Friday, June 8, 2012

Derivatives for Dummies And Why The Politicians Refuse To Discuss Them.

Introduction and background.

While attempting to engage in political and/or economic debate I frequently ask what the other person knows of financial derivatives and how they play into the economic picture.  More frequently than not I am met not with an honest admission of an absence of knowledge, but a hyper-sensitive denial that they are in any way relevant to the discussion.  Some so engaged are so sensitive on the issue that they quickly sink to the personal pejorative as a means of distracting from the issue.  I have found those on both the left and the right, to varying degrees, are guilty of this tactic.

The question of course is a rhetorical one.  I have found that putting it forth demonstrates not just their lack of understanding of what derivatives are, how they function and effect markets, but also how this absence of knowledge obviates their political posturing, not to mention any personal attacks they make.

This then leads to a follow up question; How can anyone propose a viable political direction or solution to a problem when they don’t have the first inkling of the realities that created the problem in the first place?  This then leads to several alternative reactions; 1) flatly refusing to further engage, 2) renewed vituperation's, or, 3) the favorite fall back position ,that they were just expressing an opinion, and that of course all opinions are equally valid or worthy of consideration.  It’s at this point I tell them that I have an opinion on that as well; what utter drivel. 

Anyone with any intelligence or intellectual honesty would no more ask grocery store clerk to explain a cancer diagnosis than they would ask a political partisan, particularly a liberal one to explain the implications of derivatives.

The aforementioned repeated experience inspired this piece.


Contrary to what few stories one might find among the orthodoxy of economic talking heads, derivatives aren’t really all that complex.

They can be best explained by constructing an analogy or two that even the partisans among us should be able to understand.

Derivatives are quite simply a form of insurance policy.  Nothing wrong with insurance right?  Well no, unless of course the value of those policies outweigh the assets of the underwriters on a scale of several hundreds to one.

Imagine if you will the U.S. were to experience a disastrous hurricane season.  A dozens cities along the Gulf coast and the eastern seaboard are destroyed.  Think Katrina on steroids.  Most of those homes and businesses are insured of course and the owners will file the requisite claims for financial restitution.  Except that if the sum total of all the claims exceeds the cash reserves and liquid assets of the underwriters, they go bankrupt.  Not only do the claims not get paid and the policyholders are destroyed, but all of the stockholders and bondholders in the insurance companies are also wiped out.  This includes not just individuals, but because of interconnectedness, many banks, credit unions and mutual funds.  Even more insanely insurance companies underwrite policies against each other’s insolvency.  This is a derivative know as a default swap.  The failure of one threatens the solvency of all.

This is exactly what happened to AIG. They had insured the assets and solvency of GM, Chrysler, Lehman Brothers and Merrill Lynch.  When they went belly up AIG did not have the assets to cover the losses, so the good old U.S. taxpayer was called to the rescue.

To make matters worse, the repeal of the Glass-Steagall act has allowed the banks to become insurance companies and to issue some charming little derivatives known as  “naked swaps.”  These are nothing more than insurance policies issued to individuals and corporations who hold no underlying interest or liability in the insured asset (if you want to call debt an asset, but that’s not the point).

Picture if you will, you want to buy a new car.  You have the down payment or the trade-in but you need to go to the bank and borrow $20,000.00 to complete the purchase.  In order for the bank to loan you that money you must show them that you have insurance to recover the value and repay the loan in case of theft, an accident or some other total loss.  Now imagine that 99 of your neighbors also took out insurance policies against the value of your car.  They don’t make the payments, they don’t pay the taxes and they don’t buy you gas, but if you suffer a loss, not only does the insurers have to pay off your creditor for the $20,000 loan, they also have to pay your 99 neighbors $20,000 each on their claims.  So the insurance companies end up shelling out $2,000,000 on an asset that was only worth $20,000. 

Criminal fraud you say?  My point exactly, but that is just what we are faced with.  It’s not just the $140 billion in Greek debt that would get wiped out in a default, but $1.4 TRILLION in derivative insurance policies (Credit Default Swaps) that would come due and could not possible be paid.  Now multiply that number by 4 or 5 for Spain and 6 or 7 for Italy and you might begin to see just how untenable a situation the banks have put the entire world in.  So greedy are they to collect small premiums on hundreds of huge policies that they have placed us all in peril. BofA alone has underwritten $50 Trillion in derivatives, JP Morgan another $70 Trillion (that they admit to).    The total derivative market is estimated at over $1.4 QUADRILLION!  How many people can even grasp the size of that number? I know I have a hard time with it.  I do know it is more money than exists or has ever existed.

If I am afraid of anything it most certainly is not being faced with any sort of caustic hyperbole.  But derivatives do scare me, as they should scare anyone who has even the smallest grasp of economics and the size of the numbers involved.

Unfortunately for the politicians and their media hacks, once the derivatives issue enters into any honest analysis of the current financial crisis, they destroy both the arguments of the right for so-called austerity and the arguments of the left for more stimulus and increased taxation.  Hence the refusals by both sides to consider or even discuss them in any context.  Better for them to pretend they don’t exist or are irrelevant to the situation.

