Editor’s note: This article was first published in March 2013, during the euro crisis. The estimate of some 700 trillion in derivatives against a world GDP of about 62 trillion, US interest rates at 0% and the crisis we still have all reflect that moment.
The “doom-mongers” who warned us about subprime are speaking up again. According to them, the mother of all bubbles is on its way and will burst sooner or later, for the simple reason that we are fixing the financial crisis caused by derivatives by giving the financial system a medicine loaded with even more financial derivatives.
The problem is more serious than it looks, and we’ll try to explain it simply so everyone can understand it: “We’re treating a burn victim by setting him on fire.”
What are financial derivatives?
Financial derivatives are what Warren Buffett called “financial weapons of mass destruction”. Derivatives are called investment products, when in reality you aren’t investing in anything: even though the product is linked to an underlying asset (indices, shares, commodities…), you neither buy nor sell anything. You simply place a bet, as in any other casino.
CDS, warrants, CFDs, futures, options… are highly leveraged products, not to mention the forex market, where anyone living on the 420-euro family assistance benefit (a Spanish subsidy for the long-term unemployed) could trade as much as 40,000 euros in the market. Forty thousand euros that this person obviously doesn’t have.
The problem is that nobody knows exactly how much money has been created in derivatives, although it’s estimated at around 700 trillion, or even more. That’s a serious problem when you consider that world GDP is only about 62 trillion. In other words, more than ten times world GDP is circulating around the world in products that don’t exist, backed by leveraged money (much of which doesn’t exist either).
Most financial derivatives are zero-sum games. That is, if one person wins 1,000 euros, it’s only because someone else has lost 1,000 euros. Some banks act as the counterparty to the “player” or investor. That’s why there is so much fear of certain banks going bust: the collapse of “counterparties” would trigger a huge domino effect.
What kind of bets are made with derivatives?
With derivatives, you can bet that Banco Santander’s share price will reach 6.50 euros in August. You can bet that the IBEX (Spain’s main stock index) will fall to 6,000 points in six months, or that it will rise to 10,000.
Originally, financial derivatives were used to protect an investment portfolio against losses. That is, if I own Banco Santander shares and think they’re going to fall this month, I buy CFDs or some other product betting that Santander will fall: I go short (a PUT). If Santander falls, I lose money on the shares and make it on the derivative; and if instead of falling it rises, I lose on the derivative but make money on the shares.
The real problem is that we’ve even seen the opposite happen: big funds, to protect their derivatives positions (which tend to be very large because of leverage), play with the real markets.
Everything suggests that the problems of Greece, Italy, Spain and Portugal were exaggerated and inflated because many investors bet against us, so the worse our economy did, the more money they made. Some people have made billions from this crisis thanks to derivatives.
What do financial derivatives have to do with subprime?
Subprimes are a financial derivative linked to mortgages. To get an idea of the problem: the crisis we’ve had (and still have) because of an excess of “fictitious money creation” (credit) has been eased thanks to government intervention and the efforts of ordinary people, through adjustments, cuts, public money, the creation of new money, and free money with 0% interest rates in the United States, a measure that hides the US crisis but doesn’t solve the problem.
The subprime bubble isn’t even in the same league as the problem a financial derivatives bubble could cause, basically because there wouldn’t be enough money in the world to deal with it.
“What’s more, you can’t pay off money that doesn’t exist with money we don’t have.”
If that bubble were to burst, we would be talking about the total and utter destruction of the financial system. And the curious thing is that, far from slowing this bubble down, the bets in the great casino of financial derivatives grow every day, and new derivative products are created that are linked even to other derivatives. When it comes to grey capitalism, stupidity knows no limits.
That said, the bubble may or may not burst, and it could happen in two weeks, in ten years, or never… but when certain people speak, we should at least take careful note.
Featured image: liz_noise, CC BY 2.0, via Wikimedia Commons.
