What’s a derivative?
The word “derivative” may ring a bell because Wall Street speculation in “innovative financial instruments” such as derivatives, helped tank the economy 2008.
Mayra Rodriques Valladares provides a good definition in her recent article in the New York Times. “Derivatives Markets Growing Again, With Few New Protections:”
A derivative, put simply, is a contract between two parties whose value is determined by changes in the value of an underlying asset. Those assets could be bonds, equities, commodities or currencies. The majority of contracts are traded over the counter, where details about pricing, risk measurement and collateral, if any, are not available to the public.
Michael Snyder writing at Washingtonblog weighs in on the continued dangers of banks gambling in derivatives in his article “The Size of the Derivatives Bubble Hanging Over the Global Economy Hits a Record High.”
A derivative does not have any intrinsic value. It is essentially a side bet. Most commonly, derivative contracts have to do with the movement of interest rates. But there are many, many other kinds of derivatives as well. People are betting on just about anything and everything that you can imagine, and Wall Street has been transformed into the largest casino in the history of the planet.
So how much money are we talking about?
On May 8 2014, The Bank for International Settlements (the international organization of central banks) reported:
OTC derivatives markets continued to expand in the second half of 2013. The notional amount of outstanding contracts totalled $710 trillion at end-2013, up from $693 trillion at end-June 2013 and $633 trillion at end-2012.
Does $710 trillion sound like a lot of money to you? It should because, by comparison, the U.S. GDP is projected to be around 17 trillion for 2014.
A big chunk of that $710 trillion—$236 trillion—is held by the top 25 banks in the U.S. Of the top 25 U.S. banks, the top five banks hold the lion’s share. The following figures are from Michael Snyder’s post at Washingtonblog:
JPMorgan Chase has about 2 trillion in assets and more than $70 trillion of exposure to derivatives.
Citibank has a little more than $1.3 trillion in assets and more than $62 trillion of exposure to derivatives.
Bank of America has $1.4 trillion in assets and more than $38 trillion of exposure to derivatives.
Goldman Sachs has only $105 billion in total assets, but has more than $48 trillion of exposure to derivatives. That would be 460 times greater than their total assets.
On the international scene, banking giant Deutsche Bank has $2.2 trillion in assets and more than $75 billion of exposure to derivatives
The bottom line, as it were, is this: Derivatives represent another gigantic bubble waiting to, once again, tank the global economy.
Why are banks so overexposed to derivatives?
Louise Story answers this question in her piece in the New York Times of December of 2010:
Perhaps no business in finance is as profitable today as derivatives. Not making loans. Not offering credit cards. Not advising on mergers and acquisitions. Not managing money for the wealthy.
Well that explains a lot. But how do they work? Story offers a good analogy for why derivatives are so profitable:
The profits on most derivatives are masked. In most cases, buyers are told only what they have to pay for the derivative contract, say $25 million. That amount is more than the seller gets, but how much more — $5,000, $25,000 or $50,000 more — is unknown. That’s because the seller also is told only the amount he will receive. The difference between the two is the bank’s fee and profit. So, the bigger the difference, the better for the bank — and the worse for the customers.
It would be like a real estate agent selling a house, but the buyer knowing only what he paid and the seller knowing only what he received. The agent would pocket the difference as his fee, rather than disclose it. Moreover, only the real estate agent — and neither buyer nor seller — would have easy access to the prices paid recently for other homes on the same block.
Did Dodd-Frank do anything to reign in or regulate derivatives?
Dodd Frank set up clearinghouses for derivative trading to introduce more transparency, but like banks that are too-big-to-fail, the clearinghouses were deemed too-big-to-fail by the Obama administration. So Obama insisted they be back-stopped by taxpayer money. Michael Snyder quotes The Wall Street Journal from 2012:
Little noticed is that on Tuesday Team Obama took its first formal steps toward putting taxpayers behind Wall Street derivatives trading — not behind banks that might make mistakes in derivatives markets, but behind the trading itself. Yes, the same crew that rails against the dangers of derivatives is quietly positioning these financial instruments directly above the taxpayer safety net.
Jumping ahead to May of 2014, Mayra Vakkadares explains other reasons why the purposefully weak Dodd Frank bill will not remove the risk associated with derivatives:
As regulations like the Dodd-Frank law and the European Markets Infrastructure Regulation start to take effect, some aspects of the derivatives markets, like pricing and volumes, will slowly become more transparent. What will remain opaque, however, is how banks sell derivatives to clients, in what jurisdictions derivatives are recorded, the strength of risk management, and the extent to which governments and taxpayers can be affected if derivatives are again at the center of a crisis.
As I read these articles on the continued growth of derivatives, and the risky behavior of TBTF banks, I feel betrayed by the Wall Street owned Obama administration, and the Democrats and Republicans in Congress who continue to serve bank interests at the expense of their constituents. This can’t, by any stretch, be pinned on “Republican obstructionism.” The biggest blame falls on Corporate Democrats who pretend to be the party of the people on the campaign trail, but morph into corporate shills on the floor of the House and Senate.
After the financial nightmare of 2008, in which Americans lost trillions in personal wealth, our bank owned elected officials have done nothing substantial to protect us from another financial meltdown. Too-Big-to-Fail banks have grown larger and speculative activities continue in overdrive. Since we have not really recovered from the last crisis, I’m afraid for what the future holds.
Meanwhile a tiny fraction of the population, with the full backing of the U.S. government, continues to enrich themselves at the expense of the rest of us. When people say we should put bankers in jail for their role in tanking the economy, I say forget that—we need to get the money back.