Wall Street WARZONE

Global Shadow Banking: Why Buffett & Munger see the Secretive $670 Trillion Derivatives System as Dangerous “Financial Weapons of Mass Destruction”

by Paul B Farrell, JD, PhD
| | 4/7/2010

“Charlie and I believe Berkshire should be a fortress of financial strength” wrote Warren Buffett. That was five years before the subprime-credit meltdown. “We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. I

n our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” That warning was in Buffett’s 2002 letter to Berkshire shareholders. He saw the future meltdown years before Greenspan, Bernanke, Paulson and many other political ideologues. They were in denial, ignoring the “mega-catastrophe” triggered by derivatives, the world’s new “financial weapon of mass destruction:” The Iraq war build-up was at a fever-pitch back then. The imagery of WMDs and a mushroom cloud fresh in his mind.

Also fresh on Buffett mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared to the $100’s of billions of subprime-credit write-offs now making Wall Street’s bigshots look like amateurs. Buffett tried to sell off Gen Re’s derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a “financial weapon of mass destruction.” That was 2002.

Derivatives bubble explodes five times bigger in just five years

Wall Street didn’t listen to Buffett, and any of the other leaders’ warnings, as derivatives grew into a massive bubble, from about $100 trillion in 2002 to $516 trillion by 2007. The new derivatives bubble was fueled by several economic and political trends that were driving Wall Street into what Bill Gross calls the “shadow banking system:” Derivatives, private equity, hedge funds and a world with little regulation nor taxation. The five key trends are:

  1. Sarbane-Oxley increased corporate disclosures and government oversight.
  2. Federal Reserve’s cheap money policies creating the subprime-housing boom.
  3. War budgets burdening the U.S. Treasury and future entitlements programs.
  4. Trade deficits with China and others destroying the value of the US dollar.
  5. Oil and commodity rich nations demanding equity payments rather than debt.

In short, despite Buffett’s clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession. Data on the five-fold growth of derivatives to $516 trillion in five short years comes from the most recent survey by the Bank of International Settlements, the world’s clearinghouse-for-central-banks, in Basel, Switzerland. The BIS as like the cashier’s window at a racetrack or casino, where you’d place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this five-fold bubble increase is to $516 trillion, let’s put it in the context of some other domestic and international monetary data, so you can better appreciate the potential this huge derivatives stockpile of “financial weapons of mass destruction” has to trigger another even bigger “mega-catastrophe” in the near future:

  • US gross GDP is about $15 trillion
  • US money supply is also about $15 trillion
  • Current proposed US federal budget is $3 trillion
  • US government’s maximum legal debt is $11 trillion
  • US mutual fund companies manage about $12 trillion.
  • World’s GDPs for all nations is approximately $50 trillion
  • Unfunded Social Security and Medicare benefits $50-65 trillion
  • Total value of the world’s real estate is estimated at about $75 trillion
  • Total value of world’s stock and bond markets is more than $100 trillion
  • BIS valuation of world’s derivatives back in 2002 was about $100 trillion
  • BIS 2007 valuation of the world’s derivatives is now a whopping $516 trillion

Moreover, the folks at BIS tell me their estimate of $516 trillion only includes “transactions in which a major private dealer (bank) is involved on at least one side of the transaction,” but doesn’t include private deals between two “non-reporting entities.” They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516 trillion “notional” value (maximum in case of a meltdown) of the deals is a good measure of the market’s size, the 2007 BIS study notes that the $11 trillion “gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets.”

Bubbles, domino effects and the very “bad 2%”

However, while that may be true as between a contract’s two parties in an individual deal, the broader risks to the world’s economies are minimized. Remember back in 1998 when LTCM’s little $5 billion loss nearly brought down the world’s banking system. That “domino effect” is now repeating many times over, straining the world’s monetary, economic and political system as the subprime housing mess metastasises, taking the US stock market and the world economy down with it.

This cascading “domino effect” was brilliantly described in “The $300 Trillion Time Bomb: If Buffett can’t figure out derivatives, can anybody?” published early last year in the Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger’s $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded: “There’s nothing intrinsically scary about derivatives, except when the bad 2 percent blow up.” Unfortunately, that “bad 2%” did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was “contained.”

Bottom line: Little things leverage a helluva big wallop. It only takes a little spark from a “bad 2% deal” somewhere in the “shadow banking system” to ignite this $516 trillion weapon of mass destruction. And ironically, in spite of the recession, by the end of 2008 the derivatives market had grown to $670 trillion. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile … it’s only a matter of time.

World’s newest and baddest “black market”

The fact is, derivatives have become the world’s biggest “black market,” exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today’s slowdown plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco’s bond fund king Bill Gross said “What we are witnessing, is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.” In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman, the Treasury Secretary and the rest of America’s leaders can’t “figure out” the world’s $516 trillion derivatives.

Why? Gross says we are creating a new “shadow banking system.” Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way creating money outside the normal central bank liquidity rules. How? Because they’re private contracts between two companies or institutions. BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic “shadow banking system” that has become the world’s biggest “black market.”

That’s crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don’t. They’re not “real money.” They’re paper promises closer to “Monopoly” money than real US dollars. And it takes place outside normal business channels, out there in the “free market.” That’s the wonderful world of derivatives, and it’s creating a massive bubble that could soon implode.

So what do you think about derivatives: as “financial weapons of mass destruction;” as a “shadow banking system;” as a “black market;” as the next big bubble exposing us dangerously close to that unpredictable “bad 2%?” They’re dead ahead, again!

1 Response to Global Shadow Banking: Why Buffett & Munger see the Secretive $670 Trillion Derivatives System as Dangerous “Financial Weapons of Mass Destruction”
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