While the US and some other world governments have taken some serious financial risks with overspending and excessive debt load, companies and banks around the world are taking even more startling financial risks. Some of those could easily crash the world financial system even if the governments all had no debt and strong finances. Let’s take a look at the worst financial risk — the worldwide derivatives market.
What is a derivative?
From Wikipedia:
A derivative is a term that refers to a wide variety of financial instruments or "contract whose value is derived from the performance of underlying market factors, such as market securities or indices, interest rates, currency exchange rates, and commodity, credit, and equity prices. Derivative transactions include a wide assortment of financial contracts including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards and various combinations thereof."
So what are derivatives, really? Essentially, a derivative is a contract that is entered into as a gamble, involving some future exchange of money that could either be at a profit or a loss. There are many types, including:
Swaps, in which one future cash flow is traded for another
Futures, in which a future purchase/payment is promised at a fixed price
Options, in which money is paid for the right to make a future purchase at a fixed price
Let’s look at some examples.
A swap is arranged between two bond funds where the future payouts are exchanged for a price. If one of the bond funds tanks and its payouts drop, the other bond fund who exchanged for its payout loses money. Similarly, if one of the bond funds soars, since it is now paying the other bond fund money is lost.
A futures contract is arranged between a corn farmer and an ethanol producer. At the end of the harvest all of the corn will be sold to the producer for a fixed price per bushel, agreed upon now. If corn drops in price by then, the producer will have paid too much for the corn. If corn soars in price by then, the farmer will have received too little for the corn.
An options contract is arranged where an investor pays a broker for the right to buy Acme Corporation’s stock at $5 more per share than its current price, 90 days in the future. The payment is made because the broker is taking a risk: if the stock’s price rises more than $5 by then, the broker will have to sell the specified amount of stock to the investor and the broker will lose money. If the stock doesn’t rise enough, the investor won’t exercise the option and the broker will keep the initial payment.
Although the details of these financial arrangements are often quite complex, they are all just speculation, no different than purchasing shares of stock. Any derivative can make or lose money depending on future events that cannot accurately be predicted in advance.
Why are derivatives used?
Derivatives were invented as a means of lowering risk. In the example above with the futures contract, while he might end up paying more than he would have, the ethanol producer is lowering his risk overall by knowing in advance what he will pay for the corn he needs. Derivatives are often used to hedge, meaning, as a way to limit losses incurred by a companion investment.
Unfortunately, more and more derivatives have been used as massive speculative gambles. Since derivatives are so complicated, banks and fund managers can use them to hide from their investors the level of risk they are taking.
Why are derivatives a worldwide problem?
All derivatives vary in value as the future unfolds. In the example of the futures contract between the corn farmer and the ethanol producer, at first the value will likely be zero as they have agreed on a price that they think will even out, so that neither of them loses money on the deal. As the farming season goes on, if a drought occurred and the price of corn skyrockets, the derivative will be a major asset to the ethanol producer and a major liability to the farmer. If instead the growing conditions were far better than expected and corn yields higher than normal, making the price of corn drop, the derivative would be an asset to the farmer and a liability to the ethanol producer. Derivatives are volatile; the value of a derivative can swing wildly as conditions change, alternating between being an asset and being a liability or rising and falling as an asset or a liability.
The volatility of derivatives isn’t a problem by itself. It’s the staggering level of use to which they have risen in the United States and around the world. In late 2012, the Comptroller of the Currency Administrator of National Banks issued a report that US banks were holding $227 trillion in derivatives. Yes, that was two hundred and twenty seven trillion dollars! In volatile derivatives that are gambles that can change in value. The top 25 banks in the United States together hold $212 trillion in derivatives. The total combined assets of those banks are less than $9 trillion.
Imagine those 25 banks’ derivatives dropped just 5% in value. This would be a loss of more than $10 trillion — more than all of their assets combined and far more than enough to completely wipe all of them out. In fact, a drop of only 2% would lose them almost half of all of their assets, which would likely wipe them all out. The Federal Deposit Insurance Corporation (FDIC) would have to step in and repay millions of account holders up to $250,000 for each account lost, which would require trillions of dollars. Where would this money come from?
Even worse, the worldwide derivatives market is estimated to be $600 trillion. The entire world’s GDP is estimated to be around $70 trillion – less than 12% of the derivatives market. Imagine a 2% loss of $600 trillion ($12 trillion) compared to GDP? Or a 5% loss ($30 trillion)?
There have already been huge losses from using derivatives. Barings Bank was once the oldest merchant bank in London, founded in 1762. In 1995, it collapsed because it lost $1.3 billion from investing in derivatives – mainly futures contracts. In 2009, Morgan Stanley had lost $9 billion in derivatives – mainly credit default swaps – and was bailed out by Mitsubishi UFJ . In 2008, Société Générale of France lost $7.2 billion, mostly from derivatives trading. In 2006, Amaranth Advisors collapsed after losing $6 billion in derivatives – natural gas futures contracts. The list goes on.
Imagine you found out that your bank was taking all of its investors’ money and gambling with it. How would you feel about the safety of your money? The $227 trillion on the line in the United States and the $600 trillion or more worldwide is a whole lot of gambling, and at any time, the worldwide financial system could collapse from a few bets gone wrong. The world’s financial system is now a house of cards.