(This article was first posted to survivalblog.com on Sept. 25, 2006.)
Derivatives–The Mystery Man Who’ll Break the Global Bank at Monte Carlo
By James Wesley, Rawles — Editor of SurvivalSlog.com
When I do radio interviews or lecture presentations, I’m often asked: “Mister Rawles, what do you see as a likely ‘worst case scenario’?” People expect me to say “a full scale nuclear exchange in World War III” or, “a stock market crash”, or “a flu pandemic”, or “a sudden end to the current real estate bubble.” But most of them are surprised when I respond: Economic collapse triggered by the popping of the derivatives bubble. Many people that are involved in the periphery of the investing–including most small investors–have never even heard of derivatives. They may have heard of ‘hedge funds”, but they don’t understand what they are. Yet in terms of the sheer number of Dollars, Yen, and Euros traded, these investments represent the biggest financial market of all.
What are Derivatives?
The Derivatives Primer sums it up nicely in one sentence: “Derivatives are financial contracts designed to create pure price exposure to an underlying commodity, asset, rate, index or event.” Another way of putting is it is that a derivative contract is a secondary or “derived” wager on the future price of an investment in an underlying market. It is much like the futures markets for stocks, bonds, and commodities. But a derivative can be something even more speculative. A derivative can be a bet on a incremental market change in yet another bet on an incremental change–in effect a hedge on a hedge, or bet on a bet. There is a global trade in derivatives. There are very few regulations on derivatives. The market is still The Wild West. All traders like to hedge their bets. And these days they typically use exotic derivative contracts to do so.
Derivative contracts can be traded in just about anything: stock, bonds, commodities, credit, interest rates, or currencies. You can place a derivative bet on next year’s price of QQQ (the aggregate price of all NASDAQ stocks), or you can place a bet on the price of tea in China. A corporation can make a forward rate agreement (FRA), predicting the interest rate that it will pay on money that it plans to borrow for a factory expansion in two years. (An agreement to borrow or lend a certain amount of principal at a specified interest rate and time. ) You can even bet on the future of the futures market in pork bellies. Economist Robert Chapman summed it up best when he wrote: “The point everyone misses is buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.”
Hundreds of Trillions in Play
How big is the derivatives universe? As William Shatner would say: “Big, reaalllly big!” The scary thing is that the volume of derivatives trades is much larger than their underlying markets. To give you some perspective, here is a quote from economist Gary Novak, “The total annual product of the globe is around $30 trillion. I estimate that the total value of the global real estate is around $50 trillion. A few years ago, Alan Greenspan said the amount of derivatives on the books was $200 trillion. Then it was $300 trillion. Now, someone is saying $770 trillion.” That’s a lot of zeroes.
Economist Robert Chapman was one of the first to warn the public about the full implications of the derivatives bubble. More recently, there have been many others, most notably Michael J. Panzner, (best known as the author of Stock Market Jungle), who last year penned The Coming Disaster in the Derivatives Market, and Gary Novak, who wrote Derivatives Creating Global Economic Collapse.
In a July, 2003 commentary titled “He’s Forever Blowing Bubbles” (about Alan Greenspan), Dr. Gary North encapsulated the greatest risk of the ever-expanding hedge trading universe. He wrote: “The derivatives market is an interconnected system of debts and credits that are based mainly on expected earnings of assets of all kinds. Sellers of expected earnings discount them in a highly leveraged financial futures market. Winners and losers offset each other in any transaction. It’s a zero-sum game: for every loser, there is a winner, assuming – the central assumption on which our civilization rests – the loser pays off. If he doesn’t, “the knee bone’s connected to the thigh bone; the thigh bone’s connected to the hip bone.” It’s cascading cross defaults time!”
A Precursor: The LTCM Fiasco
The first really big indication of the potential risk of derivatives came in 1999. That was when the heavy-into-hedges trading firm Long-Term Capital Management (LTCM) collapsed. At the time, they were carrying $1.4 trillion (that’s trillion with a “T”, not “B” for billion) in derivatives on their books. But LTCM had only about $4 billion in net asset value, with assets totaling over $100 billion. Again they had about $1.4 TRILLION in derivatives bets on the table when the house of cards collapsed. Then came the bailout–quiet and quick. This took a joint effort between the Federal Reserve and some big banks, minimizing the public outcry. (Unlike the Enron collapse, with the LTCM collapse, few small investors were hurt.)
