, 'derivative', comes from the fact that its value is derived from something else.
A derivative is a kind of insurance contract. A derivative demands a monthly premium be paid, just like insurance. Derivatives became a source of free money for banks in what they assumed were safe 'bets', especially on housing. House prices always go up, so they thought. They never realized that one day, they would have to pay up - they thought they had the system perfectly rigged to their advantage.
The purpose of derivatives are twofold. First, they are used to 'hedge' against unwanted risk. Derivatives transfer risk to someone else who can handle that particular kind of risk better. For example, currency fluctuations for multi-national corporations. Second, they are used for speculation, which is no different to gambling. Derivatives have a tendency to be volatile with big swings in value and are mostly unregulated.
The four major categories of derivatives are:
- Swaps: A Swap is a contract to exchange 'value' based on certain events occurring. Currency values change, as do interest rates, commodities, etc. It is a predetermined contract. Credit Default Swaps are included herein.
- Forwards: A Forward is a contract to buy or sell assets at a future date.
- Futures: Similar to Forwards, but more regulated and traded on Exchanges (oil, timber).
- Options: An Option is a contract that gives you the right but not the obligation to buy shares/stock at some future point.
Steve Liesman, a Senior Economic Reporter (You-tube) explains how subprime derivatives are created.
- Step 1: Collect mortgages (loans) into groups of about $50 milllion to create a Mortgage Backed Security (MBS).
- Step 2: Collect lots of MBSs into a $1 billion package.
- Step 3: Slice and dice the 'package' into five different groups depending upon their perceived strength based on the likelihood of the mortgage being be repaid. The five groups were: AAA; AA; A; BBB; BBB-
- Step 4: Sell the paper - Presto! Instant derivatives.
What they succeeded in doing here was to create AAA 'paper', which investors trusted, out of sub-prime 'paper'. They were lured in and hooked. And, while AAA paper retuned about 5.45%, the riskier bet on BBB- returned as much as 30%. Now, if you bought the risky high yield security, and then insured it against loss... well, you can see that it is here that the problem begins to unfold.
Michael Greenberger (You-tube, 26th May 2009) explains that banks used to be very careful about who they gave mortgages to. They would not lend you money unless they were sure you would be able to make the repayments. What has happened in recent times is that banks now sell the 'loan'. These 'loans' are collected together and packaged in groups of say, $50 million worth of mortgages. Next, third parties buy stock in these 'packages', which are really securities in mortgages. These third parties are the actual owners of the 'package' -- this form of security has not yet become a derivative.
People became so excited about these new products that there were not enough to go around. Enter: Sub-prime, where mortgage lenders took more risks to create more of these securities. Banks lent more and more money, encouraged by government policy, to more and more people, and when they ran out of people, they slowly reduced the requirements until eventually people who could not afford a house began to buy. The government (Alan Greenspan) fed this frenzy with lower and lower interest rates which in turn meant that people could take loans out on more expensive homes. Of course, rather than buying bigger homes, it was more a case of house prices increasing, way beyond reason, due to the availability of capital. Everyone believed it would continue indefinitely.
So, fueling the fire at one end we have investors desiring more of these securities, and fueling the fire at the other end we have low interest rates feeding the creation of thousands of new mortgages taken on by people who could not afford them. Likewise, risk was created at both ends: if the system were to crash, the securities would lose their value and the people would lose their homes - and few saw it coming.
Somewhere along the way, banks decided to create 'bets' on who would and who would not be able to repay their subprime mortgages and these appeared in the form of derivatives. In this case, there was no ownership, rather, they were just 'bets'. AIG decided to get into the business of insuring the value of whatever payments were made, and, naturally perhaps, people took out insurance against their risky bets. AIG apparently had 20 Divisions and all but one were successful. When AIG crashed, the successful Divisions had $20 billion in assets but that one division, which had no capital whatsoever, on 16th September 2008 announced a debt of $85 billion, which later rose to $160 billion. AIG never lay aside the capital to pay off the policies it was issuing - perhaps it expected it would never have to pay. Apparently, this lone division, located in a small office in London, issued $400 billion in 'bets' as to whether or not people would pay their mortgages. Beyond AIG, it is estimated that other companies doing likewise have an accumulated derivative debt of over $400 trillion. Now the interesting thing here is that if someone loses another must gain. The $160 billion in bailouts given to AIG went to those they had to pay - the investment banks. Those who bet people would not pay won. AIG lost, and paid with taxpayers' money, our money. What should of happened is that AIG should have gone bust, the investment banks would then not have received a penny and they too would have gone bust, all the toxic debt would have been wiped out, and we would now be halfway through the recession with light at the end of the tunnel. Alas, no.
In late 2009 the Sub-prime fiasco is still ongoing and the next phase is going to be ARMs - the Adjustable Rate Mortgage. These offered low rates for a couple of years and in the near future, many will become due for reassessment. What happens next is ...
Janet Travakoli, who has recently published a book on Warren Buffet, explains that a derivative is a financial instrument, or contract, that is based upon another financial instrument, or contract. As ownership drifts from one to the next, clauses are added - meaning becomes more and more opaque until totally obscure. She regards the creation process of derivatives as being purposefully opaque to ensure protection and regards it as a corrupt process in demand of investigation. Indeed, she also asserts that it is the interest of these newly merged investment banks to cover up what has happened and that that is exactly what they are trying to do.
Once sub-prime mortgages came along and the derivative market bust wide open, derivative contracts were now 'payable'. The sudden creation of defaults in derivatives opened up massive black holes of debt that have been renamed 'toxic waste'. The banks call it 'debt' when we owe it to them, but when they owe it, they call it 'toxic waste' - a brilliant advertising craft that cons us into thinking we must get rid of it by 'quantative easing' or 'financial stimulus'. They must think we are stupid - well, most of us are - it worked, they used our money, and we congratulated them for it. We are idiots. We bailed out those who caused the problem. They get off scot free, with bonuses, and we will face an even worse recession in coming months.
Before the 2008 crash all the main investment banks dealt in derivatives: Merrill Lynch, Bear Stearns, Morgan Stanley, Lehman Brothers, Goldman Sachs, and JP Morgan. Now, they have disappeared, merged, and have re-emerged and continue trading. According to Stacey Herbert, a senior US Market Commentator, derivative trading continues up to the present time and is stronger than ever. 1100 banks are trading them and 94% of all derivatives are currently (2009) traded by Citi Bank, JP Morgan, Goldman Sachs, and Bank of America. Despite derivatives being a key element in the 2008 crash, little discussion into them has been held and, after these mergers of companies and key personnel, it seems they are busier in trading them than ever.
Apparently, the derivative market is a $600 trillion affair. The bailouts have been a response to this derivative collapse. Although it still makes little sense to me, Stacy Herbert asserts that derivatives are a means by which investment banks have confiscated wealth. The bankers have insured various entities in the world economy ten times over, which is why it adds up to $600 trillion, or ten times world GDP of $60 trillion, and "someone needs to be paid when it crashes and burns" - the bankers - but there is no one who can pay, so they get bailed out.
Janet Travakoli explains that we are in the midst of a deflationary collapse evidenced by falling prices, falling profits, and falling tax revenues. She explains that corporate income tax revenue is down 58% and that personal income tax revenue is down 21%. Not to mention seven million new unemployed over the last year. Along with this, the government is borrowing more and more to spend, which is why Peter Schiff says we are headed for inflation, possibly massive inflation, which will overwhelm the deflationary trend.
* I will add more if it begins to make any more sense ...