We live in a modern world, which is constantly evolving and changing. Nowadays, you do not need to bomb a country in order to destroy it. Derivatives will do a much better job. You’re probably asking yourself what is a derivative? Derivative is a contract between two parties based upon an asset. Its value is dependent on the fluctuations of the price of that asset. Essentially, derivatives are bets.
The derivatives market was one of the main reasons for the financial meltdown in 2008, which costs exceeded $23 trillion only in bailouts. It left 12,5 million people unemployed, 8 million people lost their homes, 130 million of benefits and left 46,2 million people in poverty – the largest number in the 52 years for which poverty estimates have been published.
Is this enough numbers for you? I already wrote an article on why the next financial crisis is imminent. Here is one more reason why we can’t escape our faith. The 2008 crash was largely caused by the unregulated derivatives markets. And if you think the problem has been fixed, you’re mistaken.
If used right, derivatives are a useful tool of hedging risk, however if not – these could be the new weapons of mass destruction that Warren Buffet warned us about. Let’s take for an example American International Group (AIG) – the insurance giant that lost almost $100 billion in 2008. How did this happen? Well, let’s say that you are a pension fund manager. Part of your charter says that you can only invest in very safe investments, because you can’t risk all the life’s work of honest workers. You can only invest in things that are rated AAA – the highest standard. However, some major corporation (let’s call it corporation K) needs a loan, but is only rated at BBB – not high enough rating. So what do you do, the corporation needs money and you have money to spend. This is where AIG comes in with the so called credit default swaps – an insurance on the loan. So you lend the corporation a small loan of a $1 billion dollars with 10% interest. But in order to stay in the clear in front of the investors in the fund – the hardworking Americans you need to package the whole deal and declare it “safe”. So you go to AIG (a company with AAA rating, almost impossible to fail right?) and strike a deal with them. They will insure the loan in exchange for an insurance premium – 2% of the loan payments. Now, all of a sudden the loan has a rating of AAA, because it is insured by AIG.
However, AIG doesn’t have $1 billion dollar in reserve in case of corporation A fails on their loan. In fact, AIG is a highly leveraged with very few capital in reserve. So any small miss fortune will sink the whole ship, as it happened in 2008. This is only a small example of how derivatives are used, so that bankers and insurance can keep their margins high and their bonuses big. Derivatives are essentially bets, simple as that.
The derivatives market as a whole is HUGE. It is estimated to reach more than $1,2 QUADRILLION. That is 10 times the size of the total world GDP. There are virtually available derivatives on every possible asset – equities, commodities, bonds, currency exchange and even the weather. Yes, bankers can bet on the weather.
This problem wasn’t addressed after the crash of 2008 and derivatives market still remains a Ticking Time Bomb. Most of derivatives contracts are based on interest rates. Most big banks still have them on their balance sheets and even if 0,1% of the money insured by derivatives is at risk It would wipe out 10% of a bank’s equity. 1% would wipe out all of the bank’s equity. So next time when the news bombards you with news about North Korea, know that there is a far greater threat for the U.S.A. and the whole world, a new kind of weapon, invisible and yet- more deadly than most of the bombs in the world.