Janet Tavakoli: Understanding Derivatives and Their Risks

Global financial markets are awash in hundreds of trillions of dollars worth of derivatives. By some estimates, the total amount exceeds one quadrillion.

Derivatives played a central role in the 2008 credit crisis, as they had a brutal multiplying effect on the magnitude of the carnage. As a bad asset was written down, oftentimes there were derivative contracts written against it that resulted in total losses 10x greater than the initial write-down.

But what exactly are derivatives? How do they work?

And have we learned to treat these "weapons of mass financial destruction" (as Warren Buffet colorfully coined them) any more carefully in the aftermath of the global financial crisis?

Not really, claims Janet Tavakoli, derivatives expert and president of Tavakoli Structured Finance.

But the danger behind derivatives doesn't lie in their existence, she stresses. They play and important and constructive role in a healthy financial system when used responsibly.

But when abused, derivatives can create massive damages. So at the root of the "derivatives problem", Tavakoli stresses, is control fraud - the rampant unchecked criminal action by influential players on Wall Street. (This is the same method of fraud we've explored in past interviews with Bill Black and Gretchen Morgenson). Derivatives contracts are too often constructed in favor of these parties, who if they end up on the losing side of the trade, are able to socialize their losses. Until we address this root problem of corruption, says Tavakoli, derivatives (as well as other securities: stocks, bonds, etc) will continue to subject investors and our makets, overall, to unacceptable risk.

On The Nature of Derivatives


Derivative just means “derived from.” It’s just referencing another obligation, like a bond or an equity, or you can even reference an option. You can have options on futures, as an example. So a derivative is just like handing out fifty photocopies of a model; you know it’s a derivative of something that actually exists.

Let’s take an example. Goldman-Sachs used derivatives they used to help supply money to mortgage lenders by creating securitizations. And those securitizations were simply packaging up loans that were made by people like Countrywide. Countrywide of course was sued for fraud and settled for $8.3 billion with a number of different states for their predatory lending practices.

So you take these bad loans, you package them up in securities, and if you can combine them with leverage, it will always look like you are making a lot of money. That’s classic control fraud, as William Black so eloquently keeps explaining to the market and as our financial media keeps ignoring. Now, how do you combine it with leverage? Well, derivatives are a very handy item if you want to lever something up. So as an example, the Wall Street Journal looked at a $38 million dollar sub-prime mortgage bond that Goldman created in June of 2006, and yet Goldman was able to leverage that up to cost around $280 million in losses to investors.

Now how did they do that? They did that with the magic of derivatives.

Because with a derivative, you can reference that toxic bond, that $38-million-dollar bond can be referenced, you can say If that bond goes up or down in value, the value of your securitization will change as that bond goes up or down in value. So you don’t actually put that bond in a new securitization; instead you use a derivative – a credit derivative, in this case – to reference that bond. And so with the credit derivative, you can basically create as many of those referenced entities as you want. Now, they stopped at around thirty debt pools; they could have done a hundred and thirty.

Because with a credit derivative, all you’re doing is saying you are going to look to the value of that bond and we’re going to write a contract that your money is going to change when that bond goes up or down in value. That’s a derivative. You’re not actually putting the bond in; you’re just referencing that bond. You are basically betting on the outcome of something. And you don’t actually have to own its physical security. Now that’s a derivative. And that’s how derivatives were used to amplify losses and to magnify losses to make a bad situation much, much worse.                 


On Control Fraud

The root cause of it is control fraud - people in the financial system being able to do whatever they want and remain unchecked.. Where you have a group of individuals who are well rewarded for this kind of behavior and yet there is no punishment for this kind of behavior. As long as we keep that in place, you will just see more of the same. The way the Fed and regulators have chosen to deal with it is to pretend it’s not happening and just continue to print money. And, as I say, it acts as a neurotoxin in the financial system, 

On Deriviative Risk in a Market Downturn


When you most need liquidity, it isn’t there. And that’s always true of leveraged products, by the way. You know, the thing that people overlook is – and this is why fraud is such a potent neurotoxin – when the market freezes, when you end in combination with that, when you have a liquidity event, then you see even good assets deteriorate in value quickly, as people need to sell them into a market that has no liquidity. So you get sucker punched a couple of different ways. So if you can’t stand low liquidity, again, you shouldn’t be playing with credit derivatives.

