AKA, "Too Big to Fail" -- Part II.
First some not-so basic concepts and definitions ...
DEFINITION of 'Derivative' -- investopedia.com
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage.
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The Barnyard Basics Of Derivatives
by Andrew Beattie -- investopedia.com
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Gail, the owner of Healthy Hen Farms, is worried about the volatility [aka Risk] of the chicken market, with all the sporadic reports of bird flu coming out of the east. Gail wants a way to protect her business against another spell of bad news. Gail meets with an investor who enters into a futures contract with her.
The investor agrees to pay $30 per bird when the birds are ready for slaughter in six months' time, regardless of the market price. If, at that time, the price is above $30, the investor will get the benefit as he or she will be able to buy the birds for less than market cost and sell them on the market at a higher price for a gain.
If the price goes below $30, then Gail will get the benefit because she will be able to sell her birds for more than the current market price, or more than what she would get for the birds in the open market.
By entering into a futures contract, Gail is protected from price changes in the market, as she has locked in a price of $30 per bird. She may lose out if the price flies up to $50 per bird on a mad cow scare, but she will be protected if the price falls to $10 on news of a bird flu outbreak.
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Offsetting or trading away Market-Risk -- sounds reasonable. What could possibly go wrong with this picture?
Berkshire Profits Plummet Thanks To Buffett's Bets On 'Financial Weapons Of Mass Destruction'
by Sam Ro, businessinsider.com -- Nov. 5, 2011
[...] In fact, one of the most vocal critics of derivatives is Buffett himself. Check out the prescient comments he made about derivatives in his 2002 letter to shareholders:
We view them as time bombs, both for the parties that deal in them and the economic system...In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.
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In case you forgot, Berkshire had sold put options on the S&P 500, FTSE 100, Euro Stoxx 50, and the Nikkei 225. Given the stock market's poor showing in Q3, it's no surprise that the value of Berkshire's option positions fell.
However, these puts don't start to expire until June 2018, which is consistent with Buffett's long-term bullish thesis on stocks. [...] So, Buffett has plenty of time to see the stock markets rebound.
Well, if Buffett can simultaneously critique and invest in these "WMD contracts" at the same time -- they must serve some useful purpose, right?
Well, on rare occasions having excess bombs on-hand might be useful too, but that doesn't necessarily mean -- we should go crazy with them.
Such Weapons, are most usually, a short-term solution to much longer-term problems. Such Weapons have consequences. (... in ways usually too numerous to count.)
Remember when Wall Street markets collapsed due to TBTF Banks, over-use of "Derivatives" to turn our personal Mortgage Obligations -- into their own personal Poker Chips?
And then one day, all those "gambling markers" all came due -- AT ONCE!?
Remember that fun little chapter in Wall Street Deregulation?
Well, that's what can happen when normal Risk-hedging is allowed to turned into "Securitize Everything" speculating ...
"Collateral damage" too often gets left in its wake ...
Why Were Banks Allowed to Bet on Derivatives?
by busadmin, pbs.org -- May 20, 2009
Question: How did the dollar volume of U.S. mortgages get to be such a huge dollar problem? Did derivatives do that? Why are investment banks allowed to bet 34 dollars for only one they have?
Paul Solman: First, a word on behalf of “derivatives.”
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Now contracts in this market don’t just protect producers of pork, or any other commodity. Think about someone who needs to buy pork, like Kevin Bacon, for his hot dog business. The risk to him is that the price will rise. So he could take the other side of a contract like Mac’s, and lock in a price of no more than $150.
In effect, the parties would be swapping risks at a minimal cost -- basically the commission the market takes for brokering deals like these, using derivatives.
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The problem, of course, is that anyone can just gamble with them -- speculate. And that’s the cause of the current crisis: too much gambling.
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A speculator thinks he can see the future, and wants to bet on his vision. In his mind’s eye, perhaps, he sees Mad Cow Disease sweeping the land, killing the cattle industry, and thus forcing desperate meat eaters to switch to pork, driving the price way up. So, he can take the other side of the Big Mac contract, just like Kevin Bacon did, promising to pay $150 six months from now, and rooting for the price to rise. That’s speculation.
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“And that’s what makes markets efficient,” Professor Partnoy explained. “Because the price will reflect all information that’s available in the market. [...]
Or so the price level-seeking rationale goes ...
One question: Who protected the Home-owner's interest, in their Mortgage-Backed-Security investment schemes?
Answer: No one did.
Think that could never happen again -- those market-collapsing dominoes ALL being called in simultaneously -- after the watered-down Wall Street Reform, in the aftermath of the Mortgage Crisis/Scandal?
Well think again ... that reform put a big focus on Derivatives Clearinghouses ... but that basically just gives, under-staffed and unmotivated Regulators -- a Bigger Magnifying Glass ...
But not necessarily the 'fire' to use it ...
Derivatives Clearinghouses Are No Magic Bullet
by Mark J. Roe, online.wsj.com -- May 6, 2010
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Consider two of our biggest derivatives-related failures—Long-Term Capital Management in 1998 and the subprime market in 2008. When Russia's ruble dropped unexpectedly, LTCM was exposed on its more than $1 trillion in interest-rate and foreign-exchange derivatives. It could not pay up and collapsed. Ten years later the market rapidly revalued subprime mortgage securities, rendering several institutions insolvent. AIG was over-exposed in credit default swaps tied to the value of subprime mortgages.
