Financial derivatives are high priced lottery tickets on which the putative winner must pay a hugely enhanced price for the privilege of playing, an enhancement sometimes measured by a factor of several million. In return, the player gets paid a fee which small in comparison to the amount of the reverse jackpot but is significant if enough tickets get sold.
Is that the kind of a bet a cab driver or convenience store clerk would make? Actually, yes, he would, because he knows that his assets are utterly insufficient to pay for this reverse lottery ticket should he win the negative jackpot. Thus, a small but guaranteed fee makes sense regardless of the enormous [but unpayable] risk he assumes. The cab driver could care less that the ultimate outcome might be a disaster so long as his small but regular fee is forthcoming.
The Bank for International Settlements, the central bank to central banks, estimates that as of June, 2008, the total notional value of derivatives [the value of the bets which they would be required to be paid if It All Goes To Hell] is $684 trillion, an unimaginable amount. Naturally, not everyone is going to win or lose the reverse lottery derivatives represent. More reduction of this notional value takes place because some derivatives cancel themselves out when two parties hold exactly opposite positions on both sides of a bet.
Being a conservative type, I'll assume a minuscule amount of derivatives will actually ring the bell, say 5% of all outstanding notional value, or $34 trillion worth. That is still a lot of money no one on Earth can pay. Let me be really conservative, assume only 2.5% of all derivatives get called. Well, that figure is still a globally unpayable $17 trillion.
Do you see my earlier point that small risks with cataclysmic consequences should be avoided at all costs?
But if the taking of the risk is accompanied by fees that grows exponentially as the number of reverse lotttery tickets are bought, then it makes sense from a narrow greedily self-interested perspective to issue the tickets because the negative jackpot becomes even more impossible to pay. The sellers of the tickets get paid exhorbitant bonuses, they buy mansions, hang high end art on the walls of $40 million penthouses, Lamborghini and Bentley dealers prosper, etc., all of which is as addictive as heroin, while blissfully aware that winning the jackpot and being subjected to enormous liabilities simply cannot happen.
But if only 1% of these reverse lottery tickets win, the whole house of cards crashes.
And who pays? Why you, me everybody for these are lottery tickets with a vengeance. It's a very interesting thing to note that we don't get a nickel of the fees but we get to share the negative jackpot.
It didn't have to be this way if the financial regulators were doing their job. As I see it, their ultimate responsibility is to make sure that excessive risk is not allowed to accumulate in the markets because, inevitably, some amount of that risk will come to fruition. They failed miserably. This of course is old hat, not news.
As a result of the financial disaster the greedy created, the federal government has had to take on huge amounts of debt to rescue the poor souls who took in the enormous fees required to buy and sell negative lottery tickets. This will have generational implications because it will require enormous amounts of our gross national product to service the debt. In fact, the astute point out that it cannot possibly be paid and that the US government will default like Russia, Mexico and Argentina have done.
Default is indeed a possibility which I will discuss later. How you and me and The Man On the Street can prepare for it will be touched upon in future missives.
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