"It's the Derivatives, Stupid" (MUST READ!)

[Tansy_Gold]

Originally posted in the Week-end Economist thread, but I thought it deserved its own.

I got drawn into the daily Stock Market Watch thread about a year or so ago and at the time I knew nothing about the markets, derivatives, all that stuff. I asked some pretty dumb questions, but I got some pretty damn good answers. And it all came down, really, to some basic common sense.

Today, one of the SMW/WE regulars posted this. I don't often start threads and I'm not big on caps adn !! in subject lines, but I think this one deserves it.


I'm one of those at the bottom of the ponzi pyramid. I'll be among the first to be hit and hit hard when the economy collapses, as I think it will do and in spectacular fashion. Because the Paulson "bail-out" is in fact a gigantic tank of compressed air, and it's just going to blow the bubble bigger and bigger and bigger and bigger and.. . . .


Tansy Gold, who added her own emphasis to the snip below



http://www.webofdebt.com/articles/its_the_derivatives.php

Until recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can “hedge your bet” that something you own will go up by placing a side bet that it will go down. “Hedge funds” hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.

“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.”1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.” Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2

Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they don’t have, and that is where the huge increase in risk comes in.

Credit default swaps (CDS) are the most widely traded form of credit derivative. CDS are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to increase profits by gambling on market changes. In one blogger’s example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims.

And there’s the catch: what if the hedge fund doesn’t have the $100 million? The fund’s corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.

The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives “weapons of financial mass destruction.” It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly

<end snip>

[BlooInBloo]

1. Paper money also has no intrinsic value. She fails....

The issue is regulation, or its lack. Not derivatives, despite what those who don't understand them might say.


EDIT: He's a she.

[mrJJ]

2. Add this to the bill

There is $596 trillion in derivatives debt (Thank You, Sen Gramm), over $2.5 trillion in credit card debt, and $58 trillion in credit default swaps

http://www.wallstreetdigest.com/hotline.php

[BrklynLiberal]

3. The entire stock market and commodities exchanges are "legalized" gambling.

Selling short, buying long, futures, option, etc. It is all betting that the prices are going to go one way or the other.
And who gets the vig????????

[unblock]

10. one can gamble but there's a big difference between these markets and a casino

in a casino, people wager about artificial risks that have no necessity beyond entertainment. the casino creates the risk; the risk of the roulette wheel hitting 17 would not exist if the casino didn't exist. thus, the best risk mitigation strategy would be to shut down the casino.

in the markets, the risk is real, whether the markets exist or not. airlines need jet fuel and are seriously influenced by its price. that's a major risk to an airline. they'd have to bear that risk themselves if it weren't for derivative markets. because of the markets, they can hedge and someone else can take the other side -- as a different hedge for a different risk, or as a speculation. either way, it transfers the risk from someone who doesn't want it to someone who does. that's not gambling.

of course, it is possible to gamble in the stock markets easily enough. just close your eyes and pick a financial instrument. that's gambling. but it hardly means all participants are gambling.

[htuttle]

20. One other difference

Casinos are usually far more regulated than financial markets.

[KoKo]

22. Ha...you probably speak the truth...as a non-gambler I can't say...

and do know the "Mob" is always there. But, then, how do we know they aren't on Wall St.? It was a "new game" for them when the Casinos got regulated. They "moved on" to the next game. :shrug:

[Coyote_Bandit]

4. Derivatives

are a risk management tool and serve the purpose of transferring and thus reducing all or part of a risk exposure. Individually we accomplish the same thing when we purchase an insurance policy. Derivatives are bought and sold in a market with a price attached to the risk which is transferred. They serve a useful and legitimate financial function - something very similar to the use of reinsurance in the insurance industry. The derivatives aren't the problem. The real problem comes when derivatives are used for purposes other than risk management (e.g., profiteering and price control). Because derivatives ought to be a risk management tool those who trade in them ought to be restricted to trading in derivatives which are directly related to their core risk exposures. There needs to be more regulation.

[BlooInBloo]

6. You'll never get know-nothings to go along. Turns out the author cited in the OP...

is anti-science in other areas as well.

[unblock]

8. i agree with everything up to the part about restricting use to core risk exposures

first, it's not always possible to find a perfect/pure hedge, so there's nearly always some risk involved not related to core risk exposures.

second, your suggestion might work for the players who are in those markets for risk mitigation. however, the only way the market is reasonably and accurately priced and remotely liquid is because so many people are welcome to take the other side. should the other side be restricted to insurance companies?

i think there's value in letting individuals take the other side. in effect, a company might have a big, legitimate risk exposure, and it parcels it out to thousands of individuals willing to take that risk.

[FogerRox]

11. Yup, its like gamblers owning the casino.There needs to be more regulation.

[HamdenRice]

14. Wow! Something rational and informed...

in a thread that does not have a lot of rationality or informed information.

