What derivatives are and why you’re screwed

You are the Crisis

Feb 2, 2009 by Ilargi at theautomaticearth

Oh no, we’re not rid of the bad bank drivel yet, are we? I started out trying to make a point about the character of the paper a bad bank, wherever on the planet, would be set up to buy. And I wrote this:

It may well be wise, just so everyone gets a clearer picture of what we are talking about, to stop referring to all this paper as “assets” or “investments”. In this case, these are misleading terms. An asset is something that exists in the real world. A derivative, on the other hand, can best be compared to the paper slip you receive at the racetrack when you place a bet on a horse. That paper slip doesn’t buy you a part of the horse, it buys you the chance of winning an X amount of money if the horse wins the race you’re betting on. When that race is run, you have either won that X amount or you have lost the money the wager has cost you.

Now, that took me back to something I wrote on September 29, 2008, the day the original TARP bail-out was defeated in the House, and the Dow fell 777 points. It was called: Monday at the Racetrack. Allow me please to quote myself, taking into consideration that the big Dow drop came after I wrote it.

(Sep 29 2008) If you go to the racetrack and bet on a horse, you receive a piece of paper that confirms the bet you made. There are many different varieties of bets possible; for now, let’s say you simply bet on one specific horse to win the race. After the race is over, you have either won your bet or lost it. There’s nothing difficult about the process, anyone can -learn to- understand it, and everyone, except in very rare circumstances, accepts it, both the winners and the losers.

What is happening in world finance these days is that a group of very heavy betters have become very heavy losers, and they have done so with borrowed money. In the past few years, in order to hide their losses, they have turned to a very clever little trick: they want to make us believe that the race is not over, even though we can all see that it is. In fact, if they have their way, the race will never be over, unless and until their horse wins.

The US government has joined the argument on the side of the losing betters. They have allowed the losers – who are their friends-, for years, to hide their predicament, their losing tickets, through Level 3 and off-balance sheet “creative accounting”. Now that the government’s betting buddies’ creditors are losing patience, and demand their money back, which the buddies don’t have, the Fed and Treasury want to buy all those losing tickets, with money that belongs to the taxpayers whose best interests they are presumed to represent.

And they up the ante today: the president declares that this will cost the taxpayer nothing; and if you believe that one, you’ll like the guys who claim that there are profits to be made on this avalanche of losing bets. Now there’ll be plenty of “experts” who are more than willing to tell you that comparing mortgage-backed securities –to take just one sort of bet–  with horse racing is inherently flawed. Their argument will be that there is true value behind the securities: the homes that were purchased with the underlying mortgages.

At first glance, that may look plausible: it seems clear that the homes are not all of a sudden worthless, so how could the mortgages and securities be? My first thought is that the horse you bet on is not worthless either just because it lost one race. But that doesn’t make you win your bet, does it? And the horse is still tired. There are deeper problems with the “the home still has value” argument. The most flagrant is the actual purchase prices, which doubled or tripled in a decade, while no value was added to the home itself. From that follows that many homes were sold at prices that people couldn’t truly afford. The US has for that reason already seen millions of foreclosures, with many more inevitably to come. And the elevated prices, of course. are also the ones the securities are based on.

So perhaps at some time in the future your losing horse might win a race, and perhaps at one point some money can be made on a new mortgage for a foreclosed home. But that makes no difference for your losing bet, and neither does it make the securities valuable again. Both races are over. For good. Which makes it impossible for the US taxpayer to play even on the losing betting tickets their government is about to buy with their money, while making a profit on them is too ridiculous to seriously discuss.

If home sales ever recover to any kind of extent, it will be at prices that are far lower than they have been so far in this millenium. That is the only way to make them affordable. And even if it happens, it is going to take years. In the meantime, the gambling losses will have to be paid. Your government tries to convince you that your life will be miserable without their losing betting buddies. If you ask me, it will be much worse with them, because if you want to keep them around, you’ll have to pay their debts. And they’ll just use the money to go bet on the next race. Maybe you should keep the money and buy your own tickets. That way you get to keep the profits too, if there are any.

But if I were you, I’d lay off the gambling for a while. It looks to me like a sure bet that you’re going to need every penny you have just to feed your children.

Back to today: I know the above is not perfect, but it still works for me. I must admit, as I read back, I’m sort of surprised myself how little has changed since then, with all the things that have happened, including of course the new US president. Who now is discussing doing the same thing: buying leftover paperslips from bets lost long ago. And doing so with your money. But that’s not the only thing wrong with this.

Buying $1 trillion worth of toxic assets is nowhere near enough, it doesn’t even begin make a dent in the mess. And if too much of the soiled casino bathroom tissue is left behind in the banks’ vaults, two things inevitably will happen. First, no confidence is restored. None. And second, banks will have to keep hoarding cash to provide for the additional writedowns on the remaining assets, writedowns everybody knows (but doesn’t tell) that are sure to come. The report from the Office of the Comptroller of the currency we discussed last week states that just the three biggest US banks have over $170 trillion “worth” in derivatives positions. Their real assets are stated as just over $5 trillion, and even then we have to look at how real these are.

What lies in the vaults of the remaining 8500 US banks “insured” by the FDIC is an open question. Let’s assume it’s another $170 trillion when all is added up. There are scores of institutional investors, insurance companies, pension funds, hedge funds, mutual funds, etc., that have positions in these wagers. The essential point in all of it, I think, is that the bets have already been lost. That is, the paper is worth close to zero. You’re about to just about literally purchase the emperor’s clothes. As much as people like Tim Geithner, last week before the Senate Finance Committee, and the CEO’s of the banks involved, shout at the top of their lungs that it’s oh-so hard to value the paper, it’s simply not. Just lay it out on the table, and you’ll know.

Thing is, if it were on that table for everyone to see, it would have to be marked to a market value of pennies on the buck, simply because that is the market value. Thing is also that as long as it’s not on the table, it will be politically palatable to to shove additional trillions of dollars that belong to people not yet born, towards institutions whose “leaders” have amassed hundreds of millions for their individual selves, by cashing in on the 1-in-10 bets that won, while offloading the 9-in-10 that lost, onto the public coffer.

Today, your new president and his team are trying hard to find a way to make you believe the races haven’t been run yet. But they have. And that’s why it takes so long to get a bad bank plan together: They need to find the words and reasoning and excuses to make it politically palatable. That is what’s hard, that is what’s making it take so long. It’s not about applying valuations to toilet paper. We all know what that’s worth. It’s about making you believe that the valuation is indeed difficult. Because if you believe that, more of your money, and that of your children, can be stolen from you. Geithner last week talked about computer models putting values on the paper, and about independent (yeah, right!) institutions doing so. Both have failed miserably. All that’s left is a market that will slaughter the entire thing. And that’s not what they want. And that’s what makes it take so long. Nothing has changed since September 29.

Every single day, every single move by our governments dig us into ever deeper holes. Maybe you remember, or at least can imagine, how it was when you were five years old, and tried to cover a lie with another lie, and then another, and all the time you were afraid your mother would see right through you. See? That’s the essence of the emperor’s new clothes, an dof our new-fanged government policies.

Anyway, I’m just trying to tell you, once more, that assets are not necessarily assets, even if your president tries to make you believe that they are, or can be, or might be sometime in the future. So there you have it: if only 15% of the paper slips of only the 3 biggest US banks goes stale and stinky, there is a loss risk of over $25 trillion, roughly twice the annual US GDP. This is not a secret in banking circles. Therefore, $1 trillion will do nothing towards restoring confidence. It’s like the emperor in his new clothes plays hide and seek. And you’re it.

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