Wednesday, June 4, 2008

The Derivatives Market is Unwinding!

A couple of months ago, a financial analyst who sells derivatives told me that fears about a meltdown in the derivatives market were unfounded.

Yesterday, he told me - with a very worried look - "THE DERIVATIVES MARKET IS UNWINDING!"

What does this mean? What are derivatives and why should you care if the market is unwinding?

Well, it turns out that the reason that Bear Stearns was about to go belly-up before JP Morgan bought it is that it had held trillions of dollars in derivatives, which were about to go south. (The reason that JP Morgan was so eager to buy Bear Stearns is that it was on the other side of these derivative contracts -- if Bear Stearns had gone under, JP Morgan would have taken a huge hit. But the way the derivative agreements were drafted, a purchase by JP Morgan canceled the derivative contracts, so that JP Morgan didn't experience huge losses. That is probably why the Fed was so eager to broker - and fund - the shotgun marriage. JP Morgan is a much larger player, and if Bear's failure had caused the derivatives hit to JP Morgan, it probably would have rippled out to the whole financial system and potentially caused an instant depression).

In addition, the subprime prime loan crisis is intimately connected to the unwinding of the derivatives market. Specifically, loans were repackaged into derivatives called collateralized debt obligations (or "CDO's") and sold to both big and regional banks and investment companies worldwide. The CDO's were highly-leveraged -- many times the amount of the actual loans. When the subprime loan crisis hit, the high leverage magnified the fallout, and huge sums of CDO derivatives became essentially worthless.

Do you remember when wealthy Orange County, California, went bankrupt in 1994? Yup, that was because it had invested in bad derivatives.

And, according to a recent article by one of the world's top derivative insiders, the market for credit default swap ("CDS") derivatives is also unraveling.

And reported just today, Lehman Brothers is now on the edge, due to exposure to derivatives.

Derivatives are the Elephant in the Living Room

The subprime mortgage crisis is bad, and is hurting many people, and slowing the economy. High oil and food prices are bad, and are hurting many people, and bringing down the economy. But -- according to top insiders -- derivatives are the elephant in the room . . . the single largest threat to the U.S. and world economy.

One reason is that, according to Paul Volcker, the former chairman of the Federal Reserve, the entire modern financial system is based upon derivatives, and the financial system today is entirely different from the traditional American or global financial system because derivatives - a relatively new concept - now underly the entire fabric of the financial system. In short, many of the people who know the most about derivatives say that the current system is a house of cards built upon derivatives.

Moreover, as mentioned above, the subprime and derivatives crises are closely linked. Similarly, Britian's New Statesman newspaper links derivatives and rising food and commodity prices:

"This latest food emergency has developed in an incredibly short space of time - essentially over the past 18 months. The reason for food "shortages" is speculation in commodity futures following the collapse of the financial derivatives markets. Desperate for quick returns, dealers are taking trillions of dollars out of equities and mortgage bonds and ploughing them into food and raw materials. It's called the "commodities super-cycle" on Wall Street, and it is likely to cause starvation on an epic scale.

The rocketing price of wheat, soybeans, sugar, coffee - you name it - is a direct result of debt defaults that have caused financial panic in the west and encouraged investors to seek "stores of value". These range from gold and oil at one end to corn, cocoa and cattle at the other; speculators are even placing bets on water prices."

Hiding the Ball

And yet banks and financial houses have hidden their derivatives exposure off the balance sheets. No wonder almost no one understands derivatives:

"Not only [world's richest man] Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't 'figure out'" the derivatives market.
Indeed, the government may have actively helped to hide the the derivatives mess since at least 2006. For example, according to Business Week:
"President George W. Bush has bestowed on his intelligence czar, John Negroponte, broad authority, in the name of national security, to excuse publicly traded companies from their usual accounting and securities-disclosure obligations."
Former fed chairman Alan Greenspan has been a huge booster for and defender of derivatives since 1999 or before (and see this). Did you know that the same guy that pushed subprime loans has also aggressively pushed derivatives for many years?

And the other regulatory agencies and Congress have taken a totally hands-off approach towards derivatives.

How Big a Problem?

How big is the derivatives market? Worldwide, it is $596 TRILLION dollars *. The derivatives market dwarfs the real market for goods and services, and acts likes an unregulated black market.

As one writer put it:
"It’s all smoke and mirrors. The financial system has decoupled from the productive elements of the economy and is now beginning to show disturbing signs of instability."
And its not just the U.S. Derivatives salesmen have sold these babies all over the world. Because banks, financial institutions and governments world-wide have bought significant derivatives, the fall out will not be limited solely to the U.S. See this and this.

If the derivatives market is truly unwinding, as my investment advisor friend and some of the top industry insiders say, we could be in for a very bumpy ride.

For further information on derivatives, see these articles:

http://www.global-derivatives.com/index.php?option=com_content&task=view&id=185
http://en.wikipedia.org/wiki/Derivative_%28finance%29
http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2008/04/17/cnlibor117.xml
http://www.bankingtimes.co.uk/09062008-central-bank-body-warns-of-great-depression/

* This is the "notional value". The actual amount of potential losses from a meltdown in the derivatives market is smaller, although still very large.
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