The Lurking Danger of Derivatives – Wall Street’s House of Cards

September 19, 2008 by alpha-zone

(Alpha-Zone) Many Americans and lawmakers are worried about the exposure large corporations have to subprime mortgages and mortgage securities. This problem is dwarfed by their exposure to derivatives. The value of these derivatives can be more than the assets of the company.

Over 90 percent of derivatives are traded outside of the regulated exchanges. Most companies keep their holdings off the balance sheet or may include their holdings in the footnotes of their financial statements. As a result, most investors are unaware of the risk. Even if a brokerage firm is not private, it may be difficult to pull the numbers.

According to Martin D Weiss with Money and Markets, nearly 97 percent of the U.S. bank-held derivatives are concentrated in the hands of just five major U.S. banks. These banks are JPMorgan Chase, Citibank, Bank of America, Wachovia and HSBC.

What are Derivatives?

Derivatives are one of the more complicate financial instruments but can be used to hedge risk. They include futures, forwards, options, and swaps. They can be based on all sorts of assets including stocks, bonds interest rates, exchange rates or even weather. Warren Buffet called them “financial weapons of mass destruction”.

What can Go Wrong?

Weiss created a scenario to help explain the disaster that can be caused by derivatives:

Let’s say you are a senior derivatives trader for a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital). You could be responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

But you get worried and decide to hedge yourself by placing a similar bet with Bank B that interest rates will go up. This protects you right? Either way, you can’t lose.

But you can lose, and you can lose big. In our scenario the rates might go up. You lose with bank A but win with bank B. Normally you could take the winnings from B and pay A. But what if Bank B defaults because of large mortgage losses? Now you are in trouble and have to liquidate your company’s capital to pay off Bank A. Now your company is at risk for default and the whole financial network can fall like a house of cards.

Who is at risk?

Besides some of the largest banks as we pointed out above, Merrill Lynch has $4.2 trillion. Morgan Stanley has $7.1 trillion. Weiss believes Lehman Brothers has significantly less at $729 billion. But if each entity begins to default, nearly every investor and or mutual fund is at risk.

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