DERIVATIVES, DERIVATIVES, EVERYWHERE… AND NOT A DROP TO UNDERSTAND, I THINK!
By Karl Hosch – Silverrockstheworld.com
Derivatives are the key ingredient to the present, total financial collapse of all the world’s economies.
Derivatives floated into our financial vocabulary in recent decades. Wikipedia says about them:
“Derivatives are financial instruments whose values depend on the value of other underlying financial instruments.”
“The main use of Derivatives is to reduce risk for one party.”
“Derivatives can be based on a huge variety of potential underlying assets and payoff alternatives which leads to an enormous range of different types of contracts that can be constructed.”
“Derivatives can be based on different types of assets such as commodities, equities (stocks), residential mortgages, commercial real estate loans, bonds, interest rates, exchange rates, or indices (such as a stock market index, consumer price index (CPI), or even an index of WEATHER CONDITIONS, or other derivatives).”
And after extensive research, this is my best definition:
“A Derivative is an agreement between parties in which for various consideration, where one promises to pay another, a certain sum, at a certain time, under certain circumstances.” Which means a Derivative is possibly this – possibly that – or possibly the other. Possibly.
To make matters seem more impossible, consider this: There are presently about $1.4 QUADRILLION, or $1,400,000,000,000,000.00 worth of Derivative contracts presently outstanding in the world! That number is16 places to the LEFT of the decimal point!
To put the above number in perspective, the entire GDP (Gross Domestic Product) of the ENTIRE WORLD is 50 TRILLION, or $50,000,000,000,000.00. That is 14 places to the LEFT of the decimal point! The ratio of $1.4 QUADRILLION to $50 TRILLION is a staggering 28 to 1! Please understand this fact! There is 28 times more money invested in Derivatives worldwide than the combined world output for a whole year!
The world markets that function in Derivatives are more sophisticated in a negative way and the alphabet soup they use to cover their rears, makes dealing with the Derivatives or controlling them, nearly impossible. What makes them especially dangerous to the world is that they are basically backed up by nothing but phony paper contracts and/or inflated currency. They are not safe, secure or in any way represent sound economic thinking.
This is the ridiculous and basically unregulated type of market that has run rampant over the financial world in the last few decades and especially in the last several years. It is all a crap shoot at best where one party “insures” or “protects” value in something, or even tries to predict a value for something for another party or parties, no matter how obtuse it may be. At least 80% of all of these types of contracts usually expire WORTHLESS! If even a small portion of them fail, it would spell financial disaster for a country and the world!
I will attempt to bring Derivatives down to a common sense example:
Let’s say that I have some unkempt apple trees on 40 acres of unused farm land. Obviously, I would not be making much money with it.
You come by and say, “Hey, I like your apple trees and land and think I can make some money with them.”
I am a very lazy farmer and start to listen to you.
You say, “How about you give me your apple trees and 40 acres for $1000 and I will turn the trees and land into a money making orchard. I promise to pay you an additional $1000 in 3 years with 10% interest per year, plus 15% of my profits. Sound good? Let’s sign the papers!”
We now have here an agreement that has a promise to pay a sum certain with a specific interest even, over a specific time and all hinging on the success of a variable outcome! Sounds like a Derivative, smells like a Derivative… could it be at least a simple one?
Who really cares?! I am ecstatic. I make the deal and go to Vegas with my money!
–New worth of farm to me: $1000 up front, plus another potential $1000, plus an additional $300 which is $10% per year interest for 3 years, plus 15% of something that depends on how good a farmer you are.
You have a lot of great ideas. You then put an ad in the paper and ask for farmers who want to make big bucks.
Twenty farmers answer the ad and you propose to them: “Hey, guys. I have these apple trees and 40 acres. I am willing to divide the land among you into 2 acre parcels. For this privilege, all each of you do is give me $1500 down, promise to pay me $1500 at 15% interest per year for 5 years and 20% of your profits. Sound good?”
Again, we smell the familiar odor of a Derivative cooking…
The twenty farmers accept, because they are greedy and eager to make the “big bucks.”
–New worth of farm to you: $30,000 (20 farmers x $1500) up front, plus another potential $30,000 (20 farmers x $1500 second payment), plus an additional $22,500, which is 15% per year interest for 5 years (.15 interest percentage x $30,000 owed to farmers x 5 years), plus 20% of something that depends on how good at farming your greedy friends are.
