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            Derivatives – a Beginner’s Guide to “Financial Weapons of Mass Destruction”

            Over the last 4-5 years the term derivatives has been firmly embedded in todays lexicon.

            With the failure of Bear Stearns in 2008, and subsequent bailout of multiple other too big too fail banks, the term “derivative” was popping up everywhere.  Then recently we have JP Morgan’s $7 billion trading loss on credit derivatives in the news.

            But have you ever stopped to think what exactly derivatives are, how do they work, and what risks do they bring?

            Today we’ll try to unearth why Warren Buffet termed them “financial weapons of mass destruction” and cover…

            – What is a derivative?
            – How they came about
            – How they have changed over time
            – What are the main derivatives in existence today?
            – What do these derivatives mean for New Zealand?
            – New Zealand’s own “hidden” derivatives

             

            What is a Derivative?

            First up a definition may be a good place to start.  From the lazy reseachers’s dictionary wikipedia:

            Derivative: A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments are to be made between the parties;

            So they are financial instruments whose values depend on the value of other underlying financial instruments or objects such as commodities, equities (shares), residential or commercial mortgages, bonds, interest rates, or exchange rates.  They can take the form of futures, forwards, options and swaps.

            The history of derivatives dates back to the 1800’s where they were used to hedge farmed commodities, given these are affected by so many variables and have an unknown eventual sale price.  So instead of Farmer Joe doing his planting, growing and harvesting and hoping he’d have a crop of a certain size that he could sell for a certain price to make a profit, he was able to – for a comparatively small fee – guarantee a fixed income at a specified date in the “future” for his crop.  So began the Futures markets.

            Giving some level of predictability to farming income was very beneficial and enabled growth and advancement in many other sectors which eventually led to the industrial revolution.

            So derivatives have their place as they have had many positive impacts on humanity since their invention.

            Derivatives Morph: From Farmers Friend to Financial Weapons of Mass Destruction

            However in the 2 centuries that have passed since then, derivatives have morphed into more of a financial casino where a few major players (5 main banks in fact whose names will not surprise you J.P. Morgan, Bank of America, Citi, Goldman and Morgan Stanley) actually control  96% of the industries derivatives as at 30 June 2011.   The chart below shows how small a percentage of derivatives are held by actual end users (green line) looking to hedge themselves, versus merely traded by the likes of the above 5 banks (blue line).

            (For a graphical representation of the freakish size of these banks derivative books see this great infographic: http://demonocracy.info/infographics/usa/derivatives/bank_exposure.html)

            Total Notional Derivatives

            So, just who uses derivatives?

            Source

            Rob Kirby gives a detailed overview of the full history of derivatives if you want all the holes filled in here.

            Interest Rate Swaps are the Dominant Derivative

            Apart from the massive change in traders versus end users that can be seen in the chart, the other major change in the past 20 or so years was the advent of the “Interest rate swap”.

            Interestingly despite all the talk of credit derivatives (i.e. derivatives of loans/mortgages) being the cause of the 2008 financial crisis, it is actually interest rate swaps having a notional value of $504 Trillion that make up 78% of the total derivative pool of $647 Trillion (as reported by the Bank of International Settlements (BIS)  http://www.bis.org/statistics/otcder/dt1920a.pdf). Look again at the chart above and you can see the small amount that credit derivatives make up.  The yellow line represents credit derivatives versus the total notional derivatives in red.

            Why Do Interest Rate Derivatives Now Make Up So Much of the Total?

            Because as Rob Kirby states, it is these interest rate swaps which allow the US Fed/Treasury to control or manipulate the ”price of money”, that is the long term US treasury interest rate.

            In times gone by Bond Vigilantes (no they didn’t take the politicians into the street and hang them by their necks!) would sell government bonds and therefore drive interest rates up when governments were overspending.  Effectively the vigilantes would be saying to governments, “We don’t trust your ability to repay so we are selling your bonds and therefore you have to pay a higher rate to attract another buyer of your debt.”  This no longer occurs as demonstrated by Bill Gross’s PIMCO Bond Fund selling out of its massive stake of US treasuries in March 2011.  The treasury interest rate then promptly plummeted, just the opposite of what you’d expect.

            To be honest the process through which the US Exchange Stabilisation (Fund ESF) manipulates the treasury interest rates is pretty complicated.  I’m not sure we can summarise and make it any simpler than Rob Kirby’s article (which we have gained much insight from), so below is an extract from that: (Otherwise just stick with “they create the demand out of thin air” and you won’t be too far from wrong!):

