Are Derivatives Weapons of Mass Financial Destruction?

You need to understand derivatives, an arcane and boring-sounding Wall Street device that could explode the entire financial system. Warren Buffett famously dubbed derivatives as “financial weapons of mass destruction,” and I’m inclined to take that description seriously.

Hyperbole?

No, but I’m going to walk you through them so that you can decide for yourself. At a minimum, you’ll learn something cool you can talk about over the holidays. Trust me, there’s nothing extended loves more than a passionate discourse about derivatives!

This episode isn’t just about understanding derivatives for academic interest—it’s about grasping how they could potentially create colossal problems for our financial system.

Let’s break it down. A derivative, at its most basic, is a contract. That’s it. They’re bets, in essence, wagers that you see the world more clearly than the next party. They are nothing more or less than a legal agreement that derives its value (hence, derivative) from an underlying asset or event. Sounds simple enough, but the devil is in the details—the complexity arises from the myriad forms derivatives can take, and the intricate web they weave in our financial markets within and across literally hundreds of counterparties, each of whom is convinced they aren’t the one holding the bag, but bets that can have a profound impact on economies and individual fortunes alike.

And here’s where it gets especially interesting: you don’t have to even own the underlying asset to engage in these bets. There’s a massive amount of money tied up in bets placed upon bets, with risks stacked upon risks, without any requirement for a direct stake in the asset itself. Whether you’re an investor, a homeowner, or just trying to save for retirement, understanding derivatives is crucial for navigating the precarious pathways of modern finance.

Let’s get started.


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This is a companion discussion topic for the original entry at https://peakprosperity.com/are-derivatives-weapons-of-mass-financial-destruction/

Weapons Of Mass Financial Destruction

The Big Short. I loved this movie, one of the best movies ever.
Matt Taibbi explained it very nicely using regular insurance as the starting point. When you own a car, you can buy insurance to cover the cost of the car, but you can’t insure it for more than it’s worth. In derivatives, you can. With car insurance, you can’t insure a car that you don’t own. In derivatives, you can. With car insurance, you can’t buy multiple car insurance policies on one car, but in derivatives you can.
So basically you can buy a derivative on my car, even though you don’t own it, and you can insure my car for any amount you want, even though it’s only worth $5,000, and you can buy as many insurance policies (derivatives) on my car as you want.

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Legislation

Didn’t our illustrious representatives pass legislation that allowed derivatives to go the front of the line of creditors in case of bankruptcy? Around 2006? With the lowly depositor scratching his ass at the back of the unsecured creditor line?

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Yep. That’s in part II. I cover the Chase Act which normal people call the Dodd-Frank Act, named after two of the most useless DC swamp critters ever to set their mandibles on the national sill.

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So basically you can buy a derivative on my car, even though you don’t own it, and you can insure my car for any amount you want, even though it’s only worth $5,000, and you can buy as many insurance policies (derivatives) on my car as you want.
Yep - that's the essence of it!
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Michael Moore Film

There was a Michael Moore film (Capitalism: A Love Story?) where he goes down to Wall Street and asks everyone “What is a derivative?” No one could answer it. One guy said, “Oh these things are very exotic.” You gotta give Moore some credit for this.

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Yes. You no longer have property rights to your assets held at custodians. You have what’s called “security entitlements”, and behind the scenes your assets can be used as collateral in derivatives trading whether you like it or not. One of the critical paragraphs in the Universal Commercial Code reads like this:
UCC 8-511(c) “If a clearing corporation does not have sufficient financial assets to satisfy both its obligations to entitlement holders who have security entitlements with respect to a financial asset and its obligation to a creditor of the clearing corporation who has a security interest in that financial asset, the claim of the creditor has priority over the claims of entitlement holders.”
David Webb’s book “The Great Taking” explains the whole story.

