Derivatives Market a $1.2 Quadrillion Time Bomb

Financial jargon is often arcane and perplexing to the average person. While even casual observers have surely heard of derivatives, most are unlikely to know what exactly they are.

Derivatives, or swaps, are basically bets between companies and banks that are designed, in essence, to be insurance policies.

The problem with derivatives is that since they often involve highly leveraged bets, they can be very dangerous. A small change in market conditions can mean huge losses.

Such losses can occur because derivatives use extraordinary leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors can also lose large amounts if the price of the underlying asset moves against them significantly.

In fact, derivatives were used to conceal credit risk from third parties while protecting derivative counterparties, which contributed to the financial crisis in 2008.

That threat still lingers today. If interest rates were to rise unexpectedly, for example, it could result in a financial bloodbath on Wall Street.

Derivatives are used to make the really big money on Wall St. They can be many things, but are basically contracts or bets that derive their value from the performance of something else — an interest rate, a bond or stock, a loan, a currency, a commodity, virtually anything.

For traders, derivatives are a perfect product. They can also be highly lucrative to financial institutions. Over the last five years, banks earned an estimated $20 billion selling derivatives just to school districts, hospitals, and scores of state and local governments across the country.

Yet, as Warren Buffett famously stated, derivatives are "financial weapons of mass destruction."

The global derivatives market is highly complex, totally unregulated and freakishly large. According to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University, the so-called notional value of the worldwide derivatives market is $1.2 quadrillion.

A quadrillion is an incomprehensibly massive figure: 1,000 times a trillion. The market's notional value is 20 times the size of the global economy.

The annual gross domestic product of the entire planet is between $50 trillion and $60 trillion.

Even if Congress decided to regulate the stunningly massive derivatives market, regulators wouldn't be able to assess the risks of derivatives because they don't understand them. Congress doesn't understand them either.

That's by design. The whole market is set up to be incomprehensible to anyone other than those who arranged it, making it beyond regulation.

Insured U.S. banks and savings institutions held $222 trillion worth of derivatives in the second quarter of 2012, according to the Office of the Comptroller of the Currency. Yet, the total U.S. economy is approximately $15 trillion.

Most disturbingly, another financial crisis is inevitable because the causes of the previous one have never been resolved.

The "Big Six" U.S. banks (Goldman Sachs, Morgan Stanley, JPMorgan Chase, Citigroup, Bank of America, and Wells Fargo) now possess assets equivalent to approximately 60 percent of America's gross national product. If that doesn't sound healthy, it's because it isn't.

If any of these six banks fails, the repercussions to the U.S. and global economies would be disastrous.

What is particularly troubling — and appalling — is that the Dodd-Frank law places taxpayers as the backstop behind Wall Street derivatives trading.

As the Wall Street Journal reported:

Little noticed is that on Tuesday Team Obama took its first formal steps toward putting taxpayers behind Wall Street derivatives trading — not behind banks that might make mistakes in derivatives markets, but behind the trading itself. Yes, the same crew that rails against the dangers of derivatives is quietly positioning these financial instruments directly above the taxpayer safety net...

The authority for this regulatory achievement was inserted into Congress’s pending financial reform bill by then-Senator Chris Dodd...

Specifically, the law authorizes the Federal Reserve to provide “discount and borrowing privileges” to clearinghouses in emergencies.

To get help, they only needed to be deemed “systemically important” by the new Financial Stability Oversight Council chaired by the Treasury Secretary.

So, once again, American taxpayers have been set up as the bailout agents for Wall St. banks and the wider financial industry.

The question is, given the size of our economy relative to the derivatives market, where will all the necessary bailout money come from when that market eventually implodes?

Undoubtedly, the Fed will just print it. That has always been its solution to every crisis.

Rigged Markets Have Driven Out Retail Investors

"You could buy and hold a company for 15 years and then have everything you've built up disappear in five minutes. No one can take that kind of risk anymore. There's no such thing as a widows-and-orphans stock anymore." — Professor Perry Glasser, in the Wall St. Journal

Over the past few years, a series of alarming incidents and events have eroded — if not completely destroyed — the average investor's trust in the stock markets. This is a critical development since markets are founded on trust, and they don't function very well without it.

