Guest Post: Janet Tavakoli: Understanding Derivatives and Their Risks

Tyler Durden's picture

Submitted by Adam Taggart of Peak Prosperity,

Global financial markets are awash in hundreds of trillions of dollars worth of derivatives. By some estimates, the total amount exceeds one quadrillion.

Derivatives played a central role in the 2008 credit crisis, as they had a brutal multiplying effect on the magnitude of the carnage. As a bad asset was written down, oftentimes there were derivative contracts written against it that resulted in total losses 10x greater than the initial write-down.

But what exactly are derivatives? How do they work?

And have we learned to treat these "weapons of mass financial destruction" (as Warren Buffet colorfully coined them) any more carefully in the aftermath of the global financial crisis?

Not really, claims Janet Tavakoli, derivatives expert and president of Tavakoli Structure Finance.

But the danger behind derivatives doesn't lie in their existence, she stresses. They play and important and constructive role in a healthy financial system when used responsibly.

But when abused, derivatives can create massive damages. So at the root of the "derivatives problem", Tavakoli stresses, is control fraud - the rampant unchecked criminal action by influential players on Wall Street. (This is the same method of fraud we've explored in past interviews with Bill Black [13] and Gretchen Morgenson [14]). Derivatives contracts are too often constructed in favor of these parties, who if they end up on the losing side of the trade, are able to socialize their losses. Until we address this root problem of corruption, says Tavakoli, derivatives (as well as other securities: stocks, bonds, etc) will continue to subject investors and our makets, overall, to unacceptable risk.

On The Nature of Derivatives

Derivative just means “derived from.” It’s just referencing another obligation, like a bond or an equity, or you can even reference an option. You can have options on futures, as an example. So a derivative is just like handing out fifty photocopies of a model; you know it’s a derivative of something that actually exists.


Let’s take an example. Goldman-Sachs used derivatives they used to help supply money to mortgage lenders by creating securitizations. And those securitizations were simply packaging up loans that were made by people like Countrywide. Countrywide of course was sued for fraud and settled for $8.3 billion with a number of different states for their predatory lending practices.


So you take these bad loans, you package them up in securities, and if you can combine them with leverage, it will always look like you are making a lot of money. That’s classic control fraud, as William Black so eloquently keeps explaining to the market and as our financial media keeps ignoring. Now, how do you combine it with leverage? Well, derivatives are a very handy item if you want to lever something up. So as an example, the Wall Street Journal looked at a $38 million dollar sub-prime mortgage bond that Goldman created in June of 2006, and yet Goldman was able to leverage that up to cost around $280 million in losses to investors.


Now how did they do that? They did that with the magic of derivatives.


Because with a derivative, you can reference that toxic bond, that $38-million-dollar bond can be referenced, you can say If that bond goes up or down in value, the value of your securitization will change as that bond goes up or down in value. So you don’t actually put that bond in a new securitization; instead you use a derivative – a credit derivative, in this case – to reference that bond. And so with the credit derivative, you can basically create as many of those referenced entities as you want. Now, they stopped at around thirty debt pools; they could have done a hundred and thirty.


Because with a credit derivative, all you’re doing is saying you are going to look to the value of that bond and we’re going to write a contract that your money is going to change when that bond goes up or down in value. That’s a derivative. You’re not actually putting the bond in; you’re just referencing that bond. You are basically betting on the outcome of something. And you don’t actually have to own its physical security. Now that’s a derivative. And that’s how derivatives were used to amplify losses and to magnify losses to make a bad situation much, much worse.                 

On Control Fraud

The root cause of it is control fraud - people in the financial system being able to do whatever they want and remain unchecked.. Where you have a group of individuals who are well rewarded for this kind of behavior and yet there is no punishment for this kind of behavior. As long as we keep that in place, you will just see more of the same. The way the Fed and regulators have chosen to deal with it is to pretend it’s not happening and just continue to print money. And, as I say, it acts as a neurotoxin in the financial system, 

On Deriviative Risk in a Market Downturn

When you most need liquidity, it isn’t there. And that’s always true of leveraged products, by the way. You know, the thing that people overlook is – and this is why fraud is such a potent neurotoxin – when the market freezes, when you end in combination with that, when you have a liquidity event, then you see even good assets deteriorate in value quickly, as people need to sell them into a market that has no liquidity. So you get sucker punched a couple of different ways. So if you can’t stand low liquidity, again, you shouldn’t be playing with credit derivatives.


Now, if you custom tailor your contract, it will be more difficult to offload that contract because people will have to take the time to read the contract, if they bother to read it at all. But that said, that’s not a reason not to re-write the language. With the ISDA standard documentation, the hype was, take our language, because if everyone accepts it, it will make it easier to trade these securities. And that was true, until credit events happen and then everyone pulls out their documents and says Oh my god, what did I sign?