Now, if you custom tailor your contract, it will be more difficult to offload that contract because people will have to take the time to read the contract, if they bother to read it at all. But that said, that’s not a reason not to re-write the language. With the ISDA standard documentation, the hype was, take our language, because if everyone accepts it, it will make it easier to trade these securities. And that was true, until credit events happen and then everyone pulls out their documents and says Oh my god, what did I sign?


On Gold and Countyparty Risk

Counterparty risk is the biggest risk.

And if you’ve been reading the Financial Times, you see a lot of people who are dismissive of gold. Well, here’s an interesting thing: The Derivatives Exchanges accept gold in satisfaction of margin calls.

We had credit derivatives traders who wanted to have contracts on credit derivatives on the United States that would settle in gold. Because if obviously the United States is in credit trouble, what would you want? You would want gold. You don’t want euros, you don’t want any other currency; you want gold. The thing about gold is that you don’t have counterparty risk. And if you look at the rebuttal for people who are saying that gold isn’t money, well, I’m sorry, but gold is being used as money already on derivatives exchanges around the globe. Now that wasn’t true five years ago. It’s true today. J.P. Morgan itself, around eighteen months ago or two years ago, said it will accept gold as collateral in satisfaction of margin calls. So they’ve de facto said gold is a currency.

Click the play button below to listen to Chris' interview with Janet Tavakoli (54m:27s):

This is a companion discussion topic for the original entry at https://peakprosperity.com/janet-tavakoli-understanding-derivatives-and-their-risks/

Ms. Tavakoli is obviously smart, highly educated, successful and beautiful as well. I especially liked her “corruption to production” explanation. The podcast was a great tutorial. I personally didn’t hear predictions for the future or helpful suggestions for us lowly middle cass blonds. Hmm maybe I missed something.
Alaska Granny

"…invest in companies that have low amounts of debt, a strong balance sheet, and good to cash position, and who are generating cash and who produce things that people want and need. And you try not to buy them when they are overpriced."
Spot on. 

People investing in the gold miners & oil companies need to know what they are investing in very well because in the event of a huge credit crunch where gold/oil do not get hit much & possibly even go up, there will be several miners/oil companies going bankrupt.

Anyway, she's great.

Thanks for the great interview.



Hi Chris,
I listened to the entire interview, hoping she would add something new to the debate, but instead she just rehashed her 4 year old book, and basically spoke over you. 

She knows her subject matter, but does not seem to be very insightful as to where we are now in the cycle, or what she expects to happen next.

Actually, it was disappointing to hear her worn out and condescending 'bathroom tile" analysis, and yet offer really nothing tangible for any type of investor to do, to "improve the structure" of their situation.  Rewrite your contracts? Why would that be helpful when the underlying problem is still conterparty risk? The same issue would apply to settling contracts with gold, who would trust any of these institutions to actually come up wth any? Especially J.P. Morgan, which she stated is either acting fraudulently, or just has a really, really stupid CEO in Jamie Dimon.

Many people are very aware and up to speed on much of what she was discussing, regarding derivative contracts and structure, the fraud, and how we arrived where we are today.

What would have been interesting is to hear about how the players, and or structures, have shifted since 2007/2008, and where she thinks the greatest risks lie in the system today.

You were very polite, but she seemed completely unable to answer any of the questions you were asking. She is stuck, like a broken record needle, repeating what is now old history, offering nothing new in the way derivatives (and their underlying securities) may impact the system differently in the next meltdown.


Wooee. Aren't we a clever little monkeys!
Nice tiles- pity about the food supply. The fraudsters are banking everything on being able to survive sans civilisation. Good luck with that, monkey.

Here is how we see the problem from street level.


