Derivatives: The House of Cards that Will Financially Destroy the World

For you to believe, we must demystify what derivatives are

Derivatives and the derivatives market are nothing more than a name used to classify a broad set of financial instraments that "derive" their value from other financial instraments, events, or conditions.

If the last part of that definition is making you nervous hold on to you hat. When I am done you will be terrified.

How large is the derivatives market?

According to the Bank of International Settlments semi-annual OTC derivatives report in June 2008 the derivatives market is $683.7 trillion dollars.

No, I did not make a typo. $683.7 trillion dollars. Let me put this in perspective for you. The gross national product (GNP) of the United States for 2008 as reported by the World Bank was 14.3 trillion dollars. The gross national product (GNP) of the world was reported by the World Bank at 69.3 trillion dollars. So, what you know so far is that the otc derivatives market has a market capitalization 10 times the output of all goods and services produced by all people (GNP) on this planet in the same year.

You still at this moment remain clueless as to what derivatives are

Characteristics of Derivatives

They are unregulated
They are private contracts between two or more parties
They involve leverage where factors of 1,000,000 to 1 are not uncommon
There are no minimum captial requirements for entering into these contracts
They involve the principle of hedging (which was meant to spread risk)

Types of Derivatives Contracts

Interest rate derivatives
Foreign exchange derivatives
Credit derivatives
Equity derivatives
Commodity derivatives

As you can see deriviative contracts are placed against finanacial instraments and commodities. There are other types of derivative contracts as well. Here are a few.

Weather derivatives
Freight derivatives
Insurance derivatives
Inflation derivatives
Mortgage derivatives

So what are derivatives?

This likely does not help much, even after what has been presented. At this point to get into the technicals would only serve to blow you away. Very few people, including many that work directly in the business have nary a clue what derivatives really are. So, I am going to provide one example so you can understand what a derivative is. It is important that you understand before I can make my closing points.

An example of a derivatives contract

Weather derivatives are financial instruments that can be used by organizations or individuals as part of a risk management strategy to reduce risk associated with adverse or unexpected weather conditions. The difference from other derivatives is that the underlying asset (rain/temperature/snow) has no direct value to price the weather derivative. Farmers can use weather derivatives to hedge against poor harvests caused by drought or frost; theme parks may want to insure against rainy weekends during peak summer seasons; and gas and power companies may use heating degree days (HDD) or cooling degree days (CDD) contracts to smooth earnings. A sports event managing company may wish to hedge the loss by entering into a weather derivative contract because if it rains the day of the sporting event, fewer tickets will be sold.

Okay, I believe the previous example is one that anyone can swallow and understand. You may even be nodding you head as if to say, "I understand. Why is all this so complicated? It now makes perfect sense to me."

Back to the Derivatives House of Cards

If one of the main purposes of derivatives is really to spread risk we really need to ask the question...

Why do OTC derivative contracts add up to 10 times the worlds GNP?

Additionally, how in the world are we going to regulate something as large as 683 trillion dollars. The answer is we are not!

Back through the Derivatives Looking Glass - A Most Fascinating Story

We need to go back to the Clinton Administration. No kidding.

Long-Term Capital Management was a U.S. hedge fund trading in what we now refer to as derivatives. It failed spectacularly in September 1998, leading to a massive bailout by other major banks and investment houses, which was supervised by the Federal Reserve. Essentially, the Fed made the investment banks that had invested in the fund, buy the fund then shut it down.

Initially the fund was enormously successful with annualized returns of over 40% in its first years. In 1998, it lost $4.6 billion in less than four months following the Russian financial crisis and became a prominent example of the risk potential in the hedge fund industry. The fund folded in early 2000.

Brookley Born, head of the CFTC (U.S. Commodity Futures Trading Commission), which at the time had sole jurisdiction over regulating the derivatives market. Her goal was for her and her agency to do just that. Born was particularly concerned about swaps, financial instruments that are traded over the counter between banks, insurance companies or other funds or companies, and thus have no transparency except to the two counterparties and the counterparties' regulators, if any.

This move was vehemently opposed by Treasury Secretary Robert Rubin, his deputy Larry Summers, and Fed Chairman Alan Greenspan.

Greenspan deployed condescension and told Born she didn't know what she doing and she'd cause a financial crisis.

In June 1998, Greenspan, Rubin and the then head of the SEC, Arthur Levitt, Jr., called on Congress "to prevent Ms. Born from acting until more senior regulators developed their own recommendations." They were successful.

Of course Born was quite the prophet. As you already know in September of 2008 Long-Term Capital Management, a hedge fund involved in derivatives trading went into the crapper.

So the Derivatives Story Ends Happily Ever After?

One would think that this situation would have caused some regulation of the derivatives market. Think again. Actually, the CFTC, though an act of Congress, at the insistance of Greenspan, Rubin, Summers, and Levitt actually lost the ability to be able to regulate the derivatives market.

Much of the economic collapse in 2008 that led us into this period now termed the great recesssion can be attributed to derivatives. It is now March 2010 and still we have no regulation or even a move towards regulation (assuming regulation of the OTC derivatives market is even possible).

While obvious, it should also be noted, that Larry Summers is a key economic advisor to the Obama Administration. It seems the more things change, the more they stay the same.

So There is Bi-Partisan Support After All

The derivatives market was allowed to take-off during the end of the Clinton Administration. It flourished during Bush's time. Now, it seems to be alive and well and prospering under Obama.

It one looks at history, the part of the Washington landscape that does not really change is the part that is independent and in control of our money and our monetary policy. Liberals, Conservatives, Progressives come and go but these folks seem to have staying power.

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