15 Dec 2013

How banks play Russian Roulette
with our financial security

(Part 4 of a series)
The next major threat to Canadian and international financial systems is very likely to come from reckless investors gambling with derivatives, the dangerous betting vehicles that contributed to the 2008 collapse of financial services firm Lehman Brothers and the start of the Great Recession.

Used properly, simple derivatives (literally: a financial asset that "derives" its value from that of an underlying asset) can reduce the risk of some financial transactions. To use a simple example, they can help bakers guarantee what price they’ll have to pay for wheat two years from now. (Click here for an explanation on how derivatives work.)

But big-money gamblers can invest in any of a number of highly risky, extremely complicated kinds of derivatives for purely speculative purposes. When this happens, derivatives are just a form of very dangerous, virtually no-limit, betting.

The problem is that derivatives can blow up!
The problem is that derivatives can blow up. Two former JPMorgan Chase employees are facing criminal charges related to a derivatives trading scandal last year in London that cost the bank $6.2 billion -- enough money to run the City of Vancouver for more than five years. The traders also tried to hide losses from investors and federal regulators.

Cocky JPMorgan Chase CEO Jamie Dimon dismissed  its $6.2-billion loss as "a complete tempest in a teapot." Nonetheless, the image of the bank has suffered in the wake of the outrageous caper.

Hair-trigger derivatives, along with laissez-faire deregulation, greed, and poor homeownership policies in the United States, caused the 2008 economic crisis.

In the US, unethical financial institutions used a form of derivatives to put billions of dollars of mortgages they knew would be hugely overvalued into bundles that they then sold widely. The Wall Street institutions that did this, and there were many of them, showed no concern for the more than 1.5-million Americans over 50 who lost their homes -- for many, their biggest investment for retirement -- as a result of the collapse of the housing market.

Canadian banks were among those buying the mortgage bundles. They ended up with huge losses that put them in a difficult financial position, and required hefty assistance from Canadian taxpayers.

The use of practically worthless derivatives during the recession helped destroy Lehman Brothers, once an investment banking heavyweight, and pushed insurance giant American International Group (AIG) to the brink of bankruptcy. The US government stepped in to save AIG, for $182 billion. Much earlier, it was the scandalous use of derivatives that led to the 2001 collapse of Enron, a Houston-based energy, commodities and services company, that had employed close to 22,000 people.

On the other hand, when the gambles do work, derivatives can be very profitable. U.S. banks made a record $25.8 billion  in revenue in 2012 by dealing in OTC derivatives and securities.

Today, while regulators struggle with banks to get the derivatives market under control, these gambling instruments are being used just as dangerously as they were leading up to the recession.

Market gamblers have created such a massive mess of these derivatives that, should a number of them go bad at the same time, in combination with other financial setbacks, much of the world’s economy could be heavily damaged.

The value of derivatives bombs smouldering away around the world, waiting to explode, is almost unimaginable.

It’s also almost uncountable. The derivatives market is so poorly tracked that economists can’t agree within trillions of dollars as to its real value. Let’s go with the conservative estimate of the International Swaps and Derivatives Association (ISDA). They believe that, as of the end of 2012, over-the-counter notional derivatives were worth $US606 trillion.

In comparison, the gross world product (GWP) in 2012, the total of all the real goods and actual services produced on planet Earth, was about US$84.97 trillion, less than one-seventh the value of the derivatives market.

Actual cash at risk from derivatives from all sources is at least US$12-trillion -- still one seventh of humanity’s economy. Only a portion of that would have to go up in smoke to cripple much of the economy.

If this all sounds crazy, it’s because it is crazy. The whole derivatives racket has been allowed to get far out of control.

Ellen Brown of the U.S., an attorney, author, and president of the Public Banking Institute, writes: “A crisis in a major nation such as Spain or Italy could lead to a chain of defaults beyond anyone’s control, and beyond the ability of federal deposit insurance schemes to reimburse depositors.”

As derivatives are traded in microseconds by computers, we really don't know what will trigger a crash, or when it will happen. Indeed, we have even seen computer glitches themselves almost crash the stock market.

But several international banks have huge liabilities associated with derivatives. In the U.S. alone, JPMorgan Chase has about $70 trillion in derivatives, but is holding only about $2 trillion in deposits and other assets. Bank of America has about 30 times its assets in derivative bets; Citigroup and Wells Fargo have each bet many times their assets on derivatives.

The risks are particularly high in the U.S. because of the concentration of derivatives ownership. Ninety-five per cent of all derivatives there are held by just five megabanks and their holding companies. The top executives from the leading banks meet monthly, in secret, to make sure their firms continue to control the derivatives market.

“The banks in this group... have fought to block other banks from entering the market,” Louise Story of the New York Times writes, “and they are also trying to thwart efforts to make full information on prices and fees freely available.”

Mike Krauss, a founding director of the U.S. Public Banking Institute, said in August  he believes “the biggest banks on Wall Street really aren’t safe; they’ve got so much exposure in derivatives and who knows what else -- they’re in danger of going down and taking depositors with them.” He suggests people put their savings and investments in a credit union.

