ITS THE DERIVATIVES, STUPID!

http://www.webofdebt.com/
Until recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can hedge your bet that something you own will go up by placing a side bet that it will go down. Hedge funds hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.

The point everyone misses, wrote economist Robert Chapman a decade ago, is that buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives create nothing.1 They not only create nothing, but they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve risk management. Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked. But the cost was an increase in risk to the financial system as a whole.2

Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars thats 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they dont have, and that is where the huge increase in risk comes in.




Credit default swaps (CDS) are the most widely traded form of credit derivative. CDS are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the protection buyer gets a large payoff from the protection seller if the company defaults within a certain period of time, while the protection seller collects periodic payments from the protection buyer for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to increase profits by gambling on market changes. In one bloggers example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling protection on a risky BBB junk bond. The premiums are free money free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims.

And theres the catch: what if the hedge fund doesnt have the $100 million? The funds corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have hedged their bets by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.

The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives weapons of financial mass destruction. It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly CEO.




http://www.ellenbrown.com/

Ellen Brown on the Thom Hartmann program Oct. 9, 2008
http://www.thomhartmann.com/

Category:

Education

Tags:

• Bank
• Bailout
• Thom
• Hartmann
• Ellen
• Brown
• Web
• of
• Debt

[chris2fer43]

The Derivative debt out exceeds the entire supply of money on the planet. In other words GAME OVER we lose! Think of a Monopoly game and everyone is sitting at the table but the money has run out. This is why the banksters are hoarding it and no one can get loans. I predict Obama will start over and print new currency. So as you watch the LIES on the news keep this in mind. this is why they had the secret meeting in congress awhile back. Thanks to Phil Gramm Alan Greenspan and the Right Wing.

[CarryANation]

BS, the "side letters" PROVE the transactions were fraudulent. The people who did this need to be in prison for fraud.

[learninglemur]

ngonea - Greed is nothing more than insatiable desire. Everyone who strives to produce a better life for themselves is greedy. Greed is good, it's the motive that drives production.

There are two opposing sides to every CDS contract so there is no systemic vested interest in defaults -- at all times there are just as many traders betting for defaults as against.

[ngonea]

WEll we did not get another FDR, we got another BUSH, kissing the as_ of the Queen of England, our colonial master, who works for the Pope of Rome

[ngonea]

learninglemur - the primary motivation is greed, the risk that must be hedged is the created

default, they have a vested interests in defaults

just like doctors and pharma companies in America have a vested interest in us being sick, they make a profit

[ngonea]

learninglemur - classic! yeah right it's the invisible hand, right ? Keyensian = USURY period!

[learninglemur]

It isn't necessary that a CDS be fractionally backed, nor is there fraud if both parties understand that where there is a fractional backing that there is also uncovered risk.

[learninglemur]

Since you've read Human Action then let me remind you that Mises takes great pains at the outset to separate and delimit economics from morality. He takes as given the fact that men act to achieve ends, which he explicitly says are subjectively chosen and outside the scope of economics.

[CarryANation]

Thanks I've read Human Action. Austrianism is a proscriptive moral system, not a science.

If you were really an Austrian, shouldn't you be angry that CDS is basically another form of fractional reserve, and increases inflation (Austrian definition)?

[learninglemur]

It is true that there was massive fraud in this fiasco, but it is also true that the government sanctioned, aided and abetted this fraud in many ways. This crisis is bigger and deeper than derivatives. If you want to comprehend it, you'll need to study economics, in particular Austrian business cycle and monetary theory.

[learninglemur]

What is the primary motivation for buying derivatives on such a large scale in the first place?

What is the huge risk that must be hedged against?

Far from being the cause of economic crisis, the bulk of derivatives contracts are symptomatic of the market's attempt to compensate for the monetary whims of central banks, to find more stability in an inherently risky fiat money regime.