Are Derivatives a Ticking Time Bomb and How Vulnerable Is China?

Warren Buffett (in)famously referred to derivatives as financial weapons of mass destruction and, indeed, it is hard to argue against this description after seeing how derivatives did indeed risk bringing down the financial system in the aftermath of the Great Recession, with the “Mortgage-Backed Security + Credit Default Swap” equation representing the elephant in the room.

Before continuing, it is worth pointing out that derivatives are in no way “good” or “evil” in and of themselves, they are merely tools, just like a blade isn’t good/evil either (a surgeon can use one to save a life, a psychopath can use one to take a life). It ultimately all depends on the manner in which they are used or, in some cases, abused.

For example, a Chinese farmer might prefer to “sell” next season’s rice crop to someone at an agreed-upon price of $x per unit which he knows enables him to be profitable rather than wait it out and only sell when he has the rice. The same way, the buyer probably considers $x a good price and doesn’t want to wait until next year either, because he thinks the price will go up… there we have it, an example of a “good” derivative if you will, one which enables farmers to lock in decent prices and buyers to pull the proverbial trigger if/once they find a price they consider acceptable.

On the opposite end of the spectrum, derivatives can be abused in a manner that ends up putting the very sustainability of the financial system at risk, as the Great Recession made clear, with that particular situation revolving around:

1. People taking out mortgages to buy homes
2. Those mortgages being sold by the bank to an investment bank
3. The investment bank creating packages of mortgages called Mortgage-Backed Securities and selling them to investors
4. In light of the fact that investors are those who lose out if people stop paying their mortgages in this new framework, some of them have taken out a form of let’s call it insurance, Credit Default Swaps. In a nutshell, an entity such as a major insurance company sold investors Credit Default Swaps and essentially promised to reimburse them if people default on their mortgages and their Mortgage-Backed Securities take a hit

Some consider this a fairly straightforward risk management scenario, similar to our Chinese rice farmer but more complex.

However, the Great Recession has proven that this was not the case because all parties involved ended up engaging in unsustainable behavior:

1. Seeing that real estate prices went up, people got greedier and greedier, taking on unsustainable levels of debt to buy exuberantly priced real estate
2. Banks and investment banks found themselves in a moral hazard situation because given the fact that they simply sold the mortgages like hot potatoes to someone else, the incentive to be very careful when handing out loans was just not there. As such, so-called NINJA loans (no income, no job and no assets) emerged, with pretty much anyone with a pulse “qualifying”
3. The entities involved in providing Credit Default Swaps, despite hiring some of the world’s brightest mathematical minds to create what they considered to be bullet-proof models, got greedy as well and, frankly, their models didn’t meaningfully account for scenarios involving mortgage defaults on a massive scale

The rest, as they say is history, with banks as well as insurance companies ultimately having to be bailed out via coordinated actions by governments and central banks due to the “systemic risk” involved or, to put it differently, the risk that the financial system would grind to a halt in the absence of decisive action.

Fast-forward to the present and on the one hand, we have market observers who are voicing concerns with respect to the increasing popularity of for example Collateralized Loan Obligations, which are similar to Mortgage-Backed Securities but backed by corporate loans (as a fact worth including in the equation, it is important to note that Chinese corporate debt has skyrocketed in recent years) rather than mortgages. On the other hand, we have those who re-assure them and state that lessons were learned after the Great Recession and that everything from lending standards to the structure of the products themselves has been fine-tuned.

Who is right?

It is impossible to know with absolute certainty but the ChinaFund.com team always advises caution and as such, we believe the threat represented not by derivatives themselves (again, they are merely tools) but rather by the mis-use of derivatives should not be taken lightly.

In China as well?

We would say ESPECIALLY in jurisdictions such as China, for reasons we have outlined through previous articles as well and which revolve around the fact that since China is not (yet, at least) considered a safe-haven jurisdiction but rather a risk-on one, capital would be quick to flee in the event of a derivative-generated nightmare scenario.

Yes, even if the scenario in question once again has its origins in the United States because as counter-intuitive as it may seem, even a US-originated calamity will impact China more due to the fact that the US is considered a safe-haven jurisdiction and China isn’t. As unfair as this may seem, the situation is what it is and hiding from reality is never a strategy worth embracing.

Time and time again, the ChinaFund.com team has made it clear that doing well in China is predicated on a meaningful understanding of the pros and ESPECIALLY the cons related to this jurisdiction. And on the con side, it just so happens that China is not yet perceived by markets as a safe-haven jurisdiction and until that changes, your strategy needs to account for this more than vital fact. For more in-depth analysis and hands-on help with the strategy you or your organization are putting together with respect to China, the ChinaFund.com team is at your disposal.