Derivatives: A $700+ Trillion Bubble Waiting To Burst

[Injin]

http://seekingalpha.com/article/131597-der...aiting-to-burst

In the past three years, while banks all over the world and Wall Street were imploding, while some $40-$50 trillion of capital was being destroyed in global stock markets, one financial market kept growing. That market is the financial derivatives market.

According to the Bank for International Settlements [bIS], the global Over the Counter [OTC] derivatives market has grown almost 65% from $414.8 trillion in December, 2006 to $683.7 trillion in June of 2008. On the BIS’s own website, there are no updated figures for the notional derivatives market since June 2008, so we can likely assume, with some margin of safety, that this market has now grown to more than $700 trillion. Comparatively speaking, the total market cap of all major global stock markets is approximately $30 trillion.

Before I discuss how financial products could grow more than 65% during a time period when financial companies were imploding all over the world, let’s review the definition of a derivative, because this will explain how this market of financial products keeps becoming more valuable at a time when the value of many capital assets are sinking like a rock in an ocean.

....

There are two key phrases to note in the above explanation of the financial derivatives markets-

(1)The notional value of derivatives is recorded OFF the balance sheet of an institution, although the market value of derivatives is recorded ON the balance sheet; and

(2)OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.

As I’ve noted before, the $700 trillion global derivatives market is the notional value of this market, not the market value of these derivatives. The Bank for International Settlements compiles the notional value of this market worldwide from reported figures by Central Banks of the G10 countries and Switzerland. Thus, if the off-balance sheet assets of major international banks are growing so rapidly in the form of their notional values of their held financial derivative products, how can so many of these banks be in trouble?

The answer, quite simply, is that the market value of these derivatives is nowhere near the notional values of these derivatives maintained and reported by these banks, and that the global derivatives market is in serious trouble. Because derivative products are subject to counterparty risks as well, this means that the failure of one major financial institution could cause the evaporation of assets for many other financial institutions that have derivative products with exposure to that one financial institution. In other words, when the notional values of a good percent of these financial derivative products start evaporating into thin air, and they will, it will have a negative domino effect on the balance sheet of not just one major financial institution, but many.

Of course, when FASB suspended mark-to-market accounting rules recently, major international banks were allowed to re-value some of their derivative products closer to their notional value on their books to pad their balance sheets. Due to this change in accounting law, I can almost guarantee you that before market open Friday, Citigroup will announce better than expected financial results as they carried huge amounts of illiquid mortgages and financial derivatives on their balance sheets. [Editor's note: Article was written prior to earnings announcement on 4/17/09]

Though many people argue that only the market value of these derivatives, and not their notional values, is ultimately important, this would have only been valid if FASB hadn’t suspended mark-to-market accounting rules. The types of derivative products most likely to continue to blow up are Credit Default Swaps [CDS], and indeed, it was AIG’s exposure to Credit Default Swaps that caused it to collapse.

In reality, the market value of financial derivatives is only a fraction of its $700 trillion notional value; however the reality is that the potential losses from bad Credit Default Swaps can also be much more than their notional value. For example, consider a scenario where Company ABC underwrites a CDS in which they will receive $100,000 of payments from Company X in return for guaranteeing a $1,000,000 bond issued by Company Z. If all goes well, and the bond performs, then company ABC makes $100,000 in profit. However, if company Z fails, then Company ABC may now have to pay Company X $1,000,000. This is a scenario in which the losses from financial derivative products can be very real and very large. Though many analysts harp on the fact that the $700+ trillion notional figure of the derivative market is not real, it is not realistic either to only consider the much smaller market value of these derivatives as the above example illustrates.

Since it is now likely that the balance sheets of many financial institutions have been quickly “nursed back to health” by returning the book value of OTC financial derivative products to some fantasyland notional value versus their true market value, the collapse of the notional value of the $700+ trillion derivative market will indeed have future devastating consequences for global economies.

This all looks like a good, sensible banking system run by honest and honourable men - doesn't it?

Doesn't it?