Here is something I wrote last week about the first time I encountered derivatives in action:

I'm often appalled at the degree of blind condemnation of derivates here on DU, but their use is quite opaque to most people. One of the first derivates I came across in my career was a company in the U.S. that needed to buy some mineral (I think it was titanium) from South Africa under a long term supply contract. It could have put money in the bank for a contract purchase price needed two years away -- but even then, it wouldn't know what the market price would be, or the Rand/dollar exchange rate -- so it made more sense to purchase both a Rand purchse option and a titanium put hedge. People don't seem to realize there are really useful and necessary business reasons for what looks like gambling -- options and derivatives. On the other hand, I don't see why the people buying and selling things like Rand options and titanium puts should not be required to be operating companies that need Rands and titanium. So to that extent I agree.

[brindis_desala]

19. The simple problem is that the theoretical models developed

for pricing derivatives are not easily transferred to the practical world (i.e. how do they show up on one's balance sheet). Combine that with a lack of regulation and transparency and you have a time bomb waiting for a trip wire.

[Uncle Joe]

16. Screw risk management, buy the stock or don't buy the stock,

derivatives should be outlawed for everybody, no puts, no calls, just buy or sell the stock, keep it simple. If the manager loses money on a stock, fire the manager, that's risk management.

One of the many problems of this bailout being institutional management doesn't even know what they have because it's so complex, keep it simple. Buy or sell a stock and leave gambling to the casinos.

Personally I think insurance in general is nothing but a ripoff anyway, just another means for the corporations to suck the money out of the people.

[Cronopio]

18. "Derivatives are a risk management tool." Yes, and ... ?

The term "risk management tool" covers a lot of area, and means what you want it to mean. Casinos can be seen as risk management tools. Same for buying tickets in the lottery. Same for getting Mafia protection. Basing a system of credit on any of those things is not a good idea.

"The real problem comes when derivatives are used for purposes other than risk management (e.g., profiteering and price control)."

Risk management vs. profiteering - a difference without a distinction. Adding to your profits *is* managing your financial risk.

"Because derivatives ought to be a risk management tool those who trade in them ought to be restricted to trading in derivatives which are directly related to their core risk exposures."

How directly? First-order derivation? Second? Nth?

Any argument you can make for trading in first-order derivatives can be made for nth-order derivatives.

The problem with *all* derivatives is that it makes the valuation of the underlying asset much easier to obfuscate. The mere existence of the partial detachment between the value of the derivative and the value of the asset it is based on automatically creates the obfuscation - you have two separate valuations where there was one. The relationship between those valuations can, and has been, used to create even more obfuscation in the valuation of the underlying asset.

The derivative becomes, in effect, a Trojan Horse. There might be an army inside, or nothing.

You can't run an economy very long on that model of valuation. Real debt has to be paid with real assets when the debt is called. Risk management itself demands this.

[flamingdem]

5. This is the dang focus peops, this is where the hundreds of trillions are

floating around.... this is the fear factor we're dealing with and it is real.

How many years went by where these f**kers were pressing a button and making
millions ...

[valerief]

7. Why can't rich people just stand in line at Cumberland Farms and buy scratch tickets like everyone

else?

[mckara]

9. Thanks for This! I Recommend Linking to the Entire Article

n/t

[KoKo]

23. Yes it's an incredible read and not complicated so one's eyes "glaze over" either.

[specimenfred1984]

12. Great article

It's easy to read and understand and lays out the corruption involved.

[UK populist]

13. Thank You, so when they say its is like the collapse in Japan. LYING

At least the Japanese crash was caused because they actually had their economy propped by the intrinsic value of a property bubble. Which means that although there was a crash the property always had a value that could one day be re-inflated simply by the demand for that property.
In this case there is absolutely no capital value for any of these derivatives once they start to default.
So if all these banks are counting the value of these derivatives as anything more than $0 they are lying to themselves and the markets. If it is true that the size of the trade in derivatives is $1,000,000,000,000,000 and the global financial GDP is only $60,000,000,000,000 then the whole world market system is in debt at a ratio to 16.66-1. So what good is a couple of trillion $s of taxpayer money going to do to try and restore confidence in the markets.

The only solution I can see is that every one of these banks has to be left to fail and the new world markets have to be started from scratch built on the intrinsic value of the commodities that originally built current global market system.

[groovedaddy]

15. Is a "House of Cards" and it places in a precarious position. The practice should be stopped. n.t

[katty]

17. perpetual roulette wheel

[KoKo]

21. If folks knew it was "Derivatives" they were saving and not families in Mortgage Default....I wonder

if Congress would have a chance in hell of passing it. But, it's so easy for them to tell an unsophisticated American Public that our whole way of life will go down the tubes because people took out mortgages they couldn't afford.

It's amazing how they are selling this...and they will get away with it once again. You can't explain to your local neighborhood group what a Derivative is...their eyes would glaze over. Democrats in Congress can't explain it to the people because it's too complicated...and one wonders if any of them understand it, either. So both parties are sort of caught in this mess by the way the Media "frames" it to a frightened American who has insurance, 401-K or even a simple back account where some is in a money market fund for savings.

What a Scam!

Thanks for the link to the article. It's a good read and would hope more DU'ers would take the time to read it.

[Tutankhamun]

24. I see.

Derivatives are to actual goods as the letters "MUST READ" are to the OP.