DERIVATIVES EXPLAINED, PART III ... Why Financial Derivatives Are (still) Dangerous

Back in August I wrote the first two parts of a three part introduction on derivatives. The primary reason for writing these posts is because most Americans still have no idea what derivatives are, or how they almost destroyed our economy in 2008. This is unacceptable.

My goal was to provide some basic background information on complex market instruments that were not brought under control, and can still bring down our economy today. This is the final part of my three part derivative story.

DERIVATIVES 101, REVIEWED
You might recall that in Part I of "Derivatives Explained" (Early History) I explained that the logic behind derivatives isn't really as complex as we might think. To be sure, the actual trading is complex and mysterious because of the industry language and the market instruments used in the trades, but the derivative concept is really quite simple.

Think of it this way. A farmer decides to sell someone the wheat harvest he will produce in 6 months for $1 million. He signs a contract saying he will do so. Generally speaking, because this contract "derives" its value from the agreement to produce something in the future it's called a derivative contract. The contract can be sold by either the farmer or the buyer to other market players (who are then obligated to fulfill the terms of the contract). This is a derivative trade.

Ta Da! See how simple this is?

From a market perspective early agriculture derivative contracts (whose family of contracts are also referred to as futures, hedge, and forward contracts) served market players well because they

(1) Allowed farmers to hedge their bets by locking in a price for their goods.
(2) Allowed farmers to secure loans against their contracts. 
(3) Provided market players with increased confidence about the products brought to market. 

All three brought stability to markets.

However, as I explained in Part II of "The Financial Commodity Tidal Wave," by the mid-1970s things became a bit more complex as derivative markets began to change. With the uncertainty in financial markets caused by the floating dollar and soaring inflation market players began to buy and sell financial commodities just as they had done with agriculture commodities.

Only this time, they weren't agreeing to buy and sell wheat that would be produced some time in the future. In an effort to reduce uncertainty and lock in costs, market players bought currency and interest rate contracts that the sellers agreed to produce at some date in the future.

Under the terms of the contract, instead of depending on one farmer to produce a good - as is the case with agriculture derivatives - currency and interest rate futures depended on market players being able to produce and fund their end of the bargain. This is critical because, while single acts of God can sabotage an agriculture good in the future, a myriad acts of human stupidity make derivative markets a financial minefield.

By 1985 the value of derivatives contracts in the financial community would surpass the value of derivative contracts in the agriculture community. Financial derivatives would explode in size and scope after 1985. And nothing has been the same since.

WHAT IT MEANS
The interesting thing is that unlike the farmer who wants to produce something of value, and lock in prices to hedge their bets to reduce uncertainty, today's financial derivative traders have moved beyond simply trying to reduce uncertainty. Today's derivative traders are now primarily interested in creating and trading financial derivative products for speculative reasons (and the fees).

Put another way, today's derivative market players are focused on making bets, not products.

The problem isn't the deal, or the actual the bets. As long as private market players are betting against like-minded market players, who are gambling with their own cash, things are OK.

The problem is that market players are gambling against naive and hard-pressed public pension fund managers and cash-starved municipalities who - in an era of declining wages, low taxes, and recession - are looking for quick fixes. What the managers and municipalities don't understand is the market players have gotten pretty good at what they're doing.

Wall Street's most savvy market players are looking for suckers to take the other end of their bets, and are seducing them with the prospect of easy money. What public pension fund managers and municipalities are finding is that they are being led into a system of rigged and bailed out markets where "the suckers" take financial hits they cannot afford, and where private players can't lose.

The case of Detroit is one example of how this has been happening.

LEAVE NO BANKER BEHIND ... AND SCREW YOU DETROIT
In August the NY Times reported that Detroit's less than savvy municipal managers made derivative bets in 2005 with UBS and Merrill Lynch (now with Bank of America). Caught in an economic web of low employment, recession, and a declining tax base the city of Detroit was desperate to raise cash.

So why not gamble, right?

While the derivative deal was quite complex (they all are now), under the guidelines of the contract the banks would pay the city Detroit if interest rates rose. For their part Detroit would pay the banks if interest rates went down.

As we all know, interest rates collapsed after the market crashed in 2008. This was followed by the Federal Reserve effectively running over Congress (to be fair, they pretty much allowed themselves to be run over) to lower interest rates in an effort to provide cheap loans and market guarantees to the banks.

