A $516 trillion derivatives 'time-bomb'

[magellan]

Source: The Independent on Sunday

The market is worth more than $516 trillion, (£303 trillion), roughly 10 times the value of the entire world's output: it's been called the "ticking time-bomb".

It's a market in which the lead protagonists – typically aggressive, highly educated, and now wealthy young men – have flourished in the derivatives boom. But it's a market that is set to come to a crashing halt – the Great Unwind has begun.

snip....

Most markets have something behind them. Central banks require reserves – something that backs up the transaction. But derivatives don't have anything – because they are not real money, but paper money. It is also impossible to establish their worth – the $516 trillion number is actually only a notional one. In the mid-Nineties, Nick Leeson lost Barings £1.3bn trading in derivatives, and the bank went bust. In 1998 hedge fund LTCM's $5bn loss nearly brought down the entire system. In fragile times like this, another LTCM could have catastrophic results.

That is why everyone is now so frightened, even the traders, who are desperately trying to unwind their positions but finding it impossible because trading is so volatile and it's difficult to find counterparties. Nor have the hedge funds been in the slightest bit interested in succumbing to normal rules: of the world's thousands of hedge funds only 24 have volunteered to sign up to a code of conduct.

Read more: http://www.independent.co.uk/news/business/news/a-163516-trillion-derivatives-timebomb-958699.html

[Democrats_win]

1. Hedge fund guys were notorius for make a billion and not paying one penny in tax.

Let's hope that not one penny in bailout money goes to them.

[whosinpower]

2. Easy fix

Make em worth zero. Regulate future trading to outlaw derivitive trading illegal. period. end of story. It is only paper after all.

[endthewar]

3. Just tax these transactions

This proposal seems to have some traction in Congress right now. It'll discourage over-the-top speculation.

[MadrasT]

27. That's exactly what I've been thinking.

They were basically fraudulent to begin with and only ever existed on paper. And for most people who took out CDS, they were just bets anyway. Straight-up gambling. (For the cases where people took out CDS on bonds they didn't even own.)

Every one of those CDS should be valued at exactly $0.00. Wipe 'em off the books. Outlaw taking out "insurance" on bonds you don't own to start with. Regulate insurance for the owner of the bond so it's transparent.

Sometimes when you gamble, you lose big time.

[fedsron2us]

31. Are they even legal contracts that can be enforced ?

They are not true swaps but an unregulated form of insurance where the writers of the guarantees are not even obliged to post collateral. They violate most existing laws governing the provision of insurance around the world

[Waiting For Everyman]

33. Yes.

[pretzel4gore]

4. debt as asset

that's ok with big long term companys like GE or GM but c'mon....combining mortgage loans made at below the prime rate into huge billion dollar blocks and then selling them like they was pure gold (even the fact most loans still got serviced, in the beginning, it still was obviously a rippoff, with the entire economy sucked into it- shades of the 80's era reagan era Savings/Loans scandal, but this time for keeps!

[creeksneakers2]

5. How can a market equal

ten times the world's output? I've seen other estimates that put the market at $50 trillion, one tenth of the speculation here. And I have a strong hunch $50 trillion is too high.

Its not possible to lose more than exists, and even if one does lose it, he must lose it to somebody else. Its possible to hypothetically create money out of thin air, such as if I promise to pay you a $trillion and fail to deliver. Have you lost a $trillion? I don't think so.

[CatholicEdHead]

6. It is all about valuation

At least that is the most common term used. Markets of all types have always been built on the trust model. These Derivatives made money out of thin air, but it was supposedly based on a underlining trust. Even what the represent is literally nothing but numbers on paper, they go after the foundation of trust in financial markets. If the worst happens we will have destroyed ourselves over an idea of money rather than any real tangible item.

[Baby Snooks]

18. Well it's going to happen so grab a life vest and jump...

Someone should asked little Miss Chelsea Clinton how much she has made off this fraud. Of course that would be political incorrect. But also very relevant. Rumor is she has made as much as her parents.

