The Mispricing of Derivatives Risk & How the Financial World Ends

By JESSE’S CAFÉ AMÉRICAIN

Jim Sinclair does a good job of explaining the difference between the notional and real value of derivatives, and how that real value comes to bear on the financial system in the event of a default. You can read this here for a review of the basic concept if you do not understand it.

Within my own view of money, uncollateralized financial instruments like derivatives are credits, or potential money. When an event triggers them so that they become real, with a significant presence on the balance sheet and the income statement, then they become money.

In the financial world we see the extraordinary growth of derivatives in notional value, to almost unbelievable proportions. This mass of derivatives facilitates the withdrawal of money from the real economy in the form of wealth transferal, such as bonuses and commissions for example. But they do not become actual money themselves until some trigger event. To perhaps stretch our analogy to the physical world, it could be described as the withdrawal of the ocean, as money is siphoned from the real economy by the financial world, in advance of the arrival of a tsunami as derivatives start hitting the balance sheets and are transformed into ‘real money.’

This could be the cause of a hyperinflationary policy error which I have been alluding to for the past several years. The policy error is not in the simple setting interest rates, but the Fed’s failure to regulate the banking system and manage its risks. In this the Fed, particularly under Greenspan, was an abysmal failure, and improvement has not been forthcoming.

The explosion of the realization of derivatives would create enormous fortunes and unpayable debts. Depending on how the monetary authorities deal with it, the potential for a Weimer experience is there. Nationalizing the banks and canceling the transactions is one way out. Attempting to sustain these mythical financial structures will take the existing currency system down. That is the limit of the Fed’s power.

Most theories and models are tested at the extremes of their limits, and I suggest that the coming financial crisis will wash many of the current economic and monetary models away, scouring the detritus of years of conflicting interests and fanciful adornments down to their foundations. But the responsible parties will all sit back and say, “We did not know.” But of course they did. They just did not care, as long as it paid them handsomely.

Taking this discussion of derivatives an important step further, the most significant elements of concern in derivatives are the same as they are in all financial schemes: unsustainable leverage and the mispricing of risk.

In derivatives the unsustainable leverage arises from the fact that the impact or risk magnitude of the derivatives, which are often uncollateralized, are artificially reduced by the assumed effects of ‘netting.’ And the risk is mispriced, not only in the terms of the agreement itself, but in the failure to properly account for counterparty risk as the instrument plays out in a larger risk portfolio. There is individual contract risk, and then there is the cascading risk of a highly compacted financial system.

We see situations today in which a single bank may have a hundred or more trillion dollars of notional value in derivatives on their books, against much less than a trillion in assets.

But the risk in such a large position is allowed because the banks can show that they have supposedly ‘netted out’ the risk by making other derivative arrangements that offset their own risk, in the manner of a hedge. As the amounts of derivative netting grows larger and more intertwining, the secondary effects of counterparty risk become tightly compressed.

What if a counterparty fails? Then all its own agreements fail, many of which may be hedges that also fail, and a cascading failure of these financial instruments in a tightly compressed and overleveraged system becomes catastrophic.

In 2002 Warren Buffett famously referred to derivatives as ‘financial weapons of mass destruction.’ But beyond that headline, few in the media took the time to actually communicate what Buffett was really saying, and the risks that the unregulated derivatives markets posed to the banking system.

The collapse of Lehman Brothers threatened to trigger a financial meltdown. A panicked leadership of the country was able to stop it, but at the cost of many trillions of dollars, and a distortion in the real economy that still goes largely unmeasured. And this was by intent, because the leaders feared a loss of confidence in the system. And so while the meltdown was averted, a credibility trap was created that is the epitome of moral hazard.

The influence and knowledge, call it soft blackmail of mutually assured destruction if you will, that the ‘Too Big To Fail’ banks obtained in this coverup of the depths of the fraud and mispricing of risk in the financial system has given them enormous power over the political process. It would have been more effective to have nationalized the banks and cut the risk out at the source, but the new president Obama was badly advised to say the least, by advisors he himself appointed, who were in fact long time insiders in the creation of the risk situation itself.

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