What the Heck is a Derivative?
In its simplest form, a derivative is a bet. And the wager can be on almost anything: stocks, commodities, currencies, exchange rates, interest rates, etc.
You can even bet on the weather!
For example, farmers might use weather derivatives to hedge against poor harvests caused by drought or frost. That’s using a derivative as a risk-limiting hedge.
And that’s how most derivatives are used by larger financial institutions.
But accomplished derivative traders can easily become overconfident with their success and start delving into proprietary trades, commonly known as “prop trades.”
A “prop trade” is a customized bet, and it can be on just about anything.
For example, let’s say instead of hedging your business against a weather-related risk, you have this inkling that the hurricane season is going be really nasty this year.
You could form a derivative based on your guess. You bet on the number of hurricanes that will hit land this year ... or how many will hit Florida ... or how many will become category 5 storms.
Risky? Oh yeah.
But as long as you can find a counter-party who’s willing to wager against you – you’ve just created a proprietary derivative. A “prop trade.”
Each side puts down their cash, shakes hands and the deal is on.
Now out in the real-world financial derivative markets, you usually don’t have to pay the entire amount of the trade at the time the “bet” is made.
Sometimes you’ll only need to pony up as little as 1%.
So, for example, if you wanted to bet $1000 that at least one category 5 hurricane hits Florida in 2012, you might only have to put down $10.
And this is where derivatives get dangerous. Real dangerous.
In the hands of inexperienced traders, this “high leverage” can spell disaster.
If you get over-extended and start losing too many of your bets, you have to come up with the rest of the cash. Fast.
Inexperienced traders who start losing try to cover their bets with new, riskier bets. And if those fail, then everything snowballs.
Now in the real world, derivatives are a bit more complex than just betting on whether a hurricane will strike or not.
And that’s another huge problem. No one can fully identify the risk of some of these huge, complex trades.
That’s because they package up hundreds or thousands of different instruments into a single bet. The larger these collections get, the more speculative ... and risky they become.
Jamie Dimon, CEO of JP Morgan Chase, has said repeatedly that the huge losses his bank suffered started as hedging against risk.
But he told the Senate banking committee in June that these derivative bundles changed into something “I can not publicly defend.”
Meaning “prop trades.” Risky bets.
Bets that got worse and worse as the panicked traders tried to cover their tails.
Here’s what’s scary.
As bad as JP Morgan Chase’s loss was, it isn’t the first time something like this has happened. And we’re not even talking about 2008.
How a Rookie Derivatives Trader
Bankrupted the Oldest Bank in England...
In a Matter of Days!
In 1995, a 27 year-old derivatives hot-shot named Nick Leeson single-handedly brought down the fabled Barings Investment Bank.
Barings was Britain's oldest merchant bank. The Queen's bank. For 223 years this rock-solid institution was a sign of stability in Britain.
In the 19th century, Barings financed growth in the New World too, underwriting the Louisiana purchase, the Erie Canal and the Canadian-Pacific Railway.
But young Leerson, working out of a tiny office in Singapore, bankrupted the firm in a matter of days.
His losses started out relatively small. His risky derivative trading netted a £2 Million loss in 1992. He hid the losses in an “error account” shielded from management’s radar.
By 1993, those losses ballooned to £23M, and then exploded to £208M by the end of 1994.
Leeson kept carrying over the trades, taking on more risk each time. He was trying to win back his losses.
But within the first two months of 1995, those losses finally came due. Leeson skipped town and sent a confession note to his London bosses.
Before Baring management could step in and stop the carnage, Leeson’s derivative nightmare had ripped £827,000,000 off Barings’ bottom line.
That was more than double the bank’s available trading capital.
The $1.3 billion USD-equivalent loss nearly brought down the entire London Stock Exchange.
The Bank of England attempted to save Barings with a privately funded bailout. But after another £100 million in losses within days, the goodwill effort failed.
Three days later British Regulators declared the mighty Barings Bank insolvent.
Dutch bank ING stepped in and purchased Barings Bank for a token £1, assuming all of their liabilities, and averting a larger disaster.
Why Are Derivatives So Popular?
So, with so much risk, why would anyone sane person trade derivatives?
Well, the returns can be fantastic ... if you get it right.
For example, hedge fund manager John Paulson earned $4.9 billion in 2010. All by betting on the right side of derivatives.
And trader Bruno Iksil, the so-called "London Whale" responsible for the huge trading losses at JP Morgan, used the same derivative-trading techniques between 2007-2010 to net his bank $2 billion in gains.
That’s why he likely became overconfident with this trading methods.
Why this Matters To You and Me
Even though you likely aren’t involved in derivative trading, this news affects you.
You see, the entire financial industry is tethered together nowadays. If one firm sinks, they can all go down.
We saw in 2008 what can happen if a “too big to fail” financial institution actually fails.
When Lehman Brothers went belly-up in 2008, it’s losses became a millstone around the neck of all the other Wall-Street financial firms ... and the banks that backed them.
The weight of that loss dragged the entire financial market down to depths we haven’t fully recovered from 4 years later.
The big banks and the Wall Street firms got bailed out.
It’s the little guys like you and me who foot the bill.
If you had any money in the Market in 2008, you’re probably still smarting from that loss.
And even if you held on to your positions and think you’ve “recovered” the majority of that money, think again.
All of the gains in the Stock Market since 2008 have been with money inflated by the Fed’s printing press.
Those fake dollars you “made back” aren’t worth much more than the paper they’re printed on.
Warnings to Heed
JP Morgan’s huge loss is a warning sign.
“Big Finance” is still chasing the derivative markets. And the risk is huge.
JP Morgan Chase is supposedly the best run bank in the world. They are the only bank that didn’t lose money during the 2008 crisis.
But don’t think they have a crystal clear understanding how to manage billions of dollars. They’ve proven they don’t.
And that’s why we at EVG don’t trust our money to the vagaries of the market.
If you are still in the stock market, please beware.
Don’t think that any “too big to fail” business is safe. They CAN fail.
And don’t think you can “play it safe” in the stock market.
Even if you pick safe, stalwart, blue-chip companies, they can come crumbling down in a broader market crash. Even if it’s not their fault.