Caught in a Derivative World

Derivatives Grow Without Government Regulation
[courtesy Google Images]

Wikipedia

“A financial instrument which derives its value from the value of underlying entities such as an asset, index, or interest rate—It has no intrinsic value in itself.  Derivative transactions include a variety of financial contracts, including structured debt obligations and deposits, swaps, futures, options, caps, floors, collars, forwards, and various combinations of these.”

First, it’s important to grasp that, by definition, “derivatives” have no intrinsic value.  Because they have no intrinsic value, their perceived value is “derived” from something else that has an intrinsic value.  If a financial instrument has “intrinsic value,” its value would not be derived from something else and such instruments could not be “derivatives”.  Derivatives are and must be, by definition, intrinsically worthless.

Therefore, it seems strange, almost incomprehensible, to see that although derivatives have no intrinsic value, just four years ago, researchers calculated that the global value for derivatives totaled $1.4 quadrillion.   More recent calculations indicate that there are “only” $800 trillion worth of derivatives on the globe.

But how can there be $800 trillion worth of anything that’s intrinsically worthless?

Second, the term “derivative” is so broad and generic that it can be used to describe an almost unlimited variety of financial instruments and activities.   For example, our paper dollars are intrinsically worthless, but are still deemed to have value based on or “derived” from the “full faith and credit” and/or “confidence” of the American people.  From that perspective our fiat dollars are “derivatives” and any financial instrument denominated in dollars is at least party a “derivative”.

Our paper stocks and paper commodity certificates are all “derivatives” that have no intrinsic value, but nevertheless are deemed to have a value derived from the underlying value of a particular corporation or tangible commodity.

Given the enormous variety of derivatives, almost any paper financial instrument can be construed as at least partly “derivative” because the paper itself is intrinsically worthless.

Because the perceived monetary value and the variety of derivatives are both so great, the term “derivative” can mean almost anything financial.  Derivatives are therefore omnipresent and yet mysterious to the point of being incomprehensible.

●  How can anything that’s intrinsically worthless still “derive” $800 trillion in perceived value from a world whose annual Gross Domestic Product is only about $75 trillion?  Does it make sense that even though derivatives are intrinsically worthless, their total global value is nevertheless claimed to be more than ten times the world’s annual GDP?

Given that derivatives are intrinsically worthless, they seem to a kind of legal fiction, perhaps a financial illusion, that could be easily disposed of.   After all, how much harm can be caused by something that has no intrinsic value and, in a tangible sense, doesn’t even exist except in our imaginations?

Well, in our brave new world of globalism and fractional-reserve banking, everything is linked to, and dependent upon, everything.  Therefore, if even an imaginary link in our financial chain breaks, the entire global economic system can collapse—and millions, perhaps hundreds of millions, of people might die.

If derivatives somehow fail—no matter how imaginary they may be—our national economy and even the global economy could collapse.  Therefore, derivatives are profoundly important.

Seems crazy, doesn’t it?

But it’s no crazier than having a national (and even world reserve) currency whose perceived value depends on nothing more than public confidence.

●  Derivatives are often sold as a financial “hedge”—an insurance policy against disruptive financial events.

But, if an adverse financial event required all of the $300 trillion US “derivative”/insurance-policies to be paid, it would cost the entire productive effort of the entire world for 10 years.  A debt that great can’t ever be paid.

Get that?  There’s no way that all or even most of the derivatives can ever be paid in full.

OK—so let’s imagine a less extreme financial event that caused just 10% of the world’s “derivative”/insurance-policies to be paid.  That debt could only be paid by the entire productive effort of the world for one year.  Again, a debt that was just 10% of the global derivatives market is too great to ever be repaid.

The truth may be that if just 1% of the global derivatives were required to be paid, the resulting debt would probably be too great to ever actually be paid.  Thus, the derivative market may be about 1% valid and 99% fraud.

More, the illusory derivatives market is fragile.  One little screw-up and the national and/or global economies might implode.

●  Stranger still, banks that issue derivatives are obligated to make good on those derivatives before they make good on any debt owed to “unsecured creditors”.

Who are the “unsecured creditors”?

Ordinary bank depositors.

