Many years ago Warren Buffett called derivatives “financial weapons of mass destruction”. Today, Wall Street has attempted to ignore this description however, the facts tell us a different story.
So, “What is a derivative?” you may ask, we’ll it’s a kind of couched term that refers to a challenging and complex financial instrument. According to Investopedia, it’s a security that carries with it a price or it’s dependent upon underlying assets. Simply put, it’s a banking institution that’s gone the direction of an asset. It may be stocks or bonds, it may include interest rates as well as gold and other currencies. A more detailed yet depressing explanation is the movie, “The Big Short” that goes on to explain this in more detail.
In the beginning, derivatives were more of a hedge fund that was on a position that your bank would hold. If your bank had large corporate debt, the manager of such portfolios would protect the position using derivatives to show an opposite position. Thus, it was more of a hedge fund on the holdings that you held.
However, today, this isn’t the case. Today, the banks play the markets just as you play them. They’re not hedging their holdings but rather, speculating.
In 2008 and 2009, Bear Stearns, AIG, Fannie Mae and Lehman Brothers all collapsed. In fact, this was the main reason for the financial crash that year. Derivatives were the cause of these failures and are often called “daisy chains” for this reason. If one fails, they all fail.
There are scenarios that create a hedged derivative. A good example would be two banks. We’ll call them A and B. The first bank, Bank A, will have an opposite bet with Bank B. Thus, if they lose a position with the first bank, they can still win the second one. Occasionally, there is a middle man or a third bank that handles the money by handing it back and forth between the two entities. This middle man will also get a cut of the money as their commission.
This small cut or commission could wind up to be several billion in revenue. per the OCC, the bank in this position could trade as much as $247 Trillion and earn upwards of $23 Billion in the process. That’s a profit margin of about 0.0093%. That’s a lot of risk for such a paltry return of funds. However, if you’re the big bank, you’re standing to lose even more. AIG and Bear Stearns were bailed out. Fannie Mae was also bailed out. Unfortunately, they left Lehmans out of this bailout and they were the losers.
What happens when regulators get tougher? Will there be more bailouts? Unlikely. Essentially the banks will have to bail themselves out of the situation and move forward from there. The Federal Reserve Bank has full details of this and how it’s done. Bail-ins are starting up for some European countries. Consider Portugal and Cyprus and even Italy for prime examples. Others are adopting the practices. Soon, taxpayers won’t be the ones running the bailouts. The industries themselves will be fully responsible for bailing themselves out (which only stands to reason as a taxpayer if you’re in debt, you’re responsible for being the one to pay it off after all).
An easier way to explain this might be to say that a bail-in is a bank that is using unsecured creditors to help keep itself afloat. Yes, that’s us, the taxpayers once again. When you put money into the bank you assume that the bank is holding on to your cash. Right? Wrong. In reality, the bank is borrowing your money and investing it to earn interest. To you, your bank account is an asset that you have to pay your bills etc. Per the bank, you’re simply an unsecured creditor that they will be owing money to. In truth, a bank deposit is simply unsecured money.
Right now, only money that is above the FDIC insured amount (Currently $250.000 per banking institution) is used in the bail-in. Thus, if you deposit more than that you’re safe. However, In the 90s Rhode Island had a serious banking crisis. They failed and had a lot of financial issues that destroyed more than one creditor. For weeks and sometimes months, no one could access any of their money while the entire mess was sorted out. Those who were insured couldn’t’ even get their money. It took years for some of the people to get their money. It may become worse before it becomes better.
With $247 Trillion of derivatives in the top 25 banks of the U.S., it can quickly become fuzzy with the numbers. As the economy grows so does the national debt. Thus, the banks have over 13.7 times more money in their derivatives than the entire economy of the U.S. It’s not just the U.S. that is playing with all this money, it’s the foreign exchange as well.
The truth is, that the top 25 banks in the U.S., have just $14 trillion in their assets. Some of these assets are questionable at best. According to the rules that were enacted in 2009, they can allow their value to stay with the market trend. Some of these assets are really only worth 5.7% of their derivative portfolios. What if these derivatives drop? Thankfully, the banks don’t have to market these.
The lion’s share of these derivatives or $231.8 trillion have just $8.1 trillion in their assets to back them. That’s a ratio of just 3.5%
It doesn’t appear that all of the banks have learned the lesson that was shown in 2008 to 2009. While some have reduced their holdings, many haven’t and have instead increased them. Apparently, they didn’t learn by watching other fails.
This may look great on paper. It may appear that the top 25 banks have about 86.8% of their possible derivatives covered in full. However, they are betting again. There is no risk protection if something goes awry. As long as all three of the banks remain solvent, there isn’t an issue, however, when one of them fails, they could all potentially fail.
That leaves a percentage of 13.2 that isn’t covered at all. That’s a pretty high percentage when you factor in all of the potential variables. That’s nearly double the assets.
It’s not clear what a secured position would be. There are many potential offsetting derivatives that can be factored in. Are the banks playing with weapons of mass destruction? It certainly sounds like it.
Clearly investors could vary this directly and indirectly. It can be impacted by any bank failure. You may wish to reconsider your position regarding your money and stop waiting for the next domino to fall like Lehmans did.