Understanding Derivatives and Their Risks

Global financial markets are awash in hundreds of trillions of dollars worth of derivatives. By some estimates, the total amount exceeds one quadrillion dollars.

Derivatives played a central role in the 2008 credit crisis, as they had a brutal multiplying effect on the magnitude of the carnage. As a bad asset was written down, oftentimes there were derivative contracts written against it that resulted in total losses 10 times greater than the initial write-down.

What exactly are derivatives? And how do they work?

Have we learned to treat these “weapons of mass financial destruction” (as Warren Buffet colorfully coined them) any more carefully in the aftermath of the global financial crisis?

Not really, claims Janet Tavakoli, derivatives expert and president of Tavakoli Structured Finance.

But the danger behind derivatives doesn’t lie in their existence, Tavakoli stresses. They play an important and constructive role in a healthy financial system when used responsibly.

But when abused, derivatives can create massive damages. So at the root of the “derivatives problem”, Tavakoli stresses, is control fraud – the rampant unchecked criminal action by influential players on Wall Street. Derivatives contracts are too often constructed in favor of these parties, who if they end up on the losing side of the trade, are able to socialize their losses. Until we address this root problem of corruption, says Tavakoli, derivatives (as well as other securities: stocks, bonds, etc.) will continue to subject investors and our markets, overall, to unacceptable risk.

On The Nature of Derivatives

Derivative just means “derived from.” It’s just referencing another obligation, like a bond or an equity, or you can even reference an option. You can have options on futures, as an example. So a derivative is just like handing out fifty photocopies of a model; you know it’s a derivative of something that actually exists.

Let’s take an example. Goldman-Sachs used derivatives they used to help supply money to mortgage lenders by creating securitizations. And those securitizations were simply packaging up loans that were made by people like Countrywide. Countrywide of course was sued for fraud and settled for $8.3 billion with a number of different states for their predatory lending practices.

So you take these bad loans, you package them up in securities, and if you can combine them with leverage, it will always look like you are making a lot of money. That’s classic control fraud, as William Black so eloquently keeps explaining to the market and as our financial media keeps ignoring. Now, how do you combine it with leverage? Well, derivatives are a very handy item if you want to lever something up. So as an example, the Wall Street Journal looked at a $38 million dollar sub-prime mortgage bond that Goldman created in June of 2006, and yet Goldman was able to leverage that up to cost around $280 million in losses to investors.

Now how did they do that? They did that with the magic of derivatives.

Because with a derivative, you can reference that toxic bond, that $38-million-dollar bond can be referenced, you can say If that bond goes up or down in value, the value of your securitization will change as that bond goes up or down in value. So you don’t actually put that bond in a new securitization; instead you use a derivative – a credit derivative, in this case – to reference that bond. And so with the credit derivative, you can basically create as many of those referenced entities as you want. Now, they stopped at around thirty debt pools; they could have done a hundred and thirty.

Because with a credit derivative, all you’re doing is saying you are going to look to the value of that bond and we’re going to write a contract that your money is going to change when that bond goes up or down in value. That’s a derivative. You’re not actually putting the bond in; you’re just referencing that bond. You are basically betting on the outcome of something. And you don’t actually have to own its physical security. Now that’s a derivative. And that’s how derivatives were used to amplify losses and to magnify losses to make a bad situation much, much worse.                

On Control Fraud

The root cause of it is control fraud – people in the financial system being able to do whatever they want and remain unchecked.. Where you have a group of individuals who are well rewarded for this kind of behavior and yet there is no punishment for this kind of behavior. As long as we keep that in place, you will just see more of the same. The way the Fed and regulators have chosen to deal with it is to pretend it’s not happening and just continue to print money. And, as I say, it acts as a neurotoxin in the financial system,

On Derivative Risk in a Market Downturn

When you most need liquidity, it isn’t there. And that’s always true of leveraged products, by the way. You know, the thing that people overlook is – and this is why fraud is such a potent neurotoxin – when the market freezes, when you end in combination with that, when you have a liquidity event, then you see even good assets deteriorate in value quickly, as people need to sell them into a market that has no liquidity. So you get sucker punched a couple of different ways. So if you can’t stand low liquidity, again, you shouldn’t be playing with credit derivatives.

Now, if you custom tailor your contract, it will be more difficult to offload that contract because people will have to take the time to read the contract, if they bother to read it at all. But that said, that’s not a reason not to re-write the language. With the ISDA standard documentation, the hype was, take our language, because if everyone accepts it, it will make it easier to trade these securities. And that was true, until credit events happen and then everyone pulls out their documents and says Oh my god, what did I sign?

On Gold and Counter Party Risk

Counterparty risk is the biggest risk.

And if you’ve been reading the Financial Times, you see a lot of people who are dismissive of gold. Well, here’s an interesting thing: The Derivatives Exchanges accept gold in satisfaction of margin calls.

We had credit derivatives traders who wanted to have contracts on credit derivatives on the United States that would settle in gold. Because if obviously the United States is in credit trouble, what would you want? You would want gold. You don’t want euros, you don’t want any other currency; you want gold. The thing about gold is that you don’t have counterparty risk. And if you look at the rebuttal for people who are saying that gold isn’t money, well, I’m sorry, but gold is being used as money already on derivatives exchanges around the globe. Now that wasn’t true five years ago. It’s true today. J.P. Morgan itself, around eighteen months ago or two years ago, said it will accept gold as collateral in satisfaction of margin calls. So they’ve de facto said gold is a currency.

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