Friday, March 6, 2009

Gargantuan derivatives market weighs on all other issues

The $700 trillion elephant

There's a $700 trillion elephant in the room and it's time we found out how much it really weighs on the economy. Derivative contracts total about three-quarters of a quadrillion dollars in "notional" amounts, according to the Bank for International Settlements. These contracts are tallied in notional values because no one really can say how much they are worth. But valuing them correctly is exactly what we should be doing because these comprise the viral disease that has infected the financial markets and the economies of the world.

Posted by devo @ 07:40 AM (1266 views)
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16 thoughts on “Gargantuan derivatives market weighs on all other issues

  • Don’t worry folks, bob1 and 51ck will be along soon to offer their ‘zero-sum’ balm.

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  • Do people get paid to write this, or is it like a community column where people without the foggiest comment?

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  • Moning devo!

    Zero sum is not part of any argument of mine against this point. The truth is that the value of these contracts is nowhere near the notional value. The notional value is the amount from which other payments are derived, not the amount the contract could be sold for, or what it was bought for (most of such contracts are actually initialised in such a way that their value to each party is zero – that is, the net value is set to zero). Using notional values to describe the total “value” or “worth” of these products is just meaningless, that’s all.

    Regarding the trader who cannot value her portfolio, either the journalist has the wrong end of the stick, or the trader needs to get out of that business!
    If she means she cannot asses her risk to a reasonable degree of accuracy because she does not know who is on the other side, she may have a better point – counterparty risk is a tricky beast right now, but a good trader will be looking at this and attempting to hedge it away with other products.
    She should, however, be able to value her portfolio to a reasonable degree of accuracy – or at least employ someone who can.

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  • 2. 51ck-6-51x said… Using notional values to describe the total “value” or “worth” of these products is just meaningless, that’s all.

    The notional values are only meaningless if every interested party agrees that they are.

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  • Reports like these are increasing in frequency…

    Derivatives ‘elephant’ crashing ‘Four Pillars’ banks

    Yesterday’s claim by former RBA Governor—and now, ANZ board member—Ian Macfarlane that Australia’s “Four Pillars” banking policy has protected our banks from the global financial collapse is a deliberate fraud, stated CEC leader Craig Isherwood.

    “Macfarlane and his cronies are deliberately ignoring the elephant in the middle of the room—the $14.2 trillion derivatives obligations of Australia’s banks,” Mr Isherwood said.
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    “More than half of the derivatives exposure of Australia’s banks is held by the ‘Four Pillars’, NAB, Macfarlane’s ANZ, Westpac and the CBA.

    “These derivatives obligations are held ‘off-balance-sheet’, and, to date, the authorities—the Government, the RBA, ASIC, APRA and the ACCC—have allowed the banks to disguise their exposure.

    “Meanwhile, exactly as the American physical economist Lyndon LaRouche forecast as far back as 1994, derivatives, now valued at $1.4 quadrillion globally, have wiped out huge chunks of America’s and Europe’s banking and financial systems, including Lehman Brothers, AIG, Bear Stearns, and The Royal Bank of Scotland.

    “How long will the Australian government continue to ignore the actual crisis in our banking system?” Mr Isherwood asked.

    “How long will they allow mums and dads and retirees to deposit and invest and buy shares in banks that carry unpayable derivatives obligations amounting to many times their assets?

    “The overnight crisis in AIG and HSBC is simply a continuation of the meltdown that began in July 2007, which no amount of financial bailout can stop.

    “It is now evident that governments are worse than negligent, unless they take immediate steps to protect the people from any further fall-out, and put their respective financial systems through bankruptcy reorganisation, and cancel these derivatives and unpayable debts.

    “For that reason,” Mr Isherwood concluded, “the Government can no longer afford to delay implementing the CEC’s Homeowners and Bank Protection Bill.”

    Derivatives elephant crashing ‘Four Pillars’ bank
    Friday, 6 March 2009, 10:57 am
    Press Release: Citizens Electoral Council

    Citizens Electoral Council of Australia

    http://www.scoop.co.nz/stories/WO0903/S00100.htm

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  • Cleetus – It seems the columnists are paid to write. The author in question was an editor for Bloomberg, but that does not mean he has a clue about what he is writing.

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  • devo – the notional values are not meaningless. They are very meaningful. They just cant be used in the way the author is attempting to use them. They should be used to work out what payments are due, that’s what they are for!

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  • devo – you can’t just add them up across the world and quote this as some meaningful figure!

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  • 7. 51ck-6-51x said… devo – the notional values are not meaningless. They are very meaningful. They just cant be used in the way the author is attempting to use them. They should be used to work out what payments are due, that’s what they are for!

    Hence the clearing house you advocate?

    If it’s such a good idea, why isn’t a clearing house already operational?

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  • 8. 51ck-6-51x said… devo – you can’t just add them up across the world and quote this as some meaningful figure!

    And yet more knowledgeable people than me are doing just that!

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  • cleetus:

    I think devo may be expressing his frustration at some of the ‘economists’ who glibly and unconvincingly explain away the current situation (I don’t think 51ck is one of them). Very often, some of the HPC members will embark on what reads like a contest to quote as many important sounding economic and mathematical sound bites per sentence as possible.

