Let me first start off by explaining what a derivative is. Most of us associate derivatives with evil-manipulative-ponzi-scheming-ass-fucks. That is fairly close to the truth. However, it's really not the derivative that is so evil, it's the people, or groups of people, who use derivatives in an improper manner to produce income on the margin.
Derivatives are very simple in context. They are instruments that explain the movement of one thing in the terms of another. Like in Mathematics, a derivative is where the change in the slope of a curve approaches 0. more precisely, it becomes tangent with line that has a fixed slope (see image below from Wikipedia)
A financial Derivative is similar. As one financial product fluctuates in price, the corresponding derivative of this product is either becoming closer, or further, away from its contracted financial trigger. The simplest example of a Derivative is a Stock Options (yes they are actually financial derivatives) A Stock Option is a contract to buy, or sell, a stock at a predetermined date and price. Stock options carry inherent and time-values. In simplest terms, inherent value is the difference between contracted strike price and the price of the stock ($5 call with a $6 stock value gives an inherent option value of $1). Time-value can be compared to a rent-to-buy agreement. You sell the ability to buy the house at some date in time, however in the meantime, you are renting the fixture at a per-month basis generating an income. Makes sense at the simplest of terms.
The majority of stock options expire worthless, therefore, if you write these contracts, you are producing an income without being liable for the sale or purchase for what the contract states. You are generating lease income without ever having to sell your asset, even if the asset continues to slowly appreciate over time.
The problem with financial derivatives and the banks who "write" them, is the assumptions driving the writing of the contract. If the majority of Stock Options expire worthless, and if the option writer is accurately projecting price fluctuations around the triggers of the derivative 99% of the time, what happens during a 3-sigma event? Boom.
Majority of the financial derivatives written are backed with collateral, which also happens to be financial derivatives or pooled "assets". During a 3-sigma event, 99% of all assumed "worst case scenarios" become reality, simultaneously triggering trillions of dollars in financial obligations to-and-from the writers of these instruments. The smaller firms quickly perish as borrowing capital becomes non-existent (think of bear sterns over-the-weekend bankruptcy) and the bigger players begin scrambling for capital to pay for basic operating expenses as their written derivatives begin no longer paying "rental" income that is now a liability that another financial player has the ability to exercise upon.
The problem gets worse when you look at the scope and size of the outstanding derivatives floating around as "assets". The amounts are mindbogglingly enormous, almost to the point where you just laugh at it's seer ludicrousness. There are more financial obligations, in the form of derivatives, than the US produces (GDP) in over 200 years. Yep, it's that BIG. If a 3-sigma event occurs, and the major players begin to exercise their contractual obligations, which the other party is unable to service, this triggers other financial obligations that the original buyer of the 1st derivative is unable to services since their "asset" is now non-performing. This is where too-big-to-fail comes into play. The big can not fail because they take down their other players.
Below is an comparative image (and link) of the derivative pool that 9 major banks own or have written.
(those are stacked $100 bills...)
For more information on this narrative, follow this link
Derivatives are very simple in context. They are instruments that explain the movement of one thing in the terms of another. Like in Mathematics, a derivative is where the change in the slope of a curve approaches 0. more precisely, it becomes tangent with line that has a fixed slope (see image below from Wikipedia)
A financial Derivative is similar. As one financial product fluctuates in price, the corresponding derivative of this product is either becoming closer, or further, away from its contracted financial trigger. The simplest example of a Derivative is a Stock Options (yes they are actually financial derivatives) A Stock Option is a contract to buy, or sell, a stock at a predetermined date and price. Stock options carry inherent and time-values. In simplest terms, inherent value is the difference between contracted strike price and the price of the stock ($5 call with a $6 stock value gives an inherent option value of $1). Time-value can be compared to a rent-to-buy agreement. You sell the ability to buy the house at some date in time, however in the meantime, you are renting the fixture at a per-month basis generating an income. Makes sense at the simplest of terms.
The majority of stock options expire worthless, therefore, if you write these contracts, you are producing an income without being liable for the sale or purchase for what the contract states. You are generating lease income without ever having to sell your asset, even if the asset continues to slowly appreciate over time.
The problem with financial derivatives and the banks who "write" them, is the assumptions driving the writing of the contract. If the majority of Stock Options expire worthless, and if the option writer is accurately projecting price fluctuations around the triggers of the derivative 99% of the time, what happens during a 3-sigma event? Boom.
Majority of the financial derivatives written are backed with collateral, which also happens to be financial derivatives or pooled "assets". During a 3-sigma event, 99% of all assumed "worst case scenarios" become reality, simultaneously triggering trillions of dollars in financial obligations to-and-from the writers of these instruments. The smaller firms quickly perish as borrowing capital becomes non-existent (think of bear sterns over-the-weekend bankruptcy) and the bigger players begin scrambling for capital to pay for basic operating expenses as their written derivatives begin no longer paying "rental" income that is now a liability that another financial player has the ability to exercise upon.
The problem gets worse when you look at the scope and size of the outstanding derivatives floating around as "assets". The amounts are mindbogglingly enormous, almost to the point where you just laugh at it's seer ludicrousness. There are more financial obligations, in the form of derivatives, than the US produces (GDP) in over 200 years. Yep, it's that BIG. If a 3-sigma event occurs, and the major players begin to exercise their contractual obligations, which the other party is unable to service, this triggers other financial obligations that the original buyer of the 1st derivative is unable to services since their "asset" is now non-performing. This is where too-big-to-fail comes into play. The big can not fail because they take down their other players.
Below is an comparative image (and link) of the derivative pool that 9 major banks own or have written.
(those are stacked $100 bills...)
For more information on this narrative, follow this link
