Derivatives

The Armchair Economist 　

In farm country, folks are used to hearing a lot about commodity prices for corn, soybeans, wheat and anything else dealing with agriculture. Those prices are reflected daily in specific contracts that give both buyers and sellers price guarantees over a certain period of time. They were originally designed to hedge a grower or buyer’s risk of falling or rising prices during the year. These kinds of agreements are more commonly called "option contracts" or just "options" when they’re bought and sold in connection with a financial commodity like bonds or currencies.

Here’s an example of just one of these types of options; if a bank in Canada buy’s a bond from a U.S. bank for $1000, but they’re afraid that when the bond matures and the $1000 is paid back to them, it’ll be worth less than the original investment because of a falling U.S. dollar’s value. So what the Canadian bank can do, is buy a U.S. Dollar denominated option contract that hedges their "currency risk" against our Dollar. This type of " risk insurance" has been going on in our financial markets for decades and in agriculture for thousands of years.

The Chicago Board of Exchange (CBOE) and the New York Mercantile Exchanges are probably the largest, best known vehicles for buying and selling these options today. And, how much these contracts are worth is pretty easy to tell if you have a computer, financial newspaper or a broker who’ll answer his phone on a really bad day.

Brokerage types like to make fairly simple ideas like this one "fancier" by calling these type of options "Simple or Plain-Vanilla Derivatives", meaning that they’re pretty-much everyday deals and available to pretty-much anybody. Because almost anyone can buy or sell them, they’re priced and traded under the vigilant scrutiny of The Securities and Exchange Commission (SEC), courtesy of Uncle Sam.

Way back in about the mid-80s, companies like Lehman Brothers started thinking about ways of concocting creative types of new financial options to hedge different risks. So again, armed with an idea that could make some cash and penchant for exotic fanciness, the "Complex Derivative" was born.

Now, for one more example; if that same Canadian bank bought that $1000 bond issued by say… Fannie Mae (FNMA), they just might want to hedge against a falling dollar, rising U.S. interest rates (a risk that’s bad for bonds anywhere), credit-default risk and anything else that might make those northerners twitchy.

Wall Street decided that peddling these sort-of conveniently packaged, multi-risk or "unmatched risk" hedges to private "investment professionals" could put both a smile on their shareholder’s faces and a Ferrari on their CEO’s driveway.

Because complex derivatives weren’t sold to the "Joe and Joette six-packs" of our land, Uncle Sam figured that the "investment professionals" that were buying them from the other "investment professionals" would completely understand all of the risks involved and so, protect themselves and their investors both big and small.

As the derivative markets grew financial outfits started a hiring binge, recruiting recent Math grads from the likes of Wharton and Harvard to design this stuff, and by doing so created a new profession called "Financial Engineering", which produced the now infamous gaggle of Wall Street "Rocket Scientists".

It wasn’t long before other finance, banking, investment and insurance companies both here and internationally started designing, selling, buying and trading ("swapping") these contracts.

In 2000, Ex-McCain Presidential Advisor (It was that "Bunch of Whiners" comment that added the "Ex" factor.) Phil Graham, who was over the Senate Banking Committee at the time, didn’t see the need to regulate complex derivatives back then, despite their exponential growth.

So with that, let’s trundle ahead a few more years and read a recent snippet from the German Daily "Speigel":

While the US government is preoccupied with cleaning up the real estate and investment banking debacle, the insurance industry threatens to become the next trouble spot.

Financial instruments known as credit default swaps are considered especially risky. Not unlike an insurance policy, their purpose is to hedge against credit risk. Because regulation and transparency are also absent here, credit default swaps have developed into what are probably the most dangerous wagers in the global financial casino today.

At the same time, they have also experienced dizzying growth. In the past five years, the volume of these credit derivatives has grown by a factor of 30 -- to $62 billion (€43 billion), close to 20 times Germany's gross domestic product.

The "dizzying growth" of derivatives in Germany, which amounts to about "20 times" their GDP (Or, the total of what they generate in goods and services as a nation in one year) is a seriously attention-getting statement, especially if you’re a German. But, according to The Comptroller of the Currency here in the U.S., things aren’t looking any better; "The notional amount of derivatives contracts held by U. S. commercial banks in the second quarter increased by $1.8 trillion, or 1%, to $182.1 trillion." (http://www.occ.treas.gov/ftp/release/2008-115a.pdf).

Huh…let’s see; our GDP is about 14 trillion a year, so that makes the derivative exposure of just our "U.S. commercial banks" at about 13 times our GDP.

That last fact may be one of the reasons that our now infamous bank bailout package took so long to pass the House; because spending a paltry 700 billion on this might have seemed like trying to put out a wildfire with a squirt-gun.

Because so many of our largest banks already hold these tenuous contracts with one another, this also might be a reason why our banks are so hesitant to lend to each other.

As our financial system moves closer and closer to nationalization, this hasn’t seemed to quell fears either here at home or globally. After all, it was the quasi-federal agencies of FannieMae and FreddieMac that tossed the metaphoric match, which started the aforementioned global wildfire. The two CEOs at the helms of Fannie and Freddie were then, the second set of Bush appointees and just like their counterparts at Lehman or AIG, they too were paid handsomely for their efforts.