We look forward to the Van Mueller newsletter every month. It's chock-full of sound bites, sales tips, and eye-opening statistics. Here are our favorite parts of the August 2019 edition. We're sharing the full introduction, and 2 of the 7 monthly sales ideas. If you like what you read, we encourage you to click here and become a subscriber.
Reprinted with the author's permission.
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August 2019 – 7 Ideas and Views Newsletter by Van Mueller
Warren Buffet has been quoted many times calling derivatives, “Weapons of Mass Financial Destruction.” Sounds ominous, yet very few Americans even know what a derivative is. So; what is a derivative, and if it is so dangerous why do most financial institutions use them?
I was asked to comment on derivatives by one of the subscribers to this newsletter. The reason I agreed to write about this is because their use is ubiquitous by ALL financial institutions. Because interest rates continue to remain low their use will have to increase. In this ridiculously low interest rate environment, it is impossible for ALL financial institutions to make much money safely. They are being forced to take more and more risks in order to create profit. These risks could also create catastrophe.
Derivatives are a very, very complex issue. I am only attempting to provide a cursory discussion of derivatives so we can ask our prospects and clients why their use may provide much more risk than they understand they are taking. I am not an expert on derivatives; I had to study all month to provide enough information so you would have a reasonable understanding of the basics of derivatives. After my month of study, I concur with Warren Buffet. These are weapons of mass financial destruction. Most, if not all, of the people creating and selling these very complex financial agreements truly understand all the risks they are being exposed to. I will share some examples later in this opening segment.
After my month of study, I concur with Warren Buffet. These are weapons of mass financial destruction.
First, let's start with some definitions. A derivative is a contract, that is, not something previously existing in the world, between a risk dealer such as an investment banker, or a commercial bank, a mutual fund company, an insurance company or an options exchange and a customer. These contracts will have different payoffs in different future states of the world. Derivatives are entered into because the customer wants to change their risk profile. The customer endeavors to change the shape of their investment graph by the amounts of those payoffs in those different states of derivatives. This creates technicalities. There are linear derivatives, like forwards and futures and swaps that change your investment graph in ways that look like straight lines. Then, there are non-linear derivatives like options, that change your investment graph in ways that curve and kink. Now, there are even exotic derivatives which basically have additional curves and kinks. By the way, Wall Street charges by the curves and kinks, so exotic derivatives are more expensive than options, which are more expensive than linear derivatives.
Derivatives are entered into because the customer wants to change their risk profile.
Here is another definition. A derivative is a contract involving two parties that agree to make a certain payment to each other. If one party is unable or unwilling to live up to its agreement and make those payments, the other party is left holding the bag and nursing a very big loss. That's what happened in 2008. AIG almost blew up because it had written too many derivative contracts on collateralized bond obligations that held billions of dollars in sub-prime mortgages.
AIG couldn't meet its obligations, leaving thousands of counterparties around the world at risk of loss. This is why the U.S. government had to step in and bail out AIG. The government needed to save those other counterparties from massive losses that would have destroyed the financial system.
That derivatives problem was miniscule compared to the total of global credit default swaps valued at $60 trillion. These obligations posed a systemic threat to the entire financial system.
Here's another definition: Derivatives are merely contracts between parties. They are actually speculations. They are bought and sold as BETS on the future price moves of whatever securities they are based on. That is where the name derivative is derived from. That means derivatives prices are dependent on the prices of their underlying assets.
Now, I would like to share how I explain derivatives. Remember, we are trying to do this as simply and understandably as possible. Isn't it true that simplification and not complication is the key to success?
Isn't it true that simplification and not complication is the key to success?
I simply explain derivatives in one word. They are a “bet.” It is two parties making a bet about the consequences of assets they have no ownership stake in. Please think of it in this manner. Ask your prospects and clients if they have a favorite sporting team. I live in Wisconsin. I share that my favorite pro football team is the Green Bay Packers. I then ask my prospects and clients to assume they like the Chicago Bears as their favorite pro football team. Neither of us has an ownership stake in these teams yet we are able to bet on all sorts of outcomes. The first would probably be who will win. There are countless other permutations: Win by how much, scoring more points or less points, how many touchdowns, how many field goals, will there be a safety? Then you can bet on plays: How many running plays or passing plays. You can bet on players: Will Aaron Rogers throw for 300 yards or will the Bears hold him to less than 300 yards passing, how many sacks of the quarterback will the Bears have, which player on the Bears will have the most sacks? The number of bets is literally endless.
The same is true for bets in the financial markets. There are derivatives that bet on currencies. Think of all the currencies on our planet. Are currency valuations volatile at present? Can you say OMG? There are interest rate derivatives that bet on interest rate movements. Remember, we currently have over $13 trillion of government bonds paying negative interest rates. Will these rates go lower still, or will they go higher? There are countless bets that can be made on the direction of future interest rates.