Thanks for providing a bit more insight into a very complicated subject. Unlike the opinion expressed by pvmuse, who is perhaps much more sophisticated than I am, I appreciated the shiny tile analogy, and the more indepth expose of the rampant fraud that exists across the board. The massive corruption and greed is absolutely nauseating to me, all the more so because of how it is affecting we poor middle class souls both now, and in the future. We will be the one's who pay heavily for this, as will future generations.
The system needs to be purged and re-built. But it won't happen until the fraud is eliminated. And we all know that is not going to happen anytime soon. All we as individuals can do it stay informed and prepare well for what are sure to be a turbulent few decades that will no doubt see escalating social unrest from all of the masses of people who are being screwed over by the fraudsters.

Time go go tend the garden and plant more winter crops…


Was that a female robot - seemed to me she lacks basic skills in communication
When CM asked questions that did not fit her "punch card" she never could answer, so the podcast was not very informative

Further to my previous post, I do tend to agree with some of the comments re the quality of the podcast, and the fact that Ms. Tavakoli was shall we say overbearing. I find that often to be the case in highly intelligent people who have become so called experts, and forget what it is like for the rest of us. The interview certainily lacked the back and forth flow that we get from Chris and Mish. In spite of that the info I derived from it has been helpful to me in trying to understand derivatives. I am more informed that I was previous to reading it, and therein lies the value of the podcast, at least to me.

I thought this interview was intriguing.  I thought it was informative.  I have listened to it twice.  
I appreicated her candor and I thought she was the first interviewee that sounded more knowledgable than Chris Martenson.  I thought she was gracious and very pleasant to listen to.

Thanks for the calibur of interview, and the interviewee.  Very impressive.

The big message I got from this was "if you play the big boys' game, you play by big boys' rules". If you expose yourself to derivatives you're asking to get 'all et up by the big bad wolf'. Retail investors, as I imagine most of us are, are best served by keeping well clear of derivatives and other structured financial products. Avoid counter-party risk, because most counter-parties are there  to royally shaft you. And the whole story of control fraud flashes out in big flashing neon lights.
re  westcoastjan "I find that often to be the case in highly intelligent people who have become so called experts, and forget what it is like for the rest of us." Meh, I'm not sure what you're saying here - sometimes so called experts like to obfuscate to maintain their 'expert' statu8s, but I've also been in situations when I've thought "I'm not going to apologise that you're too dumb to follow what I'm saying." Sometimes the expert really is the expert and you really are the dumb schmuk. Of course, the challenge is knowing when  this is the case.

The part I thought was missing was an assessment of the risk of the current derivative tower.
The main points are easily understood; (1) derivatives are 'net zero' contracts where one party wins and the other loses by an offsetting amount, (2) a lot of institutions have used them to hedge risk, meaning they are carrying other risky assets on their books at full value because, even if impaired, they expect to be made whole by their derivative bet(s), and (3) in a big event you can toss out the idea that all counterparties will be able to pay up.

Given this, what I was hoping to secure from Ms. Tavakoli was an assessment of the risk that derivatives pose via the twin threats of masking risk and setting the table for a cascading counterparty fiasco.

Even if the answer was "you know, that's certainly a risk, but nobody can really assess just how big it is because the derivative market is just too big, too complex, and too opaque to really ever know," I would have been satisfied.

Instead, hearing that fraud is the main driver and that derivatives are an extension of that and that we therefore need to address the fraud just entirely sidesteps the question of derivative risk.

While I might agree to some extent that fraud is a big issue here, there are other matters pertaining to derivatives that are independent of the fraud angle. Fraud is certainly an aggravating factor, but it is not the only one.

At any rate, there was some useful information in this podcast for me, and hopefully you found so, too. But I am going to keep searching for someone who can speak to the outstanding risks of derivatives in such a way that I would personally be able to make some sort of decision after listening to them. Should I get out of paper entirely, sell stocks, be in bonds instead, build paper airplanes out of hundred-dollar bills and toss them from windows?

Bluntly, my underlying concern around derivatives is that they have created the appearance of controlled risk, and that counterparty failures have the possibility of spreading rapidly throughout the system in such a way that they literally seize it up. I need to know - is this a 0.0001% chance over the next ten years, or a 25% chance? My tactics and strategies will vary enormously depending on the answer.