"Noel, reassurance about financial armageedon caused by derivatives needed on aisle 3!"

Edited April 20, 2009 by Injin

[Guest BoomBoomCrash]

http://seekingalpha.com/article/131597-der...aiting-to-burst

This all looks like a good, sensible banking system run by honest and honourable men - doesn't it?

Doesn't it?

"Noel, reassurance about financial armageedon caused by derivatives needed on aisle 3!"

Indeed, and each and every one of them is a committed Capitalist.

[Injin]

Indeed, and each and every one of them is a committed Capitalist.

That's right.

If only they were allowed to fail by the state!

[Guest BoomBoomCrash]

That's right.

If only they were allowed to fail by the state!

How do you propose we handle that? Do you have an idea for making 700 trillion of liabilities vanish?

[Injin]

How do you propose we handle that? Do you have an idea for making 700 trillion of liabilities vanish?

Yes.

Let the market decide.

[Joey Buttafueco Jr]

http://seekingalpha.com/article/131597-der...aiting-to-burst

This all looks like a good, sensible banking system run by honest and honourable men - doesn't it?

Doesn't it?

"Noel, reassurance about financial armageedon caused by derivatives needed on aisle 3!"

"The types of derivative products most likely to continue to blow up are Credit Default Swaps [CDS], and indeed, it was AIG’s exposure to Credit Default Swaps that caused it to collapse."

This person is on secondment from the local merkin factory

[lowrentyieldmakessense(honest!)]

How do you propose we handle that? Do you have an idea for making 700 trillion of liabilities vanish?

the banking industry had a few ideas on that one

vanished from their balance sheet to reappear on the tax payers

[Injin]

"The types of derivative products most likely to continue to blow up are Credit Default Swaps [CDS], and indeed, it was AIG’s exposure to Credit Default Swaps that caused it to collapse."

This person is on secondment from the local merkin factory

Oh be fair, play the ball and not the wig.

[godless]

How do you propose we handle that? Do you have an idea for making 700 trillion of liabilities vanish?

Arrest the perpetrators and deem it fraud?

[Guest BoomBoomCrash]

Arrest the perpetrators and deem it fraud?

That won't make the liabilities disappear.

[bogbrush]

How do you propose we handle that? Do you have an idea for making 700 trillion of liabilities vanish?

Easy, let people settle or go bust. If that makes someone else go bust, let them.

There are no catastrophic problems around the corner that are not going to be created by states trying to rescue their financial arm.

[HAIR BEAR CRUNCH]

That won't make the liabilities disappear.

i work in sovereign cds, which helps manage the risk default of the bonds issued by the central banks which are kinda run by the politicians like gord who everyone in th uk voted in more or less. dont blame cds for everything dire blame your reliable boom bust chancellor for the last ten years for frittering all the money away.

[iserlohn]

That's right.

If only they were allowed to fail by the state!

The problem is that people have been advocating that the market takes care of everything.

It does not. The market is a complex system that is prone to fluctuations and is not self-correcting. In fact, it tends towards the amalgamation of participants in the long-term and the obfuscation of the market mechanisms (ie. risk) for competitive advantage. This has been shown time and time again.

It would be nice if everybody did business in the town market, but it's not like that any more. The capital markets that you now see are nothing like the basic premise, and that is to mask the fundamental attributes of a system that is unstable when scaled.

[Injin]

The problem is that people have been advocating that the market takes care of everything.

It does not. The market is a complex system that is prone to fluctuations and is not self-correcting. In fact, it tends towards the amalgamation of participants in the long-term and the obfuscation of the market mechanisms (ie. risk) for competitive advantage. This has been shown time and time again.

It would be nice if everybody did business in the town market, but it's not like that any more. The capital markets that you now see are nothing like the basic premise, and that is to mask the fundamental attributes of a system that is unstable when scaled.

The market works - just because it takes you to a place you don't want to go is one of those things. The financial markets do not exist in a free market - they are fundmantally government created and maintained institutions.

[iserlohn]

The market works - just because it takes you to a place you don't want to go is one of those things. The financial markets do not exist in a free market - they are fundmantally government created and maintained institutions.

