The current rush to pass the “Cromnibus” government spending bill to prevent another shutdown could put the world’s economy at risk through further deregulation of derivatives trading.
You always won, every time you placed a bet
You’re still damn good, no one’s gotten to you yet
Every time they were sure they had you caught
You were quicker than they thought
You’d just turn your back and walk
You always said, the cards would never do you wrong
The trick you said was never play the game too long
A gambler’s share, the only risk that you would take
The only loss you could forsake
The only bluff you couldn’t fake
Writer(s): Bob Seger
Copyright: Gear Publishing Co. Inc.
The world of finance used to be understandable. You called your stock broker and made an investment in a stock or bond. If the New York Stock Exchange (NYSE) went up, you likely made money. If the NYSE went down, you lost money. In the age of computers and world-wide high speed telecommunications, finance, including banking, has become much more complex and esoteric. One of the most complex and esoteric investments are derivatives.
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.
Unless you are a very wealthy financial investor, the Investopedia definition above either means nothing to you or has likely made you more confused about what is the financial industry practice known as derivatives trading. Here is my layman’s explanation.
The term derivative is based upon the word derive which means “to take or get (something) from (something else)”. Of course, the world of big banking and finance is all about getting. In this case, the form of getting, the derivative is a manmade financial asset. A share of stock is an investment of holding an equity stake in an ongoing business. You make money through the company paying dividends or by the appreciation in the trading value of the stock. A bond is a debt where you receive interest payments for the life of the bond and then your original investment is returned. Bonds are used to finance the construction of roadways and bridges. Both stocks and bonds exist in the real world. The key term used above is high leverage, which means very little of the financial institution’s money is being put up as collateral. It’s like buying a home with no money down. You bet the house, you can lose the house.
Derivatives do not exist in the real world. They are basically bets on how the price of investments — stocks, bonds, oil wells, buildings, tulips, soybeans, bowling balls, weather, whatever — will be valued at a given point of time. In theory, I could buy a derivative that the price of a hamburger will go up from $2.00 today to $2.50 next Tuesday.
If the price of hamburgers goes up to $2.50 or more next Tuesday, I make money. If not, I lose money, the amount of the loss is the difference between the lower price and $2.50 per the number of derivatives I bought. Or I could bet that the price of the hamburger will be less than $2.50 next Tuesday; make money if the price is lower and lose money if the price is higher. Derivatives are a particularly Wimpy form of investment because they rely on using OPM, Other People’s Money. Derivatives are money chasing more money.
Like in all other walks of life, derivatives traders aren’t all bad. There is John W. Henry, the principal owner of the Boston Red Sox since 2001, the leader of the “reverse the curse of Babe Ruth”, ending the Sox’ 95 year World Series drought. Mr. Henry is now the owner of the Boston Globe and is doing a good job in making the paper more enjoyable by adding new sections, such as Capitol — about Massachusetts politics, and Address — about the housing market. Mr. Henry is a brilliant man and is known as a mathematical wizard, which is how he developed a net worth of $1.5B through commodities trading derivatives.
Henry’s most notable collegiate accomplishment grew out of his aptitude for numbers. He and an instructor at UCLA published a paper about how to win at blackjack. He has said he was kicked out of Las Vegas casinos at age 22 for card counting.
Henry’s life took a more serious turn when his father died a few years later, leaving him in charge of the family soybean business. Rather than farming, Henry entered the highly speculative commodities business, which some in the industry say is closer to gambling than investing. But by 1981, Henry was winning more often than losing, using a method of statistical analysis he developed by studying decades of market prices…
The other key underpinning to that trading philosophy was a belief that humans, by nature, are trend followers, reacting mechanically to events, much as the clapping of one person in Fenway Park will typically be followed by another and another until it becomes widespread applause.
“Markets are really people,” observed Henry. “If you make a certain type of statement, you can make a pretty good prediction of how George Steinbrenner will react.”
At its peak, in 2006, his company had $2.5 billion under management.
On the other side are the billionaire Koch Brothers, who have expanded their fortunes through investments in oil and gas derivatives.
Industry groups backed by Koch Industries Inc. and Cargill Inc. are fighting a Senate bill that would reshape almost 30 years of policy that allowed the $605 trillion over-the-counter derivatives market to surge and helped trigger the financial crisis in 2008.
Legislation introduced by Senator Christopher Dodd, a Connecticut Democrat, would give the Commodity Futures Trading Commission authority over most of the U.S. market, the broadest expansion of its authority since becoming an independent agency in 1974. ….
