The Downside of Derivatives Abuse

In my hub about the Subprime Mortgage Crisis I introduced the topic of derivatives and how they played a major, major role in getting us into the worldwide financial "mortgage crisis." My point of that article was that the large Wall Street investment firms introduced derivatives to purposely cloud the value of the MBS, CDO and other packages that they were creating. Thus the buyers of these packages had no way of knowing their true value.

In this manner the Wall Street firms could sell packages that were overpriced. Way overpriced. Obscenely overpriced.

The people who worked at these firms collectively made off with billions and billions of dollars in salaries and bonuses while they left the buyers of their packages holding the bag. Alan Greenspan stated that this made the financial system stronger because it "off-loaded" risk. What a blatant lie. Off-loading risk does not make risk go away, it just transfers the risk to another group or entity.

And now those same Wall Street firms are scrambling to come up with some sort of "rescue package" by the government that will bail them all out. They duped large investors, made off with billions, and now want the taxpayers to pay for the mess that they created and profited from immensely.

I live in a small town in Maine, and to this little ole country bumpkin, that just doesn't seem right to me. Of course, being a simple-minded country folk, I'm not enlightened in the ultra-modern, sophisticated, Wall Street financial wizardry.

Derivatives in the News

There was a not-very-well-publicized news story at Bloomberg.com recently, detailing how school districts in Pennsylvania have got into big trouble due to derivative products sold by Wall Street investment firms.

Public financing used to be a low-margin and low-profit branch of business for Wall Street investment firms compared to all the other branches of business they were engaged in. It is not that much different than the real estate mortgage business in the good old days as I described in my hub about the mortgage crisis. In the last 10 to 12 years, however, just as there was a massive increase in mortgage securitization and MBS products mixed with derivatives, likewise there has been a large increase of complex OTC municipal derivative contracts between municipalities and investment firms.

The derivatives nightmare is not limited to just mortgages.

How Wall Street Gets Rich

Massive fees are not made by merely issuing municipal bonds, but by adding derivatives into the mix. Let's take a look at one particular example in details from the article. Unfortunately, this is just one example, but it is not an isolated occurrence. It is common, but these stories have not been featured in the news very much at all.

The Erie City School District in Pennsylvania, back in 2003, was in desperate need for cash. One of the schools, Roosevelt Middle School, wanted money to buy text books, fix a heating failure, leaking roof, and ceiling tile that was falling on students' heads. What can a school district do when taxpayers don't have any more room in their household budgets to pay for additional taxes? Where can the money be had?

Well, why not turn to one of the most prominent investment banks at Wall Street which happens to be the district's financial advisor firm. How can the firm get some money for the school district? They sold the idea that the school board should engage in a complex derivative swaption contract by betting basically that short term interest rates will stay low and the spread between the 1 year and 30 year rate will widen.

Now, there are two sides to every transaction, whether it is a real estate transaction, stock transaction, or derivative transaction. As a result of entering into this transaction as the seller, which means that they are bearing the risk, Erie received $785,000 upfront cash, their advisory firm got $60,000, the bond insurer received $57,000, lawyers and others received $106,000. This derivative, according to Bloomberg data, was worth $2 MILLION by selling it at the open derivative market at that time, so the Wall Street investment firm reaped $1 MILLION profit without taking any risk.

Full Disclosure or No Disclosure?

However, neither the Wall Street investment firm nor the financial advisory firm, which is supposed to be working on Erie's behalf, told the school board how much profit the Wall Street investment firm was making. Actually it was up to the investment firm to decide how much of the $2 million it would give to the school district.

It was pretty generous of them to give Erie just under 40% of the proceeds since Erie was taking 100% of the risk, don't you think? (sarcasm intended)

As you might have guessed, this derivative gamble, and they are gambles, did not work out in Erie's favor. By June 2006, the derivative had left Erie with a $2.9 million liability, which the district couldn't stand the pain any longer and got out of the deal. In July, 2006, they paid the investment firm $2.9 million to terminate the derivative contract just to get out.

This deal was an OTC derivative, meaning it doesn't get regulated by SEC, and it doesn't go through the public bidding process, and it is purely a private contract between the two parties.

Getting the Law Changed

Unfortunately, in 2003, after many years of heavy lobbying by Wall Street invesment firms, both the House and Senate in Pennsylvania passed a law by 197-0 and 45-0 margin allowing municipal derivatives. Lawmakers unanimously approved the law based on the claims made by the Wall Street firms that these products can give the municipalities much needed upfront cash and "save" them money.

Why in the world do you think these investment firms would spend hundreds of thousands of dollars hiring lobbyists and contributing to political campaigns to get this law passed? Was it for the good of the people out of the kindness of their heart? Or maybe, just maybe, that $1 million dollar fee for selling something worth $2 million might have had a small role in it?

Here's an Analogy

For a comparative example, let's say you had a car that you wanted to sell to raise some cash. I offer to sell it on Ebay for you. It sells for $10,000. I'll keep $5,000 for selling it for you. Ebay fees, transfer taxes, professional photographs, etc. add up to $1,075, so you'll be left with $3,925. Oh yeah, don't forget that the car comes with a warranty. If anything bad happens mechanically to the car after it is sold, you'll be responsible to pay for fixing it. I am going to assum that you probably wouldn't be interested in knowing how much I made from the transaction, so I will not bother to tell you how much my share was...

That's a good deal, right?

Yeah, for me!

This is not even the most outrageous deal. Another happened at Bethlehem's school district. In 2005, the school board had entered into a derivative deal with this investment firm and another prominent Wall Street investment firm jointly, again without competitive bidding. This time, the district took in $900,000, the advisory firm made a $630,000 fee, the two Wall Street investment firms each made $840,000 and $900,000 respectively. Each Wall Street firm made nearly as much from the deal as the school district received. And the advisory firm hired to consult on the district's behalf, received far more than half of what the district received.

Did I say that you received $3,925 for that car I sold for you? My mistake, I think your share was only about $2,300. So sorry.

Folks, I'm not making this stuff up. It's real, it's happened, and the world financial system really is crumbling as a result.

During the past 4 years in Pennsylvania alone, Wall Street investment firms have pitched at least 500 deals like this totaling $12 billion, and most of them have been made without public bidding, by just taking the advice from their financial advisory firms. And since these deals are over the counter, and thus private, we don't know how many and how bad the true situation with municipal derivatives really is. But as information leaks out, the evidence is that things are very bad indeed.

What to Expect

The response so far has been for central banks around the world to try to paper over the problem. Expect more of the same. More and more money will be created to try to fix the problem. Creation of money is the root of inflation. Rising prices are merely a symptom. Inflation is really the watering down of the value of money by creating more and more of it. By diluting the value of money, it takes more and more of it to buy the same item. This looks like rising prices, but rather it is the falling value of the currency.

This will continue and even accelerate. Expect and plan for prices of the things you buy to rise. Of course, the exception is the prices of homes. Because the secondary mortgage market is in its terminal phase (due to Wall Street mixing in derivatives), financing to buy a home is drying up, including first time home buyer loans. Reduced funds available for financing coupled with the fact that there will be hundreds of thousands of foreclosures, and it is easy to predict the prices of homes will continue to fall. But the price of everyday items will continue to go up as the value of money is diluted by the printing of more of it.

There is a worldwide financial storm brewing. My advice is to prepare for a rainy day. The storm clouds are on the horizon.