Derivatives 101

February 4, 2015, by Ken Jorgustin

what-are-derivatives

Unless you are in the business of banking, trading the stock market, or other such related financial industry, chances are that you’ve heard the term “Derivatives” but perhaps don’t really understand what they are, and what the big deal is regarding the apparent risks of toppling the system as we know it…

Here’s a simple definition of derivatives, and why they are so dangerous:


 
If you want the technical and financial institutional definitions of derivatives, you can search the web for all of the jargon and fine details. If you want to understand what they are in a practical sense, hear it is… simply…

EXAMPLE #1
You have a car loan.
The car loan belongs to the bank.
The bank has a whole pile of car loans.
The bank packages a few of them together (with a pretty bow on top) and sells them as an “investment” to an investor.
That is a derivative.

EXAMPLE #2
You have a mortgage.
The bank owns the mortgage.
The bank has a pile of mortgages.
The bank packages a few of them together (with yet another pretty bow on top) and sells them to an investor.
That is a derivative.

These are debt obligations, and derivatives can literally be anything. They can be packaged in any assortment of risks to the investor.

Some derivatives are bundled together with various others, such as some mortgages and car loans together (as an example) – or mortgages, car loans, and credit card debt – or any combination of others. It can get complicated as far as what exactly are in the bundles and the underlying associated risks thereof – however as long as the derivatives continue to ‘perform’ (e.g. people pay their loans on time every month, etc..), then all is apparently well.

A problem though is that much, if not most of these derivatives are apparently junk. Garbage. Selling derivatives (e.g. the risky loans) will pass on their associated risk to “investors” (who have become mesmerized with the pretty bow on top of the package), and are themselves saddled instead with the performance risks. The thing is – many of these investors are YOU, because chances are that some of your pensions and 401Ks are invested in them, etc.. and you may not even know it.

There’s an additional problem with all these derivatives, and the most important of all. That is the sheer $ number – which is staggering. JP Morgan alone holds more derivatives (~ $70 Trillion) than the entire GDP (gross domestic product – the value of all final goods and services produced) of the WORLD. Read that back… they own more of these derivatives (debt) than what everyone in the entire world produces in one year. It is said that global derivatives are somewhere in the neighborhood of $700 Trillion. Absolutely astonishing.

The thing is, these derivatives and bundles are tied together and intertwined such that it is possible that a significant failure could chain-react and topple the entire system into complete lockup or collapse. The situation is evidently much worse today than it was during the 2008 (almost) collapse of the system. This is one reason why there is so much smoke and mirrors regarding the state of the economy (here and elsewhere) as well as hiding, twisting, and distorting any bad news (to good news) so that there is not a loss of confidence throughout the system.

A derivatives meltdown would be an event that many cannot imagine (or refuse to imagine). The $ amount of derivatives is so staggeringly high, that there is absolutely no conceivable way whatsoever that when one or more of those big dominoes start falling – that it could possibly be stopped. The money will stop flowing and the system will seize up. Everything basically stops. It would not take long for complete and utter chaos as distribution systems grind to a crawl or halt completely. The govt will mandate movement of a critical supply infrastructure, but at best a trickle will flow while stores with food and supplies are pilfered and emptied. Once that happens, it’s over. A panicked populous will keep the shelves empty – even after any new deliveries. The JIT (just in time) system will have broken – and may take a very long time to repair, if at all. In the mean time, we will have descended into a deep depression and probable social chaos. A dangerous time indeed.

One good book which explains some of this in an understandable way, The Money GPS: Guiding You Through An Uncertain Economy, reads “Unpayable debts are piling up all over the world and are attempted to be resolved by adding even more debt. This system will COLLAPSE, creating the greatest wealth transfer in the history of the world: from those who hold paper, to those holding real assets.”

I agree.