This country has destroyed not only its own economy but the economy of all nations by pushing the "neo-con artist" economic policies of Alan Greenspan. The Bushes and the Clintons were one dynasty.

Our Congress stood behind this president when he said our country would not be a signatory to the International Court of Justice. To make sure there was not a Nuremberg. Which would have prosecuted many Democrats as well as Republicans for crimes against humanity committed over the course of two administrations. In the end, Democrats think they are above the law but the reality is the rich think they are above the law. They use the party system to control the masses the way religion was once used.

Perhaps this is the justice we deserve.

[muriel_volestrangler]

8. 'output' is a figure per year; this is an absolute figure

It is an astounding amount; the $50 trillion is 'credit default swaps', which is, basically (I think) company X saying to company Y 'if company Z can't pay its debts, we will pay you something; if not, you pay us something' - a sort of insurance, but it's been used just for speculation, it seems.

The higher figure is for all sorts of derivatives, just one of which is a credit default swap. Here's the estimates from the Bank of International Settlements of the state of things in 2007: http://www.bis.org/press/p071219.htm . From that:

"Notional amounts outstanding went up by 135% to $516 trillion at the end of June 2007" - the total

"Open positions in interest rate contracts increased by 119% to $389 trillion" - this is thus the largest type of derivative, when 2 companies swap their loan obligations, eg Company A has a fixed rate loan, but wants part of it to be a variable rate loan (presumably they're guessing interest rates will go down), while company B has a variable rate loan, but wants to go in the opposite direction. So they agree to swap some or all of their loans. Again, in theory you could use this to decrease risk, but it seems a lot of it is just done to bet on which way interest rates will go, and if one company gets its bets wrong, and can't pay up, then you're left with a complicated mess that could bring other companies down too.

"Growth in notional amounts outstanding of OTC foreign exchange derivatives was less brisk at 83%, taking the volume of open positions in such contracts to $58 trillion." - based on how exchange rates vary. Again, can either be used to decrease risk for real reasons (such as protecting an exporter from variations in exchange rates), or for speculation.

[creeksneakers2]

25. Notional amount is a hypothetical number

Wikipedia says its just a hypothetical number to set interest amounts and that amount of money does not change hands. The money does not exist.

http://en.wikipedia.org/wiki/Notional_amount

Gigantic financial transfers can involve loans or contracts that last for as little as seconds. So when calculating the amount of contracts in a year the same money is being counted over and over. The link in response #8 by Muriel-Volestrangler gives the following:

Notional amounts outstanding provide useful information on the structure of the OTC derivatives market but should not be interpreted as a measure of the riskiness of these positions. While a single comprehensive measure of risk does not exist, a useful concept is the cost of replacing all open contracts at the prevailing market prices. This measure, called gross market value, increased at a considerably lower rate (74%) than notional amounts during the reporting period, to $11 trillion at the end of June.

Even that is a number based on reports during a month. The above link reports daily amounts:

Average daily turnover in OTC foreign exchange and interest rate contracts went up by 74% relative to the previous survey in 2004, to reach $4.2 trillion in April.


That number must be greater than the amount of claims paid. If we took the amount of all potential liabilities for auto insurance companies it would be astounding, more money than the insurance companies could possibly pay. But the number of actual claims is always must smaller, at least smaller than the entire liability figure. So we are looking at something less, probably much less, than the $4.2 trillion figure.

I tried to find a solid number on how many real estate foreclosures either took place since the crisis began or are about to foreclose. Due to the difficulty of standardizing a counting method there is no such figure, but from what I could put together its about 2 million. Realty Trac, the reporting agency the media goes to now has 750,000 properties listed. So I'll go with the 2 million figure. Fannie Mae says the average loss per foreclosure is $60,000


http://latimesblogs.latimes.com/laland/2008/08/bloated-invento.html

http://www.therealestatebloggers.com/2007/05/07/freddie-mac-says-typical-foreclosure-costs-60000-dollars/

So I figure we're out about $120 billion so far in the US. We've got that covered with $700 billion in bailout money. Plus $100s of billion in loans have gone out. The reported losses between Fannie and Freddie and the Lehman brother type outfits seems to fit more with the $120 billion than the $700 billion.