To prove your point, maybe you can give an example of a large scale market that works without central regulation?

[Injin]

To prove your point, maybe you can give an example of a large scale market that works without central regulation?

Yes - the marriage market.

[Guest BoomBoomCrash]

Yes - the marriage market.

You not familiar with the church then? Indeed marriage is an oath taken before God (nb: I'm an atheist)

Edited April 20, 2009 by BoomBoomCrash

[Injin]

You not familiar with the church then? Indeed marriage is an oath taken before God (nb: I'm an atheist)

Quite right.

Sorry try it this way then -

The lovers market.

No regulation there - people pick what they want for mutual benefit.

[Guest BoomBoomCrash]

Quite right.

Sorry try it this way then -

The lovers market.

No regulation there - people pick what they want for mutual benefit.

Just because transactions take place does not mean that semantically to refer to it as a 'market' is accurate. I mean would you refer to high energy physics as a market? Or thermodynamics? It's rather disingenuous

Edited April 20, 2009 by BoomBoomCrash

[iserlohn]

Quite right.

Sorry try it this way then -

The lovers market.

No regulation there - people pick what they want for mutual benefit.

Even though some economists model how marriage and relationships work using economic theories, it does not make it a market.

Sex is quite complicated anthropologically. Sex could be coerced through violence, and power gained by sex. However, it is certain that what some people consider a "market" in relationships would not even remotely look like a "market" if it were not for well developed laws and customs in society. This itself is a form of regulation.

As much as libertarians and anarchists would like you to think otherwise, civilised society with its modern benefits and characteristics only survives with rules and enforcement of rules.

Likewise for any market. The reason is that a market only function effectively in only a narrow range of conditions. Market participants must be relatively balanced in power, there has to be sufficient volume, information on transactions and participants should be transparent, and that barriers of entry be kept to a minimum. These conditions are not self-optimizing, thus the need for regulation.

The question should not be whether there is too little, or too much regulation.

The question should be whether a piece of regulation does what it was supposed to achieve. If it does, we should keep it. If it doesn't, an alternative approach should be put in place. What we want is not more regulation, or less regulation, but good regulation so that we can put the market back into the zone in which it can be effective.

[interestrateripoff]

We have green shoots of recovery there is nothing to worry about.

Do you seriously think greed overcomes common sense?

[Luke Skywalker]

i work in sovereign cds, which helps manage the risk default of the bonds issued by the central banks which are kinda run by the politicians like gord who everyone in th uk voted in more or less. dont blame cds for everything dire blame your reliable boom bust chancellor for the last ten years for frittering all the money away.

The coke must have been good today if this is what we get from someone in 'sovereign cds'.

Gawd Help Us....

[bajista]

Even though some economists model how marriage and relationships work using economic theories, it does not make it a market.

Of course relationships are a market. Every single exchange between all people, be it conversation, actions, or anything, is a trade- the only question is whether that trade is part of one big market or part of one of billions of small ones - the same question, incidentally, that exercises the minds of competition regulators in every industry across the globe.

It is this sort of sloppy (mechanistic arithmetic) thinking that causes bad government. Everyone should appreciate that we don't need any money at all for a market to exist, all you need is an exchange of something. Value exists in the minds of the traders whether a currency value is put on something or not.

[stormymonday_2011]

Of course relationships are a market. Every single exchange between all people, be it conversation, actions, or anything, is a trade- the only question is whether that trade is part of one big market or part of one of billions of small ones - the same question, incidentally, that exercises the minds of competition regulators in every industry across the globe.

It is this sort of sloppy (mechanistic arithmetic) thinking that causes bad government. Everyone should appreciate that we don't need any money at all for a market to exist, all you need is an exchange of something. Value exists in the minds of the traders whether a currency value is put on something or not.

Is it Full Moon already ?

[Injin]

Is it Full Moon already ?

Straight Werewolf - Gsoh, looking for a chicken between 2 and 3 years of age for fun, romance and to have it's throat torn out at full moon.