On Gold and Countyparty Risk

Counterparty risk is the biggest risk.

And if you’ve been reading the Financial Times, you see a lot of people who are dismissive of gold. Well, here’s an interesting thing: The Derivatives Exchanges accept gold in satisfaction of margin calls.


We had credit derivatives traders who wanted to have contracts on credit derivatives on the United States that would settle in gold. Because if obviously the United States is in credit trouble, what would you want? You would want gold.


You don’t want euros, you don’t want any other currency; you want gold.


The thing about gold is that you don’t have counterparty risk. And if you look at the rebuttal for people who are saying that gold isn’t money, well, I’m sorry, but gold is being used as money already on derivatives exchanges around the globe. Now that wasn’t true five years ago. It’s true today. J.P. Morgan itself, around eighteen months ago or two years ago, said it will accept gold as collateral in satisfaction of margin calls. So they’ve de facto said gold is a currency.

Click the play button below to listen to Chris Martenson's interview with Janet Tavakoli (54m:27s):


Click here to read the full transcript

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Michael's picture

Dead Baltic Dry Index, collapsing iron ore prices, $700 trillion of worthless derivatives, collapsing muni & bond market, pension funds collapsing, no jobs, no industry in the USA because of NAFTA et al.

Yes we know.

And this;

The Muslims just thought to themselves, after all the USA murderous drone attacks on hundreds of our brown women and children to get a few bad guys, and then said to each other, Why let a good Youtube video go to waste?

centerline's picture

Come on Michael.  Enough.  They are just responding to thier programming.  Same as you.  Only you have the benefit of education and access to better information stream from which to divine the truth.  Not saying that I am right - that would be foolish - but saying that in my humble opinion you are so close to "getting it" but yet "so far".

Michael's picture

There are not as many useful idiots this time around the block. We are creating the reality we want now. TV brainwashing is virtually dead.

Benjamin Netanyahu: Iran Containment Strategy 'A New Standard For Human Stupidity' 

AldousHuxley's picture

all banksters should be paid in derivatives and must hold until retirement

Umh's picture

Perhaps the worst part of entrapping these fools is that it removes dumber terrorist candidates from the pool. This gives law enforcement good numbers while not reducing the real number of terrorist significantly.

Colonel Klink's picture

All banksters should be paid in lead, and hold it until they've expired.


Fixed it for you.

NoClueSneaker's picture

hehehe, wait untill the moment when the germa Michel wakes up amd finaly realized that he's penetrated without lube. His first act will be kinda kristallnacht reloaded. No Joos here, but the Turks burn queit as well .

Who cares - ECB makes the politis. The sock puppets hard on sucking the cocks of TBTF could deliver an fart of two ... But, they're good fed :-P

Michael's picture

51 9mm hollow points strapped to my waist says otherwise.

Fuck them thousand points of light!

NoClueSneaker's picture

hehehe, wait untill the moment when the germa Michel wakes up amd finaly realized that he's penetrated without lube. His first act will be kinda kristallnacht reloaded. No Joos here, but the Turks burn queit as well .

Who cares - ECB makes the politis. The sock puppets hard on sucking the cocks of TBTF could deliver an fart of two ... But, they're good fed :-P

ToNYC's picture

US Bedtime Story requires the non-critical 'they hate us for our freedoms' (they are jealous of course and enraged by their lack and thus hate rather than envy?).

Blowback from the drone program and mathequivalency for al Libbe A-Q #2 lasted in msm for about 24 hrs until such self-criticism was flag-washed. Now it goes in the dustbin of unpatriotism.

Criticism is proving the legitamacy of all parts of the mosaic, but dogma routinely beats scientific inquiry in the multiple-choice fractured /educated.

stocktivity's picture

Who is going to control it? Nobody can even understand it?

Urban Redneck's picture

It doesn't help when the author is mischaracterizing the nature of leverage, and grouping derivates as a homogenous class of investment vehicles.

jonjon831983's picture

Ya -noticed Morgan Stanley hitting the news circuit with derivatives shifting to banking side.  Don`t recall if ZH did a post on BAC's.


`Making Sense of Morgan Stanley’s Derivatives Moves`

`Morgan Stanley shifted derivatives in first quarter`




island's picture

Who can argue with Tavakoli?  She knows her stuff.  If only TPTB cared.  Of course, they don't because they are in bed with the fraudsters.

buzzsaw99's picture

prices are what da boyz say they are so who the hell is dumb enough to bet on price movements when the price will always be set at max pain?

centerline's picture

Precisely.  Who hasn't figured out yet the game changed from a casino to a casino going bankrupt.