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AIG needed $85 billion in government cash to avoid defaulting on its debts, including its derivatives obligations. Could one clearinghouse meet even a fraction of that call without backup from the U.S.? True, we could have many clearinghouses, each not too big to fail—but then maybe each would be too small to do enough good.
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Those new-fangled light-of-day Clearinghouses, haven't slowed the Derivative Party much, quite the contrary ... if
Volume of Derivative Activity, is any kind of significant indicator, of on-going speculation:
5 U.S. Banks Each Have More Than 40 Trillion Dollars In Exposure To Derivatives
by Michael Snyder, RINF Alternative News, rinf.com -- 2014/09/24
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According to the Bank for International Settlements, today the total notional value of derivatives contracts around the world has ballooned to a staggering 710 trillion dollars ($710,000,000,000,000).
And of course the heart of this derivatives bubble can be found on Wall Street.
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JPMorgan Chase
Total Assets: $2,476,986,000,000 (about 2.5 trillion dollars)
Total Exposure To Derivatives: $67,951,190,000,000 (more than 67 trillion dollars)
Citibank
Total Assets: $1,894,736,000,000 (almost 1.9 trillion dollars)
Total Exposure To Derivatives: $59,944,502,000,000 (nearly 60 trillion dollars)
Goldman Sachs
Total Assets: $915,705,000,000 (less than a trillion dollars)
Total Exposure To Derivatives: $54,564,516,000,000 (more than 54 trillion dollars)
Bank Of America
Total Assets: $2,152,533,000,000 (a bit more than 2.1 trillion dollars)
Total Exposure To Derivatives: $54,457,605,000,000 (more than 54 trillion dollars)
Morgan Stanley
Total Assets: $831,381,000,000 (less than a trillion dollars)
Total Exposure To Derivatives: $44,946,153,000,000 (more than 44 trillion dollars)
And how much "economic activity" does
the WORLD's total economy produce, to "back-up" those 'notional bets' -- assuming in the worse case scenario -- that too many of these "stable risk swaps" decide to fail --
simultaneously?
Well, as with those under-capitalized Banks, even the World apparently doesn't have "enough capital on hand" to cover the debts -- by about a factor of 10-to-1 [710T to 72T ... and that's in $ Trillions!!! aka. "a Million, Millions."]
The statistic shows global gross domestic product (GDP) from 2004 to 2014. In 2012, global GDP amounted to about 72.1 trillion U.S. dollars.
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The Statistics Portal
No worries though, the low-profile association of Derivative Traders, is proposing a paper solution, that forestalls and short-circuits -- that Over-levaraged D-Day ... I don't know, in case something like an Ultra-Extreme Heat-Wave wipes out most of the Chickens, Pigs, and Cows markets -- all AT ONCE ...
In case of that kind of D-Day ... these D-traders now have "a quick fix" in the hopper ... sort of:
Ending ‘Too Big to Fail’ Could Rest on Obscure Contract Language
by Jesse Hamilton and Silla Brush, bloomberg.com -- Jul 29, 2014
Wall Street and global financial regulators, trying to squash the lingering perception that banks remain “too big to fail,” are looking to an obscure change in derivatives contracts to solve the problem.
The main industry group for the $700 trillion global swaps market is rewriting international protocols to impose a “stay” or pause designed to prevent trading partners from calling in collateral all at once when a bank nears failure.
[...] The International Swaps and Derivatives Association [ISDA] is aiming to release the revised contract guidelines by November, the people said.
The change is designed to prevent a recurrence of one of the most vexing problems revealed by the 2008 financial crisis: When Lehman Brothers Holdings Inc. failed, counterparties trying to unwind derivatives contracts touched off a panic that triggered a worldwide credit crisis. [...] Lehman’s failure exposed that argument as flawed. When it filed for bankruptcy, Lehman had more than 900,000 derivatives positions and its counterparties moved immediately to terminate trades and demand collateral.
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The new terms for the ISDA contracts would bar a firm from ending swap trades with a bank being put into liquidation for 24 or 48 hours, depending on which country’s laws apply. That would give regulators time to move the contracts to a new company, limiting contagion to the larger financial system.
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Well, having such a short-circuit --
like a Market Time-out -- for Derivative bets, is probably better than the contrary:
Not having them, and simply letting every virtual paper-holder exercise their fail-safe clause
ALL-AT-ONCE ... you know, Lehman-folding-chair-style.
But it's those advocates behind this Contractual Time-out, that gives me pause ...
Because the advocates behind this Derivative-propping up [Responsibility-shifting] -- turns out to be the same usual suspects: The biggest over-leveraged 'takers' of these "risk-reducing investments," in the first place ...
ISDA’s protocols are used worldwide to draft contracts for derivatives trades. The group includes the world’s largest dealers, including Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co. (JPM) and Deutsche Bank AG, as well as asset managers and other firms that are traditional buyers, including BlackRock Inc. (BLK) and Pacific Investment Management Co.
AKA. the solution-proposers are
the usual "Too Big to Trust," leverage-other-peoples-wealth, players.
Yeah, they deserve a Stop-the-Run time-out, in the event of another 1000-to-1 disaster, actually arrives. Well that's quite the 'Notional' fix.
Virtually speaking. We got to protect ... All.That.Derivative.Paper.
By suspending and off-loading their risky contracts. Contracts designed to trade away risk, in the first place.
Now, that's their Ticket! You Betcha! Do not pass Go. Do not collect $200. Sorry market risk-takers ...
That "Get out of Debt" contract clause, may soon be of No effect. As good as the paper, it's written on.