However, a financial crisis is a much more worrisome event.  They happen quicker, hurt worse, and take longer to recover than a typical recession.  That’s what happened during the global financial crisis of 2008/9.  I have long suspected the next financial crisis would be caused by derivatives.  But, there are derivatives, and then there are derivatives.

Earlier this week, there was a derivatives failure when Credit Suisse shut down one of its exchanged-traded-notes (ETNs).  Actually, it was a derivative of a derivative of a derivative, which doesn’t make it more scary, just more difficult to explain.  Let’s try:

Puts & calls are examples of derivatives and are known as options.  Their price or value is “derived” from the price of the underlying stock.  For example, if you buy a put on Amazon stock and the price of AMZN goes down, the value of the put you bought goes up, because you can then force the seller of the put to buy the stock from you at the original price instead of the current price.  He will pay too much for it, and you have limited your  downside risk.

Now, you can measure the relationship between the puts sold and the calls sold, to approximate the volatility in the stock market.  Often called the “fear index,” the symbol is VIX.  When fear goes up, the VIX goes up.  When fear goes down, the VIX goes down.  It is a derivative-of-a-derivative.  If you have a lousy financial advisor, you can actually buy or sell the VIX — to gamble on the level of fear in the market.

If you believe the VIX is giving a non-believable reading of fear, you can gamble on an “inverse VIX,” which is an ETN.  That means your ETN goes up in value when the VIX goes down.  Conversely, if fear or VIX goes down 10%, your ETN goes up 10%.  But, what happens when the VIX doubles?  That makes your ETN worth zero.  What happens if fear triples?  The ETN issuer pays!

But, here’s the kicker — there is a difference between an exchange-traded-fund (ETF) and an exchange-traded-note (ETN).  An ETF actually owns the underlying stocks.  An ETN only has the guaranty of the bank that issued the note, which was Credit Suisse in this case.  When the fear index jumped last week, the Credit Suisse ETN (inverse VIX) plummeted.  Credit Suisse could have found itself in the position of actually having to pay owners of the ETN it issued when the value fell below zero.  Rather than risk that, the bank simply cancelled the fund, locking in huge losses for the ETN holders.  It was not a “blow-up” or default.  It was a carefully managed cancellation (even though I do find it unethical).

I didn’t watch the value of the ETN that day, but I did watch the price of the credit-default-swaps (CDS) on Credit Suisse.  The price barely moved, telling me that the bank had little exposure to their ETN and would not have been in serious trouble if they had failed to cancel the ETN.  If their CDS had spiked, that would have told me that the bank was in trouble.  Since Credit Suisse is the counter-party to billions of dollars in other CDSs from other issuers, there would have been a chance for a real “blow-up” or default.  Fortunately, that was not the case!

A first-level derivative like a CDS is much more worrisome than this exotic derivative-of-a-derivative-of-a-derivative.