JR's picture

“I can calculate the movement of the stars, but not the madness of men.”
– Sir Isaac Newton, after losing a fortune in the South Sea bubble

IT’S THE DERIVATIVES, STUPID! -- Web of Debt Ellen Hodgson Brown, J.D (September 18, 2008)

“What had to be saved at all costs was not housing or the dollar but the financial derivatives industry; and the precipice from which it had to be saved was an 'event of default' that could have collapsed a quadrillion dollar derivatives bubble, a collapse that could take the entire global banking system down with it.”

London Banker -- The real squeeze will be on corporates, asset managers and pension funds that did not formerly post margin to dealers.  Many are not invested in liquid assets, as they are positioned either to run a businss (corporates) or to secure long term yield through equity and corporate bond investments (pension funds).  They are facing mammoth disruption to business models, which coincidentally will concentrate more asset management in fewer hands. (9/11/2012)

As the Great LB said in January: “Securitisation broke the transmission. Once banks had loans off their books, they stopped having a direct interest in credit performance” 


FreedomGuy's picture

The article hints at the need for more regulation. I disagree. I would say none is needed but responsibility is required including the forms of criminal fraud and negligence. This would include jail time or civil suits bankrupting the stupid idiots who invest other people's money in these things. Invent all the financial vehicles you want, just be responsible for the results and only used money from those who volunteer it.

It is one thing if you make a pitch to Warren Buffett and he wants to put his own money on the line (which he didn't), but it is another thing for a bank or financial house to use deposits or investor money without full disclosure and agreements. In the end, the guilty get let off the hook and suffer no real loss for stupid decicsions while the public and the economy in general are left holding the bank.

One reason Swiss banks are well run is that their CEO's and leaders bear personal liability for bad decisions. How many Wall Street people personally went bankrupt over these stupid investment vehicles? I don't remember many.

Yen Cross's picture

 Sunday/Monday (Asia) joke of the day! Watch closely, as the hedge fund, "Roach Motel" is approaching 100% occumpency.

  I don't sanction this video, in any way! This is "Bernanke Theory" 101.

buzzsaw99's picture

derivatives = betting against the fed.

Yen Cross's picture

 buzz, primary dealers are forced to buy notes, for the 10/25(Fed.) basis point deposit guarantee.

Vendetta's picture

"But the danger behind derivatives doesn't lie in their existence, she stresses. They play and important and constructive role in a healthy financial system when used responsibly."

Uh huh. Sure.  We'll see about that won't we?  The whole point of them is create a shadow banking system

Dr. Sandi's picture

When the financial train wreck finally slides to a halt, those who control derivatives will decide who gets paid what's left. Not the FDIC, SEC, People's Court, Congress or my mom.

So the smart money is betting on and owning derivatives.

Otherwise, don't touch it, it's pure evil.

Yen Cross's picture

 I must be getting old Tyler! All the younger( Z/H), Bucks, get invites from " Sexy exotic women", and I just get adds for " Options trading, and " Lawn Mower companies"!   What gives?


  I got caught in a lie.  " Snow Blowers".

prains's picture

move out of your mom's basement for starters

Yen Cross's picture

? You are shopping for rice? ( HAKA) Is that code for " Starving Asians"  ( have, Asian, Korn,available)).


prains's picture

your polynesian history is weak you'll need to brush up,

there are soon to be millions of hungry people in the world,

their history will teach you a little about what to do brother

JR's picture

What gives? Ya got the Big Bucks after you, Yen. They’re tracking the smell of MONEY!!

Threeggg's picture

The thing that this article does not mention is that the banks that sell the Derivatives are only required to carry a 3% - 6% reserve on them. If they are ever called-in (insurance needs to be paid for the claim) The money does not even exist yet (not printed yet) to pay that 100% claim. That is why they have decided to have open ended printing ! If there ever was a point that these derivatives were triggered it would create 44 more dollars in printing for every dollar in existance (just on that balance sheet above) today.

Deflation would led to Hyperinflation through the triggering of printing to pay claims leveraged against those balance sheets.

buzzsaw99's picture

credit default swaps: "they" decide what constitutes a default.

ir swaps: "they" set interest rates and bond prices

the house always wins

Threeggg's picture

I was using JPM's balance sheet

(leveraged 44 to 1) to set the example above.

you enjoy myself's picture

and there's the real problem.  as a general rule, insurance companies (it obviously varies across policies/industry) have to pay out about 60-70% of their net premiums, and they're required to have reserves to meet their anticipated claims.    and with normal insurance, there's no daisy-chained defaults - if too many auto claims overwhelm Prudential, Prudential collects from their re-insurer, or if not, simply goes out of business with no effect on Geico.  

