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Chris Martenson: Welcome to another Peak Prosperity podcast. I am your host, of course, Chris Martenson, and today we are pleased to welcome Janet Tavakoli as our guest.

Janet is the President of Tavakoli Structured Finance, a Chicago-based firm providing consulting services to financial institutions and institutional investors. She’s also an expert on derivatives, a topic I’m most interested in discussing with her today. Janet is a former Adjunct Professor of Derivatives at the University of Chicago’s Graduate School of Business, as well as author of several related books, including the titles Credit Derivatives & Synthetic Structures and Structured Finance and Collateralized Debt Obligations. Perfect titles for what we’re going to talk about today.

Readers of the site are familiar with my belief that derivatives represent a truly potentially frightening financial time bomb. Global financial markets are literally awash in hundreds of trillions of dollars worth of derivatives, perhaps a quadrillion by some estimates. These are notional amounts. And I believe they are interconnected with such complexity that no one, no one really can understand or forecast how this overall market will behave in reaction to some potential systemic shock.

To be clear, I expect it’s more likely than not that one of these shocks will occur in the next two to four years and we’re going to have to live with the consequences. The global network of derivatives is enmeshed. It’s possible such a shock could create a cascading crisis that collapses faster than our current system safeguards can cope with.

But let’s ask the expert. Janet, thank you so much for joining us.

Janet Tavakoli: Hi, Chris. It’s great to be with you.

Chris Martenson: Well, I hope I haven’t scared you off with such a sobering introduction. But it reflects my idea that there’s just some confusion and maybe a fear of the unknown lurking in the derivatives markets.

Janet Tavakoli: Well, there is fear of the unknown. But let’s get to the root cause of the fear of the unknown. And that’s just not unique to derivatives, by the way; that’s true of bonds, equities, things that people are more familiar with. And the root cause of the problem remains the same, and that is unchecked fraud, widespread massive fraud in our financial system that has acted as a potent neurotoxin.

Now one example of this, that was tangentially derivatives-related, is the failure of MF Global, where we haven’t seen any indictments yet. And you’ve seen volumes collapse on the CME; they are down by around forty percent. And people that I’ve spoken with who trade derivatives are distressed and terrified by the lack of regulation and the blasé attitude by Congress – not necessarily blasé; I would say the enabling attitude by Congress and regulators that has allowed fraud to remain unchecked. And this is going to affect farmers being able to hedge the cost of growing food and producers being able to hedge the costs of their raw materials.

Chris Martenson: Well, I can’t wait to dive into this topic more fully. As bad as MF Global was, I was even more shocked – if possible – by the LIBOR scandal, and that was the manipulation of an interest rate which was and is tied to trillions in direct loans and hundreds of trillions in derivatives, so that was just remarkable. And the idea that the regulators should have known – probably did know – that this was occurring and chose to look the other way is really sobering for me.

Janet Tavakoli: Well, yes, but again, the same root cause of people in the financial system being able to do whatever they want and remain unchecked. And again, the root cause of it is control fraud. 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, so that thinking people see this, and you have a number of short sellers who point out the fallacy of being able to carry on this way, and they put their money where their mouth is.

Chris Martenson: Oh, fascinating; interesting that you mentioned neurotoxin, because I was, once upon a time, a neurotoxicologist.

Janet Tavakoli: Yes, I know that.

Chris Martenson: That’s so good of you to weave that in. Well done. So let’s start right at the beginning then. I want a few minutes here; give us an overview of what is a derivative. So what is a derivative contract? How would we explain this so that somebody who’s not familiar could then understand what they are?

Janet Tavakoli: Okay, I’d like to explain it, and then I’d like to show what happens in real life applications and why it helped bring the global financial system to its knees. 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 that might make it easier for your readers to understand. Goldman-Sachs used derivatives’ they helped supply money to mortgage lenders by creating securitizations. And those securitizations were simply packaging up loans that were made by people like Countrywide, as an example, 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.

Chris Martenson: What?

Janet Tavakoli: Yes. 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.

Chris Martenson: So if I was holding a derivative in my hands, what would I be holding, physically?

