The Haunting Specter of Derivatives — Part II
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Type of Content: Article Written by J. A. Aznello Two weeks ago, before nervous consumers and investors could pull on a loose thread of the market’s sweater, the Fed inflated our currency by another $90.3 billion in order to bail out AIG. The banksters did so to keep AIG from being sent over the edge due to its large exposure to derivatives, which would have created a larger unraveling throughout the rest of the market. In the wake of the bailout and a growing awareness about derivatives, Newsweek calms its readers by assuring us that the $668 trillion amount in derivatives is “a complete nonsense number.” They liken it to “saying every lottery ticket sold is worth the full value of the jackpot. If the jackpot is $100 million and lottery organizers sell 2 million tickets, ‘that's $200 trillion worth of lottery wealth that's circulating!” jokes one commentator. Newsweek then concedes that the number is more like “$15 trillion,” “still huge, slightly larger than the U.S. economy,” “growing fast,” “doubling in size every two or three years for the last decade,” but implying that we don’t really have to worry about it. If only if it were so simple. Because the bailout and bilking measures of Congress haven’t been enough to jumpstart the economy, the Fed recently cut rates to 1 percent. (Bernanke is ever closer to making good on his suggestion to drop bundles of money from helicopters.) Even with the rate cut two days ago, the markets continue to demonstrate that central banking manipulators can no more suspend the laws of economics than can suicide jumpers void the laws of gravity. As Forbes is now reporting, “The subprime crisis has created a distaste for derivatives, those complex financial products.” That would be putting it mild. As the derivatives mansion (not house) of cards starts to tumble, that distaste is going to be more like a full on porcelain-throne-hugging heave. In our post from a few days ago, we likened the derivatives market to a street deal made regarding the selling of a pair of rock concert tickets. And, we highlighted how one ticket investor offered insurance to our fictitious couple in case the next show didn't happen. The “insurance” you purchased for $12.50 represents both “premium income” and a future liability for the investment banker lest “market forces” require him to deliver those replacement tickets. Repeated hundreds – if not thousands of times over – the outstanding balance of all these side deals quickly eclipse the total value of the actual goods or services-for-currency trade. (Remember that Newsweek admitted the total market is "slightly larger thant the U.S. economy" and "doubling in size every two or three years.") The murky side deals (okay to call them side bets) are “derived” from the original transaction. A mansion of cards? Plastic laminate is sturdier; this amorphous financial storm is a mist of fog wrapped within a cloud of smoke. When the financial system starts buying and selling “synthetic” scenarios pegged to a future event you can see the potential harmful effect of band members splitting up in a nasty tiff and canceling all the shows on their Northeast tour. What happens if a major labor strike closes all concert venues in a 500 mile radius for six months? Your “insurance” is worthless because “performance” is impossible. There will be no show. The investment banker is now forced to reimburse the original ticket purchasers or renege entirely. Attempts by the investment banker to raise new capital by selling other “unencumbered assets” or borrow in the market fail, leading to insolvency. There are very little “unencumbered assets” on his balance sheet because every asset is “cross collateralized” to bring in additional trading revenue. You knock on the investment banker’s door for repayment. He knocks on Uncle Sam’s door for relief. We've only seen the beginning of those customers who will be lining up. The tail ends of the Bell Curve are those catastrophic consequences when the unimaginable occurs. When we transact at the “mean” the norm prevails and we innocently, blithely go about our lives. What are the odds of getting struck by lightning while riding a unicycle in a cave? Quite low – until the freak accident occurs and does so in stark, shocking regularity. Now everyone is bolted off their bikes. The seeds of our panic have been sown in the nightmares of our bliss. Take a mortgage. At the closing table you thought you were all alone with your lawyer and closing agent. Yet there are several hundred invisible voyeurs (traders and speculators) looking down your blouse or up your pants leg from behind a two way mirror, divvying up the short-term and long-term body parts of your note. Your loan walks in like a perfumed Vestal virgin and stumbles out like a scythed Venus de Milo. Unless the originating institution holds onto the loan, not only is the principal amount of the transaction sliced, diced and repackaged into another financial contract, even the stream of interest payments on these credit transactions is “synthetically” bargained. And no one asked you if they could carve up your baby. As a taxpayer you’re still trapped in that fog. Unbeknownst to you, however, an army of well-dressed Wall Street zombie cannibals follows stealthily along, each sporting night vision goggles and a new set of Ginzu’s. Yum. Further, the advent of a digitized international banking system allows for the rapid buying and selling of these instruments with a phone call and a keystroke. A derivative can be spawned from any financial contract, so long as there are traders and bankers willing to gamble and profit on a future event. Mortgages, stocks, bonds, commodities, and precious metals are all open to the ingenuity of perky Ivy League MBA’s with Excel spreadsheets. The Age of Financial Engineering now gives way to the Age of De-leveraging; that capital which we created easily is destroyed in like fashion within days if not hours. Because money is no longer backed by fixed assets, speculators have used loose monetary policies abetted by the Federal Reserve to create a giant mansion of monetary cards, based on hedged bets that the whole system won't fail. Complex? Sure. You? You just wanted to take your date to a hip concert. Who knew? Cheer up. When the cards collapse, there’s always "free" public television.
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