Australia’s big four banks have amassed over $15 trillion dollars in exposure to financial derivatives in just the past 6 years bringing their total exposure to $32 trillion. Is this sound banking or just high stakes gambling on the global stage?
In 2002 Warren Buffett described derivatives as “weapons of mass destruction”. In fact, while a lot of attention has been paid to subprime mortgages as the cause of the global financial crisis. What is less commonly realised is the damage would have been much better contained had the markets not traded over four times the mortgage value in derivatives.
Essentially a derivative is a bet that the value of an asset will go up or down. For example, today the Australian dollar is trading $0.71 US Dollars. An investor may purchase a derivative that will pay him money if the Australian dollar goes up in value in the next 30 days.
Derivatives have an important purpose in global finance, hedging risk. Major fluctuations in the value of our dollar can have important impacts on importers and exporters. By using specific types of derivatives these companies can limit their risk to fluctuations in the value of the Australian dollar.
However, derivatives open the door to huge speculation. Let’s look at an example, an investor (Tom) believes the Australian dollar will rise to $0.80 US Dollars in the next 6 months. The investor can make a bet with a financial institution by purchasing a derivative. If the financial institution believes contrary to the investor they are likely to pay good returns in the event that the dollar reaches $0.80. The investor pays a small premium to hold the derivative and gets a return if the dollar reaches $0.80. Derivatives allow investors to speculate on the price of an asset, whether currency, stocks, bonds or commodities without ever having to hold onto the asset.
The beauty of derivatives is; another investor (Jane) can come along and make a bet on whether they believe Tom will win his bet on the Aussie dollar. If Tom wins, Jane wins. And so whole chains of derivatives can be created that are increasingly divorced from the actual asset.
These investors call themselves speculators which is really just a euphemism for high stakes gambler Earlier article on Global Banks – Just One Big Casino.
In 2008 when the US mortgage bubble burst and financial institutions collapsed, many of the major banks were exposed to $4 trillion in mortgage derivatives. They had basically gone all in with their chips expecting that the value of mortgages would continue to rise. Well they didn’t and these gamblers were bankrupted and their businesses shut down. … No wait, the government stepped in and gave them the public’s money to keep playing.
You would think we would have learnt our lesson. Apparently not.
The beginning of 2016 has seen Australian banks lose around 10% of their share price. This appears to come from shareholder fears of potential bankruptcies in the commodities sector such as oil, coal and other assets resulting from prices dropping to extraordinary low levels. As indicated by Louie Gave from Gavekal, a Hong Kong based investment research firm, commodities account for at least $US4 trillion of the global derivatives market. In 2008 it only took $US500 billion in mortgage losses to wipe $US28 trillion from global share markets and $US7 trillion from global GDP. The problem was not the $US500 billion in losses, but rather the $US4 trillion in mortgage derivatives that significantly magnified the problem.
It appears we sit in a similar situation with $US4 trillion in commodity derivatives. The next obvious question is what exposure do our top four banks have to these derivatives?
The problem here is the derivatives market is basically unregulated with very little transparency available to the public. But given Australia was riding a resources boom until 2014, just like the mortgage boom in the US, I am going to speculate that the banks have considerable exposure to these markets. If this is the case, then the downgrading of BHPs credit rating in May 2015 to ‘negative’ must have made some bank executives very uncomfortable.
Our banks appeared to weather the 2008 storm quite well. In September 2008 the RBA stated, “The Australian financial system has coped better with the recent turmoil than many other financial systems.” However, what most of us don’t know is NAB and Westpac secretly borrowed $US4.5 billion and $US1.09 billion respectively from the US Federal Reserve during 2008 and 2009. It was only when the US Congress passed a bill in 2011 to audit the Federal Reserve that they discovered $16 trillion in low interest loans made to banks around the world to keep them afloat, including our NAB and Westpac. Perhaps our banks are not as secure as we have been lead to believe.
What happens if some part of the commodity chain goes under – potentially catastrophic consequences. And with $US4 trillion in global commodity derivatives we may have another GFC on our hands.
So with a combined $32 trillion in derivatives exposure, it sure seems our banks are willing to play at the high stakes gambling tables. When you look at Australia’s total productive as measured by the GDP is just a paltry $1.4 trillion in comparison it doesn’t take a rocket scientist to suspect that there is something incredibly wrong here.
Are you comfortable with our major banking institutions carrying such huge exposure to risky derivatives? I for one am not. In my opinion it is time for the derivatives market to become fully regulated just like the stock market and banks made to be completely transparent with their derivatives trading.
While all of this can appear quite scary, just remember our entire financial system is man-made. That means we can also change the system. All it would take is for sovereign nations to take back control of the financial system away from profit centric central banks, reset the financial system and reorganise it into one based entirely on production and not speculative gambling.