Derivatives: Gambling with Taxpayer Money

f parties, unknown to you,  had multimillion dollar bets that your $200 thousand house will burn down in the coming year, would you be upset?  I suspect so.  Some of those parties may need money,  may send an arsonist over, maybe not even tell you in time to get your family out.  Well… Welcome to the world of derivatives.  Only, forget the $200,000 house, start thinking in the billions and trillions.
Now, sit down, these figures may shock you:  The face (notional) value of derivatives held by US commercial banks is over $200 trillion dollars and the total derivative market over $700 trillion. Don’t believe me?  Click here for the US government’s 4th quarter OCC Report, released last Friday.  Read the first two bullets.  Remember, this is just derivatives held by US commercial banks, the total market is, as mentioned above, over $700 trillion (see here).
How much is $700 trillion dollars?  Temple University math professor John Allen Paulos says: “A million dollars a day for 2,000 years is only three-quarters of a trillion dollars”   Well, think about it a minute or so, then go figure $700 trillion.
Okay, these figures are scary and many derivatives are useful and can be unwound.  Derivatives are also useful hedges for farmers, miners and others to smooth out market fluctuations.  They increase liquidity and facilitate transactions.  Credit Default Swaps (CDSs) can measure perceived risk.  The purpose of this article is not to demonize all derivatives.  My question is: why do commercial banks doing with over $200 trillion of them?  This amount is almost four times larger than the total GNP of the entire world, more than all the combined stock and bond values of the world.  Their is only one explanation and that is large scale leveraged speculation.  Another, maybe more accurate term, would be gambling.
Which banks hold much of these derivatives?  The OCC report tells us.  It is five large commercial banks.  They are JP Morgan Chase (JPM), Citibank (C), Bank of America (BAC), HSBC Bank USA, and Goldman Sachs (GS).  Some 82%  of the holdings are interest rate swaps.  Swaps are risky with winners and losers.  Goldman Sachs is most deeply involved.
Now, like me, you may wonder what the hoot is going on here?  Credit Default Swap (CDSs)  didn’t even exist 14 years ago. Now they are a $62  trillion dollar market.  Interest swaps started slowly in the 1980’s, the five banks above alone hold $162 trillion worth.  Why is this rapidly growing market so huge?  A recent  Newsweek article even mentioned the market will be in the Quadrillions soon.
Glass-Steagal was repealed in 1999, allowing banks and others, equipped with sophisticated computer systems, to plunge into derivative trading.    A worldwide, unlimited casino opened up.  Hedge funds, banks, insurance companies took advantage.
Systemically important institutions have no business being major players in this market.  Certainly, taxpayers have not agreed to participate, much less bail out the losers.
The claim is made that derivatives are just paper entities in which assets and liabilities zero out.  Well, yes, there is truth to that.  But, this high-stakes gambling, like all gambling, has winners and losers.  Consider Bear Sterns, AIG and Lehman Brothers, all losers.  In a deleveraging world, we are getting more and more losers.  It doesn’t take much of a shift in a $600 trillion market to wipe out huge companies in days, look at AIG.  Look at what would have happened to Citigroup without taxpayer money.
So, how dangerous are derivatives?  Warren Buffett called Credit Default Swaps “financial weapons of mass destruction”.  AIG proved him right.
Forbes magazine, in their March 16, 2009 issue, has an article on how Lawrence Summers (currently heading the White House’s National Economic Council) entered into interest rate swaps at Harvard University which “burdened Harvard with a multibillion-dollar bet on interest rates that went against it”.  The Forbes article goes on to say that bad  derivative bets may have adversely affected univerisites and hospitals around the nation.
AIGFP  insured CDS derivatives, lost their bets, didn’t have the money to make good, even all of AIG couldn’t make good.  So now the American taxpayer was told they must make good, to the tune of hundreds of billions of dollars.  American taxpayers are the losers, financial institutions world wide are the winners.  Now, after AIG, tell me how you can possibly think derivatives are not dangerous.  And, doesn’t it strike you as strange: few are talking, even now, about reining in the derivative markets?
The megabanks are heavily into interest rate swaps, with a combined notional value of over $150 billion according to the OCC report.  If these systemically important institutions start losing on their interest rate derivatives, which the OCC Report said they did in the 4th quarter,  will we the taxpayers be on the hook to  bail them out again?  Remember the interest rate swap market is much bigger than the CDS market which got AIGFP into trouble.
Derivative trading seems to be a huge, unregulated market, run by the self-appointed elite all over the world amongst themselves.  They use OPM (other people’s money) skimming off profits.  Forget lotteries, forget sports betting, forget Vegas.  This stuff is the ultimate!  A powerful elixir those in power cannot resist playing with.  Doing this for there personal accounts is one thing but  Holding the world economy as hostange and involving taxpayers as backups for losses, however, is criminal.
One wonders how much of the pre TARP scare mongering last fall was true.   Now, the bailouts are bankrupting our nation and there is no end in sight.   We need to start listening to people like Richard Shelby and Ron Paul, not Paulson, Geithner and their cronies at the big banks and Goldman Sachs.  It is time to make those responsible take their losses.
The US government has printed, borrowed or promised some $14 trillion so far.  And guess what: It hasn’t worked! The London protestors suddenly don’t look so foolish, they at least aren’t bankrupting us.  AIG, FANNIE, FREDDIE, JP Morgan, Bank of America, Citigroup, Goldman Sachs want even more of our money, there is no end in sight.   This is insanity!
Disclosures: none