Reason #61: Derivatives - Playing Fast and Loose with House Money
Most hedge funds charge large fees to invest with them. By taking such huge commissions, they force themselves into high-risk, high-reward investments. That’s where another new phenomenon comes in: derivatives.
Derivatives are all the rage on Wall Street now. Put simply, instead of just buying stocks or bonds and hoping they appreciate, traders try to make money on just about anything. Nowadays, derivatives have gotten so complex, many of them aren’t even based on actual commodities or securities. Traders place massive bets on things like the weather or if a certain stock index will rise or fall in value.
In 1995, a greedy punk named Nick Leeson murdered Barings Bank, one of the oldest banking houses in the world, with these exotic transactions. Leeson bet billions of borrowed funds on “futures” and “options” derivatives, literally gambling on currency values in Singapore. Then a huge earthquake struck Japan and Leeson wagered that the Nikkei Stock Market in Tokyo would rebound quickly. It did not and another earthquake went through the financial world: Barings Bank was broke.
If an English brat and a French doofus can each sink an entire bank with derivatives, just imagine what could happen if only a small percentage of the $415 trillion in outstanding derivatives went south?
Despite the ominous warning of Barings’ fate, derivatives trading only kept growing after Nick Leeson’s folly. Thousands of mathematicians, MBAs and economics PhDs now spend all of their time thinking up gimmicky new deals. According to Bloomberg News, $415 trillion in derivative deals were floating around world markets by the end of 2006. That’s nearly eight times the GDPs of the all the world’s countries combined!
With all the complexity of derivatives, and the enormous amount of them being traded around the world, it was only a matter of time before another Barings-style disaster struck. And in early 2008, it did. A single trader in the French bank Societe Generale lost over $7 billion of the bank’s money on futures.
If an English brat and a French doofus can each sink an entire bank with derivatives, just imagine what could happen if only a small percentage of the $415 trillion in outstanding derivatives went south? We’re talking about worldwide financial cataclysms here. And don’t forget, because of that loophole in the post-Depression regulations, hedge funds-which are responsible for the riskiest derivative deals out there-do not have to disclose anything to regulators. In other words, the wolves are expected to act like sheepdogs. What else is new?
“Financial WMD”
In a 2002 letter to shareholders, mega-billionaire investor Warren Buffett called derivatives “financial weapons of mass destruction.” He warned that they posed a “mega-catastrophic risk” to the stability of global markets and said that some of the more complex derivatives seem to be designed by “madmen.” Buffett knew first hand of what he spoke. A subsidiary he bought in the 1990s went hog wild in derivatives trading and cost the usually well-positioned “sage of Omaha” billions.
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