Did I mention that the twenty farmers also thought they were clever businessmen?
As soon as you turned your back, they promptly went out and each one found 5 REALLY greedy friends. The farmers then proposed to the 100 new greedy friends: “Hey, guys. We will give you an interest… 5 guys in each one of our 2 acre ‘apple orchards.’”
Each of the twenty farmers would then receive from every one of his 5 greedy friends $2000 down and a promise to pay $2000 back at 20% interest for 10 years to acquire a 25% INTEREST in each farmer’s profits from the “orchards!”
Uh, oh…. A slightly different slant, but still going down the same Derivative slope…
–New worth of farm to the twenty farmers: $200,000 (100 really greedy friends x $2000 start up) up front, plus another potential $200,000 (100 really greedy friends x $2000 second payment), plus an additional $400,000 which is $40,000 per year interest at 20% for 10 years (100 really greedy friends x $2000 second payment = $200,000 x .20 interest percentage = $40,000 x 10 years = $400,000). All the twenty farmers give up is 25% of profits which all depend on how good at farming they are.
We have created a pile of money out of almost nothing. This whole thing started because I had some apple trees, 40 unused acres and limited ambition. However… everyone was now as happy as a pig in manure!
Until…
All this initial new wealth that the twenty farmers were accumulating enabled them to spend a lot of money they never had before. This caused competition in the small town for goods and services and drove the prices up. Taxes went up. Bug sprays and fertilizer for the trees went up. The cost of shipping apples went up. Another farm nearby was doing the same thing and drove the profit margin of all the local orchards down. The weather wasn’t perfect for growing apples. The farmers started to hurt.
In addition, due to the general rising inflation, the 100 really greedy friends didn’t want to keep paying on the principal of $200,000, let alone the interest of $40,000 per year, because the lousy return on the crops from the apple orchards they invested in was not what they had expected. Money started to disappear. They started to hurt also, and default on payments to the farmers.
The twenty farmers did not need this additional shortage of funds and started to loose money even faster. Then, the really greedy friends stopped paying the farmers the principle and interest and walked away from their investment all together. Money disappeared for good. Thus, the farmers lost $200,000 and an additional $400,000 in interest at 20% for 10 years. The twenty farmers went bankrupt.
You are now back in the picture. Since the farmers went bankrupt, they stopped paying you principle and interest. Money disappeared again. You are now out $30,000, plus $22,500, the interest of $4500 per year for 5 years and now you have 20% of nothing! You have to walk away from the farm… out of business.
I am back from Vegas and in the picture again. I am annoyed that I gambled away my $1000 dollars, and even more annoyed that you went out of business. I don’t get my other $1000 dollars and $300 in interest of 10% for 3 years. Also, I now own 15% of nothing!
All is not lost though… I had a job with a big automaker. I have a nice, fat retirement pension waiting for me soon.
What?!… What did you just say??? That company has announced that it is on the ropes, its financial paper is rated “junk,” and they have also announced that they no longer have a pension fund… and have stopped their health care plan!?!?!?
How dare they?! What is going on here? Doesn’t anybody have any common sense any more??? How on Earth could this happen???! You would think people would know better! I’ve never heard of anything so stupid in all my life… uh… well… maaaaybe… I have…
In this brief example we have seen a microcosm of the big picture of Derivatives. We have seen a Leveraged Derivative Market Situation go through three basic transactions. And, we have seen the value being manipulated and leveraged over 200 times higher in the process… that’s 20,000%! Can one comprehend that number? We’ve also seen the playing out of a very sad, simple, yet common Meltdown scenario in today’s failing market place.
In actuality, more risky, expansive, devious and potentially very destructive Derivative Instruments have been created. The Leveraged Derivative Market is collapsing around the world… NOW! It is so big and potentially hazardous that it will take down all the world economies in its all consuming path by pulling out the pillars that keep all currencies from falling. Is the horse out of the barn, is the barn burning, has the barn burned down? And where IS the horse?! Even if we are lucky, these questions will haunt us for who knows how many years.
When you hear about the “Big Bang” in the near future… they will not be talking about the beginning of the universe. They will sadly be pointing to the Derivative Market Meltdown that hardly anyone even wanted to acknowledge.
Tags: Derivative, Derivative Meltdown, Derivatives, Economics, Economy, Explaining Derivatives, Financial Collapse