Of course, there are derivatives out there for currencies and commodities and the like, but the actual exposure is probably far less than what's worried about here.

[muriel_volestrangler]

36. Following on from that paragrpah you quote, we have:

Discrepancies between growth in notional amounts and in gross market values have also been recorded in previous surveys. As a consequence, the ratio of market values to notional amounts fell to 2.2%, from 3.1% in 2001. One reason why the replacement values of derivatives positions increased at a lower rate than face values is that long-term government bond yields in the major currencies, which are the main driver of the market value of interest rate swaps, on balance changed by only very small amounts between mid-2004 and mid-2007. Since interest rate swaps, similar to most other derivatives contracts other than options, tend to be priced such that their initial value is zero, stable long-term rates are usually associated with low replacement values. Implied volatilities, an important input for the market value of options, also remained stable at a low level between the 2004 and the 2007 surveys. By contrast, stock prices rose sharply in most regions, which is consistent with the fact that the replacement value of equity contracts increased at a much faster rate (278%) than notional amounts (111%).

So I think this means that the loans that have been swapped have a total amount of $516 trillion, but, in the case of interest rate swaps, the gross market value isn't that much, since variable interest rates haven't changed much relative to the fixed interest rates for which they were swapped (from that PDF attached to that link: notional amount $389 trillion, gross market value $6.7 trillion).

So that $11 trillion was the cost, when that report was written, that would have to be found, by everyone, to undo all the contracts and get the loans back to those who originally took them out. But if interest rates change, then that amount could increase - a lot, I think. How much, I'm not sure, but perhaps the worst case scenario is that if general interest rates change by 1%, then you add 1% of $516 trillion, ie $5.16 trillion, onto that market value.

Another bit from the PDF:

OTC derivatives are contracts between two parties, not assets that can be sold off freely; terminating these contracts therefore requires the consent of all counterparties. Traders often exit positions by entering a second contract that offsets the original exposure to eliminate the market (but not counterparty) risk of a position. Notional amounts outstanding double in consequence, even though the effective market risk position has dropped to zero. This practice introduces a sort of “piling-up” of contracts, leading to high notional amounts relative to the underlying exposures to market risk.

Which I think means the added risk wouldn't go up by that $5.16 trillion for the market as a whole; but if a player in the game went bankrupt, that could be the amount that their partners were potentially going to lose unless something could be worked out - and that may have been what happened with Lehman Brothers, and the auction to do with them that happened on Friday.

So I think we're still looking at that $11 trillion figure at least, which is scary enough. Here's a posting on a board from someone who describes themselves as a layman, from about 3 weeks ago:

I have written several times in the past about the large size of the derivatives market that is traded over-the-counter. As of the end of last year, the sum notional amount of the OTC derivatives market is nearly $600 trillion. The gross market value of the OTC derivatives market is over $14.5 trillion. I am sure we are well past both now.
...
It should be noted that the notional amount is really used to provide a comparison of market size between related derivatives markets and does not provide a measure of counter-party risk. That is, it is not a measurement of exposure as principal payments are not made in derivatives transactions as they are with equities, bonds, loans, etc. But the periodic payments made in derivatives are based on the notional amount (the payments are not the notional amounts themselves). The gross market value refers to the replacement cost of the outstanding contracts at prevailing market prices.
...
The problem with these derivatives is that the investor is exposed to counter-party risk. And when there are only a limited number of trading partners comprising the pool of investors for all of these derivatives, the counter-party risk is elevated considerably. Most all of the outstanding OTC derivatives are held by ten banks and primary dealers - JP Morgan I believe is the largest with about $100 trillion in notional value. The tangled web of counter-parties is so complex, that nobody understands the inherent risk in a particular party defaulting. As we have seen with the default of Lehman debt in the credit markets, it has already had a ripple effect in the money markets (look at the money market funds that have recently broken the sacred $1/share benchmark) as well as the credit default swaps on the balance sheets of these financial institutions. And now you can see that the size of the interest rate derivative market is substantially larger than the credit default swap market currently causing significant problems in our financial markets.