Chris, obviously we are just not communicating very well. You keep talking about this derivatives thing, and it's the cracked grout supporting the tile. Look, it's the fraud, and the fraud is perpetrated through the language of the contract that I assure you favor me over you. So while the Italian tile is so shiny and beautiful, the bathroom represents an illusion of gradure because we have a leaking pipe beyond the tack strips that hold the plaster, and as you know or as a common person like me would know is that once the plaster fails, and the grout cracks everything must be torn apart to fix the beautiful shiny Italian tile. The problem though is that you didn't order extra shiny Italian tile and the lot number has been discontinued, and therefore you must start all over again with the bathroom as you have no tiles left to repair the problem. Dah!!!
Seriously now, I work hard at this, I am relatively new to all things financial, and crave every bit of information, and am starting to understand things pretty well. I focus on one subject and that is Oil because I like to keep things simple and focused. This Podcast did absolutely nothing for me except tell me what I already know and it is this: We live in a world that is not of my making, it is far to dangerous for any of us to completely understand and appreciate. My only controlled actions that I can take is to live every day joyfully and as honestly, with sound character as I can because I do not want to invest so much time trying to get into the minds of psychopaths as I am afraid it will rub off somehow.

Needs are relative and mine are frankly less is more. I just want enough 'less-es' to afford my more-s. Capeesh!?

I am only concerned with the next serious contraction as I believe it is near, and this is all I want information on. Do you have anything to report that may suggest one is imminent?


Go Tigers


Hey young man, happy birthday!  Welcome to AARP land…  being a mid level boomer… you'll soon be revelling in the increased respect and status we all enjoy   hahaha  For a great perspective on derivatives (none better short of truth serum for Blyth Masters) interview Dan Amerman… he's long been on a stump warning of the dangers at least since the early '90s… back when we were all younger!

"you'll soon be reveling in the increased respect we all enjoy. hahahahah!".
I had to laugh and out loud at this tricky rick. Why? Grandson's think I'm a stitch because I bought them their first whoopee cushions this weekend, and they haven't stopped laughing yet!

To anyone who aren't grandparents your grand kids, especially boys, love their grandpa's because they have status (imaginary) over their fathers. We get to undo all the hard work of the parents during their week come Saturday or Sunday on Crappa (my grandfather name that I love) and Grandma Angel day.

I would love to share the sequence of events that led up to the moment when they received their whoopie cushions but truthfully it is an age appropriate subject and most you kiddies here would probably think I am inappropriate and give me a thumbs down when it was so HILARIOUS!!!

OK, now, I am a counter party risk, to a party that assumed no risks, and the party who couldn't pay, then took out a Derivative to ensure that my Italian tiles were shiny…?!$$^(*)(+_…Arrrrggghhhh!!!

I'll have to listen to that Derivative Podcast again because I am sure I am misunderstanding something.

Gooooo Tigers!!!


"The dollar will always be valuable" according to Edward Harrison on Capital Account "because you have to pay your taxes with it." That argument didn't work in Zimbabwe, or a few other places.
In Korea a packet of biscuits cost Yook Chon. (5000 Won). This means that a currency can become severely debased and still be functional. Korea has a strong economy, but a weak currency. The weak currency contributes to the strong economy.

The USA would like to follow Korea's example but unfortunately it's dollar is the reserve currency of the world, which seemed like a good thing at the time, (what with being able to write cheques and all), but has the down-side of not being able to be debased. If the USA could break the connection between Oil and the dollar, then it would be able to debase with the best of them. This is a very strong argument to give oxygen to the Cold Fusion and Focused Beam Fusion researchers.

OK, so you loose the prestige but you get to eat. You might even be able to slide down the back of the Limits to Growth curves gracefully.

Lauren claimed in the same program that Marc Faber argued for a deflationary event but I could not follow the bouncing ball.

As far as positioning yourself to preserve your wealth, that's easy.

Just do the opposite of whatever I do.

OK, Arthur, you have just added to my day of joys and laughter. Then again, if you were serious about all that you wrote I'll be laughing alone. Actually, you made solid points but the ending shows your sense of humor.
Today I set out as part of my mental preparations (as my over-all preparations are completed to my satisfaction) to have laughter and a sense of humor to my every days. If this is offensive to anyone I truly apologize.

