October 29, 2011 in Finance
The current gambling games being played by the banking industry are mind boggling. One game is so outlandish that, when it became popular in 2003, Warren Buffet called it a “financial weapon of mass destruction.” Certain banks, labeled as too big to fail, lost badly at this casino game in 2008, resulting in a need for bailouts via taxpayer funding.
This game is called derivatives.
Now, before your eyes glass over and your mind goes cloudy, I suggest you shake yourself awake and read this article. I’ll do my best to keep it simple because this topic is important, especially if you want to understand the cause of the next financial crisis, one that promises to impact us more intensely than the last one.
Derivatives are bets. These bets are hedges against investments going sour. An astute investor invests in something with the hope of the price increasing. Then, he purchases a derivative or bets that the price will go down. That way, he wins no matter what the price does. The bet has significant odds in the investor’s favor so it is highly leveraged. In other words, the derivative costs less than its value.
This practice has become a booming business. In fact, since they are highly leveraged with favorable odds for the investor, many gamblers – er…investors purchase derivatives as their only investment. Some estimates put the combined value of these bets at six hundred trillion dollars. That’s ten times the entire world’s Gross Domestic Product.
Do you see the problem?
If all of those derivatives came due at the same time, there wouldn’t be enough money in the world to pay them. Granted, this is unlikely to happen. It would take a perfect storm of events.
Of course, unlikely doesn’t mean impossible because this IS exactly what happened in 2008 when the mortgage crisis hit. That segment of the market suddenly lost value and all the related derivatives came due. The banks and insurance companies didn’t have enough money to pay their bets so they asked the government for help. (The documentary Inside Job tells this story. I don’t agree with its message of a need for increased government regulation. However, it does an entertaining job of explaining exactly what happened.)
Banks, insurance companies, and investors did not learn from the 2008 situation. They are repeating the same behaviors today. The situation is setting up for another crisis with the difference being that, this time, the banks are manipulating the system to guarantee that the government will provide funding. Last time, they had to beg. This time, the bailout will be legal.
As a rule, derivatives are not insured by the FDIC because they are not deposits in a bank account. They are uninsured investments that can suffer loss. Bank of America recently found a way around this and transferred derivatives, valued at seventy-five trillion (YES – that’s with a T) from its investment bank arm into its depository arm. This was done upon insistence by the Federal Reserve and without approval of the FDIC.
If those derivatives fail, government will be responsible for an amount that is greater the world’s Gross Domestic Product.
Will they fail? They will if they, like in 2008, are tied to the mortgage market. I’ll explain why in my next article.