Derivatives May Be a Lethal Financial Bubble

Tuesday, 11 May 2010 10:32 AM

By Arnaud de Borchgrave

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Even the world's most savvy stock-market giants (e.g., Warren E. Buffett) have warned over the past decade that derivatives are the fiscal equivalent of a weapon of mass destruction (WMD) — potentially lethal.

And the consequences of such an explosion would make the recent global financial and economic crisis seem like penny ante. But generously lubricated lobbyists for the unrestricted, unsupervised derivatives markets tell congressional committees and government regulators to butt out.

While banks all over the world were imploding and some $50 trillion vanished in global stock markets, the derivatives market grew by an estimated 65 percent, according the Bank for International Settlements (BIS). The BIS convenes the world's 57 most powerful central bankers in Basel, Switzerland, for periodic secret meetings. Occasionally, they issue a cry of alarm. This time, derivatives had soared from $414.8 trillion at the end of 2006 to $683.7 trillion in mid-2008 — 18 months' time.

The derivatives market is now estimated at $700 trillion (notional, or face, value, not market value). The world's gross domestic product in 2009: $69.8 trillion; America's, $14.2 trillion. The total market cap of all major global stock markets? A mere $30 trillion. And the total amount of dollar bills in circulation, most of them abroad: $830 billion (not trillion).

One of the Middle East's most powerful bankers conceded recently that even after listening to experts explain the drill, he still does not understand derivatives and therefore doesn't trust them and won't have anything to do with them. And when that weapon of mass destruction explodes, he explained, "Our bank's customers, from all over the world, will be saved from the disaster."

What's so difficult to understand about derivatives? Essentially, they are bets for or against the house — red or black at the roulette wheel. Or betting for or against the weather in situations in which the weather is critical (e.g., vineyards). Forwards, futures, options, and swaps form the panoply of derivatives. Credit derivatives are based on loans, bonds or other forms of credit. Over-the-counter (OTC) derivatives are contracts that are traded and privately negotiated directly between two parties, outside of a regular exchange.

All of this is unregulated. What happens between two parties — notably hedge funds — is like what happens between two individuals who bet on the final score of a football or baseball game. Congressional committees have been warned time and again about "ticking time bombs" and "financial weapons of mass destruction" — to no avail, demonstrating that both the U.S. government and the U.S. Congress are dysfunctional.

The need for constitutional reform comes up frequently in Washington think-tank discussions, only to end with the observation that Democrats and Republicans would never agree on anything that momentous.

On May 16, 2006, for example, Richard T. McCormack, vice chairman of Bank of America's Merrill Lynch and former undersecretary of state for economic and agricultural affairs, told a Senate Banking hearing on derivatives and hedge funds in 2006, when the derivatives industry was in the $300 trillion range, "the increasing internationalization of finance and investment suggests the need for an ever-more-global approach to monitoring potentially dangerous problems."

Derivatives played a key role in camouflaging the multibillion-dollar Enron scam in 2001. Similarly, the Long-Term Capital Management (LTCM) hedge fund debacle of 1998 almost slayed the global monetary system. Yet its trading losses was a mere $5 billion. But this derivative-driven collapse seriously threatened the soundness of financial markets.

When the Russian ruble suddenly nose-dived without warning, LTCM found itself exposed with more than $1 trillion in foreign-exchange derivatives. It couldn't pay. The New York Federal Reserve Bank organized a consortium of companies (Bear Stearns, Merrill Lynch, Lehman Brothers) to buy out LTCM and cover its debts. LTCM shareholders were wiped out, but none of the creditors took losses. LTCM was a hedge fund with just 200 employees, but without the New York Fed's intervention, it would have caused a crash felt around the world.

Mr. McCormack pleaded with congressional banking experts to correct any structural or technical problems that could increase the likelihood of systemic risk in the event of future shock to the financial system, such as the Russian default (i.e., debacle) in 1998. No response.

On Feb. 28, 2006, when he was president of the New York Federal Reserve Bank, Treasury Secretary Timothy F. Geithner outlined challenges to financial stability posed by derivatives. No response.

The 2007 U.S. subprime mortgage global disaster was also derivatives-driven — and provoked the biggest financial and economic disaster since the Great Depression.

Mr. McCormack, then a senior fellow at the Center for Strategic and International Studies, explained to the Banking Committee how Italy had secured entrance into the euro by purchasing exotic derivatives that "obscured the true financial condition of the country until after they were admitted" to the new European common currency. No reaction.

The same thing happened with Japan when some banks "purchased derivative instruments, which disguised the actual catastrophic state of their balance sheets at the time." No action.

Today's massive new derivatives bubble is driving the domestic and global economies, far outstripping the subprime-credit meltdown.

Hopefully not belatedly, Congress is considering legislation to curb the use of derivatives and other methods that artificially boost returns. But 13 members of Congress or their wives used derivatives to magnify their daily moves. And one measure proposed by Sen. Blanche Lincoln, Arkansas Democrat, would bar banks from trading in derivatives. This, in turn, would push almost $300 trillion beyond the reach of regulators. Derivatives would become still more opaque. Some say abolish derivatives trading in the U.S. and push it offshore.

The now-bloody Greek tragedy over its debt crisis is echoing through the Federal Reserve and the halls of Congress. Greece's public debt exceeds 100 percent of its economy versus 90 percent (at $13 trillion) for the United States. If you add unfunded U.S. liabilities for Social Security, Medicare, and Medicaid, the long-term shortfall is $62 trillion, or about $200,000 for each American. At least that's the estimate of the Peter G. Peterson Foundation. And Peter Peterson himself says he's now in the business of promoting awareness about public borrowing.

With probable trader error plunging the Dow Jones into a 1,000-point tailspin and back up in 16 minutes, economic and financial prognostication made astrology look respectable. Could Greece be a harbinger of ugly things to come for the rest of the world? Prominent investor Marc Faber, hedge-fund manager Jim Chanos and Harvard's Kenneth Rogoff told Bloomberg China's economy will slow and possibly "crash" within a year as the nation's property bubble is set to burst.


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