    If this is indeed what frustrates devo on this sunny morning (is it devo?), then I am inclined to agree. The trouble is that many don’t realise that economic theory and its associated mathematics is hopelessly unfit for purpose. Like negative ions bonded together, economic theories are prone to tearing themselves apart. Each one of these theories is imperfect but when cobbled together they form an incoherent and hopeless mass of information. Sound and fury signifying nothing. If Economists and mathematicians want to be useful then they need to free themselves from the intellectual tyranny of believing that their craft is in any way capable of capturing or prescribing for the current situation.

    The economy/market defies economists because it is an elemental beast that dwarfs their pompous craft. The market beast is mercurial in nature and gigantic in stature. It absorbs and reflects ALL information in the world. It is entirely unpredictable because the world around it is unpredictable and ever changing. I have never met an economist or mathematician who understands that their theories are like feathers blowing in a random wind. The weather forecast for Peking and Chiddinfold-on-sea is every bit as important as Mervin Kings latest pronouncement. Paying attention to everyone and everything is important. Keynes and Friedman give valuable insight but no more than Steinbeck, Chaucer or Coronation Street. To understanding the economy and profit from it, you must become the same type of elemental beast as the economy. You must absorb and reflect information in the same way. Conceit in your knowledge will strangle your ability to understand the world. Being a polymath is important. You can’t understand the world unless you supplement economics with poetry and the occasional fistfight. The views of STR1 and Troy are as important as those of the more conventional posters. If there are riots this summer, make sure you’re part of them. I’m happy with my lot but there’s no way I’m going to miss them because it’s a wonderful opportunity to absorb concentrated information. Listen to everyone’s view. Mix with people who are not part of your social clique. Read everything possible (its why I read this site). Perhaps the most important thing is of all is too realise that even when an understanding of the economy is achieved it will only be fleeting. Allow yourself to absorb more of the world and then constantly reset your opinion.

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  • devo –
    “Hence the clearing house you advocate?”
    I support the ideals of a free market, and if a free market finds a clearing house a popular model then that is the way to go.
    “If it’s such a good idea, why isn’t a clearing house already operational?”
    I believe a truly free market would have got there already.
    The question you pose is almost like someone near the end of the stone age saying, if this bronze stuff is so good for making weapons, why haven’t we got these spears and arrows already?
    Besides, new products will trade over the counter rather than through an exchange, because the number of market participants will be small, at some point a clearing house is an efficient solution to the problem of counterparty risk. Counterparty risk is definitely an issue to address with CDS, because the aim of such a contract is often to hedge away counterparty risk, but inherently there is another counterparty – this is the argument for a clearing house for them being a necessary regulation (but I would reiterate my first statement again!)
    “And yet more knowledgeable people than me are doing just that!”
    I really don’t think this guy has a clue, sorry.

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  • 11. flashman said… I think devo may be expressing his frustration at some of the ‘economists’ who glibly and unconvincingly explain away the current situation.

    I wouldn’t use the word ‘frustration’ and wouldn’t limit my disdain to just the economists, but other than that you are correct.

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  • Good comment flashman.

    Everything is indeed relevant even the use of the cumulative notional of derivatives contracts to attempt to describe the inherent risk in the system – the market is not driven only by true information, it is driven by available information, including misunderstandings and rumours.

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  • flashman 11:26AM ~~~ “Perhaps the most important thing is of all is too realise that even when an understanding of the economy is achieved it will only be fleeting. Allow yourself to absorb more of the world and then constantly reset your opinion.”

    in particular “when an understanding of the economy is achieved it will only be fleeting”

    I’m in the process of presenting Channel 4’s “Silly Money” four part Bremner, Bird & Fortune series as film &discussion nights in my local community.

    Although originally aired just last autumn, with a brilliance of wit and insight, it is quite incredible how quickly events have moved on and how we have all accepted bizarre events and what at face value appear to be quite absurd and idiotic commitments by our elected leaders.

    I am instinctively suspicious of anyone who feels inclined to defend the derivatives markets no matter how skillfully and politely, in fact more so if these features are present as I am familiar with their most frequent source.

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  • troy said “I am instinctively suspicious of anyone who feels inclined to defend the derivatives markets”

    Thanks troy, I enjoy being suspected ;p
    Mind you, I believe there is no financial instrument* that is, in reality, not a derivative. For example, I believe a share of ownership in a company (public or private) is a derivative on the cash flow of the company and that money is a derivative of trust in the state. If you agree with this idea, and still think derivatives are inherently bad, then I would class you as a pure anti-capitalist**

    * By financial instrument I mean something created for trading, rather than a physical asset or something that exists in nature like the weather or oil.

    ** Which is not a dig at all – this stance could well be correct, but if it is I want to know what is better, whilst allowing for liberty to be expanded and prosperity to be achieved across society. I think the hinderers here are not the capitalist and free market principles, but rather the systems of control that support themselves which have been built up by the politically powerful over centuries, including the central bank which whilst it does provide a safety, only does so with the consequence of integrating the state with the free market in such a way that fundamental properties of the free market are destroyed. Liberalisation is the key in my opinion – we need to move away from governmental democracy and toward a social democracy. I am interested in your opinions.

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