Derivatives Could Make a Chinese Collapse Much Worse

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The 2008 Financial Crisis nearly destroyed the world financial system and consequently the global economy. As the U.S. housing market collapsed numerous institutions struggled to cover bad bets they made via the derivatives market. Massive insurer American International Group, Inc. (NYSE:AIG) had to be bailed out by the US government. Lehman Brothers went bankrupt. Bear Stearns was forced into a fire sale to JPMorgan Chase & Co. (NYSE:JPM), and numerous other banks faced derivatives related crises. Only massive efforts by the United States government & others staved off what could have been another global Great Depression. We must now ask if the worst derivative related problems have passed or if the 2008 Financial Crisis was merely a prelude of things to come.

In layman’s terms derivatives are a sort of “side-bet.” They are essentially contracts that outline specific conditions in which parties must pay one another. This vague definition reflects the vague reality of the derivatives market. Derivatives have been drawn up to reflect conditions in weather patterns, stock prices, mortgage repayments, and numerous other events.

As a large global market derivatives are important for spreading risk and creating investment vehicles for various parties. They can also act as a form of insurance against certain events. For example, a ski resort could take out a derivative to protect itself against low snowfall. If a certain number of inches of snow do not fall the ski company could receive compensation from the underwriter of the derivative.

Yet while these financial instruments are important, a lack of regulation and transparency has resulted in a large and unwieldy market. Few people understand the derivatives market and no one knows the true size and scope of it.

To understand the risk posed by derivatives, it’s important to understand the size of the market, which unfortunately is hard to measure. Some of the numbers being tossed around, such as the now infamous 1.2 quadrillion dollar estimate, are based on nominal values, an accounting measurement that does not accurately reflect the true risk posed by the market. While the actual liabilities created by derivatives almost certainly do not rise that high, the amount is likely in the trillions of dollars. While the market is large, its exact size is not known which poses a risk in-and-of itself.

Importantly, derivatives can act as “amplifiers” for economic downturns. For example, when the U.S. housing market collapsed in 2007-08 many banks and other financial companies suddenly found themselves on the hook for numerous “bad bets” on derivatives. This makes the potential risk created by derivatives all the more real and substantial.

And while financial markets have stabilized since the crisis, some banks have continued to record major losses caused by bad bets in derivatives. The most recent headline breaking news is coming from JPMorgan, which lost 4.4. Billion dollars in the second quarter to bad bets made in the derivatives market.  Even with these losses JPMorgan will record a profit of USD 4.96 billion dollars so clearly the bank will survive this crisis. Still we must ask whether this was an isolated incident or a red flag for things to come?

And while the potential losses caused by derivatives can be overwhelming, most derivatives are unregulated by any national government, though the U.S. government has been working to both regulate and monitor the massive derivatives market through the Dodd-Frank Financial Regulatory Wall Street Reform and Consumer Protection Act. Still, even if the United States moves to regulate derivatives there is a high chance that banks will simply move their trading to unregulated markets or otherwise lobby for loopholes that will allow them to work around regulations.

Banks will of course fight against increased oversight and with good reason, derivatives can be immensely profitable. Still while regulations are often panned for creating red tape and inefficient markets, with so many “too big to fail” organizations betting via such exotic and opaque financial instruments it is now necessary for governments around the world to enact at least some minimal regulations and reporting measures to ensure that derivatives do not pose a threat to global markets.

Of course one could always wonder if attempts at regulation and reporting will simply be too little and too late. If another major bubble were to pop, say the Chinese housing market, it’s possible that the amplifying effect of derivatives would overpower the world Financial System and lead to a true global economic meltdown. This may sound like an unlikely doomsday scenario but the 2008 Financial Crisis has already pushed many of the global financial market’s safety mechanisms to the point of being overwhelmed and many governments and institutions no longer have the cash to combat another major crisis. Only time will tell if it’s too late but in these unstable economic times once-unthinkable crises are now a genuine possibility.

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