RockyRacoon's picture

Yeah.  Tell that to Hank Greenberg.

you enjoy myself's picture

that's precisely the point.  AIG's legitimate insurance business was the world's best - its derivative desk blew it up.

Colonel Klink's picture

Hank Greenberg is a slimy piece of shit.

RockyRacoon's picture

You're being too kind.  ...and you left out vengeful, arrogant, and ugly.

He could have just taken his millions, bought himself one of those Greek islands now on sale, and retired.  But, nooooo.

CDSMonkey's picture

Insurance reserves aren't much different than derivative margins. Same principal. Insurance companies tend to have more diversification which helps, but still at risk for large unforeseen events.

The daisy chain risk in insurance also exists. They all use the same reinsurers (which may be more dangerous than banks - their leverage ratios are off the charts) so if one fails it affects them all.

The insurance companies tend to have big bond portfolios often with bonds issued by other insurance companies so connected.

And whatever event that knocks out prudential is likely to have left a mark on the entire economy so those little things above have a large impact at the time.

Goldenballs's picture

When everyone cashes them in at the same time we will see how much they are really worth,like,

The Gold bar you thought you owned that 250 people also own.

Your futures account which suddenly disappears.

When you try to get your cash out of the bank and there is a 5 mile queue.

When you get into the bank you find out the maximum withdrawal has been lowered.

The pension you retire on will not even cover breakfast everyday.


Just buy and stack physical leave this shit where it belongs,in the bankrupt Bank.

RockyRacoon's picture

Agreed.  And keep a couple of months worth of expenses in the ole fiat currency -- just in case.  When you go to check out at Sam's with your pallet of dried beans, bottled water, 50 lb bags of rice, canned tuna, etc., they might just not take your plastic.   Throw a couple of handfuls of green at the checkout clerk and smile.  The folks in line behind you will be envious.  No, they won't accept your 1 oz gold eagle... yet.

Mr. Lucky's picture

Fractional rehypothecated equity.  Nothing to see here; just keep moving along.

Atlantis Consigliore's picture

we can get justice from the DOJ,  and the lawyers (depeding on what is IS) and sue sue sue the instigators regulators, propogators, facilitators, politicgators, 

and eat any gaters at Mc Fraudsters,  after the banksters churn burn steal and freeze, and wire out your accounts, and the brokers,

slices, dices, and rehypoticates the F.... out of your account

till even the bk lawyers  see theres nothing left, cause you see,   everyone left the Casino, and the Casino, is Foreclosed.

Futures Accounts anyone....suckers and sheeple......baaaaah baaaaah baaaaaah

Volume down 40% and mounting,  anyone know how to store anything physical without an account no, and a banker that will sell you out?

Cmon Hans, we re not German, we re Swiss and you can trust us;  we would sell you out.....sniff sniff sniff,  I smell something in the ovens...taxpayers well done?

LOL,  Liars, lawyers, NY money laundering banksters, all hooker prostitute politicans, seg funds accounts, and crooks, oh my!  walk with the streetwalker property pooshers,

Its a bottom its a bottom its a bottm its a bottom,  stick it in my bottom....

I'll trade  you 1 Crookzini and a Treasury head draft choice for a Weimer Berflunky and $ 5 trillion in fake assets and a old copy of used condom and turbo flax ointment for the dollars infected with cooties. 

We are the FED know the mounted police.

Badges, for those who stole your wealth?  Badges, we dont need no stinkin badges.   



Yen Cross's picture

Turbo,flax "ointment" for the " cooties" !   I love that analogy!

RockyRacoon's picture

I don't worry a whole lot about the lack of prosecutions at this point.  When it gets really bad they will devour each other.   It will start small like some law suits and such, but will escalate to the point of all of them going to the mattresses soon enough.   I'm gonna grab some popcorn and watch the spectacle.  After all, I've paid the price of admission.

And this to highlight your comment:

Marcy Wheeler: Lanny Breuer Admits That Economists Have Convinced Him Not to Indict Corporations


Its_the_economy_stupid's picture

Tavakoli is the bomb. She offers hope in a hopeless world. Her views on risk management allow me to dresam that the world may one day be safe again.

Nice dream anyway.

falak pema's picture

never sleep with a ticking bomb; Mae west did when she bedded the Tramp and he went cuckoo at every hour of the night. 

Imagine if Tavakoli said cuckoo to you every hour of the night and you discussed risk management, hands on style; would your tête a tit be a dream or a cat and dog fight?