What about equity derivatives? Don't these include equity futures contracts, options on equity futures contracts, equity options on all sorts of equity related swaps, such as a total return swap on equity securities? Think about all the markets we can bet on. The Dow Jones Averages of all kinds, the S&P 500, the Nasdaq, the Russell 2000, the New York Stock Exchange, just to name a few. Globally, there are Chinese and Japanese and European stock markets. Again, the number of bets is endless.
Here's a scary one: Credit derivatives. The world is more in debt than it has ever been in history. It is estimated that the world is now more than $300 trillion in debt. Will all these debts be repaid? How do you leverage the risk you are taking? You use credit derivatives such as default swaps which have been in the news lately.
The world is more in debt than it has ever been in history. It is estimated that the world is now more than $300 trillion in debt. Will all these debts be repaid?
Here is a list of just a few more types of derivatives.
- Foreign Exchange Derivatives
- Commodities Derivatives
- Unallocated Derivatives
- Mortgage Derivatives
What if I bet on the Packers and the Bears win and I then lose? What if I don't have the money to pay my lost bet? Under certain circumstances I could be in trouble. Can you imagine what happens globally when trillions of dollars are bet, if many of the parties don't have the ability to pay if they lose?
If you Google the Bank for International Settlements (BIS), you will find that they are essentially the Central Bank for all the Central Banks. They attempt to keep track of all these derivative contracts. At one time it was estimated that globally there was over $1 quadrillion of these bets on planet earth. That is a one followed by fifteen zeros. At the end of 2018 it was estimated that globally there were $594 trillion of derivatives and that number decreased further to $544 trillion by June of 2019. Please don't get excited. Most CPA's expect derivatives to become a larger percentage of balance sheets over the next one to three years.
Please think about this: If the global gross domestic product (GDP) is estimated to be around $77 trillion, that means that derivatives at their current low point are over 7 times the size of the GDP of our planet. GDP is a measurement of the output of goods and services of every person on the planet. It is easy to see that if someone made a wrong bet, it could really cause a catastrophe.
Derivatives at their current low point are over 7 times the size of the GDP of our planet. It is easy to see that if someone made a wrong bet, it could really cause a catastrophe.
Here are four examples of catastrophes that have happened in the past.
1. The so-called rogue trader. Nick Leeson who made a huge derivative bet on the direction of the Japanese Nikkei index. This brought about the collapse of Barings Bank in 1995.
2. The collapse of Long Term Capital Management. This was a hedge fund that had a former derivatives and bond dealer from Solomon Brothers. They also had two Nobel Prize winners in Economics as principals. The hedge fund collapsed because of huge leveraged bets in currencies and bonds in 1998. It was later discovered that our government had to bail them out or the losses would have severely damaged our economy. Can you imagine?
3. Many of the problems of Enron in 2000 were brought on by leveraged derivatives and the use of derivatives to hide severe problems on Enron's balance sheets. Remember, this was one of the most highly touted stocks in the world until it went bankrupt. Many people lost everything.
4. Derivatives allowed Fannie Mae and Freddie Mac to engage in massive misstatements of earnings for years. Freddie's and Fannie's books were so indecipherable that their Federal regulator OFHEO, whose more than 100 employees' only job was the oversight of these two institutions, totally missed the cooking of the books.
Freddie's and Fannie's books were so indecipherable that their Federal regulator OFHEO, whose more than 100 employees' only job was the oversight of these two institutions, totally missed the cooking of the books.
Banks are the largest holders globally of leveraged loans and collateralized loan obligations. The United States' 5 biggest banks have exposure to over $150 trillion of derivatives. It is estimated that the banks in this country have exposure to over $200 trillion of derivatives, (bets). This is approximately one third of the entire globe's exposure to derivatives.
Here's the scary part: One bank, Deutsche Bank, the biggest bank in Germany has exposure to $49 trillion of derivatives which is down from $75 trillion just a few years ago. Deutsche Bank is currently having great difficulties financially. They won't go under; they will be bailed out. They ARE too big to fail. The money that will be used to bail them out will not be available to create new jobs or new products or new services. In fact, Deutsche Bank is laying off 18,000 workers globally. Deutsche Bank is the most important bank in Europe. This $49 trillion in exposure to derivatives, most of the largest too big to fail banks in the United States have huge financial connections to Deutsche Bank. They also have huge exposure to derivatives. According to the Office of the Comptroller of the Currency, JP Morgan Chase has exposure to $48 trillion in derivatives. Citigroup has exposure to $47 trillion in derivatives. Goldman Sachs has exposure to $42 trillion in derivatives. Really pay attention to any news about any of these banks. Deutsche Bank with exposure to $49 trillion in derivatives has only $1.54 trillion of assets and total liabilities of $1.47 trillion. These numbers are deteriorating fast for Deutsche Bank. If the world economy tanks as predicted, Deutsche Bank would suffer great damage.