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Derivatives

Derivatives are a key subject. My memory is poor but i will try to go back a few decades and relate some experiences. Again I will try to relate some figures as best as I remember them.
First; I used to receive copies of business briefs (to expensive to subscribe for) from Mr Harry Schultz. He was a Swiss economist who I had extremely high regard for. In this letter (almost 20 years ago) he addressed his subscribers, “It is the derivatives you idiots.” He continued that all banks were bankrupt. I then placed a call to the head of a central bank of a country whom I knew. He informed me that a person would call me anonymously in a few days with some information.
In the following call i received 50 names, including of some of the worlds largest banks, that this central bank would only do superficial business with.
Second; If I remember correctly, the actual subprime losses were in actuality only 360 billion dollars. The total losses were 19.7 trillion and were only stoped there because the worlds financial
 institutions stepped in to stop the crisis. This crisis occurred due directly to the derivative market. In those days there was about 620-640 trillion of derivatives that were leveraged 30 times on average. The losses were so large BECAUSE YOU CAN NOT UNWIND 30 BETS IN A SHORT
AMOUNT OF TIME. The saying then was that it would take 30 professional experts 30 days to try to unwind these derivatives. Today we have this amount of derivatives with many zeroes added and they are levered by 100 times on the average. The amount of money and the explosive power buried away from public scrutiny is truly inconceivable. 
Third; I was walking with a gentleman that I have known for many years who now advises banks on which derivatives to buy or sell. I brought up the subject of derivatives with him. He immediately responded, “There is no need to worry, “because every bet is covered with COUNTER PARTY COLLATERAL”. I quickly reminded him of the last 2008 crash and that almost the entire COUNTER PARTY COLLATERAL was nothing more that LEVERAGE of the preceding bet. And therein lies the rub. So the banks blow up, who cares?
Fourth; now please read “THE BANK RESOLUTION ACT “ signed by the G20 long time ago. It clearly states that in time of bank bankruptcy (resolution is the new fancy word for bankruptcy)
all “UNSECURED DEBT” (deposit monies) belongs to the bank. Another such act was signed by one country in 2013 stating that the second debt to be paid after the CEO were the derivatives.
 

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Creature

“The Creature from Jekyll Island”, G. Edward Griffin - Great Book….
Griffin says that we have a “Bail Out Model” financial governance system. Seemingly, the bigger the disaster, the more money that the US government will throw at them….
There’s that big, fancy “President Wilson” hotel on Lake Geneva in Geneva, Switzerland.
I always thought that it is a bit weird that even to this day, US President Woodrow Wilson is still a big hero in Switzerland, the banking capital of Europe.
President Wilson had to move quickly to intervene in WWI before Britain capitulated to the Germans and the Bankers (JP Morgan) lost big on all of their British and French War Bonds.
What happens when the US Military becomes so degraded that it is no longer able to Bail Out the Bankers on their bad war bets?

Quadrillion?

Chris, I know you just misspoke, but maybe you can edit over the last few minutes of this post. It is 2.3 quadrillion = 2,300 trillion. It sure is easy to forget how many times you moved that decimal place over three digits. Then there is the British system…

Thank You

Chris - thank you for providing such a coherent and concise explanation on derivatives. I have been trying to get my head around this topic for quite awhile with no success. Until now the only thing I understood was “Derivatives Bad.” Your video was a good investment in 25 mins. I now see what they are and understand the actual threat they present. Now on tot he next video and begin the process of mitigating exposure to them. Great job.

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Mike

Your video was a good investment in 25 mins doodle jump

Look Up Your Bank

When I researched this topic several years ago, I found the following resource which is updated regularly:
https://www.usbanklocations.com/bank-rank/derivatives.html
I chose a local bank that had no derivatives, and was amazed that it was on the list. I know no bank is safe in general due to the small FDIC insurance amount, but I feel better with a bank that does not participate in the derivatives scheme.

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My bank has been expanding rapidly as of late, and I see that they now have been participating in the derivative market.  ?  I guess it’s time to find a new, smaller local bank.
I love that you can drill down into the reports and assets of any particular bank and learn about their financing. Not that I drill too deep because I don’t know what I would be looking for, but it’s handy to have all of that info accessible in one place.

Wow- thank you for that! I thought custodial accounts were much safer. Maybe they are, but I probably should have known better.

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Hope I can ask this question making sense: If I own my car (hold title) but it is insured, can the insurance company hold a derivative contract on the underlying value of the car; therefore, being able to take my car away from me if the derivative contract blows up?

By chance would you know how to find the same information about credit unions?

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