We would expect high-rolling banks and financial institutions to be ready to cover the risk they’re taking on derivative bets, but that’s not the case. Instead, if the Canadian government decides to approach the handling of derivatives the same way the U.S. has, derivatives obligations will be given “super priority” status in the event a big bank were to collapse.

This means that the holders of these derivatives contracts will have first priority for payment. Unsecured creditors such as business depositors, suppliers, and individuals with uninsured accounts will go to the back of line.

Even in insured accounts, we will have to see what our federal government decides to do, but it is possible that ordinary folk’s pensions and savings beyond $100,000 may go up in smoke if there is a major crisis.

Regulators in the U.S. and Europe have been trying for three years to get the banks to agree to laws that would reduce the risk of a repeat of the mayhem that occurred when Lehman Brothers collapsed.

Roger Lowenstein of Bloomberg writes  that regulators want “to bring the derivatives business out of the shadows -- first to get a handle on systemic risk, second to create greater price transparency and narrower margins in a business dominated by a handful of banks, and third to protect the sort of customers who shouldn’t be playing with matches.”

Big banking is fighting back with what it has most of: money and influence. Says Lowenstein: “The derivatives industry is squeezing Washington like a python.”

Bloomberg’s Silla Brush and Robert Schmidt, write that, “Wall Street preserved its dominance in derivatives trading with one of the largest sustained lobbying attacks on a single Washington agency.”

It appears that yet-to-be finalized U.S. laws will apply to perhaps 20 per cent of the global derivatives market. Large and important parts of the trade will be exempt.

Europe and the U.S. are bickering about how derivatives will be regulated. Europe hopes  that a planned free-trade agreement will include financial regulation, but the U.S. doubts this can be done. They do agree that over-the-counter trades will be moved to clearing houses.

It’s questionable whether some expected changes will be effective. Regulators do not seem to be pushing to limit either the size of derivatives or the number that any one institution may hold. Instead, U.S. officials seem to be satisfied if, in the event a bank does go bust, derivative holders will allow a cooling-off period before demanding that their claims be settled. Authorities believe this would give them time to (hopefully) transfer the contracts to parties that are not in danger of collapsing.

It is a little-known fact that at the start of the Great Recession, at the same time as our Big Five banks were getting into trouble, a group of largely na├»ve Canadian investors got involved in a complicated, and far too risky, $30-billion derivative-related transaction.

While the investors -- individuals as well as representatives of mining companies, governments and financial institutions -- were innocent, there eventually turned out to be plenty of deceit among the Canadian and foreign banks that put the deal together.

When it unraveled, the Financial Post later said, the Canadian banking system avoided a “Financial Armageddon.” The Globe and Mail said disaster had been averted by defusing a $30-billion bomb.

The story had played out over a period of six years in the financial pages, while ordinary Canadians -- the people on who could have lost millions of dollars if the bomb had gone off -- heard next to nothing of it.

The investing group of Canadians held $30 billion in a very particular kind of derivative: “ABCP” notes. ABCP notes, asset-backed commercial paper, are promissory notes supposedly backed by assets from a variety of sellers.

The investors believed their $30 billion was safe in the commercial paper. Then the subprime mortgage debacle dried up credit, and no one was buying ABCP notes. The investors could neither sell nor trade what they held.

Moreover, the banks involved went back on their word to provide emergency cash to the trusts that had issued the ABCP. (Something the banks later paid dearly for.)

“This left the holders of the $30 billion in limbo,” Boyd Erman wrote in the Globe and Mail in September 2011. “Their money wasn’t gone -- yet -- it was just locked up.”

By 2009, the highly risky derivatives had lost much of their $30-billion value. The potential losses facing hundreds of Canadian companies, pension plans, governments, and more than 2,000 regular investors, were huge.

A messy battle followed in Ontario Superior Court before the investors could manage a sigh of relief. They got new, tradable paper to replace the old notes. The investors were told the revamped paper would be valued at par to their ABCP investment if they held it until 2017, but many chose to walk away earlier at a loss.

The last act came only in February 2013, when Deutsche Bank of Germany agreed to pay $1 million to settle allegations that it had failed to warn investors the product included dreaded toxic subprime U.S. mortgages, which had become practically worthless.

Many of the banks involved in this bizarre fiasco behaved unethically, possibly fraudulently. The fact that several Canadian banks paid huge penalties was hardly covered beyond the financial pages.

Nonetheless, securities offices collected fines of $75 million from National Bank of Canada, $29.3 million from Bank of Nova Scotia, $22 million from Canadian Imperial Bank of Commerce, $6 million from HSBC's Canadian unit, $3.2 million from Laurentian Bank, $3.1 million from Canaccord Financial and $200,000 from Credential Securities.

Our Big Five Canadian banks are still handling lots of derivatives. Collectively last year they had total notional derivative bets of $18.6 trillion -- 10 times the entire Canadian economy (GDP $1.82 trillion). RBC stands out for its particularly large derivative holdings, at $7.1 trillion.