If this is all true why do all these financial entities continue to involve themselves so deeply in derivatives? FOR BANKS, FUND COMPANIES AND THE REST OF WALL STREET, IT IS ALL ABOUT FEES, NOT PERFORMANCE. Interest rates are so low that banks cannot make money lending. Funds cannot make money with all the market volatility and more and more Americans declining to participate in the stock market. Bonds are at the bottom of a 30-year bull market. When interest rates finally do rise again, people will lose money investing in bonds. So, how do these entities make money? The same way Las Vegas does. We make bets and the house takes a fee for making those bets. Does Las Vegas care if we win or lose? Do the banks and mutual fund companies and Wall Street care if we win or lose? No, just as long as we keep making trades or bets and they keep raking in fees. This is all so dangerous.
Do the banks and mutual fund companies and Wall Street care if we win or lose? No, just as long as we keep making trades or bets and they keep raking in fees. This is all so dangerous.
People like to think that derivatives dealers have a black box and that all of this is very scientific when actually, it's just an educated guess. Most of the derivatives managers try to hedge their risks, but even the hedges are a guess. A small miscalculation on derivatives contracts can pose enormous problems if the assumptions used to underwrite agreements get the risk wrong. Even though derivatives are notional amounts until they are crystallized, actual exposure is measured by the net credit equivalent. This will normally be a lower figure unless numerous variables plot movements of these derivative in the wrong direction simultaneously. This can be caused by catastrophic unpredictable events. You heard me refer to them as Black Swan events. Cascading bankruptcies, nationalizations, trade wars are just a few examples.
Let's review: Derivatives are securities whose value depends on the underlying value of other basic securities and their associated risks. Derivatives have increased dramatically over the last two decades. It is almost impossible to properly define many classes of derivative because they are amazingly complex instruments and come in many shapes, sizes, colors and flavors and display different characteristics under different market conditions.
Derivatives are unregulated. They are not traded on any public exchange. They have no universal standards. They are dealt with by private agreement. They have no bid or ask market, are unguaranteed and have no central clearing house. They are not even considered a tangible asset.
Derivatives even include well known financial instruments such as futures and options which are actively traded on many exchanges as well as many over the counter financial instruments such as interest rate swaps, forward contracts in foreign exchanges and interest rates, all sorts of commodities and equity contracts. Everyone from the large financial institutions, governments, corporations, mutual funds, pension funds, hedge funds and large and small speculators use derivatives. They have never existed in history in the overwhelming amount they exist now.
Everyone from the large financial institutions, governments, corporations, mutual funds, pension funds, hedge funds and large and small speculators use derivatives. They have never existed in history in the overwhelming amount they exist now.
These derivatives are unraveling at a fast rate beginning with the start of the Great De-Leveraging of global credit markets which began in 2007 and for sure after the collapse of Freddie Mac and Fannie Mae.
When derivatives unravel significantly the entire world economy would be in peril. Remember, derivatives are many, many times larger than the Gross Domestic Product of our planet.
If it happens, a derivatives market collapse would make the housing and stock market collapse look insignificant.
Well, I hope I haven't made this explanation as clear as mud. However, if you remember the analogy of a bet, think about betting on the outcome of anything that you have no ownership stake in, and you have a very simple explanation of a derivative. If the person or entity doesn't have the money to pay the bet when they lose, we have a problem. There are many bets being made where the loser may not have the money to make good on the bet. That is the danger of derivatives.
Let's get started with idea number one. There is a lot to write about this month.
We're passing on two of the newsletter's monthly sales ideas - every issue of the newsletter contains 7 ideas, plus one idea for the Canadian market. Subscribe to get them all.
Idea #3: 10 Things Every Advisor Should Know about IRAs
Ed Slott provided 10 of his “must know” rules for IRAs. I thought you should know them also. Ed Slott provides wonderfully coherent and useful information that can be used to inspire prospects and clients to take action. He is one of my top three people in our industry. At the very least you should be subscribing to his newsletter.
By the way, this is the kind of article I would always keep handy in my presentations and I would also endeavor to learn the other 15 “must knows” for IRAs. This is ALWAYS accurate and well researched information. Ed Slott is a “must have”.
Title: Slott: 10 Things Every Advisor Should Know About IRAs
https://www.fa-mag.com/ (Financial Advisor, March 4, 2019)
Idea #8: Is Life Insurance a Good Investment?
What a great question. An article in Forbes magazine answers the question reasonably well in my opinion. I am adding this in as a bonus article because there are very few times that articles about cash value life insurance are written in a positive way. The plus is that this article appears in a respected magazine like Forbes.
Title: Is Life Insurance An Investment?
https://www.forbes.com/#3370f94e2254 (Forbes, July 9, 2019)
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