Historically, transparent markets helped raise capital, build business and create jobs. But that system, which had worked fairly well for more than a century, has been jeopardized by recent events.

Most of them have been caused by high-frequency trading, in which supercomputers trade more than a billion shares a day at lightning speed. These trades have obliterated the age old strategy of "buy and hold." High-frequency trading is about buying and then quickly selling in a matter of minutes, seconds, or even mili-seconds.

By some estimates, "high frequency trading" is responsible for close to 70% of all volume in US markets. Computers can track hot stocks and immediately buy up all available shares. Since volume moves markets, this is quite advantageous. Almost instantly, these shares are then sold at higher prices. Millions of shares can be dumped in just milli-seconds.

High frequency trading has tripled market volume, giving a false sense of the size and activity of markets.

In August, the investment firm Knight Capital Group lost $440 million and was brought to the brink of bankruptcy due to erroneous trades caused by a software malfunction. Knight's trading algorithms went haywire, creating twice the normal volume the New York Stock Exchange. It was just the latest example of high-frequency trading gone awry.

In May, a technical error at Nasdaq (caused by high-speed trading) delayed the start of trading for Facebook’s initial public offering, limiting the ability of some investors to identify whether they had successfully purchased or sold their shares. Moreover, the offering price had also increased to $38 from an initial target of $28 - $31. Additionally, the number of shares had increased by 25 percent just days before the offering, diluting overall share value.

Ultimately, Facebook saw its stock collapse 32 percent in just 12 trading days.

Though top investors got word that research analysts at the banks underwriting the IPO had all cut their earnings estimates for Facebook just days before the stock went public, that news didn't reach the average investor until it was too late.

High frequency trading also helped drive the liquidity crisis and set in motion the ‘Flash Crash’ that rattled the markets worldwide in May 2010. In a matter of minutes, the Dow Jones Industrial Average plummeted a jaw-dropping 1,000 points.

But high-frequency trading isn't the only concern. There's also the matter of collateralized debt obligations (CDOs), credit default swaps (CDSs), interest rate swaps and derivatives. Credit default swaps were the things that got Wall St. behemoth JP Morgan Chase into so much trouble last spring.

In May, JPMorgan Chase suffered a multi-billion dollar trading loss that shook investor confidence. A single trader at the bank's chief investment office in London took huge positions in credit default swaps that resulted in massive losses. The threat of systemic risk in the banking sector was once again on full display, a reminder of its threat to the wider economy.

Each of these events undermined the essence of the markets; investor confidence. But cumulatively, they have had a most pernicious effect.

In June, the TABB Group, a financial research and advisory firm, released a report indicating that 31 percent of those polled said they had "weak" or "very weak" confidence in the stock market, compared to 15 percent after the Flash Crash.

In TABB's survey, a group of "market participants," including hedge funds, investment managers, exchanges and brokers, were asked to pick which recent market snafu did the most damage to the confidence of mom-and-pop investors in the stock market. Thirty-seven percent picked the Facebook IPO. Thirty-nine percent picked the Flash Crash.

Not surprisingly, retail investors have abandoned the stock market, moving their money into savings accounts, bond funds and annuities. Over the last few years, all of their suspicions have been confirmed that the stock market is a rigged game and they have largely refused to play anymore.

This is no small matter. Investors have been fleeing the stock market in droves due to a loss of confidence. The Investment Company Institute says that investors are pulling billions out of stock mutual funds on a weekly basis. In fact, investors have been consistently pulling money out of stock funds for five years running.

During the week ended Sept. 5, U.S. stock mutual funds bled another $2.9 billion, according to the Investment Company Institute, bringing the 2012 outflow total to more than $79 billion. By comparison, those funds lost in the neighborhood of $70 billion during the first eight months of 2011, and just $52 billion during the first eight months of 2010.

Vast numbers of Americans no longer understand the stock market and they certainly don't trust it. People would rather hide their money under the mattress than hand it over to Wall St.

According to the June Fed survey, just 15.1% of American families had any stock holdings in 2010, down from a peak of 21.3% in the 2001 survey. And just 8.7% of families had direct ownership of pooled investment funds (mostly mutual funds) in 2010.

Clearly, the ballooning stock market is not a reflection of the financial well-being of the vast majority of Americans. Most of them aren't even invested. The markets are simply Wall Street's betting games.

