The Catskill Chronicle

By Mort Malkin

What’s a derivative? You could just as well ask “What’s a unicorn?” A derivative is an imaginary creature dreamed up by Wall Street so they could make obscene amounts of money. The derivatives may be imaginary, but the money is real. Of course, some historians would conjecture that money, itself, is an imaginary creature.

As to making obscene amounts of money by trading (investing? speculating?) in derivatives, recent research in sociology and psychology has found that the very qualities of a successful Wall Street CEO fit the profile of a psychopath. The investigation was reported in the Journal of Business Ethics.

Next, let us look at the amounts of money we’re discussing when we speak of “obscene.” It would be best to note a few points of reference. A minimum wage worker gets $15,080 ($7.25 an hour, 40 hour weeks, and 52 weeks a year). Most workers are doing a little better – say $40,000 to $90,000 per year. Professionals – doctors, lawyers, accountants, engineers – might earn $150,000 to $300,000. CEOs and CFOs of large corporations are good for a few million a year. The top ten CEOs averaged $70 million in 2012. The highest paid hedge fund managers rake in over a billion dollars a year. A billion dollars a year? If you don’t know how to spend a billion dollars a year, Harper’s Index says to be patient – the average American household would take 20,786 years to spend a billion dollars.

The US owes China, Japan, the other Pacific nations, Saudi Arabia, the other oil exporting nations, and the Central and South American banana republics $5.4 trillion. The US national debt is $16 trillion, including over $2 trillion of bonds held by the Social Security Trust fund, but even that amount is small potatoes compared to the money secreted in untaxed off-shore accounts in Luxembourg, Switzerland, Singapore, the Bahamas, the Cayman Islands … Now don’t get any ideas – you’d need some fancy, high priced lawyers and accountants to set one up for yourself. Only very rich individuals and largish corporations can afford to do so. Enron, you may remember, pioneered the early model. Today, off-shore unaccountability is much more sophisticated.

An illustrious British economist, after exhaustive investigation, reports that the off-shore subsidiaries around the world hold between $21 trillion (at the conservative end) to $32 trillion (more realistically), most of it deposited in these three-monkey accounts by American corporations and super rich American individuals.

But, even $32 trillion isn’t much more than the GDP of the whole world. Nowadays, you have to think big. There’s a whole galaxy out there – derivatives are the way to extend financial limits out beyond the solar system.

Derivatives started out modestly with farmers who needed to lock in a fair price for their produce in the time between sowing and harvesting. They could buy futures in corn, wheat, coffee, pork bellies … That way they could borrow enough money to plant, fertilize, and grow their crops but wouldn’t get hit with a sudden decline in the price of their produce come harvest time. The history of futures contracts dates back to antiquity. It kept agricultural markets stable for 2000 years.

Then, in the 20^th century, derivatives of futures contracts were created. Unimaginatively, they were named Calls and Puts. With these options, you could bet that a particular stock on the NY Stock Exchange would either rise above a certain price or fall below the current price within, say, 90 days. Calls and Puts Options enabled people with a gambling proclivity to “play the market.” It was legalized gambling. The low priced options permitted great leverage, and quick profits, if you guessed right. Or, great losses if you had to deliver a stock you didn’t own but had to buy in a rising market.

In 1998, the Glass Steagall Act was repealed. Since 1933 this law had wisely kept banks separated by function – a) savings and home mortgage, b) business and checking, and c) investment. On repeal of Glass Steagall, banks could do anything and everything, and the large ones did. All the big banks soon had investment divisions, and the investment officers were not the staid, risk-averse bankers of yore. To produce improved profits, they had to do more than invest in plain old stocks and bonds. Options, which provided leverage, were the answer. So, they expanded calls and puts into such inventions as vanilla options, pin options, rainbow options, and look back options. They took the concept of swaps – as in credit default swaps – and created swaptions. Then came diagonal spreads, iron butterflies, straddles, and strangles. It was a hall of mirrors – reflections of reflections, the reality so far back that no one could remember it. Yet, the money was in actual dollars – both the rewards and the risks. When JP Morgan Stanley recently lost $2 billion on a single web of transactions, you may be sure it wasn’t in AT&T stocks and municipal bonds. All trading in derivatives has been free of oversight – no regulations at all – since the inception of the go-go era.

Derivative trading has reached galactic heights in recent years. In 2008, the derivatives market (sit down, please) was $600 trillion. The very latest figure is $1.14 quadrillion ($1,140,000,000,000,000). Don’t ask.

When Scott Walker, the governor of Wisconsin, says there’s no money for school teachers or poor people on Medicaid, when Paul Ryan says there’s no money for Social Security, when Mitt Romney says there’s no money for Sesame Street or Public Television, when Speaker of the House John Boehner says there’s no money for Planned Parenthood – tell them how much money there is off-shore just waiting to be taxed. Tell them the size of the derivatives market and suggest a tiny fee, say one half of one percent per transaction, to pay for funding the SEC, paying for all social services, and balancing the federal budget. One quadrillion dollars goes a long way. The heroes of Wall Street would be worthy of the Nobel Prize in Economics.