I am reading an interesting book called ‘F.I.A.S.C.O.’ by Frank Partnoy. (Ironically, I bought the book in Borders closing down sale for around 20% of the normal price.)
It recounts Franks experiences of working for Morgan Stanley as a derivatives trader on Wall Street.
Simply put, a derivative is a either a right to buy or sell something in the future (called a option) or an obligation to buy or sell something in the future (called a forward) or a combination of them both.
I spent 25 years in banking and I still find derivatives hard to understand and evidence is beginning to show that even those directly involved in trading them don’t fully understand what they are doing.
On page 54 Frank explains how some derivatives were sold.
They would print a piece of marketing literature that was marked ‘For Internal Use Only’ and ‘CONFIDENTIAL’. The traders would send these out to clients as if they were giving them the inside-track. However, each of these marketing pieces would have comprehensive disclaimer clauses written into them.
Now you have to ask yourself why internal memos would require a disclaimer clause anyway. Frank says ‘The important message I took from the disclaimers was this:
The way you made money selling derivatives was by trying to blow up your clients.’
There it is in black and white.
Their purpose was not to add value to clients but to earn large fees from clients irrespective of whether the client made money or not. If the client lost big money as a result of a trade it was called ‘ripping his face off.‘
To my mind they were just putting together high-risk, complex gambling deals and by taking upfront fees on every transaction, they generated massive fees and bonuses for themselves.
From the research I have carried out on the internet, the total amount of derivative trades currently outstanding exceed $1.2 quadrillion (a quadrillion is 1000 x trillion). This compares to the total asset value in the world of $190 trillion. About 95% of derivative trades are on margin i.e. based on borrowed money
Given the trading practices of the investment banks, I think it is fair to say that a fair proportion of derivatives, as they unwind, will result in losses – some say up to a third, based on previous experience.
Now many of the derivative trades have been sold to buyers who do not understand the risks involved in these trades, including pension funds and insurance companies.
I also think it is probably fair to say that there is a large time bomb ticking away within the financial system planted by the financial terrorists within investment banks as described by Frank. (‘Financial terrorists’ is my term for them!)
We came close to a banking melt-down in 2008 and the problems in the banking system have still not been fully addressed by the regulators. The banks have continued to trade as before. Well, why wouldn’t they when they can continue to privatise the profits and the Government/taxpayer has shown that they will take over the losses to save bank customer deposits?
In 1933 America passed the banking act that became known as the Glass-Steagall Act to separate investment banking activities from deposit taking. As recent as 1999 this Act was repealed and within 10 years we have suffered a full-blown banking crisis. In December 2009, a proposal to re-enact Glass-Steagall was put forward by Senator John McCain.
As we have seen, securities activities can be risky, leading to enormous losses. In future, such losses could again threaten the integrity of the deposit-taking institutions. In turn, the Government insures deposits and could be required to pay large sums if depository institutions were to collapse as the result of securities losses.
I therefore strongly advocate that investment banking activities must be separated from depositing taking banks.
The problem is that it may be too late for the risks already attached to the derivative time bomb to be transferred away from the deposit-taking banks that have investment banks attached to them.
Also, the derivative trades are already embedded in the very fabric of our financial institutions.
To sum up.
We have a massive amount of derivative trades currently in the market. The risks are unknown and unquantifiable, although evidence based on experience to date suggests there will be further massive losses. The question is ‘who will be holding the baby when those losses come home to roost?’
No wonder Warren Buffett, the worlds greatest investor, labelled derivatives as ‘weapons of mass destruction’ because that’s exactly what they are. The next decade will be very interesting as these trades mature.
In the meantime, Robert Kiyosaki has written an interesting article entitled ‘2010: The Best Of Times Or The Worst‘ – see if you agree with his predictions of where the US economy is headed over the next 12 months.
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Tags: banking crisis, derivatives, glass steagall, the next decade, weapons of mass destruction
