Big Banks and Derivatives: Why Another Financial Crisis Is Inevitable

This article appeared on the Forbes website 8 January 2013.

I also refer to the thread on ATS entitled Global banking rules won't stop next meltdown.

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.

I think in addition to a lack of transparency and risky derivatives trading, it is the last part that should give some pause for concern. Should there be a repeat of anything like 2008, where is the capacity from central banks and governments to effectively respond? Well it could be argued that there won't be another financial crisis of that level so it doesn't matter. That could be very hopeful thinking at best, and hence this article, cited only in part.

We're reading a lot of positive hopium in the media lately that suggests, or perhaps masks, any risk that may be underlying the financial system is contained and controlled. Even discussions on this forum have slowed markedly in recent months.

There's renewed hope about China economic growth gaining traction again and the world economy benefiting from that. There's increased optimism about the Eurozone crisis with the likes of delusional Draghi trumpeting the worst is over, that there will be a return to economic growth later in 2013, though provides absolutely no data that I have seen to support his forecast besides lower borrowing costs, even as government debts and unemployment continue to rise among the Eurozone countries involved. The US, despite trillion dollar annual deficits which don't seem to matter much to anyone it would seem, is seeing some economic and job growth.

So what do ATS members think? Does any of this matter? Is such a financial crisis on par or greater than the 2008 meltdown an inevitability? Anything you might be aware of as traders yourselves (I'm not) or otherwise, suggest such a financial crisis is forthcoming? Any comments appreciated.

The reality is, we're a really really stupid breed.

The human race makes the same mistakes over and over and over and over an over and over and over, never learning that blatant greed, crass commercialism, the lust for power and the never-ending drive for the almighty buck don't mean jack squat when the busride is over.

The peckerheads that run the banks are probably worse than the rest of us because they actually get paid more to fiscally probe the rear ends of those who don't have more than five zeros behind the initial digit on the applicable 'gross income' line of their tax return. They'll keep spinnin' the bottle until it breaks, then they'll invent a new game to bolster their never ending revenue stream.

We'll all continue to play their game because we're all too consumed with coloring inside their lines as opposed to actually stepping outside of their parameters and living life for the sake of . . . well . . . living life.

When will people ever learn, there ain't no luggage rack on a hearse?

Probably never.

I've been expecting another crack since 2010, and yes, the next one will hit much harder. The higher you go, the harder you fall.
The current system depends on constant growth, and simply isn't sustainable.

It's sad really.

Mere details....The crash is planned. they didnt accomplish the meltdown they wanted yet...the next one will make slaves of us all........

No more bailouts! Let them fail this time. They wouldn't bailout the common citizen if they made financial mistakes. Failure leads to positive changes if they learn from their mistakes. That's a big "if" though.

I think the problem is, that the banks were allowed so much self-regulation and lack of oversight that they were allowed to run rampant. Basically, they ran out of things to bet on, so created ever more complex and risky vehicles on which to bet and through the complete lack of oversight, it has all mushroomed into the ridiculous notional amounts we see bandied about today.

I mean, what is a "derivative"? How can it be explained in a meaningful way to the ordinary man or woman in the street in a way that can be understood and actually mean something? It doesn't relate to any tangible "thing" or commodity and is simply a created virtual betting vehicle.
So, what good to mankind is a derivative? It can't be seen, touched, used to build anything or be eaten, and as such is a meaningless creation.

Problem though is that we are all still on the hook if the derivatives market implodes, not just the bankers who created them and got rich from gaming these markets of pointless and meaningless virtual things!

If I might add an opinion here:

"We" (meaning people of the world) never "allowed" the Central banking Cartel to schmooze and romance our representatives - making them beneficiaries of the "fractional reserve" scam that has existed since the royals bought into it centuries ago.

This is an "imposed" framework for economic control - the monopoly is the Bank. The illusion of the "competition" is what keeps us thinking they are "legit."

Their creation of financial vehicles that exist only as a gambling scheme was however - allowed - by the high-powered, socialite businessmen we were persuaded to elect... thank you Big Media....

Anyone tying these loose ends together yet?

When looking at the lead up to the last financial crisis, the sub prime house loan situation was well known with many media investigations in the lead up. The risks of neglecting basic economic responsibility are very clear, it is just a matter of who ends up paying in all the resulting complex and convoluted chaos.

Now all the issues with the fiscal cliff and debt ceiling problems are getting the media attention as basic economic responsibility is once again lost with a very reasonable and growing risk of government default. The financial sector is very highly tuned to maximize wealth generation amongst the usual social risks. When a larger than usual risk emerges, liquidity is quickly diminished and the longer term assets lose value as demand fades, perceptions alter and priorities change. In a market crash or economic collapse, the status quo is no longer as the organizational structure of the cash flow is redefined and needs to be rebuilt.

With the Euro built on similar economic foundations as the USD the same risks are present as government debt levels become unmanageable and out of control. Things do not appear to be as critical with the Euro as it is with the USD, but if one should fall the stress on the other will be immense. There is no such thing as too big to fail, but the bigger it is the more slowly and forceful it moves. With the governments saving the banks in the last economic crisis a lot of the pressure has shifted from the private to the public purse. While a lot of effort has gone into fixing up economic flaws there are still ongoing problems and risks remaining.

The BRIC nations have considered the option of setting up their own central bank with a gold backed currency. If the USD does fail taking down the Euro, global trade will still continue as these BRIC nations will still be able to trade while the US and Europe sort their mess out. As for how far and how likely such an option is I am not sure, but there has been many discussions about many options with the direction the global economy is to take.

Raising the debt ceiling to infinity is another option that has been raised to avoid the current problems and find a solution. This will force the position of economic growth and like all ponsi schemes, once there are no new takers to the plan it all falls apart. For the US this will be expressed through the bond market, more bonds will have to be sold as the debt continues to mount. As more bonds enter the market demand fades, eventually there will not be enough buyers for the bonds needed, so the government defaults and the money moves to other markets as the US is no longer a safe bet. Then the chain reaction of this very high debt is set off.

Overall all, China is set to be the next global dominant currency in the short to medium term. It does appear and will be good to see it more inclusive of other currencies in how it approaches the issues of global trade. As for America, does it go out with a bang as its responsibilities catches up with it or a more gradual slide as it tries to get its responsibilities in order?

I've got 50 fishing poles, 6 tackle boxes, 1000 top of the line lures, 2 fishing kayaks, a 17ft lowe big water boat, 3 rifles, 2 shot guns, 3 pistols, a bow, and a crossbow. I also have portable cooking equipment and water purification equipment. I'm surrounded by wood and water. I hunt and fish for sport and fun but if I had to I could survive off of it.

I survive on less then $12K a year.