My beautiful wife, my lady, and my dearest friend are celebrating our anniversary week. We mark 38 years together on the 21st and 40 continuous years as boyfriend and girlfriend. She is the love of my life, highschool sweatheart, and I say with all humility that I am not the Man I am without having her in my life. I only hope she comes home in a good mood because she scares the hell out of me. Hahaha! 

Best Wishes.

Gooooooooooo Tigers!!!


Hey Macs, you are right, it is hard at times to differentiate the experts from the bags of wind who like to think they are experts. No shortage of windbags on Fox, CNBC and elsewhere the mainstream media. My point is more along the line of there really are some great, knowledgable people out there who may be brilliant in their field of endeavour, however, they lack the skill to communicate that brillliance to ordinary people like me. It's kind of like athletes in a way - just because they are star players does not mean they will be excellent coaches. We need look no further than Gretzky for a prime example. I think that this site, and what Chris is trying to do for us, is to bring in people who can help us make sense of serious and at times complicated issues. It is inevitable that some of those people will be talented at sharing their knowledge and others will not be able to make a good connection with us because they don't know how to share expert information with "non-experts". C'est la vie.
I will just continue to take from each podcast what I can understand, and use that info to help me do my planning and decision making.

I think, your guest lady was on point about all the unchecked (naturally) fraud running amok causing unsustainable, surely predictable sometime in the future collapse of such, and creating a mother-of-all-… financial tsunamis to wipe out all too close to the shore (the invested). You can't put a number on greed & secrecy that goes with it. All she can be is an expert witness to the liar-loan type of financial instruments of sure destruction that are being concocted by these thieves in power. I'm sure there could be a timetable one could construct to predict the timing of such collapse, but it's not really possible when so much done under the table, out of sight of the public. I think if we strictly stick to logic and do a bit of deductive reasoning we'll have no problem arriving at the root of all these financial problems - the monetary system itself. Power corrupts, and absolute power corrupts absolutely. Money is such power. No wonder then that there are players who don't play by the rules but rather side-step it and control the game itself and in the process gaining all the leverage to become the Ultimate Game Masters.


I haven't listened to the podcast yet.  The one comment you made on the product being net zero is in theory mostly correct, it falls apart when you look at what is backing each side of the net zero product.  It's the same people that really don't have the money to back the derivatives.  When you evaluate the size of the market, and realize it's as large or larger than the entire world's GDP, if one large chunk of derivative market, aka PIIGS, fails, the rest of the derivative market begins to fail too, because nobody can cover their own loses, and the "insurer" has insufficient resources to cover the market loss.

I agree with some of the other comments on this podcast - I skimmed the transcript rather than read it through, and didn't see much new information.   Clearly, it's hard to know how renewed stress to derivatives will play out.  I second your wish, Chris, to get more ideas on what players think the risk level is, and what may actually happen and therefore how we might prepare for the possibility that this giant market could go sideways.   Since it would be uncharted territory again, like 2008, likely kicking in new and experimental gov't interventions, informed speculation might be the most useful.   For example, it seems quite possible that if derivatives start to look like they're going into a falling domino collapse as AIG threatened, governments might try to coodinate to intervene to freeze contracts in place in some way so they can slow down market reactions while they work out some kind of settlement process at a company and perhaps national level - nationalizing some institutions and forcing specific terms on big banks - but not all might agree to collaborate, etc.  And as we saw threatened with Greece's default, if there's any sense that contract may not be honored, or payment delayed through go'vt or legal intervention, it seems likely that risk might immediately start pricing back into the underlying securities - eg PIIGS bonds would likely have plummeted and their yield and perceived risk strongly spiked upward if the International Swaps and Derivatives Association hadn't ruled that Greece did default, since that would have exposed derivative protection as potentially worthless.   I think that smart people in the field trying to visualize various sequences of events and reactions to events can be useful information and assist good mental and financial preparation, even if some of the specific scenarios don't play out as imagined.