Joseph Saluzzi, a founder of the institutional brokerage firm Themis Trading, has long been an outspoken critic of high-frequency trading. In fact, Saluzzi thinks the practice is ruining the stock markets. He says it has created a loss of confidence that is scaring off mom-and-pop investors.

Here's what Saluzzi told the Huffington Post:

"The purpose of the stock market is supposed to be capital raising and capital formation. Investors are supposed to come, see what’s going on and say, "You know what, I like that company, I can invest and I’m going to hold the stock." Fifteen or 20 years ago, that’s what you had. Now ... the whole model for capital formation has gotten twisted into a short-term trading [system] where an average holding period for a high-frequency trader is seconds, not days or years... It turns it into a casino... You’ve lost the whole point of what a stock exchange is supposed to do. Which is identify undervalued assets, identify stocks that you think are going to grow... [The result is] a continued loss of trust and confidence in the stock markets. And that is the worst thing you can do. Because you don’t build trust and confidence overnight, but when you lose it, it goes quick."

The problem has been brought to the attention of Congress, yet nothing has been done to curb high-frequency trading and other risky practices that place undo risk on retail investors and the economy as a whole.

SEC Commission chair Mary Schapiro told a House Oversight subcommittee in June that investors have a "concern about the integrity of the marketplace," and U.S. markets are currently threatened with "an unwillingness [on the part of investors] to ever engage in the markets again."

People are unsure "whether they're getting accurate and honest information from [companies looking to list on exchanges]," Schapiro said, and unsure "whether the market structure itself is tilted against the individual investor and in favor the institutional investor." She added, "At the end of the day, investor confidence is the oxygen markets survive on, and if we lose it, it is extraordinarily hard to regain it."

Rather than curbing risky practices, government regulators are allowing them to spread. High frequency traders are now moving into currency and commodity markets.

This is an ominous development. Capitalism requires transparency and truly free markets to function properly. What we have, instead, are rigged markets.

Wall Street's intention has been to make the capital markets so opaque and so complex that no one — not even the regulators — can understand them. It's all been by design, and they've succeeded.

In the view of Wall St. bankers, they are the Masters of the Universe and no one should dare question them. They claim to know things the rest of us will never even understand. But in truth, their game is so convoluted that it's become incomprehensible even to them. They wrote the rules to this game and made it far too complex for anyone to follow or comprehend — even themselves.

Millions of individual investors have paid for that, and the price has been their savings — as well as their faith in the markets. That's a shameful development.

Our Economy Was Just an Illusion of Prosperity, Fueled by Debt

The U.S. continues to be burdened by the fallout from the 2008 financial meltdown. That collapse, and the subsequent recession, took many people by surprise because, aside from the bursting of the dot-com/internet bubble in 2000, the economy had appeared to be humming along quite smoothly.

But that appearance was the byproduct of a lot of smoke and mirrors.

Much of the growth in corporate profits leading up to our economic collapse was driven by the financial sector. After-tax corporate profits in the financial sector were considerably better than the non-financial sector from 1997 to 20007. So the supposed "economic boom" during this period was largely limited to the financial sector, which doesn't produce anything — other than debt.

As a result, all of that financial sector growth was a sham. Our economy was nothing more than a paper tiger. Wages were stagnant for many years and Americans lived on cheap and easy credit (or debt) to make up for that fact. It made people feel prosperous, as if we were all benefitting from the supposed "economic boom."

From 1948 to 1985, the financial sector accounted for around 12 percent of American corporate profits, never reaching 20 percent nor dipping below 5 percent. After 1985, however, the profits of the sector rose dramatically, going from 19 percent in 1986 to 41 percent in 2000.

That meant that more than 40 cents out of every corporate dollar of profit was paper profit, not created by actual wealth-generating activity, but by monetary inflation and corporate gambling.

The earnings of typical Americans couldn't (and still can't) keep up with the rate of inflation. From 1914 until 2010, the average inflation rate in United States was 3.38 percent. This means that inflation has been running at roughly 33 percent per decade over the past century.

Since wages weren't keeping up in recent decades, the only way to maintain consumer spending — the engine of our economy — was to continually expand available credit, putting Americans into ever deeper debt.

