Hah! You thought that figure had something to do with economics, didn’t you? No sir, it is part of a nursery rhyme. Remember “Four and twenty blackbirds baked in a pie?” I have no idea of how that is possible, but I have an idea. Let’s guess how many feathers the blackbirds have. Or let’s guess how thick the pie-crust is. In other words let’s do a derivative. Derivative? What’s a derivative? It’s a bet, pure and simple. Just like going to Las Vegas and watching where the marble lands, the wheel stops, how close you can guess your cards are to 21, or how the fruit stacks up on a slot machine. A derivative is a bet, pure and simple.
Let’s examine a few recent derivatives, where betting cost a fortune. Remember Barings Bank? Remember the name Nick Leeson? Just a kid really, in his twenties, but he had managed to become the head trader and general manager of the Barings Singapore bank. Barings had been in existence for hundreds of years, and went down without a whimper, thanks to Leeson. He was a better. He loved derivatives! He bet the Japanese stock market would go up, and he bought derivatives with the bank’s credit. It went down. He bought more, and the stock market went down again. The lower it went, the more he bought! The bank suffered $830 million in losses, and collapsed.
Ever hear of John Rusnak? He was 37 when he lost hundreds of millions for the Allied Irish Bank. He thought he was a genius trader in foreign currencies, and others around him actually believed him. He did pretty well, until something in his brain flipped into “rogue,” which is what traders are called, when they take huge gambles with other’s money usually a bank’s, and always with derivatives. He was betting on the Japanese yen. He bet it would go up, and it went down. He bet more, and it went down more all with derivatives. Rusnak lost his bank $792 million, and went to jail after lying through his teeth by attempting to cover and hide his trades.
What are derivatives? Besides “bets,” is there a better definition? Not really, but one author describes them as, ” Financial instruments that have no intrinsic value, but derive their value from something else. They hedge the risk of owning things that are subject to unexpected price fluctuations, e.g foreign currencies, bushels of wheat, stocks and government bonds.” Got it? In other words a bet, usually on another bet. I, long ago stopped trading in futures after losing my shirt, and have since watched hundreds of others have the same experience, and futures aren’t a bet on a bet, but a simple bet.
Warren Buffett is a pretty savvy guy, and he says of derivatives: “We view them as time bombs both for the parties that deal in them and the economic system in our view derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Away back in 1634, in Holland, tulips became popular, as real estate now is, and the NASDAQ was a few years ago. Everyone loved tulips, and single bulbs went for today’s thousands of dollars. Like real estate today, everyone thought the price would go on forever. Tulips were wildly popular, and speculated upon a sort or early day derivative. Three years later, in 1637, the bloom wore off, and the tulip market crashed. Those who bet the price would go on forever, crashed also.
I have just finished reading a book titled, “Conspiracy of Fools,” and don’t advise buying it, as it is new and expensive, and I can summarize it for you fully, in just a few sentences. It is the week by week account of Enron, and how ego, abject stupidity, and greed, coupled with derivatives, brought down America’s largest energy trader, and the 7th largest American corporation.
Remember when Orange County California went down with unpayable debts? Thanks to their egotistic financial manager’s betting with derivatives, Orange County went bust. Sears Roebuck and Procter and Gamble, took huge hits, when their financial wizards went berserk with bets via derivatives.
Futures contracts are derivatives of a sort, and have been around since the 1300’s. In modern times, they serve a useful purpose, even though for each winner in a gamble, there is an equal loser. Example: Suppose you have a field of corn, which looks pretty good. A corn buyer comes by, and says he’ll pay you a thousand dollars for all the corn in that field when it ripens. You agree, because with his offer, you’ll show a profit. A “futures contract” is drawn up. In the middle of the summer, a tornado strikes, and whisks away 90% of the corn. The farmer wins, and the buyer loses. For a manufacturer, grower, or miner; futures contracts may be a gamble, but they are understandable. The buyer of that field of corn, thought that corn prices would go up, and he could make a nice profit at the price he bought. The farmer made a profit at the onset, and everyone was happy. If prices had gone heavenward, the farmer could have made a lot more, but no one knew either about future prices or the weather. Both buyer and seller gambled.
Suppose someone decided that they were so smart, that they would take bets on the bet made by either the farmer or buyer of his field. Then you have a derivative, and every cent that the price of corn goes up or down, is leveraged to a huge degree. Derivatives traders, with their huge leverage, can make huge profits on each cent of that farmer’s field, the weather, and markets for corn. Transfer those bets away from corn and farmers, to interest rates on treasury bills, mortgages, prime rate, or foreign currency ratios. Then take millions of wagers on those things, and risk a bank’s or a nation’s money on those bets. We have gotten away from four and twenty blackbirds, and into real dough. No one can know what will happen tomorrow.
It is estimated that today, there are over $100 trillion in derivatives in the world, and $71 trillion in the US alone. This is more than the GDP of practically the entire world. Futures contracts have to do with production and tangible things, whereas derivatives have little to do with production, or even services.
Sir Julian Hodge founded the Chartered Trust, Bank of Wales, the Julian Hodge Bank, and endowed a number of chairs to the University of Wales. Hodge is known all over Europe, and especially the British Isles, as one of the finest, most honest, and trustworthy of all bankers. Sir Julian wrote in 1990, “In no circumstances enter the derivatives trading market without first agreeing in writing with me at some time in the future it could bring the world’s financial system to its knees.”
Remember LTCM? (Long Term Capital Management) It was a derivatives trading outfit, manned by “experts,” who thought they could do no wrong. When LTCM went down, its losses were so great, that the US treasury, under Sir Greenspan, bailed them out with taxpayer money, because of fears that it could bring down the entire US economy. Not to rub it in, but before the NASDAQ crashed, myself and many other scribes for Gold Eagle, warned that it was on rickety ground, and sure to fall. “Experts” said that we had entered a new age, where crashes would never happen. “Experts” said that in 1929 too. Now, “experts” every day, say that real estate is no where near a bubble stage. Real estate today, is like 1929, 2001, or the tulip bubble. As if that weren’t bad enough, I wonder how many derivatives have been bet on mortgage rates, real estate prices, etc?
Americans today, have $123 trillion in debt, which includes government debt. This is three times the number of dollars in existence in the entire world, including home and business equity, stock equity, bank savings and checking accounts, plus foreign holdings, (which are 66% of all dollars in existence). There are not enough dollars in existence to pay this debt, and derivatives traders daily, in America alone, play with $71 trillion in derivatives, and this $71 trillion does not exist either. The entire economic system is in danger, just like Barings Bank, LTCM, Enron, Sears, and Procter and Gamble were. Enron failed, as did Barings and LTCM. Sears and Procter and Gamble made it, but Sears is a has been.
No matter what happens, it bodes extremely well for silver and gold. No one can predict the future, and especially the near future, and that’s why the derivative exposure is so critical. Might it be smart to latch on to some real money, and forget the fiat? They are real money, and not subject to the whims of a derivatives trader, or government printing press. Protect yourself.