Former Fed Chairman Al Greenspan ominously noted this in testimony before congress about the LTCM. In his testimony he said: “…on occasion there will be mistakes made, as there were in LTCM and I will forecast without knowing who, what or where, that there will be many more. I would suspect there are potential disasters running into a very large number, in the hundreds.”
Robert Chapman pointed out that had not the Federal Reserve and the big lenders stepped in on the LTCM debacle, the markets would have had to absorb an $80 billion hit. At the time that LTCM went down in ’99, only six banks had notional derivatives exposure above $1 trillion. But there are now dozens and perhaps a hundred or more private banks, investment firms, central banks, and national governments with that much derivatives exposure.
Even before the 1999 LTCM fiasco, there were some forewarnings of derivatives disasters:
- The 1994 bankruptcy of Orange County, to the tune of $1.6 billion, due to some incredibly naïve and foolhardy investments in derivatives by one man that handled investments for the county.
- The 1995 failure of the 233-year old Barings Bank, $27 billion in derivatives bets gone bad were reportedly the result of unauthorized futures and options trading by just one man, described as a “rogue employee.”
- The Asian financial crisis of 1997, where derivatives “played a key role.”
The global derivatives universe hums along nicely in times like these–in times like we’ve had since 1988. There are no nasty LTCM-type headlines. In such times market changes are gradual and incremental. Here are some examples of how derivatives traders make their profits:
- A derivatives trader bets that the Dow Jones will be 2.2% higher next year, while others expect a 1.9% gain.
- A derivatives trader bets that interest rates will increase by .02% while most analysts are predicting a decrease of .02%
- Another trader bets that higher fuel costs will put the pinch on bird guano miners in the South Pacific, curtailing their annual profits.
What the hedge book boys have never encountered is a market with huge swings. (Something like the equities markets between 1929 and 1935.) This would wipe out any derivatives traders if that volatility were to re-occur. Their losses would be monumental.
Again, we are talking about somewhere between $300 trillion and $770 trillion (notional) presently on the casino table. These are boggling figures. The risks, in absolute terms, are incalculable. Don’t forget that directly or indirectly, central (“state”) banks and national governments themselves are now inextricably tied to the derivatives trading universe. They are not just “dabbling in derivatives”. Rather, they are in derivatives up to their necks. If and when the global derivatives bubble ever pops, it may topple not just trading companies like Goldman Sachs, or corporations like GM, Daimler-Chrysler, or RCA, but entire nations. I’m not kidding.
The derivatives market was relatively small when the U.S. markets had their last big hiccup in 1987. And it was even smaller when the commodities markets went through their last big spikes in 1978 to 1981. The whole derivatives universe has grown up since then. So we are in essentially uncharted waters, with no way to predict the effects of huge markets swings on the derivatives markets. The hedge boys will be entering terra incognita. The big market swings will blind-side the hedge traders. The implications could be huge. This will wipe out more than just trading firms and their clients.
As another precursor of trouble ahead, the latest hedge fund fiasco was reported in September of 2006 by Bill Bonner and Lila Rajiva: “Hedge fund Amaranth Advisors [an Energy derivatives firm] managed to lose $4.6 billion – about half its entire value – in a matter of just a few days through a sensational miscalculation of the price of natural gas futures in the spring of 2007. Today’s news tells us the figure has now grown to $6 billion.”
Protect Yourself with Tangible Investments
Be ready for a derivatives implosion. Because of their derivatives books, some major corporations may go down in flames, wiping out investors. Entire currencies might even cease to exist. Protect yourself. Diversify out of dollar denominated paper investments. Hedge into tangibles like silver and gold. Buy some productive farm or ranch land with plentiful water where you’ll fare better if the power grid goes down.
In closing, my advice is to do your own form of hedging. Hedge against the future follies of the big hedge funds. Diversify out of dollars and into tangibles. You can expect trouble to occur when you start to see radical swings in interest rates or in the stock and bond markets. I predict that someday there will be big, bad, financial news about derivatives in the headlines. How big? Reaalllly big.
James Wesley, Rawles (JWR) is a former U.S. Army Intelligence officer and a noted author and lecturer on survival and preparedness topics. JWR is the editor of SurvivalBlog.com.
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