America’s major banks now hold derivatives with a notational worth of $225 trillion — about a third of the world total. No kidding. Trillion.
And that’s up from a mere $120 trillion six years ago. Rather than being weened off derivatives, America’s big banks are more deeply entrenched then ever.
Hopefully Wall Street has it figured out just right and there won’t be any major losses, say a few billion here or there. After all, when has Wall Street ever been wrong about financial instruments?
“Derivatives are dangerous,” says Warren Buffett. “They have dramatically increased the leverage and risks in our financial system. They have made it almost impossible for investors to understand and analyze our largest commercial banks and investment banks.”
While many in Washington would like to limit derivatives trading, make such trades open to public scrutiny or both, Wall Street is vehemently against regulation.
In fact, there’s a simple way to resolve derivative worries. Allow unlimited derivatives trading — but only by individuals and partnerships willing to personally take the risk of profits and losses.
What’s A Derivative?
In basic terms a derivative is a bet tied to the movement of anything that can be valued. We could have a derivative bet which says the price of a mortgage-backed security (MBS), Hungarian currency or lemonade indexes will go up by a certain date. If the value rises then one party to the derivative will make money and the other will lose. And vice versa.
Notice, however, that derivatives are not like stocks or bonds — or mortgages or home loans.
First, unlike mortgages there’s no limit to the size of a derivative bet or the size of the derivative marketplace because none of the bettors actually are required to own the underlying asset. For instance you might bet that the price of oil will rise or fall without owning a single drop. The bet concerns the movement of value and not the ownership of the oil.
Second, there’s huge leverage because not much cash is needed to enter into a derivative agreement.
Third, if you bet on a derivative you typically make an off-setting bet to limit risk. Hopefully you do it right.
According to the Bank for International Settlements (BIS), the notational value of derivatives at the end of 2011 was $648 trillion.
The gross credit exposure from these securities was believed to be $3.912 trillion according to the BIS — that’s up from $3.5 trillion at the end of 2009.
But what if the estimates are wrong? For instance, let’s say losses are just one tenth of one percent bigger than expected. Not a big deal, except in the context of international derivative levels that’s more than $640 billion.
Do taxpayers have exposure? You bet. According to the FDIC, at the end of June 2012 all depository institutions held derivatives with a notational value of $224,998 trillion. However, such bets are not spread across the entire banking system. Banks with at least $10 billion in assets hold virtually all derivatives, securities with a notational value of $224.803 trillion. While the FDIC insures deposits in some 7,200 banks and savings associations, only 59 FDIC-insured institutions have deposits of more than $10 billion. Your little community bank, savings association or credit union likely has no derivatives department.
Derivatives are simply bets. They finance no factories, no research, no colleges, no homes and no cars. Any jobs they produce are incidental and inconsequential relative to the potential risk they represent, the risk that credit exposure has been incorrectly figured by hundreds of billions of dollars if not more. Since big banks hold virtually all derivatives, and since taxpayers can face massive costs if big banks fail, it follows that something should be done to limit taxpayer risk.
“In banking,” said Buffett in 2003, “the recognition of a ‘linkage’ problem was one of the reasons for the formation of the Federal Reserve System. Before the Fed was established, the failure of weak banks would sometimes put sudden and unanticipated liquidity demands on previously-strong banks, causing them to fail in turn. The Fed now insulates the strong from the troubles of the weak. But there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives. In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain. When a ‘chain reaction’ threat exists within an industry, it pays to minimize links of any kind.”
How can we control derivative worries? If they’re so necessary and safe, let bankers and traders take the risk. Personally.
This can be done with regulations which restrict the ownership of derivatives and derivative interests to individuals and partnerships. Federally-regulated banks, savings associations and credit unions would be prohibited from originating, buying, selling, brokering, owning, trading, holding or financing derivative interests, directly and indirectly, for themselves or for another party.
Such rules, of course, would apply to regulated financial institutions as well as their subsidiaries and partnerships, both in the US and abroad. And the regulations would also apply to financial products which fit within the definition of a derivative, even if called something else.
Under this system, derivative profits would be owned entirely by individuals and partnerships. And derivative losses? They too would be owned entirely by individuals and partnerships. No longer would taxpayers be forced to pick up the pieces if something goes wrong.
For those who believe in less government regulation here’s your chance….
This posting has been updated and expanded from material published originally by the author on the Huffington Post.