Janet Tavakoli: You’d be holding a piece of paper.

Chris Martenson: So it’s a contract?

Janet Tavakoli: That’s right, and as I keep telling people, when banks trade with each other, they often get into disputes because these nice kids write the contracts with something that we call “asymmetry of information.” So that the smarter bank will put terms into the contract that can disadvantage the other guy even more. And you found that happening in the securitizations. So that the contracts would basically say that if this minor event happens, I can basically say, you’re entertaining a total loss, and you are going to lose your money. So that you were not only referencing a bad security, you were writing the contract in a bad way to disadvantage the person who would be on the hook for losses.

Chris Martenson: So this is a contract, then – to maybe make it tangible for the average listener – it’s a legal contract, maybe like a Purchase and Sale Agreement or something. There’s terms and conditions in there. We’ve identified some things. Like in the case of when Greece was clearly defaulting, there were a whole lot of credit default swaps outstanding, maybe $78 billion dollars’ worth at the notional level. And then those contracts would only get triggered because they had provisions in them for if an actual default event occurred and there was language, I guess, in this contract around that. And then there was an organizational body that was charged with determining whether a credit event had occurred or not, whether a default had occurred. Is that right?

Janet Tavakoli: Well, that was ISDA (the International Swaps and Derivatives Association), but ISDA basically took it upon themselves to try to interpret the language of the contracts. And these are over-the-counter contracts and are basically stalled in terms of their definition of default. And its people like me – I’ve written a whole book on creditors that say you don’t want to accept a contract that someone gives you. And you don’t have to accept the language of ISDA, which is basically an organization that was created by the banks to trade credit-default swaps. So they’re going to have the most influence over what ISDA says – and that’s happened time and again, by the way, and time and again through the years – there have been disputes about the interpretation of the language.

So I always say, you want to re-write that language to make it as clear as possible, and if you don’t like the terms and conditions, then re-write them. And if you aren’t in a strong enough position to make that happen, then don’t play. And of course, people widely ignore that advice. And why do they ignore it? Because of the temptation of leverage. People on the wrong side of the contract, time and again, hope and pray that leverage will work to their advantage and they’ll have the big pay day. And usually they are disappointed because the smarter guy wrote a contract that can disadvantage them when the chips are down.

Greece was a good example; in the end, the people who bought credit default protection on Greece did prevail because the situation in Greece deteriorated so badly. But ISDA did stall – they are very effective in stalling – and again, I tell people who are on the other side of that contract, well, you have to re-write the contract at the outset; it’s too late after you’ve done the contract to argue about the language.

Chris Martenson: So let’s imagine you and I wrote a contract together, it was a derivatives contract, you are Party A, I am Party B, and we traded it over the counter so it’s in that market. And how –

Janet Tavakoli: By the way, Chris, I guarantee you, you do not want to be on the other side of the contract with me.

Chris Martenson: I’m sure of that! So let’s pretend you and I wrote a contract together against another party. First of all, how complex is this piece of paper as you described it? Is it one page? Is it thirty pages?

Janet Tavakoli: It can be as many pages as you like. The important thing isn’t the number of pages. The important thing is that you make the language clear so that you are only on the hook or you are protecting the scenarios that you want to protect or the scenarios for which you want to be on the hook. And that’s the crucial element that people keep overlooking. Don’t look at the number of pages; read the actual language.

Chris Martenson: Yes, so let’s imagine we’ve written one of these things. But now I don’t want it anymore. Do we close it out with each other, or can I just pass this on to another party? Sell it to somebody else?

Janet Tavakoli: Well, it depends on what’s going on in the market. Because 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?

Chris Martenson: So in this case, we have derivatives, which actually can have a moderating influence. So if I actually bought – for whatever reasons, I’m a pension fund and I’m holding a whole lot of Greek debt, a couple of years ago, and I’m looking at it and I’m saying, you know what? I’d like to hedge this; I would like to protect myself. I might buy a credit default swap to cover my underlying position. That’s a covered derivative, I guess. But where you’re saying we have this incredible amount of leverage, I suppose almost by definition those have to be naked positions. Meaning it’s not possible for everybody to own the underlying $38 million contract in the Goldman example, right? So these are – basically, they are just speculations – it’s just bets at this point, right?