Finally, think about this ... if interest rates go hard one way (up significantly would be very, very bad), it will trigger a number of defaults on these contracts. As the financial world has learned, these "insurance" instruments work fine if the level of losses and default is reasonable. But if a significant portion of counter-parties cannot afford to "pay up", significant damage can be inflicted upon the financial system (the counter-party on the winning side of the contract does not get paid). Especially when you again consider the complex web of counter-party positions (small number of counter-parties, lots of contracts). This is exactly why Bear Stearns and AIG were rescued (avoid the domino effect at all costs). And as far as interest rates going up significantly ... folks, we are in a bond bubble. What do you think is going to happen with interest rates when foreigners finally get tired of accepting trash rates for their rapidly depreciating dollars (the printing presses are being warmed up)? They are going to demand higher rates. If the Treasury chooses not to pay these higher rates at auction, the Federal Reserve has no choice but to monetize its own debt. That is, purchase its own debt with money created out of thin air. Hello inflation and a vicious cycle.

http://www.usmessageboard.com/economy/58537-subprime-mortgages-the-real-threat-is-credit-derivatives.html

[rhett o rick]

12. It's an elaborate Ponzi scheme. The "value" is of course nothing. It is only worth what

people think at the time. As soon as they realize that the scheme is over, it is worth nothing. Until then it is worth whatever people think.

[whistle]

14. The whole thing has been a Ponzi scheme covered up by the perpetrators

...who need to be rounded up, prosecuted and placed in prison

[Odin2005]

21. Our entire monetary system is totally based on non-existent wealth...

...in the first place.

http://video.google.com/videosearch?q=money+as+a+debt&hl=en&emb=0&aq=2&oq=Money+as#

This BS is just more of the same BS funny money concocted by "banksters" that do no useful work.

[girl gone mad]

41. The CDS market alone is 60T. n/t

[UpInArms]

7. I heard it is $531 trillion

www.nytimes.com/2008/10/09/business/economy/09greenspan.html?_r=1&em=&oref=slogin&adxnnlx=1223730103-3rDvTY2h0NZqLVlld2krAw&pagewanted=print

Taking Hard New Look at a Greenspan Legacy
By PETER S. GOODMAN

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives — exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added.

<snip>

“Clearly, derivatives are a centerpiece of the crisis, and he was the leading proponent of the deregulation of derivatives,” said Frank Partnoy, a law professor at the University of San Diego and an expert on financial regulation.

The derivatives market is $531 trillion, up from $106 trillion in 2002 and a relative pittance just two decades ago. Theoretically intended to limit risk and ward off financial problems, the contracts instead have stoked uncertainty and actually spread risk amid doubts about how companies value them.

If Mr. Greenspan had acted differently during his tenure as Federal Reserve chairman from 1987 to 2006, many economists say, the current crisis might have been averted or muted.

...more...

[Tutonic]

11. I recall five years ago when Buffet warned investors about derivatives.

Every investor knew then that they were worthless paper money and yet the greed of many allowed them to gamble our future. Thee worthless paper receipts need to be counted as ZERO. The government should not provide any relief for these investors--they have almost as big of a mess with the credit card debt.

[creeksneakers2]

34. Please see response #25

[jaybeat]

9. Here's a link to the first thing I've read that I could *really* understand

http://www.theoildrum.com/node/4629

The bottom line appears to be that, when you or I buy goods or services with money, that's "real" money. Hard currency. The definition of liquid assets.

However, when someone loans you money, they're basically creating it out of thin air. Because, while you have the cash, liquid money they loaned you, they can still claim the loan to you, which you promised to pay back, as an "asset"--as money that they in some sense still "have."

So, you have the "real" money, total economic output, goods and services, blah, blah, and then you have all of this "pretend" money. I'll loan this to you and sell your promise to pay back to someone else, who can use that as collateral to get a loan... blah, blah.

And now, without any regulation or standards of conduct, I think it has gotten so completely fucked up that nobody knows what's REAL money and what's PRETEND--and so the people who buy and sell things all day are SCARED SHITLESS, because they don't know if what they are selling is worth REAL money, AND they don't know if the person buying is buying with REAL money.

