Are derivatives the "secret sauce"?

Investment Analysis Clubs Macro Economic Trends and Risks
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David L. Bahnsen, Chief Investment Officer and Managing Partner of The Bahnsen Group, posts a weekly analysis called “Dividend Cafe.” Mr. Bahnsen is intelligent and has a unique take on the marketplace so I enjoy reading this.

https://thebahnsengroup.com/dividend-cafe/

The latest Dividend Cafe makes a rather unique claim.

https://thebahnsengroup.com/dividend-cafe/exceptio…

Exceptional Markets Require an Exceptional Economic Framework – September 5, 2025

…
(Capital) Market Forces

One extraordinary thing the United States has done is foster robust capital markets to promote economic growth. While many have decried “financialization” as somehow impeding economic progress, the United States has long used innovations in financial markets to facilitate risk-taking and the deployment of capital to all sorts of economic endeavors, and we have reaped the rewards.

Securitization accounts for approximately 50% of U.S. GDP, compared to about 7% in Europe. We have a $30 trillion GDP and $15 trillion in securitization issuance. The financial instrumentation I refer to is often demonized as “tools for Wall Street dealmaking,” when, in reality, they are tools of lowering borrowing costs, creating investor liquidity, distributing risk efficiently, and expanding opportunities for capital to be deployed across a variety of markets far more expansively (from automobiles to consumer goods to commercial real estate to aviation to anything else creative minds can figure out a way to efficiently securitize). European resistance to securitization is not the opposite of “financialization” – it is resistance to growth and the unlocking of value creation… [end quote]

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I wasn’t sure what “securitization” means so I looked it up with Google Gemini.

Securitization is the same as derivatives.

For example, in the old days banks used to issue mortgages and hold them on the books. The banks carefully vetted every mortgage since a default would hit the bank directly. With securitization the bank can bundle many mortgages into a derivative which investors can buy fractions of. The income from the mortgage payments are then divided up among the owners of the fractions of the derivative. This gives all kinds of investors the opportunity to access cash flows. Meanwhile the bank takes the money from the issuing the derivative and creates more mortgages which then are re-packaged into more derivatives. The bank manages the cash flow from the derivative but is no longer at risk from defaults. Even Fed Chair Alan Greenspan said that derivatives help to spread risk.

What could possibly go wrong???

Are derivatives the “secret sauce” for the growing U.S. economy? Or is the immense scope of securitization setting us up for another 2008-style financial crisis when the spread risk pulled down investors all over the world?

Wendy

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They are two separate processes (which can be used sequentially). Securitization is, as you/Gemini noted, the bundling of X – which can then be sold more easily than each one individually. And with less risk (more diversification).

Derivatives are financial ‘instruments’ which are tied to the performance of the underlying (their value derives from said performance). The underlying can be stocks, futures, the above bundled mortgages, etc. but they are two different layers if you will.

DB2

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To piggy back on Bob, securitization - at its heart - is little more than bundling like a closed-end bond mutual fund. The problem is created when there is either dishonesty or a lack of transparency.

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@DrBob2 thank you for this correction. As a result I looked up the dollar amounts of the securitization market. According to Google Gemini, Tthe total U.S. securitization market is estimated to be approximately $14 trillion. That’s what the Dividend Cafe said.

Then I asked about the derivatives market.

The derivatives market is often discussed in terms of two different values: notional value and gross market value. The notional value is the total face value of the underlying assets, which is a massive number and is often the one quoted in headlines. The gross market value represents the actual cost of replacing the contracts and is a much more realistic measure of the market’s size.

For the U.S. specifically, reports from the Office of the Comptroller of the Currency (OCC) indicate that the notional amount of derivatives held by insured U.S. commercial banks and savings associations was around $206.1 trillion in the first quarter of 2024. This value is dominated by interest rate derivatives. This gigantic number is far greater than the actual amount of the bonds that speculators are betting on.

The OCC’s Quarterly Report on Bank Trading and Derivatives Activities for the third quarter of 2024 reported the “gross positive fair value” of derivatives held by insured U.S. commercial banks and savings associations to be $2.441 trillion. A small number of large U.S. banks hold a vast majority of these derivatives, with the top four banks holding over 87% of the total notional amount.

This shows that the risk is concentrated in a few banks.

  1. JPMorgan Chase Bank, N.A.
  2. Citibank, N.A.
  3. Goldman Sachs Bank USA
  4. Bank of America, N.A.

This concentration is a key point of focus for financial regulators, who monitor the systemic risks associated with such a large amount of trading activity being concentrated in so few institutions.

Sudden unexpected interest rate moves could destabilize these “too big to fail” banks which could put the taxpayer on the hook.

Wendy

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Curious - does the report suggest that the banks hold/own those derivatives or their clients do? I would be more concerned if those are assets/liabilities of the institutions and not just their clients.

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The banks hold the derivatives. That’s why Google Gemini said that “This concentration is a key point of focus for financial regulators.”

Imagine a scenario where a bank holds long-dated Treasury bonds, the safest security on the planet. Suddenly, interest rates rise. The value of these bonds plummet. Then there’s a run on the bank but it can’t raise the cash. This is what happened to Silicon Valley Bank.

Now imagine a scenario where everyone “knows” that the Federal Reserve will cut the fed funds rate because employment is falling. Banks assume that the long-term bond yields will fall along with the fed funds rate so they create derivatives based on this assumption.

However, inflation is still high. Cutting the fed funds rate increases inflation. The “bond vigilantes” raise the yield of the long-dated bonds to compensate for inflation. Suddenly the derivatives move in the “wrong” direction.

Yes, it’s a reason to be concerned. This is why I monitor the financial stress every week.

Wendy

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And it is because you do so with useful commentary questions from other stalwarts here (thanks hawkwin bob on this round) that I have far less personal financial stress in my life. Recs to you all.

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Securitization was at the root of the 2007/8 crash. What was supposedly rock solid blew up.

There are derivatives and there are derivatives, they don’t all have the same risk profile. Options, futures, short selling, etc.

Short selling is interesting. You have to borrow the shares to sell them. Suppose

A buys 100 TSLA shares
B borrows 100 TSLA shares from A and sells them to C
D borrows 100 TSLA shares from C and sells them to E
F borrows 100 TSLA shares from E and sells them to G
H borrows 100 TSLA shares from G and sells them to I

Tesla only issued 100 TSLA shares but five investors (A, C, E, G, and I) think they each own 100 shares.

The Captain

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