Janet Tavakoli: Well, it’s not possible for everyone to own the $38-million-dollar sub-prime mortgage bond or the tranche of the CDO (Collateralized debt obligation), which is a type of sub-prime mortgage bond. So therefore, they use credit derivatives to reference that bond. And that way you can amplify the effect of that given bond. Well if the given bond was poorly constructed or a piece of trash in the first place, then you’ve basically just allowed more people to accept the risk of a piece of trash. And that’s what the problem was with the global financial crisis.

Now when you look at what happened with AIG and AIG’s credit derivative, AIG got into trouble because it sold protection with some very bad terms by the way. As did MBIA and AMVAC, who are the former muni bond insurers; they amplified their risk by using credit derivatives, by not understanding the underlying risk, and not really – in some cases – understanding the implications of their contracts.

Chris Martenson: So as you’re describing it, this sounds fairly endemic to the system, is this sort of how it operates?

Janet Tavakoli: It’s how it doesn’t operate, isn’t it Chris?

Chris Martenson: Yes.

Janet Tavakoli: And time and again, if you read the profiles of the people who run these institutions, they are Hague geographies [sic] where these people are lauded.

Let’s take another example of problems with derivatives – J.P. Morgan, a recent example.

Chris Martenson: Right, the whale.

Janet Tavakoli: You have the President of the United State saying that he thinks that Jamie Dimon is a good bank manager. Well, that’s not true; he has a silo within J.P Morgan that he reported to him that blew up. I don’t see how you can say that Jamie Dimon is a good manager. This was his responsibility, and they are kind of saying, well, since the rest of the farm is profitable, it doesn’t matter that this particular silo blew up in a spectacular way due to negligence and basically ignoring every safety practice around grain dust. It’s just pretty ridiculous for the President of the United States to say that he’s a good bank manager. But they’re counting on the American people not being very bright or not being able to handle the truth.

Chris Martenson: Right.

Janet Tavakoli: Let me give you another example that most people can understand. You can have a great-looking bathroom with tiles that you imported from Italy and wonderful fixtures, but if you have cracks in your grout, you failed at the most basic level. And anyone who knows anything about it can tell you that there’s a huge problem, and that the person who’s telling you they installed a great bathroom is not a good installer, right? Well that’s Jamie Dimon; not a good installer. And it doesn’t matter what Jamie Dimon says, and it doesn’t matter what the President of the United States says; water doesn’t care what the President says, what Jamie Dimon says; it doesn’t care that you imported your tiles from Italy. It only cares that you have a crack in your grout, and it’s going to do what water does.

Chris Martenson: Yes.

Janet Tavakoli: And that’s exactly what happened with Jamie Dimon’s derivatives. He had leverage; he had a position that was way too big for that unit; they were making bets. This was all reported to him, but he wants to claim he didn’t understand the size of the position and what was happening. And there was not just one failure. It wasn’t just a crack in the grout; it was poor backing behind it. It was a whole bunch of other things that went wrong at J.P. Morgan that shows failure after management failure. The wrong risk manager, they had a series of risk managers, their earliest one wasn’t qualified, they didn’t have a CFO. You know I can go on.

It’s a pretty big list that the evidence shows that Jamie Dimon was not a good manager and should be held on the hook for Sarbanes-Oxley violations. So again, when people point their finger at derivatives, yes, the size of derivatives is a problem, but the reason it’s a problem is because of control fraud. And because of, you know, installers who show you their shiny imported tiles, and you are looking at it and saying yeah, but I see a huge humongous crack in your grout here, and anyone who knows what they’re doing sees these problems. So you have people like myself and Bill Black who are looking at this and saying, nice tile, but I don’t really care about that, because you’ve got a huge problem that’s quite obvious. And that’s what we’re looking at in the global financial system right now.

