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HomeMega Bank ProblemsHow Derivatives Caused the Economic Crisis
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 Derivatives contributed to the Economic Crisis

     “In plain terms, derivatives are THE cause of the Financial Crisis. They are behind EVERY failure and default that has occurred thus far.

The fact that virtually no one is willing to address this issue or include it in the discussion of how to insure we don’t have a Second Round of the Crisis only confirms the fact that no one has a clue how to resolve this situation.”            ---Graham Summers, Investment Advisor

 

What Exactly is a Derivative?

  A derivative is a financial contract "a deal" used to insure or predict the value of something. One person is a derivative buyer and one person is a derivative seller. Typically a financial institution, like a hedge fund or a bank, enters into a derivative contract with another financial institution. Derivative buyers pays a monthly fee to the derivative sellers for a set amount of time.

      For example, let's say a pension fund invests in mortgage backed securities as an investment for its retired folks. It doesn't want its pensioners to lose money, so it pays the bank or hedge fund $2,000 a month for 9 months to make sure that the mortgage backed security doesn't lose value. In the event that the mortgage backed securities lose value, the derivative seller agrees to pay the pension fund $1,000,000. This kind of derivative is called a credit default swap.  

Countless derivative contracts are entered into daily to insure that a stock doesn't lose value past a certain point. They are like insurance policies.

     Can you see how if you are a derivative seller on the "losing end" of a lot of derivative contracts what happens if you have to pay out $1,000,000 on a regular basis?  You would lose a massive amount of money. That's what happens. Derivatives are gambling, hedging one's bets on future imagined and hoped for profits. This isn't the form of capitalism most of us were taught. It's similar to gambling.

     Also, some banks, hedge funds and individuals bet on a stock's downfall. They buy a contract to short a stock. Again, a monthly fee is paid to a derivative seller for a set amount of time. For example, if an individual believes that gold will go below $1,500 an ounce in six months time, he or she will buy a derivative contract making a bet with another person, bank, or hedge fund. The buyer pays the seller $4,000 a month and agrees to pay it for six months with hopes that gold will go below $1,500 an ounce. And the seller agrees to that and promises that he will pay the buyer $1,000,000 if the price of gold goes below $1,500 an ounce. Clearly, the seller doesn't believe that the price of gold will fall below $1,500 an ounce. Sometimes, the seller collects the $4,000 a month and doesn't even have the $1,000,000 in the event the gold price falls! That is known as naked short selling. Naked short selling is widespread. It causes massive banking losses. It should be illegal. These are just two example of many kinds of derivative contracts.

 The Derivative Market Touches our Lives 

     Worldwide, in 2011, there was an estimated $1.3 quadrillion tied up in derivative contracts. Much of our collective tax dollars and public assets are tied up in the derivatives market. Our pension funds, money for education and city budgets are at risk.  

We can clearly see the explosion in the derivative market from when they were deregulated. In fact, if you look at the chart you can see that the market had increased nearly 10-fold between 1999 and 2009.

Derivative buyers and sellers don't make things like cars, food or houses. They don't teach school and they don't pave roads. Derivatives are created by the financial industry for them to hedge their bets. Most Americans have never invested in a derivative contract.

     However, sadly, all Americans and people worldwide have been hurt by the derivative market. Because when the big banks lost lots of money in the derivative market, the American people and people worldwide were (and are) being called on to bail them out, not to mention that people's pension funds and city and state budget monies were tied up in these markets.  "Privatize the gains. Socialize the losses." That seems to be the mantra in the new world economy. 

Trillions of Dollars in Derivative Products Worldwide


 Notice the trillions and trillions of dollars involved in the global derivative market. If you had started spending $1,000,000 per day 2000 years ago and kept spending until now, you would still not have spent one trillion dollars. That's $1,000,000,000,000.  A "1" with 12 "0's"

Most of the money in derivative contracts is in interest rate swaps. 

Notice the acronym OTC. It stands for Over The Counter. It means they are unregulated.

Is it OK  to bailout the banks when their losses are due to gambling?

 

 

 

The Big Banks are Heavily "invested" in the Derivatives Market

 

     This graph is from 2008. Notice how the banks hold a lot of derivative contracts (red bar) in comparison to their assets (green bar). A lot of their assets are our savings accounts and loans they have made to us. No wonder the banks fell in 2008. If you are on the losing end of a derivative contract, you lose. It's gambling.

