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Derivatives May Still Endanger The Financial System

This article is more than 10 years old.

Derivative instruments held by US banks have a nominal value of $250 trillion-- or about 150 times the aggregate balance sheet equity of these same banks, according to figures compiled by the Federal Deposit Insurance Corporation, the FDIC,  the regulatory agency responsible for  ensuring the safety of banks across America.

It is for this reason that  you might ponder on whether the absurd level of leverage in the banking system might well rock the nation at a moment when economic recovery is still relatively fragile.

You won't read these warnings in  2012 annual reports of Goldman Sachs, JP Morgan Chase,  Citigroup, or Bank of America or Morgan Stanley. But,  if you  are lucky enough to lay your hands  on the report from the privately help Plymouth Rock Company, an insurance company chaired by Jim Stone, a former chairman of the CFTC, you will read the following:

"It was the systemic risk arising from oversized and interconnected derivative positions that turned a real estate price correction into a general collapse, and now exacerbates the European debt crisis,": Stone writes. The $250 trillion open interest in derivatives-- held mainly by about 6 too- big- to -fail US banks-- "is out of scale with any legitimate hedging function, incompatible with the notion of financial services as a lubricant rather than a driver in a free economy, and a source of risk beyond the ability of any executive or board member to fathom, let alone manage prudently."

My friend Stone sounds here even more passionately worked up than Buffett or other prominent critics of the way unregulated, often difficult to value derivative contracts, might someday lead to another meltdown we cannot possibly imagine.

Stone does raise the netting operation between and among these banks-- which is supposed to mightily lessen the risks-- and finds them wanting.  'The true leverage faced by the banks, which can net t heir derivatives holdings for accounting purposes to show only the market gain or loss rather than the nominal position size and offset one position against anther according to internally generated markets, is many times the published numbers."

Then, Stone goes after the Street's self- aggrandizement of derivatives without proper transparency or oversight. "Because t he markets for derivatives have minimal price transparency, allowing them to be sold to less expert buyers for inflated prices, and because non-financial client companies insist on over-purchasing proffered hedging instruments, profits have been lofty for the dealers."

Stones solution will be rejected by the financial community; "Banks,just like insurers, should post a reserve for every new position opened, thus recognizing that counter-party risk and basis  risk (as well as systemic risk when the institutions are large) are always and necessarily non-zero."

If you are worried about this issue of derivatives, I recommend you write The  Plymouth Rock Company at 695 Atlantic Avenue, Boston, Mass, 02111 and request the 2012 annual report.