With the cost of living outstripping wage and salary increases, Americans began draining their savings just to keep up. During the previous decade, the U.S. savings rate reached its lowest level since the Great Depression and actually turned negative for a couple of years. The cost of living had simply exceeded incomes.

According to Census figures, the median annual income for a male, full-time, year-round worker in 2010 was $47,715. Adjusted for inflation, that was less than in 1973, when it was $49,065. This means that the American male's income is now negative after four decades.

Yet, the problem seems to be accelerating.

Across the country, in almost every demographic, Americans earn less today than they did in June 2009, when the recovery technically started. As of June, the median household income for all Americans was $50,964, or 4.8 percent lower than its level three years earlier, when the inflation-adjusted median income was $53,508.

That's nearly double the 2.6 percent drop during the recession, which means that — when it comes to incomes, at least— our supposed recovery has been even worse than the recession.

The decline looks even worse when comparing today’s incomes to those when the recession began in December 2007. Then, the median household income was $54,916, meaning that incomes have fallen 7.2 percent since the economy last peaked.

This decline is critical because 70 percent of all U.S. economic activity (GDP) is the result of consumer spending, and retail sales account for about half of that.

For many years, Americans used credit to buy whatever they couldn't afford — including houses — which masked the decline in incomes. But now that the bubble has burst, the lingering hangover remains debilitating.

Falling home prices have slashed home equity 49 percent, from $13.2 trillion in 2005 to $6.7 trillion early this year. One-third of homes with a mortgage are underwater. And roughly 27 million workers—or about one out of every six U.S. workers—are either unemployed or underemployed.

All of this is killing demand and consumption.

Decades of easy credit resulted in significant increases in the American standard of living. But the reality is that all of those debts need to be serviced. However, there isn't enough income to do that while also maintaining past rates of spending. Consequently, less disposable income is being directed back into the economy, which is stunting economic growth.

The Federal Reserve was well aware of all of this. The Fed is responsible for the erosion of the dollar and the average American's savings by continually creating money from nothing and holding interest rates at historically low levels. That's because it has to keep us all spending in order to uphold the economy.

So, lending practices were loosened and money made cheap and easy. People were made to feel affluent by going ever further into debt, spending money they didn't actually have. But the sobering reality it that all of those debts eventually need to paid back — with interest.

This is how the masses, the common folks, were allowed to participate in the consumption economy along with the truly affluent. It was simply an illusion of wealth for millions. Accompanying the continual expansion of credit/debt was the seemingly perpetual increase in home prices.

However, all of it has now finally, depressingly, come to a crushing end. There is no re-inflating the debt bubble that propped up our phony economy. The lifestyle we maintained for more than a quarter of a century was simply unsustainable, and our crash inevitable. To double-down on our debt binge would only be an attempt to forestall the necessary de-leveraging of our economy and be even more crippling in the long run.

A recent report from the Federal Reserve Bank of New York shows that total household debt declined from nearly $12.7 trillion in 2008 to $11.4 trillion as of the first quarter of 2012. Yet, much of that has been due to foreclosures and defaults. If you default on your mortgage, you no longer have that liability, which makes total household debt look better.

Mortgage debt makes up the vast majority of Americans' household debt, so a decline in home ownership means less debt, even though it also results in a drag on the economy, as salable homes sit empty.

Yet, this decline in household debt hasn't stopped the Fed and its fellow banker cronies from trying to reinflate the bubble. The federal funds rate has been held at a range of between zero to 0.25 percent since 2008. Most incredibly, total outstanding consumer credit has increased to $2.7 trillion from $2.55 trillion when the financial crisis struck in 2008.

Economic growth is predicated on debt, so unless Americans keep on borrowing the economy will move from stagnation back to recession. The standard of living for millions of Americans has already declined considerably over the past four years. Considering the long term decline in wages and salaries, something has to give.

Either Americans realize they can never repay all of their incurred debt and stop adding to it, or they try to forestall an even lower standard of living by attempting to borrow their way into a false prosperity once again.

For many years, our national economic growth has been fictitious — an illusion of prosperity rooted in debt.

We've consumed more than we produced. We've imported more than we exported. We've borrowed more than we saved.

We've done all this for a quarter-century, and now we remain mired in day of reckoning that just won't end.