Russian Roulette…Derivative Style

Russian Roulette:  Put one bullet in the cylinder of a revolver, spin the cylinder, point the gun at YOUR head, and pull the trigger.  Most revolvers have 6 chambers so your odds of surviving are 5 in 6, IF you quit after pulling the trigger once.

Press your luck, spin the cylinder, point the gun, and pull the trigger again.  It might be okay.  Try for a third time?

Now play Russian Roulette – Derivative Style

Note:  I have no insider knowledge regarding derivatives, so I am merely speculating.  But I think we can assume the following:

·Total face value of unregulated derivative contracts is something around 1,000 Trillion dollars – depending on who is counting and who is lying.

·Banks (Goldman, JP Morgan, Deutsche Bank etc.) sell these contracts because they generate huge commissions and probably other long-term profits.

·Wall Street banks poured mega-bucks into DC lobbyists to keep the derivative game running with minimal regulation and oversight.  Obscene profits, not the public good, are the reason.

·Except for commissions upfront, derivatives are supposedly a zero sum game.  I win, you lose, and the bank gets a fee.  It sounds like a bookie in Las Vegas.  You put up $1.1 Billion to win $1.0 Billion.  Somebody wins, somebody loses, and the casinos (derivative banks) take the $100 Million as a fee – roughly 5% of every dollar bet on either side.

·Let’s be trusting and assume the derivative banks only take 1%, not 5%.  If the notional value of derivative contracts is $1,000 Trillion and the fee is only 1%, the cumulative take for the banks writing contracts was $10 Trillion.  That is a lot of CEO bonuses.

·Even if the commission was one-tenth of a percent the take was $1 Trillion in fees.

·Eventually the system must fail, as commissions and fees suck capital out of the system each time a contract is written.  More leverage and more indebtedness will not improve an unsustainable system.

·But fees are collected as contracts are written, bonuses are paid, and taxpayers (via bail-outs) or depositors (via bail-ins) might have to cover the losses.  Remember TARP and the Cyprus bail-ins!

Another Trigger Pull!

·Nothing goes wrong - no crash, no bank failures, no government default.  This is unlikely and more so each day.

·Banks continue writing derivative contracts because … they can and why would they stop?  Let’s guess another $1,000 Trillion each decade in new contracts.

·Banks collect a commission which generates perhaps $1 Trillion or more in fees; this is $1 Trillion (or maybe much more) sucked out of the financial system each decade – and it produced nothing.  It reminds me of the phrase, “the rich get richer, and the poor get poorer.”

Implications

·In ideal circumstances there is no crash, no bank failures and all debts get paid. 

·But derivatives suck a huge amount of capital out of the global economies each year, and that makes ideal circumstances increasingly difficult to maintain.  Instead of paying banker bonuses, that capital could be used for constructive projects.

·The financial system is unlikely to continue operating under ideal circumstances.  When another 2008 crisis arrives the supposed zero sum game, less commissions of course, becomes a black hole of daisy-chained obligations that might collapse the American, European and Asian financial systems.  It has happened before. 

·The resulting financial and social chaos will not be pretty! 

Got gold?  Own silver?  They are financial insurance, unless you trust that Wall Street will take care of your needs. 

GE Christenson

The Deviant Investor