Chris Martenson: So this is fascinating to me, because when the sub-prime crisis was developing, I was writing about a housing bubble back in 2005 and 2006, and it was patently obvious with just any sort of metrics that we might want to use. The house-price-to-incomes, how many standard deviations around a normal price rise we were, how far above inflation we were; there was all kinds of evidence to say gosh, we’ve got a housing bubble here. And the Federal Reserve chose not to see it, and so many players chose not to see it. And now in the aftermath we find out that in fact, several inside players did see the cracks in this and were actively constructing bonds that were ready to blow up – Goldman being a prime example of that, with their work that they were doing in writing, and being the market-maker on both sides of bonds that were designed to fail on the collateralized debt obligations – not bonds but –

So here we are. You can look into this system, you and Bill Black and others can clearly look into the system and say this is constructed in a faulty manner, therefore there’s cracks in this. And these cracks – it’s in your mind then – as it was with the case of the housing market, is it just a question of when? Not if, but when at some point we’re going to have that water just flood through the cracks in this and create extraordinary difficulties?

Janet Tavakoli: Well, we’re seeing the difficulties already. That’s why you’ve got the Fed printing money like crazy and why the banks needed accounting changes within the banks. It’s not as if the problem went away. We just decided we’d try to cover it up, put some Scotch tape on where the grout – [laugh] It’s really pretty silly, what we’ve been doing. But these problems have been obvious for a long time, and here’s how perverse the system has been.

We have the fascination of our ambassador to Libya in the new – well, let’s talk about another ambassador. Roland Arnold was the ambassador to the Netherlands, and before he was the ambassador to the Netherlands, he was the founder of an institution, a high-risk lender called Ameriquest. Ameriquest was sued by, I believe, every state in the Union except perhaps one. And instead of Roland Arnold being held accountable for that, he said, Well, I was just the CEO, I really didn’t know it was going on underneath me. And incredibly, Congress approved his appointment to be the ambassador to the Netherlands under George W. Bush. So instead of being held accountable, it was as if this guy was rewarded. Even the Netherlands didn’t like it, their newspapers were alive with why is this guy being made ambassador to the Netherlands with his track record?

So this isn’t a new problem, and this isn’t just a problem that’s occurred under the past four years; this has been building up under the Clinton Administration, under George W. Bush’s administration, through Obama’s Administration. It’s a bi-partisan betrayal. And again, it all comes down to control fraud. If we didn’t have these toxic mortgages, we would have a much smaller problem.

You talk about a housing bubble, but what is the source of the housing bubble? It’s giving out loans to people who could not afford those loans, and often giving out loans on overvalued properties to people who couldn’t afford to pay back a loan on a property that was fairly valued. So you had a lot of that kind of thing going on, which causes the housing bubble. So when you look at the root causes – I can’t stress this strongly enough – widespread massive fraud has been the most potent neurotoxin that has taken down our financial system. And instead of getting people to face this head on, you’re getting massive denial from Congress. Who keep talking about the imported tiles from Italy and how shiny they are.

It’s like they are a bunch of blondes in Congress and in our regulatory system. But because the regulators have a swinging door with Wall Street and they know they’re going to be well rewarded, that probably won’t change, and it probably won’t change under Mitt Romney either. If you look at Mitt Romney’s track record, he hired a former regulator from the FDIC and he got a loan with terms that were very favorable to Bain; in fact, the loan terms were so favorable that they actually had a poison pellet hatched so that rather than pay back creditors, Bain could pay its management huge bonuses.

Chris Martenson: Right.

Janet Tavakoli: And of course, you know the FDIC gave Bain these favorable loan terms, and wouldn’t you know it, a key man from the FDIC was then hired by Bain, so he gets to participate in the bonus payday. And you see that sort of back-scratching between regulators and the people they are supposed to regulate all the time. So that pretty much means, for everyone in the financial system who’s an investor, you are on your own. If you aren’t part of the crony capitalist’s system, you are on your own.

Chris Martenson: And by “on your own,” what do you mean?

Janet Tavakoli: What I mean is, no one has your back.

Chris Martenson: Not the regulators?

Janet Tavakoli: No.