The over-the-counter derivatives market has escaped the commission’s reach since the first interest rate swap was traded in 1981. The transactions fell outside a law requiring that all futures be traded on regulated exchanges. Before swaps came along, risk-management trading outside of the exchanges was generally restricted to “forwards,” or bilateral trades that provided for physical delivery between commercial parties, such as a farmer and a grain elevator.
What has not been reported is that a big part of Koch Industries’ expansion over the past few decades has occurred in the dark realms of unregulated derivative trading. The Koch Brothers weren’t just playing the market for themselves, but provided financial and risk management services to other companies. Now their clients include airlines, utilities, oil companies, pension funds, hedge funds and endowments.
So why did the Kochs hand out so much money to groups and lawmakers that support the Keystone XL pipeline in the 2014 midterm elections? Money. BIG MONEY...
According to a new report released by the International Forum on Globalization, the brothers stand to make up to $100 billion in profits with the approval of the pipeline.
Keep in mind they’re only worth $68 billion. This could double their net-worth.
The report found that the Kochs and Koch Industries hold up to 2 million acres of land in Alberta, Canada, which is the proposed starting point of the Keystone XL pipeline.
And many Koch Industries subsidiaries stand to make millions from the pipeline’s construction, including Koch Exploration Canada, which would profit from oil exploration on its land, and Koch Supply and Trading, which would benefit from the trading of oil derivatives.
In the fantasy world of Big Banks and Big Finance, these derivatives, these risky bets mean billions and billions of dollars at the risk of real world investors and taxpayers. How much? Enough to lose $3 billion in just a few weeks — $3 billion of your bank deposits, pensions, 401(K)s, and other savings and investments that you were counting on having for your future. You have no knowledge that these institutions are making big risky bets with your money or say about what they are doing.
Even worse, when these bets don’t pay off, these banks and financial institutions expect you (through the Federal Deposit Insurance Corporation – FDIC) to pay them to cover their losses. The big banks and financial institutions made bets on mortgage-backed securities based upon below prime interest rate (subprime) mortgages called credit swaps and wrecked the economy in the process. Derivatives trading by banks and financial institutions is not illegal. Derivatives trading with your investment money is now, but may not be very soon.
Derivatives trading are so bad and economically risky that even the pro-big business Forbes Magazine is against them.
Fast forward to the financial meltdown of 2008 and what do we see? America again was celebrating. The economy was booming. Everyone seemed to be getting wealthier, even though the warning signs were everywhere: too much borrowing, foolish investments, greedy banks, regulators asleep at the wheel, politicians eager to promote home-ownership for those who couldn’t afford it, and distinguished analysts openly predicting this could only end badly. And then, when Lehman Bros fell, the financial system froze and world economy almost collapsed. Why?
The root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency. After Lehman’s (financial institution Lehman Brothers) collapse, no one could understand any particular bank’s risks from derivative trading and so no bank wanted to lend to or trade with any other bank. Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode.
And no one seems to know how much trading in derivatives is being done because of the lack of regulatory oversight.
Some derivatives, such as typical stock options, trade on exchanges. But many are simply private contracts between banks or other sophisticated investors. As a result, it’s hard to know the total volume of derivatives now outstanding. The worldwide nominal value – also known as the notional or “face” value – of derivatives tripled in the five years leading up to the recession, at which time it was around $600 trillion, according to the Bank for International Settlements. Since then, although some specific categories of derivatives have shrunk, the total value of the derivatives market has not been reduced at all, but has actually gotten bigger.
Although recent BIS data shows only a little growth in the overall value of derivatives, some leading bond portfolio managers and derivatives experts believe that the market has continued to expand rapidly, without being especially visible. While there’s no way of knowing for sure, estimates of the face value of all derivatives outstanding tops a quadrillion (1,000 trillion) dollars, or more than 14 times the entire world’s annual GDP. By comparison, the total value of all the stocks trading on the New York Stock Exchange is roughly $15 trillion. Indeed, the New York Stock Exchange itself is being acquired by an up-and-coming derivatives exchange.
The very fact that reliable figures are hard to come by is itself part of the problem. The $638 trillion currently reported by the BIS is only a floor. Estimates for the total capital employed in derivatives trading is somewhere between $10 and $20 trillion, roughly comparable to the capitalization of the NYSE. That means that each actual dollar in the derivatives market is supporting between $35 and $70 of nominal value. Losses of only a few percent of face value therefore would be enough to wipe out even the best-capitalized derivatives traders.
Myth – Bank management has derivatives risks under control using mathematical models that capture the complex interaction of factors embedded in derivatives trades. This view is laughable on its face given the continual series of notorious derivatives fiascoes from Long-Term Capital Management to AIG to J.P. Morgan and many others.