So everything stops. Because our shit-head government and shit-head Alan Greenscum let these fuckers print money. Hundreds of trillions of dollars of basically counterfeiting. Except no one can tell what's real and what's Monopoly money.

Go directly to Jail. Do NOT pass Go. Do NOT collect $200,000,000,000,000.

[sarcasmo]

26. Thanks for the link, and it's good to be back to cold hard cash.

[profgoose]

43. thanks for the link to us...

we appreciate it. :)

thx, DU!

[madrchsod]

10. amazing what one can achieve by constructing something out of thin air.

...these guys forgot the first chapter of econ 101

[rhett o rick]

13. Ponzi invented it. n m

[madrchsod]

42. yup, i forgot about that guy....

[Joe Chi Minh]

15. I wonder how countries first started minting money to replace bartering?How they went about it?

When it was new-fangled, what made people want to risk exchanging a bartering item, for a coin that was claimed to have a certain value? Would it be a notional value, or would become legal tender as we know it.

[skepticscott]

19. Well, don't forget

the first coins, or "currency" were made of materials that had a recognized and accepted value, like gold, silver, or even salt, just like the items that were being bartered (like skins, horses, food, etc.). Each physical coin carried its own value with it. Even paper currency, when it was backed by something like gold, still had that underlying value (depending to some extent of course on the price of the commodity backing it). Now, of course, value is entirely perceived, and the door is wide open to anything.

[Joe Chi Minh]

35. But, I mean, how could it be restored, to in any way, reflect the current

possession of it? I can't see that it would be possible. Very, very scary. Back to square one, I suppose with metals of various transferable values.

[NBachers]

16. Steal a bicycle under Three Strikes

and you could end up with a life sentence.

Steal a trillion bucks and you get a taxpayer-funded bailout.

Let's get the bench-warmers out of prison and send in the real A-Team.

Braydon-Twyman Appelwaithe, meet Bubba.

[Odin2005]

22. Laws are only for us little people, The corporate elities are "world citizens" who obey no laws.

The only way to rein in these parasites is to destroy them.

[Festivito]

17. This just seems overstated. Where is this 56T$???

If it is in overpriced stocks, then those stocks should fall.

If it is in overpriced housing, then housing should fall, but only to some level depending on the national output worth.

If it is out there on overpriced paper, then it is simply disposable.

If it is paper held in lieu of retirement savings, this is a problem, but there should be some worth still left.

I don't see where this 56T$ problem might be. And, it might only be stating the gross amount, not the overvaluization that would be in risk.

There's around a trillion in debt to other countries from federal strategies/stupidities. Beyond that, I don't think anything but the rich have worries on this.

I don't know. I could be all wet. I just don't see where it could be.

ON EDIT: I can see where there might be a couple trillion, but not fifty or more.

[dipsydoodle]

23. It's the notional value

of a heap of unmitigated shit and as such is completely arbitary.

[Festivito]

28. To where has is migrated? Who holds it?

56T$ has to be held by many entities. And, does it lie as a separate agglomeration of worth to land, industry, and banks? Is then the sum total of more real assets such as land, industry and bank assets near this 56T$ amount?

[librechik]

37. It time- traveled into the future

seriously. They make the value what they expect it to be worth a few years into the future, promising to even up the details at the (profitable, of course) back end.

I wish I could get paid three years worth of salary in advance and make it up in the (imaginary ) back end. However, only derivatives traders get to do that. And of course, real estate ALWAYS appreciates, or gets flipped for big bucks, so there are never any "bad mortgages" And btw, you don't have to pay taxes on non-existent profits, so you put those off to the "back end" too!

Uh Oh. Not.

[Festivito]

39. I see. And I begin to see how little I see. Who bought it?

So, these derived papers derived off other derived worthlessnesses and minuscule smattering of real assets are traded into the future, but, for now, one cannot buy a luxury car based on a future payment unless someone buys that future payment. Who bought it?

