A Primer on Derivatives

Series: Bail-in At Your Local Bank

With no fanfare and little to no media coverage, your government has just put in place a mechanism to use your deposit money to bail-in a failing bank, like what happened in Cyprus a short time ago.

The derivatives market, the trigger of the 2008 global financial crisis, has since gotten even bigger and more concentrated into fewer hands. A mutually assured destruction awaits the global economy next time it goes off again.

Herded along by the Financial Stability Board, governments of leading economies endorsed a framework during the past G20 Summit whereby depositors’ money will be used to rescue a failing bank when the global derivatives casino blows up again next time.

G20 governments are quietly slipping bail-in provisions into law to make sure that next time a too big to fail bank blows up again by derivatives it will be rescued using depositors’ money, in the name of protecting the taxpayers.

Financial derivatives are financial contracts in which the promised payoffs are derived from the performance of another underlying entity. The underlying entity can be an equity (such as an individual stock or a stock index), interest rate, credit or c …

Financial derivatives are financial contracts in which the promised payoffs are derived from the performance of another underlying entity. The underlying entity can be an equity (such as an individual stock or a stock index), interest rate, credit or commodities.

Types of Derivatives

The types of derivatives most commonly known to the retail public are stock options (calls and puts) and various types of futures. These derivatives are traded on regulated exchanges which act as a clearing house and guarantee the trades. The importance of the presence of a regulated clearinghouse will be apparent later in the article.

The other types of derivatives are little known outside of the financial industry due to the fact that there is no exchange for retail investors through which to trade them. These financial instruments are only traded by hedge funds, banks and other financial institutions, and are traded over the counter (OTC, or via private arrangements).  The most common underlying entities are interest rate (most notably interest rate swaps) and credit (most notably credit default swaps or CDS and repurchase agreements or Repos).

Credit Default Swaps

CDS is essentially an insurance contract against the risk of a firm defaulting. Let’s say a pension fund invests $100 million in bonds issued by a junior company paying 15% per annum.  To protect itself from the company defaulting on the bond, the pension fund purchases a CDS from a writer/seller (e.g. a bank) for the cost of, say, 2% per annum. If no default occurs, the CDS writer pockets the 2% per year. If the underlying bond goes bust, the writer coughs up $100 million to the pension fund.  The notional amount of the CDS in this case is $100 million.

As illustrated in the example above, in many ways CDSs are little different than buying and selling casualty insurance, with one important difference. That is, the buyer of a CDS does not have to own the underlying asset. In order words, in the case of the $100 million in bonds above, two other parties who have nothing to do with the original buyer and writer of the CDS can enter into similar side bets on the same bonds. In other words, the two parties can place a ‘naked’ side bet on the non-creditworthiness of the company which issued the bonds.

Hmmm… Imagine your neighbor taking out a life insurance on you….. And starts inviting you over for dinner with rich food. The plot pot thickens….

With all these side bets going on, it is not hard to image the notional values of the CDSs can be many times greater than the underlying instruments.

It is also important to note that, OTC derivates are unregulated. Unlike the insurance industry, there is little to no oversight over the writers of these CDSs to make sure they have adequate financial resources to guarantee the payout should a default occur.

The 2008 Subprime Mortgage Crisis

Overtaken by irrational exuberance from the forever rising real estate market and armed with a false sense of security provided by the assumed protection from CDS, banks, pension funds and hedge funds gorged on various forms of subprime mortgages. When the market went into a full blown crisis mode in 2008, CDS made up an estimated $35 to $65 trillion of the notional value of the OTC derivatives market.

Having a large swath of subprime mortgage securities going sour was downright awful and would have bankrupted a bunch of players involved under the best of circumstances, but that in itself would not have taken down the entire financial market. However, with the problem magnified multiple times by derivatives, the failure of one company quickly cascaded to others across the entire financial sector.

Counterparty Risks: When Notional Becomes Net

Going back to the $100 million bonds example above, let’s say that the writer of the CDS (Bank X) decides to spread the risk and buys $80 million protection from Bank Y. So in its books it has a notional exposure of $100 million but net exposure of only $20 million. When the $100 million bonds go south, Bank X immediately calls on Bank Y to collect on the $80 million in order to pay out its $100 million obligated to the pension fund.

To the horror of Bank X, Bank Y is unable to come up with $80 million and defaults on the CDS. All of a sudden, Bank X is faced with the $100 million liability instead of $20 million that it was counting on. When its counterparty fails, its notional exposure now becomes its net exposure.  What happens to Bank X next is pretty easy to predict.

Such was what happened to AIG in 2008. When mortgage securities started tumbling down, the insurance company was required to post more collateral to its CDS counterparties as part of the terms of the CDS. It quickly ran out of cash, and the US government had to take over the company. Had the government not done so, several big banks, one of which notably Goldman Sachs, which were counterparties to AIG would have become insolvent within hours. So the real reason for rescuing AIG was really about making sure Goldman escape whole and paid full for the CDS which it did.

Lessons Learned

The list of mistakes that were made along the way is simply too long to capture in this article. Beside the generic human greed and stupidity, here are a few key takeaways.

  • If the underlying investment is fundamentally flawed, as in the case of subprime mortgages, no amount of candy wrapping can shield the toxicity or spread it wide enough.
  • An unregulated and opaque derivatives market growing out of control is a recipe for disaster.
  • The speculative nature of derivatives and the amount of leverage employed made the problems many times bigger and the blowup more spectacular.
  • The protection a company buys from a counterparty is only as good as the creditworthiness of his counterparty who is, in turn, dependent on the creditworthiness of his counterparties. In a web of interlocking dependency, cascading failures are all but guaranteed when multiple failures occur.

Are These Problems Fixed?

Nope.

In fact, it has gotten worse since the 2008 crisis. Not only has the derivatives market grown from $500 trillion before the crisis to $700 trillion in 2014, they are now more concentrated in a smaller number of too big to fail banks which were bailed out by the governments the last time.

 

References:

 

 

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  1. dave rush

    Scary.
    Stand way back from the edge…..

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