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The root cause wasn’t just the reckless lending and the excessive risk taking. The problem at the core was a lack of transparency. After Lehman’s collapse, no one could understand any particular bank’s risks from derivative trading and so no bank wanted to lend to or trade with any other bank. Because all the big banks’ had been involved to an unknown degree in risky derivative trading, no one could tell whether any particular financial institution might suddenly implode.
Another global financial crisis is on the way
Financial reform didn’t work. Banks today are bigger and more opaque than ever, and they continue to trade in derivatives in many of the same ways they did before the crash, but on a larger scale and with precisely the same unknown risks.
Ignoring warning signs has inevitable consequences. We ignored them before and we saw what happened. We can say this with virtual certainty: if we continue as now and ignore them again, the great white shark of a global financial meltdown will gobble up the meager economic recovery and make 2008 look like a hiccup.
We can’t say when this will happen. We can’t say which bank or which particular instrument will trigger the debacle. What we can say with virtual certainty is that if we continue as now is that it will happen. Because the scale of the trading is larger, and because the depleted government treasures are not well placed for another huge bailout, the impact will be worse than 2008.
The world’s scariest story: trading in derivatives
Bad as these scandals are and vast as the money involved in them is by any normal standard, they are mere blips on the screen, compared to the risk that is still staring us in the face: the lack of transparency in derivative trading that now totals in notional amount more than $700 trillion. That is more than ten times the size of the entire world economy.Yet incredibly, we have little information about it or its implications for the financial strength of any of the big banks.
Moreover the derivatives market is steadily growing. “The total notional value, or face value, of the global derivatives market when the housing bubble popped in 2007 stood at around $500 trillion… The Over-The-Counter derivatives market alone had grown to a notional value of at least $648 trillion as of the end of 2011… the market is likely worth closer to $707 trillion and perhaps more,” writes analyst Jenny Walsh in The Paper Boat.
“The market has grown so unfathomably vast, the global economy is at risk of massive damage should even a small percentage of contracts go sour. Its size and potential influence are difficult just to comprehend, let alone assess.”
The bulk of this derivative trading is conducted by the big banks. Bankers generally assume that the likely risk of gain or loss on derivatives is much smaller than their “notional amount.” Wells Fargo for instance says the concept “is not, when viewed in isolation, a meaningful measure of the risk profile of the instruments” and “many of its derivatives offset each other”.
However as we learned in 2008, it is possible to lose a large portion of the “notional amount” of a derivatives trade if the bet goes terribly wrong, particularly if the bet is linked to other bets, resulting in losses by other organizations occurring at the same time. The ripple effects can be massive and unpredictable.
Banks don’t tell investors how much of the “notional amount” that they could lose in a worst-case scenario, nor are they required to. Even a savvy investor who reads the footnotes can only guess at what a bank’s potential risk exposure from the complicated interactions of derivatives might be. And when experts can’t assess risk, and large bets go wrong simultaneously, the whole financial system can freeze and lead to a global financial meltdown.
In 2008, governments had enough resources to avert total calamity. Today’s cash-strapped governments are in no position to cope with another massive bailout.