That’s interesting because, according to Tyler Durden at ZeroHedge.com, there are about $9.3 trillion in US bank deposits and almost $300 trillion in “total US financial derivative exposure”.  Thus, if just 1% ($3 trillion) of the US derivatives had to be repaid, that payment could wipe out the savings accounts of nearly one-third of US bank depositors.   If 2% of derivatives had to be paid, two-thirds of American bank deposits could be wiped out.  If 3% of derivatives ad to be paid, bank depositors might lose all of their deposits.

Some depositors suppose that all of their savings are protected by FDIC insurance.   That’s true, but only up to the limit of the FDIC’s total capital reserves.  Currently, the FDIC has $25 billion in reserves.  $25 billion is enough to insure only 0.26% of all US bank deposits.  $25 billion is enough to insure repayment of only  0.0083%—less than one one-hundredth of a percent—of total US derivative exposure.

Thus, if just a fraction of a percent of total US derivatives exposure had to be repaid, the FDIC could be wiped out.  Once FDIC reserves were exhausted, we’d see a national banking system panic that would quickly bankrupt the vast majority of US banks.  Result?  The vast majority of US bank depositors would quickly see that their credit cards, debit cards, checking accounts and bank deposits were gone, gone, gone and, um, gone.

Thus, the entire US savings deposit system is extraordinarily vulnerable to any event that might cause the repayment of even 1% of derivatives.

●  Bonds are vulnerable to losses caused by rising interest rates.   Many derivatives are tied to interest rates.  They’re “insurance policies” that guarantee that if interest rates climb significantly, those companies that invested in financial instruments (like bonds) would be protected against losses.

For example, suppose I were fabulously wealthy and I decided to invest $1 billion in US bonds when the interest rates were low and likely to go lower.   So long as interest rates stayed low, my investment would be safe.  If interest rates continued to decline, I might even make a handsome profit.

I might be bright enough to know that investing in paper debt instruments was risky.  If interest rates rose, I could lose a lot.  But, I might still believe that such a huge profit could be made in bonds that I couldn’t resist the temptation to invest in paper-debt instruments.

But—seeing as I didn’t acquire $1 billion by being a complete idiot—I could hedge my “bet” on bonds by also investing in some derivatives.  Those derivatives would act as an insurance policy against the possibility that interest rates would climb so high that my bond investments might suffer losses.

By buying both bonds and derivatives, my investment strategy would be something like “Heads I win, Tails You Lose”.

But there’s a problem with my “heads I win, tails you lose” investment strategy:  I’m not the only guy smart enough to use it.  The other “big boys” are just as smart and just as greedy as I am.  Therefore, they’ve also invested in (i.e., “bet on”) paper bonds and also bought paper derivatives to hedge (insure) their bets.

So, if interest rates ever climbed high enough to cause me to lose money on my bond investments, all of the other “big boys” would also lose money on their bond investments.  Thus, at the same time I made claims on my derivative/insurance policy, all of the other “big boys” would also be making claims on their derivatives.  In a sense, rising interest rates could cause a “bank run” on the financial institutions that had sold the derivatives.

But, this wouldn’t be an ordinary bank run of the sort seen in the A.D. 1946 movie “It’s a Wonderful Life” (starring Jimmy Stewart and Donna Reed).  In that movie we saw a bank run at a small bank where scores, perhaps hundreds, of “little guys” heard the bank was in trouble and therefore jostled to get their $10, $20 or even $100 out of the bank’s vault.  Today, if we saw a similar bank run, we might see thousands of “little guys” pushing, shoving and cursing to get their $2,000, $5,000 or even $50,000 out of their savings accounts.

However, if there were an event that triggered claims on derivatives, we wouldn’t see an ordinary “bank run”.   We’d see a “derivatives bank run” that would be very different in that only a few individuals—the few “big boys” who held derivatives—would be demanding that banks pay whatever financial obligations were associated with their derivatives.  But each of those individuals (or institutions) would be trying to collect billions—not thousands—but billions of dollars from the bank.

Thus, a “derivative bank run” might barely be visible in a physical sense.  There’d be no crowd of bank customers screaming for their savings.   There’d be only a few lawyers, politely demanding the funds owed to a handful of individuals or institutions.  But a “derivative bank run” could still be monumental in a financial sense because each lawyer would be demanding billions of dollars.

The FDIC’s $25 billion “insurance policy” is intended to protect against one, two, perhaps even five “bank runs” by the “little guys”.

But there’s no insurance policy—not one—that can protect against a “derivative bank run” by the “big boys”—except for massive and perhaps unconstitutional government intervention of the sort we’ve seen since A.D. 2008.   In a fractional-reserve banking system where every dollar is leveraged ten or a hundred times, the likely result of even a small “derivative bank run” could be a systemic collapse.

●  Why?  Because the bankers engaged in fraud by selling far more “insurance policies” than they could ever hope to repay.  in the event of a “derivatives bank run,” the financial institutions that sold the derivatives would be forced to default on all or even most, of the “big boys’” claims.

That would cause a bunch of the “big boys” to lose much of their investments in bonds—and in derivatives—and therefore suffer huge losses.

Because one man’s paper debt is another man’s paper asset, if the debts due on derivatives can’t be paid, the value of correlative “assets” (the paper derivatives, themselves) would vaporize.   The ripple effect could be massive.

I.e., if I were holding a derivative, made a claim on that derivative and the bank that issued my derivative defaulted, then I’d not only lose money on my bond investments, I’d also lose whatever value was attached to my derivative.  In an instant, I might be reduced from the status of a paper multi-billionaire to that of a man merely holding a handful of paper.

Well, big deal, right?  Who cares if one of the “big boys” is suddenly impoverished?

In fact, everyone should care if a paper-billionaire goes broke because some or all of that billionaire’s paper wealth is probably being used as collateral to fund more loans.  I.e., under fractional-reserve banking, if I had $50 billion in paper-derivatives, I or some financial institution might be able to use that $50 billion as paper collateral sufficient to justify lending as much as another $500 billion in paper loans to others.   Some of my $50 billion in paper wealth might fund construction of new skyscrapers, bridges, businesses, homes or cars.

But—suppose that the bank that issued my $50 billion paper-derivative was forced to default.  Then, the perceived value of my (intrinsically-worthless) $50 billion derivative would instantly crash.   If my $50 billion derivative was suddenly seen to be worthless, it could no longer suffice as collateral for the $500 billion loaned out to fund the building of skyscrapers, bridges, businesses, etc.  All of those loans might have to be called in.  All of those projects might have to stop.  All of the people who’d invested in those projects might lose much of their capital.  All of those working on those projects would be suddenly unemployed.  If banks defaulted on $50 billion in derivatives, the banking system might have to call in $500 billion in loans.  The result could be catastrophe.

All of these numbers are only hypothetical.   My hypothetical $50 billion derivative might only be used as collateral to lend $10 billion.   Nevertheless, the principle remains:  in a fractional-reserve world, almost every investment is so leveraged and inter-dependent, that if just one “little thing” screws up, the entire banking system might collapse.

$300 trillion in US derivatives is not a “little thing”.

$300 trillion in US derivatives is arguably the single biggest thing in US finance.  If just 1% of that $300 trillion defaults, the whole financial system could collapse.  In the midst of such collapse, millions of Americans might not merely be inconvenienced or infuriated—they might die.

Thus, on the one hand, derivatives are no game.  On the other hand, they’re the biggest game in town, the biggest in the country, the biggest in the world—the biggest financial “con-game” of all time.

●  You might suppose that big banks (being lenders) would want higher interest rates so they can make more profits off lending capital to borrowers.  That’d be true—if banks weren’t up to their ears in derivatives.

However, so long as the big banks have issued derivatives which must pay off if interest rates rise excessively, those banks have an unexpected interest in suppressing interest rates.  There’s a mathematical point where rising interest rates could cause banks to lose more money paying off derivatives than they could gain by charging higher interest rates on their loans.

I don’t know where that mathematical point is.  However, given the massive quantity of derivatives, it’s likely that the “mathematical point” in interest rates is fairly low.

I.e., if bankers saw the interest rates rise from 3% to 6%, they’d double their profits from their loans.  Hooray!

But if bankers saw interest rates double, that rise might also be sufficient to cause the bankers to pay out hundreds of billions of dollars on derivative claims.   Unable to pay those billions, the banks would be bankrupt.  Boo!

