In my view, derivatives are not bad in and of themselves. They can assist producers and users of materials or commodities and help, for instance, to insulate exporters/importers against rapid currency fluctuations that might wipe out the margins that they normally operate under. For example, I myself have bought "puts" which are a form of options, which are a form of derivatives, to insulate or insure myself against a possible fall in certain stocks that I have owned. As an owner of an underlying asset such as a stock I could also have sold (or underwritten) "calls" on my stock. This would give me an additional revenue stream from the premiums paid to me by those who bought calls in anticipation of a price rise of that stock (speculators, typically) or those who wished to protect themselves from a possible price rise in a commodity or industry (hedging). Note that in my example, I owned the underlying stock or commodity. Thus, if events turned against me, the writer of the call, I would be in a position to deliver the underlying asset for the original contract price and honour my commitments in an entirely unleveraged and safe fashion. Those who underwrite (sell) call options or similar derivatives without owning the underlying assets or only counting on other paper guarantees from third parties to bail them out of derivative positions are often referred to as "naked" or partially naked writers.
The current problem with derivatives is that increasingly, especially over the last 10 years, derivatives have become essentially an end in themselves. The value of these derivatives first began to exceed and in time to dwarf the underlying assets. Furthermore, many of those engaged in the profitable business of underwriting these policies were/are completely unable to honour their commitments (pay out the policyholders, so to speak) in the event of a dramatic reversal in the prices of the insured commodity, mortgage fund, the value or stock price of a corporate entity or other security or asset. In the simple example of my options calls described earlier, more and more derivatives came onto the market as naked or entirely leveraged instruments.
In the United States, 5 large commercial banks represent 96% of the total derivatives outstanding. You will recognize the names pretty quickly: JPMORGAN CHASE BANK, BANK OF AMERICA, CITIBANK NATIONAL,GOLDMAN SACHS BANK, HSBC BANK USA NATIONAL. The top one is JPMORGAN CHASE. It has assets of almost 2 Trillion $ but has derivative exposure of $87 Trillion. Or take a look at Goldman Sachs. It has assets of only $162 Billion yet has derivative exposure of almost 32,000 Billion, or 32 Trillion, or over 180 times its assets. The U.S. GDP is only about $15 Trillion. Does this look like a problem? Bubbles upon bubbles. It sends shivers up and down my spine! Furthermore, an additional really troubling thing is that the first 4 of these in particular basically run the federal reserve and the U.S. Treasury Department. Operating at such leverage levels, these are simply disguised Ponzi schemes. It's like borrowing not 90 or 100% of the value of your house but the equivalent of borrowing 10, 100 or 300 times the value of your house. So why do they do it? Well, the premiums and profits, of course. Now these are all just financial manipulations and there is no true profit no more than there is any GDP or value associated with it. But many people have become very, very rich in the process of hollowing out America (and, again, to a lesser extent, Canada). You and I are picking up the tab to bail these folks out. You see AIG provided "insurance" for these bozos, so if it didn't get bailed out, the real culprits would hang - the likes of JPMORGAN CHASE. Now some argue that Greenspan, Bernanke et alteri were taken in by mathematicians whose models explained that leverage could be made riskless via complicated hedges. Well, it is hard to believe that such apparently sophisticated and educated folks could be that naive. In the end, they totally abdicated their responsibility to enforce sensible reserve requirements for banks, pretending that derivatives are "different" and needn't be compensated for. The so-called ratings agencies were complicit as well. Take a look at this article from 2 years ago. Everyone was looking the other way - knowingly! The sales pitch to us is: We have to rescue these banks (and corporations, insurance companies, mortgage lenders, yada, yada, yada because otherwise the whole world will collapse and suffer. How does one suppose that all that money being borrowed or printed on our behalf is going to occur without some very serious impacts and suffering -ours? Overall bailouts now amount to about $30,000 for every man, woman and child in the U.S.
Many of these folks should be in jail. Instead, most of them are just fine, some of them employed at the Treasury or federal reserve or key US gov't posts: See here or here. The second article deals with a possible conspiracy and I can't comment sensibly on that aspect but further along in the article there is a great list of positions occupied by former Goldman Sachs folks, including our own Bank of Canada Governor, Mark Carney, h'mmm. As yet another sidebar, one may wish to note that most of these banks are on the top 10 of Obama's contributor's. See here. In case one thinks that this is limited to one presidential hopeful, look at this article from the Washington Post. More Goldman Sachs related stuff here.
Now, honestly, anyone who wanted to know that unbridled, massive derivative creation and trading was going to bring major trouble had no trouble knowing or finding out. Some very well spoken and well known individuals and organizations have been sounding the alarms for a long time. See the article below, for example. Warren Buffet warned about derivatives being a "financial weapon of mass destruction." When? In 2002. See the following: http://www.marketwatch.com/story/derivatives-are-the-new-ticking-time-bomb (there are 2 pages here). Numerous analysts and writers have warned and commented on the growing dangers.
One of the biggest derivative debacles had to do with mortgage debt. While debt is OK and even necessary to a degree, excessive debt is one of the most serious cancers possible in an economy, whether it be for an individual, a family unit, a corporation or a nation. Cheap mortgages were pushed onto equally hungry potential homeowners and speculators to earn commissions for the brokers and packagers of this debt (sub-prime being the worst). The packaged securities were subsequently insured (derivatives, again) and traded to pension funds, investors, etc. Problem was that many of the folks receiving these mortgages or liar loans, as they were sometimes referred to, could not possibly pay their monthly installments. The lenders knew that but didn't care, often telling borrowers that they could sell the house for a higher price in a few months, so not to worry. Well, we know what happened. We have pyramid schemes or vapourware everywhere, it seems.
GM (not really derivatives but still operating in an artificial environment and part of the bailouts, so I will comment) Companies like GM were doing the same crooked things that Nortel did. In Nortel's business-to-business dealings it was called vendor financing. Nortel would "sell" telecom equipment to a firm who didn't have money by advancing a loan for its purchase and would record a sale and profit from the transaction. In fact it had given away merchandise in exchange for a questionable IOU. GM's business became exactly the same. They have not been so much in the business of selling cars as operating a specialized lending facility. The customer walks into a dealership, takes a car and leaves an IOU in return. If these folks were credit-worthy it could work but increasingly people are borrowing for everything - couches, printers, cars, homes, holidays, etc. and increasingly a lot of folks can't service the debt. So a lot of these IOU's have become junk debt. "As of October 15, 2008, GMAC had $173 billion of debt against $140 billion of income-producing assets (loans and leases), some of which are almost worthless, in addition to GMAC Bank’s $17 billion in deposits (a liability). Even if GMAC liquidated the loans and leases, it couldn’t pay back all of its debt." The above is from the GMAC Wiki.
Finally, an entertaining article on debt abuse (and some GM comments) from 2004: http://www.gold-eagle.com/editorials_04/willie060904.html