I know where the car is. Where is that bought future payment? Perhaps in all parts of the paper holders of the world?

Sorry, you've been kind to make an answer. I guess I need a quick MBA and an estimate of total world wealth by country.

I want to put this thing into some perspective.

Thank you.

[librechik]

48. Well, everybody stopped believing in time travel. And now they won't lend money

to those they suspect of having such exotic instruments in their portfolios.

And they all have them, hidden somewhere,, hiding in bundles of funds with Premium stuff.

And everybody dreads an audit.

I'm just speaking in metaphors. It's obviously more complicated than that, and I'm no expert.

Here is a good DU thread which explains a lot:

http://www.democraticunderground.com/discuss/duboard.php?az=show_mesg&forum=389&topic_id=4221335&mesg_id=4221335

[Odin2005]

24. It's nowhere, it's all "funny money" created out of thin air by the banksters. n/t

[Festivito]

30. Even as a number, it must exist somewhere. /nt

[OwnedByFerrets]

20. I posted on this last week.......

there is some great reading here. Ms Brown gets it..

www.webofdebt.com

[Danascot]

44. Great quote from a republican from the webofdebt website

“These capitalists generally act harmoniously and in concert to fleece the people, and now that they have got into a quarrel with themselves, we are called upon to appropriate the people’s money to settle the quarrel.”

– Abraham Lincoln, speech to Illinois legislature, January 1837

[PurityOfEssence]

29. Hey, it all works fine unless ONE of them fails...

Everyone's betting on everyone else who are betting on others betting on others betting on ALL others continually being able to bet.

It's sort of like the Strategic Defense Initiative: it has to work 100% of the time.

One breakdown on a freeway, and all hell breaks loose.

That Santayana guy didn't know what he was talking about.

Looks like Lehman WAS too big to be allowed to fail.

[Waiting For Everyman]

32. The buyers and sellers both chose to play in that game.

If it's worth zero, oh well. If that causes bankruptcies, oh well. If that means banks or big corporations get nationalized, then that's what happens.

The public is not going to pay for it, on some delusional value of it. For one thing, it would be impossible. The game's over. Everyone knows it. Now, it's only about how something new gets restructured.

Here's what's real... the homes and structures and systems that were built (including businesses), and actual assets that exist, are real. The payments millions of workers can make from their labor is real. Those are what we protect, and keep running. We can do that by nationalizing the banking system and restructuring all the debts if we have to.

If Uncle Sam now owns GM, ok. If there's a Bank of the U.S. instead of Wells Fargo, ok. As long as our currency works here, and the Treasury makes loans to people and corporations here, and can maintain necessary trade in some fashion, life goes on and the rest of it will recover.

[Hannah Bell]

38. derivative holders listed here:

http://www.occ.treas.gov/ftp/release/2008-74a.pdf

The information is there, p. 22.

There's something wrong with this picture.

[dysfunctional press]

40. wealth tax. wealth tax. wealth tax. wealth tax. wealth tax. wealth tax.

join in any time...

[Leopolds Ghost]

45. What this means is a social contract giving certain people literally infinite wealth

Unlimited access to the world's resources, relative to the buying power of everyone else.

This wealth is acknowledged only so long as it is not required to be made liquid; i.e.
only so long as their wealth is on paper, they can stake a claim to any product and
command any number of workers or professionals in the service of whatever they want
to buy, as enforced by the US military and the backing of the US dollar that props up
the paper value of their billions.

[originalpckelly]

46. This article contradicts itself, twice...

first it says the market is 516 trillion dollars, then only 56 trillion. The pound values also are the same. So what is it?

[Greyhound]

47. I love how the estimates of the size of this looming disaster keep getting smaller

with each week that passes. The "bailout" (ruling class welfare) is showing itself to be completely ineffectual and a few items are getting through the white-noise of the M$M about the consumer debt crisis which inevitably leads to somebody mentioning the many times larger derivative clusterfuck.

Since they will not be able to keep people from knowing how badly they're fucked, it is time to start minimizing the bad news, make it seem manageable.


All sheep share a common destiny.