If the financial community runs into any kind of a serious problem again -- say, a repeat of 2008 conditions -- the fact that our biggest financial houses are built on such holdings will only raise the risk of a collapse.

The Conservative government has largely shrugged off the danger of a derivative disaster. A September 2013 report  from the University of Toronto’s G20 Research Group, criticizes the government for failing to carry out reforms that would help protect Canada’s financial system against abuses by rogue bankers -- mostly involving derivatives.

Globe and Mail Report on Business journalist David Parkinson echoes the criticism: “When you consider that it was a combination of a largely-unregulated $80-trillion OTC [over the counter] derivatives market and an unsupervised banking industry that brought the global system to the brink of collapse, this is a pretty big deal. Without better oversight, we run the risk that a massive pool of little-understood assets could again blow up in our faces.”

The federal government continues to move along, rather slowly, in making changes they hope will keep the derivatives market in check.

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  1. And what is the opinion of our fearless Finance Minister and Head of the Bank of Canada-----I have been asking for any type of explanation and debate on the bundled clause(in the 2013 Budget) allowing our 'too big to fail' banks to play a shell game with our banking assets ---not once has CBC news even mentioned this clause-----Canadians need to know how to protect their money from this type of outright theft---some are also saying that if derivatives to blow our too big to fail banks will use monies confiscated to go after smaller banks such as credit unions. This would leave no place for Canadians to feel safe, especially since there are no real public financial institutions that are not under the Bank Act? Comment please.

  2. If I was regulating this, I would limit transactions to "functional" and "no middle men".

    Here's what I mean, Dole makes a deal to buy a future crop of pineapples at a particular price. Dole intends to accept the delivery and the farmer expects to supply the delivery. This is "functional".

    Then we have people who step in the middle and buy the contract from Dole because they believe that the price of pineapple will be even higher at the future date. But they don't intend to ever accept delivery. This would be "non functional". It would be OK for Libby's to buy the contract from Dole because they also intended to take delivery and are therefore "functional".

    This would allow the futures market but keep the banks and others out of the process.

    We want derivatives to work in a helpful way where there are valid "functional" buyers and sellers and keep the speculating middlemen out of the process.

  3. Posted on behalf of Mike Nickerson:

    Hi Nick, well put. It is critical for people to understand the problems with our present monetary/economic process.

    I spent a half decade touring with my book "Life, Money and Illusion" speaking about "Living on Earth as if we want to stay."

    My study has been cultural evolution. The key material is now available in a free mini-course on Shifting Society's Goals at:

    There is a summary with links at:

    The times are ripe, Yours, Mike N.

    To be truly radical is to make hope possible,
    rather than despair convincing.
    Raymond Henry Williams

  4. Posted on behalf of Anonymous:

    Nick, You will know that the Cdn budget, passed earlier this year, on pages 145-146 includes provisions for bail-ins by bank creditors, which includes depositors, and that the FDIC funds carry insufficient to redeem all losses to depositors in the event of a bail-in. Canada was early in passing legislation to “resolve” the banks via bail-ins when the need arises.

    You will also know that Mark Carney runs the Bank of England as his day job, and moonlights as chair of the Financial Stability Board under the auspices of the BIS.

    Prior to G-20 meetings Carney puts out a report to the central bankers of the G-20 updating them on “resolution” plans for the next bank crisis.
    The thrust is to hit the depositors and bank bond holders to bail-in the banks, and not the general taxpayers and Treasuries as was done in the US after 2008. You can find Carney’s reports on the web.
    He is literally the money master of the western world.

    There was a time, twenty or thirty years back when politicians couldn’t get through the front door of the BIS, but now at G-20 meetings you have world leaders on one side of the table and central bankers or their deputies on the other side.

    Oh, and incidentally, the FASB (financial accounting stability board, not part of the BIS) changed the standards after the 2008 crisis, enabling the giant US banks to ‘mark to fantasy’ their toxic assets, and thereby show a profit with added bankster bonuses, rather than ‘mark to market’. Without that change, most of the big banks, at least in the US, would be bankrupt.

  5. The real menace in all this is the inattention of the banks (and almost everybody else) to the question of satisfactory jobs for all the people being encouraged to take out home loans. Don't they KNOW that if those loans are to be reliably paid off, then the borrowers involved need satisfactory jobs in order to have the necessary income to meet the loan repayment committments? In my view the whole stupid mess involving the subprime mortgage fiasco in the U.S. , and its world-wide fallout from late 2008 onwards, was caused by the general inattention to this question of jobs combined with the un-founded assumption that real estate values would continue to rise "ad infinitum". Another un-founded assumption here was that stimulating the housing market would of itself cure the U.S.'s economic problems, but in fact such stimulus only affects the domestic economy with no positive benefit for the industries that generate export revenues. The trades and professions connected with the housing industry also don't account for the majority of jobs either in the U.S. or in Canada. The banks and the politicians should know that.

  6. Anonymous: I wrote a post on that subject: http://canadiantrends.blogspot.ca/2013/10/job-creation-we-actually-need-to-start.html

    Job creation? We actually need to start talking wealth creation.

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