Derivative Disconnect: The True Weapons of Mass Destruction

“Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal” Warren E. Buffett, 2003

Well, now we know that he was right. It does not make things any better though.

But why are derivatives WOMD? For me, in spite of all the positives mentioned by the financial industry and economists, it is because they remove the original link and logic to the underlying instrument and create counter-objectives for users of the derivatives?

First, a definition, courtesy of Wikipedia (as usual these days):

————————–

Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying on which a derivative is based can be an asset (e.g.,commoditiesequities (stocks), residential mortgagescommercial real estateloansbonds), an index (e.g.,interest ratesexchange ratesstock market indicesconsumer price index (CPI) — see inflation derivatives), or other items (e.g., weather conditions, or other derivatives). Credit derivatives are based on loans, bonds or other forms of credit.

The main types of derivatives are forwardsfuturesoptions, and swaps.

Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.

————————–

What the derivatives do is create an instrument that is related to the underlying instrument, but not necessarily in the same way that the original instrument intended it to be.

Take stocks, for example. The shareholding structure of a public company is meant to align the goals of the shareholder with those of the company. A shareholder wants his or her share to go up. A short seller, in contrast, a holder of a derivative instrument, wants the share to go down. This is counter to the purpose of the original share instrument.

Take loans. A bank providing a mortgage loan to an individual wants the loan to be paid back on time. However a bank who then securitizes the loan immediately passes all or part of it to another party. The other party now should bear the need to have the loan paid back, and the originator has now practically walked away from their responsibility for the loan.

It is this breakdown in purpose – derivative disconnect – that is the real reason why derivatives are natural weapons of destruction.

Now, they are not necessarily weapons of mass destruction, at least not in their raw state. What happens to make them lethal at mass scale, in my view, is the following:

  • People in the financial industry make money when money ‘turns’ – taking a percentage or portion of each transaction
  • This percentage benefits the banks, institutions and individual workers directly as they receive bonuses based on transactions, and the more the volume, the more the personal and corporate benefit
  • The first users of derivative instruments could benefit tremendously as it would give them a first mover advantage in terms of extension of capital it could ‘create’
  • But rapidly other institutions and individuals would follow…
  • And the number, type and scope of derivatives would multiply massively…
  • Creating layer upon layer of derivative instrument…
  • All interconnected… either directly as the credit card loan spawned syndicated loans, sliced up slice after slice…
  • or indirectly as the same institutions took on a merry-go-round of different types of derivative…
  • And at each turn of the merry-go-round, the amount of ‘money’ created through these derivatives became larger, and larger…
  • … much larger than the value of the ‘real assets’ or transactions upon which they were, once upon a time, based

The amount of derivative assets in the system is mind-bogglingly massive (I spotted a post at NB Charts on quantifying the size of derivatives in the system).

So, to wrap up as I have real-world work to do, my argument is simple:

Derivative instruments disconnect the derivative from the purpose of the underlying instrument. In doing so, given the way that people follow and people try to get more money, the derivative instruments multiply and expand massively, so that they no longer bear any relationship at all to the underlying instrument. They become, in effect, a vast non-regulated Ponzi scheme. And the size of the industry that has been created, within a few short years, is nothing short of a lethal Weapon of Mass Destruction.

Go to California, Vegas or Florida and look at the empty homes if you do not believe me – or the UK. Go to Detroit and ask the car workers. Just don’t go to the Hamptons where the recently unemployed bankers get to put their feet up, relax, enjoying their pyramid-scheme bonuses from the last few years whilst they do not have to fight the morning commute into Wall Street.

Advertisements

2 Responses to “Derivative Disconnect: The True Weapons of Mass Destruction”

  1. I cannot agree that derivatives are the weapons of mass destruction you describe, at least when used for their intended purpose of risk management.

    Short selling is not a derivative, it is a manner of borrowing a security and then selling it, to buy it again later when the price hopefully goes down. Naked shorting is no longer allowed and thus all market participants must hold the securities they sell. While there may be some argument for reinstating the uptick rule, I firmly believe that short selling is one of the ways through which true price discovery comes about.

    And just the same, derivative use is a means for accurately creating a balance between the supply and demand, and subsequent pricing of risk in the marketplace.

    The reason for the failure of so many of these institutions was not their use of derivatives in their truest form, but excess risk taking (which could be argued should have been hedged through even greater derivative use – and not by using derivatives for speculative purposes), and also due to, as you argue, their treatment of structured products (MBS, CMBS, CDO) on their balance sheets. Coupling an absolute reliance on rating agencies (who ultimately failed miserably) with this poor visibility into underlying risks (how will I know how many of these people will actually pay their mortgages when I was not the originator?) caused these failures we are seeing. The hubris of “too big to fail” has sunk ships from the Titanic to the titans of banking today. It is with their tails between their legs that they will learn their lesson…but the next iceberg is always just over the horizon.

  2. Short selling is a derivative, when the instrument is not connected to the underlying instrument. It is a derivative of the original.

    My argument specifically against this use of derivatives is that it disconnects the purpose of the original instrument from the new derivative instrument, often in ways that run deeply counter to the original purpose. Short selling, naked or not, is a classic example. A short seller wants the price to go down. A shareholder wants the price to go up. The original instrument is the share in the company.

    I did read a very interesting article on Wired about how the price of these various instruments were set, using a correlation coefficient that did not require any actual real-life data to work out the chance of correlation taking place. The reference is here:
    http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=3

    These new instruments were based on something ‘real’ – they had to be based on something, as opposed to pure counter-party trading. Unfortunately they were just based on pure counter-party trading (or non-trading, in reality), but pretended to connect to the real by pretending to be backed by real world assets, such as mortgages and corporate loans.

    As for weapons of mass destruction… the $14 trillion of fake money vastly outweighs the real economy. And this unwinding of debt and fake money is causing the problems we are all experiencing today. Not real loans against real assets – fake loans, based on derivative instruments (in the truest sense of the word), that created the fake money mess we live in in the real world. In my opinion 🙂

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s

%d bloggers like this: