The Monster In The Closet: Derivatives Will Create The Next Financial Crisis


From Bloomberg:

Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group, said another financial crisis is inevitable because the causes of the previous one haven’t been resolved.

“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” Mobius said at the Foreign Correspondents’ Club of Japan in Tokyo today in response to a question about price swings. “Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.”

The total value of derivatives in the world exceeds total global gross domestic product by a factor of 10, said Mobius, who oversees more than $50 billion. With that volume of bets in different directions, volatility and equity market crises will occur, he said.

Let that sink in.  TEN TIMES GLOBAL GROSS DOMESTIC PRODUCT.  In other words, banks have created enough ‘financial weapons of mass destruction’ to wipe out every human being’s production….ten times over.

For those who don’t quite understand what a derivative is, it is a financial instrument the value of which depends upon other, more basic, underlying variables.  Such a variable is called an ‘underlying’ and can be a traded asset, such as an economic index (like the S&P 500) or even the unemployment rate.  People may know the most popular of these, which are the stock market futures.  People place ‘bets’ on which way the market will go and if they are right, they make money, if they are wrong, they lose money.

In the above example, the ‘underlying’ is the actual stock market value.  This is something that has a tangible, measurable value.  The stock market value at any given time is completely transparent and available for anyone to see.  However, the prevailing derivatives over the past decade were not something that could be readily and transparently measured.  They were derivatives on collateralized debt obligations.  These were the other weapons of financial destruction designed by our favorite investment banks on Wall Street to capitalize on the bad mortgages they were peddling and shoving down people’s throats.  It was never about the quality of the loans; it was instead, about the quantity of loans they could make, so that they could be bundled into these CDOs, slapped with a nice AAA rating (by the agencies the banks themselves owned), and re-sold to unsuspecting investors (suckers), the majority of which happen to be your retirement plans.

Derivatives were the key to not only maximizing their return profits, but also off-setting the massive risk in writing these bad loans.  Matter of fact, the worse the loan, the more the profit, because while they were busy bundling and selling the CDOs, the investment banks were also placing bets that these loans would fail – i.e. in market parlance, taking a short position against what they were selling and, in some cases, against the very firms to which they were selling the CDOs. 

While hedging or mitigating risk is certainly a legitimate investment practice (everyone should do so with their investments), the problems here were:  (1) there was absolutely no transparent way to gauge the value of the asset being traded; they were all dependent upon the rating the agencies gave to them, and as mentioned above, the ratings agencies were and still are owned by the banks themselves; and (2) none of the banks selling these instruments ever disclosed whether or not they themselves had a position for or against these investments they were selling.

In many cases, these instruments had no true underlying value at all.  Still, the little bundles of CDOs were sold and re-sold and sold again, each time it changed hands, the seller pocketed a profit and passed it off to the next unsuspecting investor.   Since the underlying value was only as much or as good as the original mortgage loan, one can see exactly how the collapse began in late 2007.  With all these ‘easy credit’ mortgages being bought and sold, and Wall Street’s insatiable appetite for the CDOs, this pushed up home prices to the point at which the majority of people could not afford them.  At the peak of the housing boom, many markets had average home prices at SIX TIMES the average income.  Historically speaking, it has never been possible to sustain home prices over three times average income.  Collapse was inevitable when the majority of people could no longer sustain monthly mortgage payments even with ‘creative financing.’ 

So, as we have been saying here at FedUpUSA, the homeowners are not to blame.  You did exactly as the banks planned you should do: took a loan you couldn’t afford.  The world has been scammed, defrauded, robbed and it is now all over but the big kaboom.  These derivatives are still out there, lurking under the bed like the monster from your childhood.  Nothing has been fixed.   Many of these derivatives are worthless because a great majority of the CDOs are, in reality (as opposed to the falsified balance sheets banks are allowed to have) worth pennies on the dollar at best, or absolutely nothing.  All it will take is one big bank to be unable to pay out on its bets.  The monster must be fed, which is why governments around the world are using taxpayer money to support the banks and it is also why we have quantitative easing (i.e. money printing), which is causing the massive price increases in everything we need to buy.  Governments will keep trying to cover up the lies and they’ll keep stealing money from you to do it.  The question now is, how long will you let them?  I know what this guy would do.