DOES ANYONE REALLY KNOW WHAT “DERIVATIVES” ARE? HOW THEY WORK?

Back when the George W. Bush Administration was advising the American People of the “Financial Abyss” that America was staring into, just prior to Lehman Brothers going into bankruptcy, a reporter asked Henry Paulson, the Secretary of the Treasury, how the various “Toxic Assets” worked.  He responded that he wasn’t really sure.  Just two years earlier, Secretary Paulson had been the CEO of Goldman Sachs (for ten years), which is arguable Wall Street’s most renowned securities firm.

Since that press conference, at which the initial bail-out of the largest banks, which were considered “too big to fail” was announced, they used the term Toxic–generally understood to mean evil–rather than the more financially-appropriate term of “Derivatives”.  I have used derivatives in prior Blog Posts and, no doubt, you have probably noticed it in the financial pages of your newspaper.

Derivatives are basically contracts that can be used in place of an asset–such as securities, commodities or currencies.  Some derivatives have a valid purpose in the operation of a business or a financial transaction, oftentimes reducing risk.  Other types of derivatives seem, at least to me, to be mostly for taking risks–somewhat like at a casino–where one side wins and the other side loses.  The riskier ones, however, are mostly used in the institutional financial markets, in denominations of tens, if not hundreds, of millions of Dollars.

Let me suggest several valid uses of derivatives:

1.  I had a client in Florida who once sold a vacation home in Nova Scotia, Canada, for a million dollars, but it was denominated in Canadian dollars which generally trade at around 75 to 85 cents U.S.  However, he was required by law to leave 25% in escrow in Canada for three months following the sale.  At that time, however, the price of oil was much higher and the Canadian dollar was trading roughly even with the U.S. dollar.  But, what would the deposit be worth when he could bring it home?

So, he entered into a foreign exchange “futures” contact–selling Canadian dollars in return for U.S. dollars, for delivery around the time he could access his Canadian escrow proceeds.  The client was, in effect, insuring against a drop in the value of the Canadian dollar, by say 15 to 25%, which would have cost him anywhere from $37,500 to $62,500 U.S.  Either way, he was going to bring the rest of his sale price back to the U.S.; so, why not lock the value in now?  Thus, if the Canadian dollar dropped, he was protected; but, if it rose further, he was willing to take that risk.  As an American, he was bringing his money here, either way.

2. Some time ago, I met a man who was a wheat trader for a large international producer of cereals and animal feed.  A trader spends the day watching the trading activity–purchases and sales of generally one commodity, but again in the”futures” market (for future delivery)–and makes transactions whenever a particular price looks good.  His colleagues were buying and selling other grains.  So, why would a company do this?

Since I know nothing about farming, let’s just assume that the planting season is in April and the crop will be harvested in October.  A large corporation would be assuming extensive risks if it tried to predict what the cost of the various grains would be at the time that they are shipping their products to market.  So, my friend‘s job was to lock-in a price today, and continue to fine-tune it throughout the growing season. In the case of a professional trader, besides enabling the company to lock-in its projected cost of goods to be produced in October, he might also trade on an “in-and-out basis”, trying to earn a little more revenue, along the way.

These are both normal transactional risks that can be taken to lock-in a future price today.  Such transactions have been going on, around-the-world, for centuries.  But, those toxic assets are much different types of derivatives.  Besides being much riskier, they can also be somewhat manipulative, and can thereby achieve a self-fulfilling prophecy.

Once the Government advised America–and the World–of the financial crisis, and that the Treasury Department was forcing huge amounts of money on the banks, Wall Street (collectively, the Worldwide financial markets) began to try to determine which banks were the weakest–and especially after Lehman went down–which bank would be next.  In the financial services industry, when the public loses confidence in an institution, it takes its deposits and the rest of it business elsewhere.  Once the spiral starts, it’s hard to stop it

Such a vote of No-Confidence seemed to shift from bank-to-bank, but mostly among the very largest ones. And, those were the very ones that the government was trying to prop-up; because, they had the largest share of the overall banking and securities business, as well as the most potential impact on the global financial markets.

There were two vehicles through which the individual members of the financial community demonstrated their lack of confidence in each other:  short sales and credit default swaps:

A short-sale is when anyone sells a stock, which it might not even own, and borrows it from another securities firm (to make delivery).  Basically, someone sells short (or “shorts”) a stock when it expects the price of that stock to decline in value. It costs more and more to borrow stock as its price declines and, if the seller guesses wrong and the price rises, it loses.  As more and more investors jump on the same stock, however, it can be manipulative and force the stock into a downward spiral.

Credit default swaps are private contracts between two firms, basically in which one firm is betting that the corporation in question will default on its debt, and the other guarantees to pay the amount of the contract (for a fee) if it does.  Neither the corporation that issued the debt nor any other investor is a party to the CDS.  Once again, as more and more CDSs are executed with regard to an individual corporation’s debt, the cost of the contract increases swiftly, the practice become manipulative, and itv could, once again, force the corporation into financial oblivion.

In a prior Blog Post, I had written about the fact that the Dodd-Franks legislation, which became law in 2010, took some of those various toxic assets “off the table”, so to speak.  But, the Republican Party, and perhaps a few Democrats, with the vigorous urging of Wall Street and, no doubt, sizable campaign contributions, is trying to de-fang Dodd-Frank.  That was what I meant by “Is America setting itself up for another Financial Melt-Down?”, linked as follows: https://thetruthoncommonsense.com/2014/12/28/is-america-setting-itself-up-for-another-financial-melt-down-2/.  The new Congress which starts on Tuesday will be interesting to watch; but, President Barack Obama still has Veto Power.

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  1. #1 by John Michael Brummer on January 5, 2015 - 9:37 AM

    Cheerio Cheekos! At least one US citizen – an former bank-employeé – has drawn the right conslusions!This is hopeful……

    • #2 by cheekos on January 5, 2015 - 3:02 PM

      John Michael, I worked for the Brokerage Subsidiary of a Financial Services Corp, not the Bank.

  2. #3 by cheekos on January 21, 2015 - 1:28 PM

    An related story from the Wall Street. JPMorgan Chase is setting-up a new department to trade indexes on credit default swaps. That’s basically a bet on a bet. The link is: http://blogs.wsj.com/moneybeat/2015/01/21/j-p-morgan-creates-unit-to-meet-new-bond-trading-patterns/

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