            “++The ESF participates in these trades taking “NAKED INTEREST RATE RISK” – meaning they do not provide their counterparties with the requisite amount of bonds to hedge their trades – thus forcing them into the “free market” to purchase them. This generates UNBELIEVABLE “stealth” settlement demand for U.S. Government securities. This is how/why U.S. Government bonds and hence the Dollar can be made to appear “bid-unlimited” – even when economic fundamentals are SCREAMING otherwise. The amount of demand for cash government bonds that can be conjured out-of-thin-air in the derivative interest rate swap complex, which might be best described as “high-frequency-trade” on steroids – measured in hundreds of Trillions in notional – literally OVERWHELMS the cash bond settlement process. This means bond yields are set arbitrarily – in accordance with Fed / Treasury policy – NOT IN FREE MARKETS. This also explains why there are no identifiable end-users for the dizzying growth in interest rate derivatives [swaps] – the trade is all attributable to the Treasury’s ‘invisible’ ESF – an institution that is not publicly accountable to ANYONE or ANYTHING. This is why other nations can and do have, from time to time, failed bond auctions while America never has and NEVER WILL BE ALLOWED TO. This is all done in stealth to facilitate and give an air of legitimacy to the U.S. Treasury’s ZIRP [zero interest rate policy].”

            So this is how they keep interest rates fixed close to zero in the US.  Of course this isn’t the case across the Atlantic in Europe where interest rates on government bonds of the likes of Greece and Spain have been reaching nosebleed levels of late.

            Euro Denominated Interest Rate Derivatives could be the Source of Big Trouble

            Going back to the BIS data we can see that $184 trillion of interest rate derivatives are in Euros while only $161 trillion are in US dollars (as of Dec 2011).  So factor in that most banks borrow short but have large loan books at fixed rates for long periods. Therefore a big rise in interest rates could trigger claims on these interest rate derivatives.  (Hat tip to Alf Field for this point).

            Euro denominated-interest-rates-derivatives

            Could Euro denominated interest rate derivatives be where the big trouble starts?

            As Alf Field (who we enjoyed listening to at last year’s Gold Symposium in Sydney) pointed out in an article earlier this year:

            Crikey!“If just 10% of the interest rate derivatives in Euro’s produce losses, the world’s banking system would be looking down the barrel of a loss of $22 trillion. That is enough to bankrupt the entire world’s banking system, something that the politicians of the world could not tolerate. What would a bail out of $22 trillion do to financial markets? What would it do to the gold price?
            If it is not interest rates, there are $64 trillion of foreign exchange derivatives and a “mere” $32 trillion of credit default swaps outstanding that could produce “black swan” surprises.”

            What do these Derivatives Mean for New Zealand?

            So how does all this affect little old New Zealand on the other side of the world?  Well, bankrupting the entire world’s financial system doesn’t sound too good to us.  Don’t think our geography will necessarily help us too much on that one.

            But we may also have some derivatives of our own to worry about closer to home.

            Earlier in the year we stumbled across this report where an Australian economist Associate Professor Dr Sue Newberry, said that NZ government accounts ignore “off-balance sheet exposures” amounting to more than $112 billion.

            “There has been a significant increase in the government’s activity in financial markets over the past decade, she said. However, the government’s accounts do not show that clearly.

            “What happens if you do show the extent of exposures to derivatives is really quite massive,” she said.”

            Derivatives are both an asset and a liability. Newberry said the way these are accounted for is by netting these off rather than showing the totals of each. However, the dangers of derivatives were revealed in the global financial crisis in that one side of a contract can collapse while the other side remains in force. “Netting off obscures that,” she said.

            [She] said adopting “Generally Accepted Accounting Practice” standards is disguising the rapid growth in financial market activities and the extent of the government’s exposures.”

            The point we’ve highlighted is a good one and one that seems to be ignored by the establishment.  The massive size of the global derivative tower is often explained away by saying they “net” each other out.

            Anyway back to NZ, a treasury spokesperson said in reply to Dr Newberry:

            “Derivatives with the Debt Management Office (NZDMO) mainly consist of interest rate and cross currency swaps [hhhmmm sound familiar???]  used to manage risks associated with either debt issuance or with fixed-income asset purchases. The office also executes derivatives with other parts of the Crown.

            “NZDMO tends to manage risk associated with these trades by transacting with the private sector. The other Crown entities use the trades with NZDMO as hedges for their own risks,” it said. However, to get a complete picture of derivatives used would require talking to all entities involved.

            Delegation to transact is subject to controls and managed by skilled professionals, Treasury said.

            “These professionals act within transparent risk policies and parameters and are accountable for their efforts and must meet detailed reporting guidelines and frameworks.”

            Not sure how much better the fact they are “managed by skilled professionals” makes us feel!  $112 Billion seems pretty sizable to us to be “off book”.  Consider that  NZ’s gross domestic product is about $202 Billion, this off book derivative figure amounts to over half that figure!

            We’re no forensic accountants but that number even if only half right seems scary to us.  But then again probably every other country uses similar accounting methods, so what’s the big deal?!!  Who knows exactly what these numbers mean, but that is the point with derivatives – no one really knows what their impact will be as this is all new territory.

            As Rob Kirby commented in the article we referenced earlier physical precious metals are “the achilles heel” of financial fraud.  And if all the above isn’t reason enough to remove some paper money from within the manipulated financial system and exchange it for physical gold and silver we don’t know what is!

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