Yet, this myth is pernicious at a deeper level because many bank managers actually believe it. They have constructed elaborate management tools based on empirically false assumptions about the frequency and severity of bad events and the correlations among them. Risk managers sometimes acknowledge these limitations but then say their tools are “better than nothing.” This is false too. Bad tools are not better than nothing. They lead to bad investments with the taxpayers picking up the losses every time things go wrong. It would be more honest to admit what we don’t know and limit derivatives until the state of the art improves.
The next time some derivatives proponent says that derivatives reduce risk, increase transparency, and are well hedged, stop them in their tracks and ask if they believe in tooth fairies, Easter bunnies and leprechauns. Actually, it’s safer betting on the leprechauns than in the soundness of modern derivatives finance. Since markets seem not to have learned from past disasters, one should expect worse to come.”
Forbes Magazine goes further to name names: “Trading gone awry: JPMorgan’s [JPM] loss of $6 billion from trading activities of which CEO Jamie Dimon was blissfully unaware.” JP Morgan is one of the top 5 financial institutions that dominate total derivatives and total credit swaps investments, as of December 31, 2011 are (in nominal/face value):
Right now, there is a huge battle over the financial and political control of the United States in the post-Citizens United era. The House of Representatives has passed and the Senate is deliberating on the omnibus legislation to keep the U.S. government from shutting down again. The federal spending bill is called Cromnibus because it is crammed with all kinds of legislation and rules that benefit wealthy and powerful special interests. Senator John McCain has slipped into it legislation that would allow copper mining on Indian reservation lands in Arizona, which appears to be a smokescreen for furthering Koch Industries’ copper mining interests. No one seems to know how legislation was inserted to allow corporate and the 1%’s campaign spending to increase 10-fold . This legislation proposes that up to $330,000 in contributions can be made to every political organization.
And included is legislation to allow cuts in pension plan payments.
The debate over the bill’s pension language centers around multi-employer retirement plans — the large, union-backed funds created in the explosion of labor unions after the Great Depression. The government-insured plans cover an estimated 10 million Americans from the private sector workforce. Many of those funds now face unfunded liabilities.
Lawmakers pushing to allow benefit cuts are citing the example of the $18.7 billion Teamsters’ Central States Fund, which has 410,000 members and is the nation’s second-largest multi-employer pension plan. There’s an estimated $22 billion gap between assets in the Central States Fund and promised benefits to the system’s current and future retirees — a shortfall that legislators point to as a rationale to pass a new law permitting multi-employer plans to slash promised retirement benefits. ….
But critics of the provisions say the plight of the Central States Fund is not a cautionary tale about unsustainable benefits but an example of Wall Street mismanagement. They note that Central States is the only major private pension fund where all the discretionary investment decisions are made by financial firms rather than by the fund’s board. Roughly a third of the pension system’s shortfalls — or almost $9 billion — can be traced to investment losses accrued during the financial industry’s 2008 collapse. Those losses were in addition to more than $250 million in fees paid by the plan to financial firms in just the last 5 years.
So it’s OK if these banks and financial institutions are bailed out from risky derivatives trading, but pensioners, who had no control over how their pensions were invested, are not.
But the most insidious legislation in Cromnibus was written by Citibank lobbyists to weaken regulations on derivatives trading by banks and financial institutions.
Senator Elizabeth Warren has been the most prominent politician against unregulated derivatives trading and the Cromnibus legislation. She is rapidly becoming the leader of the new populist movement to reclaim the country from the wealthy and special interests.
While derivatives trading is just daily business to the financial and banking industries, it is a threat to the United States and world economies. We have experienced the effects of loosened banking and finance regulations in the Great Depression of the Roaring 20’s. The U.S. economy was going through an 18-month recession before a period of tremendous growth, followed by the huge collapse.
We are following the same pattern again. The U.S. economy is recovering well from the Great Recession ,which was fueled by trading of the subprime rate mortgage credit swap derivatives. Now, the Republicans, assisted by a few Democrats, want to risk going through another period of economic downturn so that their wealthy campaign contributors can become bigger billionaires. The House vote was 219 to 216 in favor, with 57 Democrats voting in favor.
Cromnibus is just latest example that everything in Washington D.C. is still the same, and about to get worse. They are so derivative.
And you’re still the same
I caught up with you yesterday
Moving game to game
No one standing in your way
Turning on the charm
Long enough to get you by
You’re still the same
You still aim high
There you stood, everybody watched you play
I just turned and walked away
I had nothing left to say
‘Cause you’re still the same
You’re still the same
Moving game to game
Some thlngs never change
You’re still the same
Copyright 2014 Michael A. Maynard, Stow, Massachusetts.
For more articles, go to mmaynard119.wordpress.com
UPDATE: Here is Senator Warren’s Senate floor speech on Cromnibus