Derivatives pose threat

For all the pretending by U.S. government officials and the regular media, it is obvious that, outside of the public eye, something terrible is developing. Ultimately, the problem may be a developing crash in the derivatives markets.

Derivatives, simply stated, are contracts that derive their value from the performance of an underlying entity. This entity can be a stock, an index, a currency exchange rate, or an interest rate, to name some of the most common kinds. Common kinds of derivatives are forwards, futures, options, caps, floors, collars and swaps. You probably have also heard of collateralized debt obligations, mortgage-backed securities and credit default swaps.

Derivatives, along with stocks and bonds, are the three major categories of financial instruments. In terms of size, they may be the largest of the three markets. A few years ago, The Economist reported that there were $700 trillion of derivatives in the over-the-counter (OTC) market. According to the December 2014 quarterly report from the U.S. Office of the Comptroller of the Currency (http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq414.pdf), JPMorgan, Chase Bank NA, Bank of America NA, Citibank NA, and Goldman Sachs by themselves had more than $200 trillion of derivatives contracts.

In theory, these trading companies balance their risk positions by holding offsetting derivative contracts. However, don’t count on it. As Raghuram Rajan, a former chief economist for the International Monetary Fund said, “... it may well be that the managers of these firms have figured out the correlations between the various instruments they hold and believe they are hedged. Yet as Chan and others (2005) point out, the lesson of summer 1998 following the default of Russian government debt is that correlations that are zero or negative in normal times can turn overnight to one – a phenomenon they term “phase lock-in.” In other words, a hedged position can become unhedged at the worst possible time, inflicting massive losses on holders of derivatives contracts where they thought they were protected.

In 2002, Berkshire Hathaway’s Warren Buffet pointed out that derivatives could be considered as “financial weapons of mass destruction.” The reason for this is that if any one party liable to make good on a derivatives contract defaults, that could lead to a chain reaction of defaulting contracts. Goldman Sachs, for instance, at the end of 2014 risked potential derivatives losses in the event of major defaults greater than five times the net worth of the company.

What are some of the events happening right now that puts the global financial market at greater risk than usual? Here are just three of them:

• The world price of oil is down roughly 50 percent from a year ago. Many creditors who have loaned funds for exploration and construction of oil wells, especially in the shale oil niche, face the risk of loan defaults. As these defaults occur, a number of derivative contract sellers will become liable to make payments.

• The Greek, Austrian and Ukranian financial crises could force major central and private banks to stop valuing loans to these governments on their books at 100 percent of face value. The resulting tens to hundreds of billions of dollars of losses by banks would trigger massive claims on derivatives contracts.

• China’s creation of the Asian Infrastructure Investment Bank and its pressure to include the Chinese yuan (renminbi) as a component of the Special Drawing Rights system is attacking the value of the U.S. dollar.

By itself, the U.S. government is battling these financial problems with two main visible efforts. First, the U.S. stock markets are being propped up. Second, the prices of gold and silver are being suppressed. As long as paper assets appear to be strong and precious metals are held in check, many investors will sit tight with stocks and bonds.

There are many more global financial crises right now, but the impact of just these three is leading to semi-secret meetings to try to cope. For example, the non-profit Official Monetary and Financial Institutions Forum (OMFIF) held a little-reported meeting last Friday in Washington, D.C., titled, “Gold, the renminbi and the multicurrency reserve system.” Only those invited, such as representatives of central banks, governments and major private banks could attend. This meeting was apparently cobbled together in conjunction with the spring meeting of the International Monetary Fund and of the World Bank Group.

Apparently the major media had no interest in covering these meetings or were barred from them. It would be interesting to know why gold is so important to the international monetary system in secret gatherings yet the official U.S. government line is that gold is an obsolete asset.

Perhaps even more important, shouldn’t the public be informed about all the lurking crises about to erupt?

Patrick A. Heller was the American Numismatic Association 2012 Harry Forman Numismatic Dealer of the Year Award winner. He is the owner emeritus and communications officer of Liberty Coin Service in Lansing, Mich., and writes “Liberty’s Outlook,” a monthly newsletter on rare coins and precious metals subjects. Past newsletter issues can be viewed at http://www.libertycoinservice.com. Other commentaries are available at Coin Week (http://www.coinweek.com). He also writes a bi-monthly column on collectibles for “The Greater Lansing Business Monthly” (http://www.lansingbusinessmonthly.com/articles/department-columns). His Numismatic Literary Guild award-winning radio show “Things You ‘Know’ That Just Aren’t So, And Important News You Need To Know” can be heard at 8:45 a.m.Wednesday and Friday mornings on 1320-AM WILS in Lansing (which streams live and becomes part of the audio and text archives posted at http://www.1320wils.com).