Anyone who knows me understands that I hold the POLITICAL right and left in equal contempt as they are both beholding to the same crony capitalist (i.e. fascist/Fabian socialist) financial interests on Wall Street and at the Eccles Building.  The concepts of formation and implementation of policy have not been subsumed but completely lost in the obfuscations of political arguing.

What I am is an unrepentant classical liberal and capitalist, the very thing that both sides mutually fear and loathe.  Neither side wants the voting public or even their own political hacks and operatives to understand that in the post Eisenhower/Kennedy period we have politically devolved into a one party state that just happens to have a façade of right and left wings. 

We elect Republicans for a term or two and they pillage our economy and rights.  We get tired of them so we elect Democrats for a term or two and they do the same thing until the public grows weary of their pillaging.  Rinse repeat, rinse repeat. Nothing changes except for the worse, and the game goes on with each side concerned with nothing but the maintenance of their own position and power. 

As it now stands we are reaching the limits of this corrupt game.  The cancerous infection of debt and deficits has grown beyond the point of any possible political excising, not that either party would be willing to do that even if it were possible.  Their aforementioned financial owners would never allow it.  Such an action would not only destroy their institutions but would leave individuals exposed to criminal charges both nationally and internationally.

The precedent for such trials was established at Nuremberg where Nazi finance minister Hjalmar Schacht was in the dock along with the other leading Nazis.  That he was acquitted was a great travesty of justice.

(As an aside, I state that not just as a personal opinion. In the early ‘70’s I had the great pleasure of meeting Bernard Metzler, the man who was originally charged with preparing the prosecution’s case against Schacht.  He asked to be removed from that charge after complaining to Chief Prosecutor Roberts that he was coming under pressure from other member of the staff to drop the charges “for political reasons.”  He also stated that in conversations he had with Roberts and some of the judges after the trial, that Schacht was acquitted because “the political pressures were to great.”  He further said that in his mind he interpreted that to mean threats, but he didn’t think it could ever be proven.  Schacht’s personal and financial connections to FDR’s Ambassador to the USSR, Averell Harriman, were to numerous and ugly to withstand scrutiny at the time. He was too powerful and too well placed within the Truman administration.)

So then the financial elites will fight to the very end to protect themselves and their power, to keep the citizens in perpetual debt bondage.  They will use their politicians and media operatives as their front line shock troops to hide their own culpability.  They know full well that the end result of their game will be disastrous, but they think they are well enough insulated by power and money that they will be left as the last man standing so to speak.  They will be laughing all the way to the their vaults as the politicians, media shills, and naïve hacks end up bearing the brunt of the public’s wrath.

We need to wake up, all this talk about raising taxes a few billion here or there or cutting the budget a few billion over 10 years is utterly meaningless.  You might as well try to lower the level of Lake Michigan with a bucket.

Nothing in the worlds of political economy or financial gamesmanship is as simple as any left vs. right argument.  Anyone who tells you it is, is either a fool or trying to play for one.

And that is why I have said taking everything, all sovereign debt back to zero is the one and only debt solution.  Would that be fair to some and unfair to others?  Yes but it would strip the banksters of much of their power and provide a foundation upon which economies might be rebuilt.  Unless of course you like the idea of a deflationary collapse followed by hyper-inflation like no one has ever seen.

5 comments:

  1. Yes, great article. Why haven't we heard much more from this writer before? I found his article on Greg Hunter's USA Watchdog. Love to read more from this guy. Keep buying gold and silver friends, especially if you are unlucky enough to live in America. Good luck to you all . . . Thank you for the article. (Brian, Sydney Australia).

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  2. Good read. I agree with much of what was said, however, the insurance analogy is incomplete.. not necessarily incorrect though. Derivatives are often used as a form of insurance. Although, just as the definition of a "car" is not "a Ford Taurus". A Ford Taurus is a car, but not all Ford cars are Tauruses, nor are all cars made by Ford.
    In the simplest term a derivative is "an agreement between two or more parties" (these days a "bet" is more accurate). Typically a derivative is simply something, ie an ETF, that derives it's value from an underlying asset.
    Say you wanted to invest in some gold.. you could go to the COMEX and buy a wholesale lot of gold which would be the physical asset (or at least rights to it). Or you could buy into an ETF. The ETF share is not gold (or the rights to) but the value of that ETF is derived from the Gold holdings (or futures or whatever) held by the ETF.
    They're often used as a form of insurance. Though the derivative market is much broader and encompasses much more than just default insurance or hedging. The total global derivative market is about $700 Trillion dollars right now.. much of it leveraged multiple times to boot.
    Anyway.. Good article I enjoyed reading it. Thank you, Bob in Phx AZ.

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  3. This article is the most on-target solution to end the bankers' strange hold on our doomed economy I have ever read.

    For more informmation on this topic, read "The Bond Jubilee" by Jeff Nelson which described the numerous downfalls of "fiat money' that was first introduced by the Chinese 1,000 years ago.

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  4. Ed,
    50 Trillion by BofA and a Quadrillion are staggering numbers. I have shared some of this information with my conservative friends and they do not believe these numbers. Can you give me some additional info and possibly the resources you used to find this information.

    Mdrudy1@aol.com

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