Derivatives: Another Blowup?

07/08/2015 9:00 am EST

Focus: STOCKS

Alan Newman

Founder, Crosscurrents Publications, LLC

In a span of 28 years, we have seen three major derivative events, each of these events pushed the financial world to the brink of collapse, suggests Alan Newman, editor of CrossCurrents.

Each of the three events proved that reliance on derivatives and the assumption of correct pricing models to justify those derivatives simply invites disaster.

In 1987, stocks had become grossly overvalued accompanied by margin debt at levels last seen in the Roaring Twenties.

However, portfolio managers were convinced their holdings were protected by a brand new strategy known as portfolio insurance.

This scheme was made possible by stock index futures, a derivative product developed only a few years earlier. The selling of stock futures became a self-fulfilling prophecy and the 1987 crash was enabled.

One decade later, derivatives were far more widely utilized for trading and offered huge potential for gains. Notional values had grown to 2.6 times total US stock market cap and 3.7 times GDP.

Long Term Capital Management (LTCM) seemed to be the savviest player of all, utilizing extreme leverage to return over 21% after fees in its first year, 43% in the second year, and 41% in the third year.

The Board of Directors included Myron S. Scholes and Robert C. Merton, who shared the 1997 Nobel Memorial Prize in Economic Sciences for a "new method to determine the value of derivatives."

What could possibly go wrong? In 1998, LTCM lost $4.6 billion in less than four months.

At one point, it was posited that the LTCM derivatives portfolio threatened a daisy chain of $2 trillion in risk, placing the stability of several of our largest financial institutions in doubt.

Less than a decade later, banks and brokers created a bubble in housing, with low quality loans repackaged and touted as higher quality. It was all an illusion that rapidly fell apart.

Today, nine large banks tie up virtually all notional values and 95% of the total belongs to just the five largest. Banks that were too big to fail in the last blowup remain too big to fail.

At the end of the fourth quarter of 2014, the total notional value of derivatives was $220.4 trillion; this represents 12.6 times the country’s GDP and nine times total stock market capitalization.

In my view, there is simply so much risk built into the financial system that a disaster seems inevitable. Indeed, in 51 years of observation, I have never been more fearful than today.

Although our present downside bear target is Dow 14,719, we would caution that a 25% decline occurs on average every 5.8 years.

A bear market of this magnitude would actually be quite ordinary. That would take us to under Dow 13,500, down roughly 25% from today.

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