Derivatives: The toxic financial instrument on par with terrorism

'The Big Short' exposes and attempts to deconstruct the subprime mortgage collapse and disaster of 2008. Wait until Hollywood hears about derivatives!

'The Big Short' opens nationwide on December 23 and as Variety notes, it details the “sprawling account of the byzantine financial instruments that brought global commerce to its knees.” It’s the cinema account of Michael Lewis’s The Big Short: Inside the Doomsday Machine. But it’s more than that.

It’s more than a tutorial on credit default swaps and collateralized debt obligation (CDO) and synthetic financial instrument hocus-pocus. It’s about how society and government have yet again abnegated its responsibility to entrust its financial system with those who can be trusted. And, as you can imagine, how the mainstream media yet again stood by and watched in horror, mouths agape and with nary a clue.

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I commend to you the author Michael Lewis’s own Vanity Fair piece that provides a most thorough overview of the use of an arcane and recondite argot used to camouflage and shield the toxicity of these instruments – and apparently quite effectively.

The Big Short is a cautionary tale of what happens when the nation’s (and world’s) financial systems are left in the hands of the unscrupulous. The well-connected and politically significant unscrupulous, that is. It illustrates how little oversight there was and, I submit, is. Throughout the film the primarily characters repeat the refrain, “How can his be?”

Well, should Mr. Lewis or another enterprising Hollywood type want to follow up with a sequel to The Big Short, let me describe the world of the derivatives market and how it makes the alleged venomous nature of the subprime stratum seem anodyne in comparison.

First, let’s look at what derivatives are in general. As you know, a share of stock represents ownership of a company. A deed to real estate represents ownership in fee simple. A bond is a debt obligation of a government or company. They represent a connection to ownership in the tangible and real world. Now, it gets tricky.

When we speak of derivatives we speak of other instruments and paper that derive its worth and value from the underlying event or basis. Stated differently, a derivative

is a financial contract with a value that is derived from an underlying asset. Derivatives have no direct value in and of themselves -- their value is based on the expected future price movements of their underlying asset.

Did you catch this one piece? Derivatives have no direct value in and of themselves. And as they say on QVC, “But wait, there’s more.”

Derivatives have grown exponentially in the last 30 or so years and represent the most dangerous, toxic and potentially explosive form of speculation and, much like the putrescent subprime world, you will sooner than later hear of these minefields and will wonder again how they were allowed to fester, how no one mentioned them and how those charged with monitoring the stability and safety of the financial world looked the other way.

The estimates of the notional value, defined as the total value of a leveraged position’s assets, of the world’s derivatives market ranges from $600 trillion to $4 quadrillion. Remember that the GDP of the entire world ranges between $70-75 trillion. At some point, if history is any guide, the derivatives bubble will burst and the effects worldwide will be beyond catastrophic.

Every stock on the planet, the entire market capitalization is estimated at $36-60 trillion. The same process for bonds yields a market capitalization of $72-100 trillion. No matter the particular figure or range, the notional value of the world’s derivative market was $1.2 trillion in 2010 and the world's annual gross domestic product was between $50 trillion and $60 trillion.

Are you seeing this? The very idea of a quadrillion anything is heady enough, but imagine having derivatives represent over 40 times the world’s stock market and 20 times the world GDP.

Exchange traded derivatives along with futures, options and indices and every combination and permutation available are somewhat accountable and range from $700-900 trillion. But over the counter derivates and swaps are in effect private contracts and they could represent another $700-900 trillion; no one knows exactly. In most countries they’re not reportable. And nobody knows or apparently cares. Derivatives have no value, they’re in effect side bets.
According to the Office of the Comptroller of Currency (OCC) and its quarterly report on trading revenue and bank derivatives activities for the first quarter of 2014 cited in 5 U.S. Banks Each Have More Than 40 Trillion Dollars In Exposure To Derivatives, the following should get your attention.

JPMorgan Chase

Total Assets: $2,476,986,000,000 (about 2.5 trillion dollars)

Total Exposure To Derivatives: $67,951,190,000,000 (more than 67 trillion dollars)

Citibank

Total Assets: $1,894,736,000,000 (almost 1.9 trillion dollars)

Total Exposure To Derivatives: $59,944,502,000,000 (nearly 60 trillion dollars)

Goldman Sachs

Total Assets: $915,705,000,000 (less than a trillion dollars)

Total Exposure To Derivatives: $54,564,516,000,000 (more than 54 trillion dollars)

Bank Of America

Total Assets: $2,152,533,000,000 (a bit more than 2.1 trillion dollars)

Total Exposure To Derivatives: $54,457,605,000,000 (more than 54 trillion dollars)

Morgan Stanley

Total Assets: $831,381,000,000 (less than a trillion dollars)

Total Exposure To Derivatives: $44,946,153,000,000 (more than 44 trillion dollars)

Let’s stop and take a breath. We’re not talking about a dot com bubble. This is in effect an existential threat to the financial system worldwide. Again, the derivatives market has exploded exponentially with no end in sight. A series of cascading events, a multiplicity of catastrophes could mean utter collapse of... everything. A collapse that will not be able to be bailed out. Where no one would be too big to fail as the failure itself would be too big.

And while The Big Short speaks to the subprime world, even it failed (or refused) to reference or mention the instrument that dare not speak its name. You might have heard of toxic assets or exotic financial instruments or even troubled assets as in The Troubled Asset Relief Program (TARP)

Derivatives are at the center of everything. For far too long citizens have been told and convinced that these issues are beyond their pay grade, too heady and too complicated. What’s more, many think that certainly someone is watching over the system. Some agency or regulatory body surely is keeping a mindful eye on the future of the world – the idea that the captain or pilot has a concomitant interest with the passengers in landing and arriving safely. Wall Street would never let itself succumb to its own greed. Right?

The end of the world, many believe, is nigh. And the catalyst for destruction won’t be a bomb or terrorism or whatever the latest denomination of bogeyman is.

No, the instrument of destruction will be the instrument of the derivative.