When people talk about huge and worrying numbers in finance the one they focus on most is the US national debt. At $17 trillion that’s a number too big for most people to comprehend. The odds of it ever being paid back are remote, and eventually it’s going to reach a size where just trying to cover the interest will bankrupt the nation. Believe it or not, though, in the big scheme of things it’s pocket change.
We’ve all heard of banks that are too big to fail. There used to be four of them in the USA; now there are five. The expression isn’t exaggerated; every one of those five banks is exposed to the mood of the global financial market on a scale that dwarfs the national debt. Yes, it really does. The total size of that exposure is difficult to work out because it’s such a complicated web, but by picking out one strand of it we can get an idea of how big the problem really is. That strand is derivatives.
If you’re looking for secure investments you need to buy things that are real, that have actual inherent value and that somebody will want to buy. Gold is the classic one; it’s what used to back up the US dollar as well as the other major currencies. The value of the bills in your wallet was backed up by a stockpile of real gold in a vault. Oil is another. It’s valuable, there’s a limited supply and if you have some to sell, somebody’s going to buy it. You don’t even need to stash the barrels in your basement – the markets give you plenty ways to invest your money in oil. The key thing is that you’ve bought something real and you can sell it again, hopefully at a profit. Whatever price you get, though, your asset – gold, oil, palladium, whatever – is real. But derivatives are different.
Derivatives aren’t backed up by real assets. They might be deals about assets that will exist in the future, or contracts based on predictions about the way prices will go – bets, in other words. The futures market is basically just a huge casino, and as the 2008 financial crisis showed it’s such a complex one that when an asset turns out to be worthless nobody can really tell who owns it. Remember all those sub-prime mortgages? Worthless “assets” that had been chopped, mixed up, reformed and sliced like cheap hamburger, then sold all over the world. Nobody who’d bought a package of mortgage debt as an investment knew how much of it was good loans and how much was junk. The result was the whole lot became a toxic product.
Imagine another crisis, another supposed asset being revealed as worthless. Exactly the same will happen again. It’s so complicated that by the time the markets have figured out who owns the good investments and who owns the dreck, confidence in the whole system will have been shaken and fortunes will be lost across the board. And before you start thinking that only affects rich bankers who brought it on themselves, no it doesn’t. The value of every trust fund, every pension scheme, every saving plan for the kids’ college fund, is tied up in this mess of opaque deals.
How big is the problem? It’s huge. Enormous. Too big for words to do it justice. But every single one of those five big banks has at least $40 trillion tied up in derivatives. Between them, in total, the figure is $280 trillion. If those banks go down the economy goes with them. The national debt is bad enough, but this mess is unsustainable. Someone needs to bring some clarity and transparency back into the system before the next disaster strikes.