●  So, here we are, living in a world where big banks—whose principle business is supposed to be earning profits by making loans at relatively high interest rates—have a vested interest  in keeping interest rates low.

Does that make sense to you?

Isn’t the big banks’ interest in suppressing interest rates evidence of the financial madness that’s inherent in our current economic system?

Since A.D. 2008, the Federal Reserve has held interest rates down close to 1%.  The express purpose of these low interest rates was to encourage borrowers to take out cheap loans, spend the money, and thereby stimulate the economy.

However, I believe the primary reason that the federal government and Federal Reserve have both:  1) subsidized the big banks with nearly $2 trillion in Quantitative Easing; and, 2) held interest rates artificially low—was to  prevent interest rates from rising high enough to trigger disastrous claims on derivatives.

The financial collapse of A.D. 2007-2008 was allegedly triggered by a collapse real estate values.  But the real problem was the mortgage-backed securities that were suddenly shown to be “toxic” (worthless) when borrowers began to default on the underlying mortgages.

The “mortgage-backed securities” were derivatives.  They had no intrinsic value.  Their perceived value was “derived from” the value of the underlying mortgages.  When borrowers started to default on their home loans, the underlying mortgages were shown to be worthless.  The resulting loss in home prices was not as critical as the resulting, leveraged losses in the “derivatives” we called “mortgage-backed securities”.

The reason some banks were deemed “too big to fail” was probably that they’d issued more derivatives than they could make good on.  If they defaulted on the derivatives, the whole system might collapse.  Therefore, the gov-co did everything from give the banks free money and also to “buy” the customer’s “toxic assets” (failed derivatives) in order to hold the system together.

But, despite gov-co’s Herculean efforts to save the banks from a “derivatives bank run,” our economy has not recovered.  Instead, the consequences of the failure of “mortgage-backed securities” (derivatives) in A.D. 2008 are still plaguing our economy.

Plus, there’s another round of defaults headed our way based on derivatives that allegedly insure against high Interest rates.  Does government have sufficient resources to withstand another wave of derivative defaults?

●  If US bonds become “toxic assets,” will the Federal Reserve buy them as they once bought the “mortgage-backed securities”?  Isn’t the Federal Reserve already buying US bonds as “toxic assets” insofar as the Fed is purchasing about 80% of all US bonds issued by the federal gov-co?

Still, I have to give the gov-co credit.  I begin to see that gov-co efforts helped us to weather our first big derivative default (“mortgage-backed securities”).  The US and global economies suffered huge losses and slipped in recessions and/or depressions. But we haven’t seen economic collapse.  We haven’t seen economic chaos.  Not yet.

But interest rates are rising and threatening to touch off another wave of derivative defaults.  Does gov-co still have enough resources to weather a second wave of failed derivatives?

75% of Derivatives based on Interest Rates
[courtesy of Google Images]

I don’t think so.  While the “mortgage-backed securities” comprised a relatively small slice of America’s derivatives, the Bureau of Labor Statistics estimates that 75% of derivatives are based on interest rates.  If 75% of America’s current $300 trillion in derivatives failed, there’s no way that even a world government could prevent a collapse.

Sooner or later, the world’s $800 trillion in derivatives will likely collapse the US and global economies.  The only question is “When?”

●  Derivative are defined as “intrinsically worthless”.  Derivatives are known to be intrinsically worthless.

Nevertheless, we’re living in a world wherein, if derivatives are actually shown to be worthless, our national and global economies could collapse.  Thus, a widespread appreciation of the truth about derivatives might be sufficient to plunge our economy into chaos.  Conversely, we are dependent on lies and illusions to sustain our economy.

Our fiat-currency/fractional-reserve financial system is a kind of madness that’s based on illusions and lies.  And almost every one of us is caught in that system, right up to our ears.  The only people who are separated from this madness are those who hold their wealth in a form that is not derivative and not intrinsically worthless.

In view of America’s collective madness, do you begin to understand why it’s so important to flee intrinsically-worthless, paper-debt instruments (whose values are “derivative”) and store your wealth in a tangible media like gold or silver whose value is “intrinsic”?