Unfortunately, while bending over to help the banks with almost zero percent interest rates the Federal Reserve didn't make any provisions or stipulations that would help cities like Detroit deal with these artificially low rates.

The Fed essentially said, "Here bankers, take the cheap money ... and have your way with cities like Detroit while you're at it."

As a result, cities like Detroit were left to fend for themselves, especially in bankruptcy court. Meanwhile Wall Street feasted at the trough of the Federal Reserves low interest rate policies, and the myriad number of bailout programs fostered by the Treasury Department and the Fed (which totaled more than $14 trillion).

For their part, to cover their failed bets, Detroit started paying $50 million a year to the banks in 2009. Then they pledged about $11 million a month from their casino-tax revenue as collateral. To end their derivative obligations nightmare Detroit will emerge from bankruptcy owing about $250 million to the banks. It's also suggested that they cut pensions by 90 percent. But Detroit does get to keep their casino-tax revenue. Nice.

Here's the real fun part. If the market had not collapsed most analysts were predicting that interest rates would rise. Rising debt loads under President Bush had everyone expecting higher interest rates. Under this scenario Detroit would have pocketed some really nice profits.

But this isn't the point.

The point is Detroit is now one of America's many financial canaries in the mine, but no one wants to see it.

The point is cash-strapped cities and pension fund managers - worried about declining contributions (low employment, declining tax base, recession, etc.) - are gambling against seasoned market players whose industry leaders went in front of Congress and effectively said that helping their clients get the best return on their investment was not their job.

The point is that private gamblers and speculators who got bailed out when their bets soured and collapsed the economy are able to collect on the other side of the market collapse because Wall Street can still force cities like Detroit - who get no bailout help - into huge settlements.

Put another way, what's the big deal if Wall Street cons the cities and pensions out of their money?

Especially galling here is that many of the big financial firms on Wall Street were able to avoid bankruptcy, and avoid going into settlements that they are forcing on cities like Detroit. They were able to avoid this because of bailouts and favorable regulatory rulings that allow the banks to dump their toxic crap on the American taxpayer (in various forms, like legacy assets). Even better, for the banks, is that they're also getting trillions in loans and other market guarantees (see graph above), courtesy of the American taxpayer.

So, yeah, heads they win, tails we lose. And screw you Detroit.

Then we have the case of Goldman Sachs, who was recently fined (again) $100 million after they experienced the biggest loss in bank history.


GOLDMAN SACHS FINED (AGAIN) ... AND THE BEAT GOES ON
On October 16 the Commodity Futures Trading Commission (CFTC) reported that Goldman Sachs would pay yet another multi-million dollar fine ($100 million). Only this one is for traders misleading management about the extent of their losses, and then doubling down on those losses in an effort to try and win back (hide) their losses. The strategy failed, cost Goldman Sachs at least $6.2 billion, and is known in the industry as the London Whale.

Higher ups at Goldman Sachs claimed they had no idea what was happening when they lost $6.2 billion, which set yet another record in the industry.

Goldman Sachs execs claiming ignorance is a tough pill to swallow.

One could argue that Goldman Sachs knew about these trading strategies long before the losses started to pile up. More specifically, one might even argue that Goldman Sachs encouraged them - cough, cough - by doing absolutely nothing to stop their traders when they were making money on the same derivative bets years earlier (bonuses have a way of doing that).

This is especially the case since the deal makers were dipping into FDIC backed funds - which is supposed to be under extra scrutiny after 2008 - to make their bets.

THE END RESULT ... DERIVATIVE BETTING CONTINUES
In effect, by winning on the bailout side and coming up ahead on bankruptcy side - when pensions and municipalities are forced to take financial hits - Wall Street banks really have nothing to lose by continuing to pursue their derivative-laced bets. And, besides, companies like Goldman Sachs have been ripping off markets for years and getting away with it, with little more than small (for them) slap on the wrist fines.

Winning on both sides of their derivative bets, coupled with smallish fines, after helping to collapse markets and the economy in 2008 helps explain why derivative trading continues to grow in America. Simply put, without any real changes or market discipline for almost crashing the economy in 2008 there's no real downside to playing in the derivative casino in America.

And that, my friends, explains why financial derivatives are still dangerous.

- Mark

Part I: Derivatives Explained, Part I ... Early History.

Part II: Derivatives Explained, Part II ... The Financial Commodities Tidal Wave.