The world of global finance is still very crazy. I am talking about derivatives.
A derivative is a financial instrument whose value depends on something else—a share of stock, an interest rate, a foreign currency, or a barrel of oil, for example. One kind of derivative might be a contract that allows you to buy oil at a given price six months from now. But since we don't yet know how the price of oil will change, the value of that contract can be very hard to estimate. (In contrast, it's relatively easy to add together the value of every share being traded on the stock market.)
Derivatives have always had a hallowed place in markets. They are used to hedge risk in the face of volatile commodity prices (wheat, oil). Without this hedging, these markets couldn't function. But in today's Happy World, the vast majority of derivatives are sidebets on interest rates or foreign exchange (FX) rates or anything, really. I am talking about gambling.
I don't want to get into the notional versus market value of the derivatives market, but take my word for it, there are many, many trillions of dollars worth of these contracts floating around out there. And the Too-Big-To-Fail banks make lots of money from these contracts. Robert Kuttner's Blowing a Hole in Dodd-Frank gives us the low-down skinny on FX trades.
Foreign-currency trades, nearly all using derivative instruments, accounted for an estimated 38 percent of total bank profits in the first three quarters of 2010, according to the Comptroller of the Currency. The five largest banks — JPMorgan Chase, Goldman Sachs, Bank of America, Citibank, and Wells Fargo — control fully 97 percent of this market.
To comprehend the real risks today, all you really need to understand is this paragraph from Kuttner's article.
Lehman Brothers collapsed when other large institutions refused to lend it money. The bankruptcy proceeding of Lehman — the one large financial institution that the Treasury refused to rescue in the carnage of September 2008 — reveals that when Lehman went bust, it was the "counterparty" or guarantor of some 930,000 derivative contracts, including credit-default swaps, interest rate, foreign exchange, and energy swaps. When Lehman went down, the party on the other side of the transaction was left holding the bag, hence the need for massive Fed intervention.
Kuttner goes on to describe how Treasury Secretary Timothy Geithner has lobbied to exempt foreign exchange derivatives from over-the-counter (OTC) trading as prescribed by Dodd-Frank, despite the fact that—
... previously confidential information recently made public by the Federal Reserve Board reveals that in the aftermath of the collapse of Lehman Brothers in September 2008, the Fed pumped in $5.4 trillion over a three-month period to keep the foreign-currency market from collapsing. The Fed's peak injection of dollars on any one day occurred on Oct. 22, 2008, when it reached $823 billion, according to a Wall Street watchdog group's, Better Markets, analysis of the Fed data release.
But we are just warming up. You may have heard that Standard & Poors (S&P) downgraded the credit rating of the United States. Huffington Post report Shahien Nasiripour covered the story in Financial System Riskier, Next Bailout Will Be Costlier, S&P Says.
The next bailout? This is where things go over-the-top, bat-shit crazy, so I feel compelled to whip out the red font.
The financial system poses an even greater risk to taxpayers than before the crisis, according to analysts at Standard & Poor's. The next rescue could be about a trillion dollars costlier, the credit rating agency warned...
The potential for further extraordinary official assistance to large players in the U.S. financial sector poses a negative risk to the government's credit rating,” S&P said in its Monday report.
But, the agency's analysts warned, "we believe the risks from the U.S. financial sector are higher than we considered them to be before 2008."
Because of the increased risk, S&P forecasts the potential initial cost to taxpayers of the next crisis cleanup to approach 34 percent of the nation's annual economic output, or gross domestic product. In 2007, the agency's analysts estimated it could cost 26 percent of GDP.
Last year, U.S. output neared $14.7 trillion, according to the Commerce Department. By S&P’s estimate, that means taxpayers could be hit with $5 trillion in costs in the event of another financial collapse.
S&P doesn't want to get caught with its pants down this time! You may recall that they certified as AAA all those garbage subprime loans that went bust when the housing bubble had its inevitable meeting with a pin. However, that's just a nitpick. The real insanity is the assessed "potential initial cost to taxpayers," which S&P puts at 34% of nominal GDP, or about $5 trillion (5,000,000,000,000). Where's the risk?
"Systemic risk is greater now," said Mark T. Williams, a finance professor at Boston University and a former bank examiner for the Federal Reserve. "It was uncorked because of the fall of Lehman Brothers, and the genie has been let out of the bottle," he said, referring to the September 2008 failure of the former investment bank.
The continued rise of globalization and the separate growth of derivatives — financial instruments that aim to spread risk — have led to greater connections between countries, industries and companies, Williams said. The level of so-called interconnection has tied firms to one another in ways experts do not completely understand. Regulators and policymakers didn't know how interconnected various banks and insurance companies were prior to the near-financial meltdown of 2008.
Note that the phrase "spread risk" is ambiguous. Here it is used to mean "dilute" risk, but perhaps the more accurate reading would be to literally spread risk so that in the end, there is risk everywhere you look. After all, that's what we've got. You can see why it's important that all derivatives be traded OTC so that risks can be prevented or assessed ahead of time. Let's go on.
Because the giant insurer American International Group, better known as AIG, was connected to so many firms through derivatives, policymakers felt forced to bail the company out when it ran into trouble.
"Systemic risk knows no national boundaries," said Williams, who published "Uncontrolled Risk," a book on the topic, last year. "It is not random or a force of nature, it is man made. [And] the global financial market remains fragile due to weak policies, lax regulation, poor accountability and systems not designed to capture global risk management."
All this led Marc Faber, aka. Dr. Doom, to make the following assessment on CNBC in July, 2009.
I think we had a crisis and nothing has been solved. If you look at how the system works, the derviatives market, how banks operate, the profits at Goldman Sachs...usually, a major crisis like we had should clean the system. And nothing has been cleaned, its gotten worse. Politically, the linkage between the politicians in America, and the Federal Reserve, and the Treasury Department, and Wall Street and so forth. The big crisis will yet come. It will be huge, it will be total collapse. A total collapse!
The unstated assumption throughout Nasiripour's Next Bailout article goes like this—
The "taxpayer" (that's you and me) assumes all of the risk without partaking in any of the benefits of our crazy (but highly profitable) financial system.
This is not a world I want to live in. Why should you and I be put at risk by sociopathic politicians and bankers? Why should we be at their mercy? Who made them special? I know it's only wishful thinking to say it, but I say let it fail, let it collapse, let's start over.
Unfortunately, that's not how Life Works. After all, if these mentally unbalanced psychologically challenged financial and political wackos big shots weren't screwing us, what would they do with themselves all day long?
Bonus Video
[tongue planted firmly in cheek]You're just jealous of all those rich people who are so much more successful than you are![/tpfic]
Posted by: Loveandlight | 04/22/2011 at 11:30 AM