Chris Martenson: Not the –

Janet Tavakoli: The regulators serve the people that they are supposed to be regulating.

Chris Martenson: And not the prime brokerages? You are on your own.

Janet Tavakoli: Well, prime brokerages often are the people they are supposed to be regulating. If you look at the largest prime brokers, you know, CSSB, J. P. Morgan, Goldman, and so on, those are prime brokers. So I don’t know what you mean, not the prime brokers?

Chris Martenson: Those people don’t have your best interests at heart either – that’s what I mean.

Janet Tavakoli: Lord, no. [laugh] That’s like saying NF Global had your best interests at heart.

Chris Martenson: So when did all this start? At first – is it just because we have the Internet now and we can actually see these things happening in real time so we’re just observing something that’s always been there, or did this start to go off the rails?

Janet Tavakoli: No, I think people just haven’t been reading the – I think the financial media gets a bad rap sometimes. Obviously a lot of people in the financial media have been enablers, but I think that’s just because there’s been a plethora of financial media that’s exploded. But if you read the Wall Street Journal in the pre-Internet days, they did expose the Kidder Peabodys and the Drexalls and so on. And we’ve had books written about it in different areas. It’s all finance, of course, but it’s all related. You know, Barbarians at the Gate, Den of Thieves. We have had a good body of work in pre-Internet days. It’s just that we have a whole generation that grew up not having read that.

And so they think that the Internet is the source of truth – which, by the way, it isn’t. I’ve seen a lot of bad information and a lot of hysteria. And a lot of just wrong conclusions drawn on the Internet. And it doesn’t matter – again, as I say – it doesn’t matter what the Internet says, or what people who don’t know that they’re talking about on the Internet say, it doesn’t matter what the President says, and it doesn’t matter what Jamie Dimon says; if you’ve got a crack in your grout, water’s going to do what it does.

And if people are looking at the wrong problem or identifying the wrong problem, it doesn’t matter. So, I wouldn’t say that the Internet has been the be-all and end-all; I would say that people who are comparing some of the bad things in the print media today and can’t tell the difference then seem to dismiss all of print media. And there are some very good investigative reporters that are worth your time. And the other thing about the print media, they have the money and resources to go to the site, to physically go there to check things out and often to get the phone call returned, which people on the Internet do not have.

So it would be, I think, a bad thing if the financial media were not able to fund investigations. Because often a lot of the things that you see on the Internet are simply derived from what has been in the financial media. And they’re often piecing it together based on the investigative good work of print media reporters. So it’s a mixed bag. And if you don’t know what you’re doing, gullible people can read a lot of clap trap in both the print media and the Internet and come to the wrong conclusion. So I am a mixed fan of the Internet.

Chris Martenson: Well, you certainly have to learn to separate the wheat from the chaff, but there’s some incredibly good reporting out there on the Internet as well.

Janet Tavakoli: There is, and also I would say that there are also a lot of anonymous agendas; you have a lot of anonymous bloggers, and I’m not a big fan of that, by the way.

Chris Martenson: Yes.

Janet Tavakoli: I really think, why can’t you stand behind your work and let your name be known? And you see a lot of trolls who are anonymous on the Internet. So I’m not dismissive of the Internet; I actually use the internet to disseminate information. But I would say, be wary, especially of people who are putting information out anonymously.

Chris Martenson: Oh, absolutely.

Janet Tavakoli: And that’s not to detract from good anonymous bloggers; I understand that there are reasons why people may not want their identity to be known. But as some point, as useful as pen names can be, I do think you have to stand up and be counted, because this is a country of individuals who need to back up their work.

Chris Martenson: I totally agree.

Now I want to get back to derivatives, very quickly. So here we are. You say there’s this neurotoxin that’s in our system; there’s a lot of control fraud; this has been going on for a long time. And 2008 was our shot across the bow, I guess. That would have been a great time to look across the derivative universe and say Whoa! Maybe we’ve got a little too much leverage; maybe we’ve piled things up. Since then, I believe we’ve actually increased the notional amount of derivatives by a little over $100 trillion. So, message not learned, if indeed there was risk concent