Should you be wondering what is really behind the Wall Street versus Main Street divide, it is necessary to understand the derivative market. Derivatives were the catalyst for the 2008 near collapse of the financial system. Without reform, I believe the potential exists for a repeat financial earthquake and this time with a much larger asymmetric seismic wave.
A derivative is anything that “derives its value” based on some other asset or the affect or outcome of movements by the other asset. It consists of multiple parties, counter entities, betting that something will or will not occur. In banking it is a contract whose value is based on underlying financial assets such as bonds, commodities, currencies, etc., with parties betting certain movements and results all of which are interest rate sensitive.
What was once a “bail out” may become a “bail in”. What this means is that the Federal Deposit Insurance Corporation (FDIC) will be in charge of what may be called an “orderly liquidation” where depositors and stockholders in banks could lose in favor of protecting derivative losses.
To begin, some simple math to help you relate to the magnitude while reading this article: one billion is 1000 times one million; one trillion is 1000 times one billion; and, one quadrillion is 1000 times one trillion.
Now, on to Banking 101:
Banks are supposed to hold deposits in checking accounts, savings accounts, and in time deposits in the form of certificates of deposit received from individuals and entities in exchange for the payment of interest on the accounts (unless expressly excluded from earning interest by banking regulations, e.g., certain checking accounts).
Banks then use these collected funds to make loans to borrowers to whom they charge market interest rates, typically in three categories; consumer installment, commercial business, or real estate. The ability to pool deposits and make loans to many different borrowers at interest rates higher than deposit rates is intended to create a “spread” in the form of profit for the banks. Banks also add fees and charges for banking services which are received by depositors and borrowers and which enhance the bank’s profits.
Bank balance sheets are different from other businesses because the money they loan out is considered an asset and the deposits they receive are considered liabilities (presumably because the depositor may remove the money at any time, except for time deposits consistent with the then current banking regulations). Assets minus Liabilities equal the shareholder’s equity, or “Bank Capital”. In other words, the bank’s assets can be defined as bank liabilities plus bank capital.
The derivatives market is largely unregulated. In fact, the U.S. Congress, on the advice of investment banks, made it largely illegal to regulate derivatives. The Dodd-Frank Act has allowed future derivative claims to have a super or senior in priority over all other claims against the banks. The Dodd-Frank Act also reorganized the priorities of all debts, after the costs of administration necessary in any liquidation process, first to the government, then to the banks, then to derivatives, then to secured and unsecured creditors of the bank, and then finally to equity. (The shareholders could be subject to substantial losses when these financial institutions are liquidated to first pay the derivative claims.
Depositor’s savings could be reassigned to equity and, thus, wiped out or the repayment of amounts owing could be delayed for an extended period of time. Some observers believe that depositors may be given drawing rights or credit lines to be used only with government approval.
The 2008 economic meltdown was solved by the Federal Reserve creating 7 trillion in new money through fiat and using that money to bail out the banks. That strategy may no longer be effective or practical in the future.
In 2007 there were approximately 600 trillion derivatives outstanding worldwide. Many major banks became insolvent as did Lehman Brothers and American International Group (AIG), the leading international insurance corporation that insures against losses on derivative contracts.
Today there are 1,200 trillion or 1.2 quadrillion derivatives (counter party bets) worldwide; most are highly leveraged and interest rate sensitive. To put this in perspective the entire world’s GDP is 72 trillion dollars.
The 5 too big to fail (“TBTF”) banks account for 42% of all the outstanding loans in the United States. The largest 6 banks have 67% of all outstanding bank assets.
The risk in the derivatives market is concentrated in the U.S. In 2011, four U.S. banks held 95.9% of U.S. derivatives. As previously noted in this article, depositors maintaining accounts with U.S. banks are subordinated to the risks presented by derivatives pursuant to the Dodd-Frank Act, should derivative contracts default, no government insurance exists, i.e., “derivatives are not backed by the full faith of the government” nor does FDIC Insurance safety net derivatives. In effect, the DoddFrank Act has shifted the ultimate risk for derivatives which have resulted in significant profits for the banking industry and Wall Street to depositors in U.S. banks which are typically members of the middle class.
Warren Buffet has called derivatives “financial weapons of mass destruction.” The bank statistics below begin to explain why:
- Citicorp has a market cap of 112 billion and its total exposure to derivatives is about 53 trillion. Its exposure is 473 times its market value.
- J P Morgan has a market cap of 211 billion and its total exposure to derivatives is 51 trillion or 241 times its market value.
- Goldman Sachs has a market cap of 62 billion and its total exposure to derivatives is 51 trillion or 822 times its market value.
- Bank of America has a market cap of 124.8 billion and its total exposure to derivatives is 45 trillion or 361 times its market value.
The deposit accounts are specifically subordinated to derivative participants in the event of a market collapse. The risk associated with the total sum of 247 trillion counter-party bets in the derivative market by these banks through Wall Street includes hedging interest rates, and depositor accounts held in the U.S. banking system carry the greatest risk exposure for total loss or for the potential of a long delayed or deferred recovery.
Part of the obvious conclusion is where and how to invest your available cash. An option exists in First Trust Deed investing which currently yields between 8% and 9% interest per annum. An investor uses his or her capital to make a loan to a borrower who owns or wish to acquire real property. The borrower signs a promissory note and a deed of trust to be recorded as a security interest in the borrower’s property.
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