Clearly, our banks have become too big to fail. If they fail, a lot of people get hurt. If they are allowed to survive a lot of people get hurt because we end up bailing them out. Again, remember our new world economic mantra:  
"Privatize the wins and socialize the losses".

 We are in a real bind.

 An Unregulated Market


     Because the derivative market is unregulated, there has been corruption. For example, in many cases the derivative seller pays a credit rating agency to rate his derivative product. And the credit agency gives the seller a AAA rating because he was bought off. Clearly, that is corrupt. It is like a person going to a doctor and paying the doctor to tell him that his health is perfect even though he might be very sick.

 Matt Taibbi has written a lot about this.

 

 Corruption Out in the Open

 Goldman Sachs bundled mortgages and sold them as investments known as collateralized debt obligations to pension funds, foreign governments, cities, states and individual investors. Goldman Sachs fully knew that those investments were bad even though the credit rating agencies, which Goldman had paid to rate their CDO’S, gave these securities a high grade. In fact, these investments were top rated: AAA.They were made to look like solid investments.    

 

The investors were fooled. It seems like these investors were deliberatively fooled!

 

These securities were actually bundles of mortgages that had been sold to people who couldn't afford to pay their mortgages. These securities were junk. When people couldn't pay their mortgages, the investors lost their money.

To make matters worse, before the housing market crashed, Goldman entered into credit default swaps with AIG, an insurance company. It entered into these contracts so that they would get paid with the collateralized debt obligations went bad. Sure enough, the CDOs went bad and Goldman Sachs made LOTS of money, upwards of $13 billion from AIG.

See Bill Black explaining to Bill Moyers what happened in this case of open fraud. http://www.youtube.com/watch?v=Rz1b__Mdt

 

How Derivatives Contracts Steal From State Economies

Derivative contracts are complicated. Unfortunately, some of our public institutions have entered into these contracts without maybe fully understanding the fine print.

Detroit

       Detroit struck a derivative deal with the Union Bank of Switzerland (UBS), --Switzerland is pretty far away from Detroit. This derivative was an interest rate swap. In an interest rate swap, one institution trades its interest rate with another, from fixed to variable or from variable to fixed. The interest rate swap contract between UBS and Detroit was written with strings attached. If the city's credit rating dropped, UBS could get out of the contract and demand a sizable breakup fee.
    
That's what happened. Detroit’s credit rating dropped, and Detroit had to pay $303 million to UBS, money that was needed for the city residents who knew nothing about this derivative contract. The citizens faced cuts and had no idea why.

 Pennsylvania

      Likewise, many public institutions in Pennsylvania, including many schools, entered interest rate swap contracts with banks and ended up having to pay huge break-up fees to these banks. Philadelphia had to pay Citibank, Goldman Sachs and JP Morgan, (and other banks) a total of $332 million. Huge break-up fees with banks greatly contributed to Pennsylvania’s $14.9 billion debt in 2010.

Here are more samples of interest rate swaps entered into by public entitites. We the people are the backstop to this debt resulting from termination fees!

An analysis of some of the interest rate swap contracts entered into nationwide and the amount of money our cities, states and public institutions have owed to banks see:

http://online.wsj.com/public/resources/documents/Interest_Rate_Swaps.pdf

Do you think the people would have voted to have this system?!

 Stop Risking Public Money



“Money that should be invested in students, classrooms and fixing infrastructure in Pennsylvania is instead lining the pockets of Wall Street. State and local governments must stop gambling with government money.”

----
Jack Wagner, Pennsylvania State Auditor

 

 

Derivatives are Financial Weapons of Mass Destruction.

  Derivatives, Really?

 

A:  These derivative instruments are scary. Are they really necessary? They don't seem to do much for the real economy, nothing for me!


B:  I know what you mean.... the sellers who lose money go under and don't expect a bailout. I don't want my tax dollar involved in legalized gambling. That's for sure.

 

We are facing a very sad and scary situation. People in the U.S. and worldwide are being hurt by our current financial system. I think we could do better than what we have now.

 

 Changing the System

 

 

     The first step in changing any system is in making transparent and understanding what's happening. While this website is quite simple and is simply a start for some people, there is a lot of information out in the open which explains what has happened to us as a result of casino capitalism.

   There is no reason that our state revenue should be risked in the derivative market.

 A public bank with its high level of transparency and accountability would protect our state revenues from risky speculation in things like interest rate swaps and other risky derivative instruments. 

 Join the effort to start a public bank here in Washington!

 For more information about the derivative market and how it is hurting us. Google these names: