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The 600 Trillion Derivatives Emergency Meeting

GeezerMan

Platinum Member
Jan 28, 2005
2,103
6
81
What are the odds of an orderly unwinding of this mess? Kind of like taking apart a house of cards without the whole thing collapsing.


Link

Here is an update on the size of the derivatives market with the latest official figures (.pdf) from the Bank for International Settlements (BIS). Hold your breath, as we are not anymore talking paltry billions but TRILLIONS of whichever fiat currency.

Current emergency meetings on banks and markets are still only in the stage where politicians and central bankers are bickering over how to create a few more hundred billions Euros and FRNs. But toxic MBS pale in comparison to the mushrooming growth of the derivatives market. According to figures released in the quarterly review of the BIS (pp A103) in September the total notional amount of outstanding derivatives in all categories rose 15% to a mindboggling $596 TRILLION as of December 2007.

Two thirds of contracts by volume or $393 TRILLION fell into the category of interest rate derivatives. Credit Default Swaps had a notional volume of $58 TRILLION, seeing the sharpest relative increase after a volume of $43 TRILLION a year earlier.

Currency derivatives reached a volume of $56 TRILLION.

Oh, and every grand balance sheet comes with a trash can. Unallocated derivatives with a notional amount of $71 TRILLION are looming over the heads of the disintegrating investment community too.
However You Look At It, This Is an Accident Waiting To Happen

Don't lose your sleep because of these numbers that KO my desktop calculator. In an ideal world - in which we are not - long and short derivatives would net out each other, leaving only a fraction of risk. The BIS tries to assess this net risk with a total of $14.5 TRILLION (2006: 11.1 TRILLION) in gross market value for all contracts but comes up with a second figure.

The so called Gross Credit Exposure appears almost moderate at $3.256 TRILLION after $2.672 TRILLION a year earlier.

Even when taking the lowest of these figures shudders run down my spine. All emergency talks have so far focused on a few hundred billions in fiat currencies, but the current nervousness demonstrated by hectic talks of finance ministers and central bankers all over the globe should give everybody a vague idea that something here may blow up any day. This pool of so far silent derivatives without a major bust can come to life any day with the failure of a multinational financial firm.

The BIS review is a good way to grasp the dimensions long term monetary expansion has brought upon us. A net risk of $14 TRILLION compares with the annual GDP of the USA. Nobody, absolutely nobody can afford this tab in the case of an unorderly unwinding of this market that is roughly 12 times the size of the global economy. I conclude a lot more paper promises will be burnt in the coming derivatives tsunami. As a reminder, most of these contracts have been moved off balance sheets into under capitalized subsidiaries that profited from the good rating of the parent company. But in case of a default it is this nasty, nasty huge notional amount that becomes a liability.

As the vast majority of these contracts have no market, failure will come in the form of counterparty risk. This makes all the current emergency meeting a bit more understandable if politicians are already aware of the biggest bubble that may find no other way of deflation than a sudden burst. I base my sense of urgency on the rapid growth of the net risk in only one year, rising a stunning 30% at a time when the first signs of the credit crunch appeared.

German chancellor Angela Merkel said ahead of an emergency meeting with French president Nicolas Sarkozy in a TV interview that she would present a rescue package for German banks on Monday. This is also expected from several other European countries. Italian president Silvio Berlusconi went so far as to suggest a concerted stock exchange holiday. It would fit the other crooked nails in the coffin of free markets.
 

ICRS

Banned
Apr 20, 2008
1,328
0
0
We had swaps with Lehman Brothers that were rated AAA, nearly $300 million in outstanding notional amounts when it went bankrupt. In one sweep our AAA rated swaps became C rated. LOL.

IMHO for derivatives, you should pay attention to the Mark to Market not to the Notional. The Notional could be 1 billion, but the mark to market might be 0. The mark to market is the price to terminate a derivative contract.
 
Dec 30, 2004
12,554
2
76
The truly scary thing is nobody, and I mean nobody, knows what's going to happen, let alone what we should do to fix it, if it needs fixing. Economics is vastly more complicated than it was in the early 90's.
 

Lemon law

Lifer
Nov 6, 2005
20,984
2
0
Its not that economic became more complicated, its derivatives that have no limit on how complex they can become. And because these derivatives and swaps are unregulated insurance policies, the unregulated part means that infinite bets can be made with no backing.

Its high time to eliminate derivatives or strongly regulate them.
 

dmcowen674

No Lifer
Oct 13, 1999
54,894
46
91
www.alienbabeltech.com
Originally posted by: Lemon law
Its not that economic became more complicated, its derivatives that have no limit on how complex they can become. And because these derivatives and swaps are unregulated insurance policies, the unregulated part means that infinite bets can be made with no backing.

Its high time to eliminate derivatives or strongly regulate them.
Originally posted by: soccerballtux
The truly scary thing is nobody, and I mean nobody, knows what's going to happen, let alone what we should do to fix it, if it needs fixing. Economics is vastly more complicated than it was in the early 90's.
That's because it's a whole new crime made up by people masquerading as Financial companies and investors thanks to the nefarious use of computers.

Put the criminals in prison where they belong and watch the problem go away.
 

StageLeft

No Lifer
Sep 29, 2000
70,150
2
0
Originally posted by: Lemon law
Its not that economic became more complicated, its derivatives that have no limit on how complex they can become. And because these derivatives and swaps are unregulated insurance policies, the unregulated part means that infinite bets can be made with no backing.

Its high time to eliminate derivatives or strongly regulate them.
But if they're part of the economy in some sense, it's become more complicated, right? I agree with soccer's sentiment anyway, or at least would supplement it by saying that economics is so complex that nobody ever has completely understood it, and least of all now. Experts with vast backing to their stances can be in complete contrast to other experts with backing to theirs. None of us can see the picture. It's rather like a physician using a microscope to see one part of your body in crystal clarity and minute detail and using it to diagnose something that's ailing the entire body. If all he ever has is a microscope he cannot pull out for a complete picture.

 

Fern

Elite Member
Super Moderator
Sep 30, 2003
26,907
173
106
Originally posted by: Lemon law
-snip-
Its high time to eliminate derivatives
Hahahaha

That's as likely as an ATOT nerd dating Natalie Portman.

In one form or another, they've (derivatives) been around for quite a while.

The lexicon is new, the concept is old.

Fern

 

ICRS

Banned
Apr 20, 2008
1,328
0
0
Have any of you ever read your typical ISDA agreement. I have, and let me tell you it written so only a lawyer could understand most of it. It often over a 100 pages long when you include the annexation to the ISDA and termination conditions. This is also one of the problems to I think. Something is wrong when an agreement needs to be over a 100 pages long.
 

chess9

Elite member
Apr 15, 2000
7,748
0
0
Originally posted by: GeezerMan
What are the odds of an orderly unwinding of this mess? Kind of like taking apart a house of cards without the whole thing collapsing.


Link

Here is an update on the size of the derivatives market with the latest official figures (.pdf) from the Bank for International Settlements (BIS). Hold your breath, as we are not anymore talking paltry billions but TRILLIONS of whichever fiat currency.

Current emergency meetings on banks and markets are still only in the stage where politicians and central bankers are bickering over how to create a few more hundred billions Euros and FRNs. But toxic MBS pale in comparison to the mushrooming growth of the derivatives market. According to figures released in the quarterly review of the BIS (pp A103) in September the total notional amount of outstanding derivatives in all categories rose 15% to a mindboggling $596 TRILLION as of December 2007.

Two thirds of contracts by volume or $393 TRILLION fell into the category of interest rate derivatives. Credit Default Swaps had a notional volume of $58 TRILLION, seeing the sharpest relative increase after a volume of $43 TRILLION a year earlier.

Currency derivatives reached a volume of $56 TRILLION.

Oh, and every grand balance sheet comes with a trash can. Unallocated derivatives with a notional amount of $71 TRILLION are looming over the heads of the disintegrating investment community too.
However You Look At It, This Is an Accident Waiting To Happen

Don't lose your sleep because of these numbers that KO my desktop calculator. In an ideal world - in which we are not - long and short derivatives would net out each other, leaving only a fraction of risk. The BIS tries to assess this net risk with a total of $14.5 TRILLION (2006: 11.1 TRILLION) in gross market value for all contracts but comes up with a second figure.

The so called Gross Credit Exposure appears almost moderate at $3.256 TRILLION after $2.672 TRILLION a year earlier.

Even when taking the lowest of these figures shudders run down my spine. All emergency talks have so far focused on a few hundred billions in fiat currencies, but the current nervousness demonstrated by hectic talks of finance ministers and central bankers all over the globe should give everybody a vague idea that something here may blow up any day. This pool of so far silent derivatives without a major bust can come to life any day with the failure of a multinational financial firm.

The BIS review is a good way to grasp the dimensions long term monetary expansion has brought upon us. A net risk of $14 TRILLION compares with the annual GDP of the USA. Nobody, absolutely nobody can afford this tab in the case of an unorderly unwinding of this market that is roughly 12 times the size of the global economy. I conclude a lot more paper promises will be burnt in the coming derivatives tsunami. As a reminder, most of these contracts have been moved off balance sheets into under capitalized subsidiaries that profited from the good rating of the parent company. But in case of a default it is this nasty, nasty huge notional amount that becomes a liability.

As the vast majority of these contracts have no market, failure will come in the form of counterparty risk. This makes all the current emergency meeting a bit more understandable if politicians are already aware of the biggest bubble that may find no other way of deflation than a sudden burst. I base my sense of urgency on the rapid growth of the net risk in only one year, rising a stunning 30% at a time when the first signs of the credit crunch appeared.

German chancellor Angela Merkel said ahead of an emergency meeting with French president Nicolas Sarkozy in a TV interview that she would present a rescue package for German banks on Monday. This is also expected from several other European countries. Italian president Silvio Berlusconi went so far as to suggest a concerted stock exchange holiday. It would fit the other crooked nails in the coffin of free markets.
No, no, you haven't been listening to Rush Limbaugh. He knows what caused this problem! It was a loan made to a black couple in downtown Columbus, Ohio. ACORN set up the transaction, and signed up the couple to vote.

Derivatives? No, couldn't have happened. Wall Street is too smart for that.

-Robert
 

chess9

Elite member
Apr 15, 2000
7,748
0
0
Originally posted by: ICRS
We had swaps with Lehman Brothers that were rated AAA, nearly $300 million in outstanding notional amounts when it went bankrupt. In one sweep our AAA rated swaps became C rated. LOL.

IMHO for derivatives, you should pay attention to the Mark to Market not to the Notional. The Notional could be 1 billion, but the mark to market might be 0. The mark to market is the price to terminate a derivative contract.
Yes. I've been saying for a month that because these derivatives now have no market, their value is zero or close to it.

-Robert
 

wwswimming

Banned
Jan 21, 2006
3,702
1
0
Originally posted by: soccerballtux
The truly scary thing is nobody, and I mean nobody, knows what's going to happen, let alone what we should do to fix it, if it needs fixing. Economics is vastly more complicated than it was in the early 90's.
Satyajit Das knows. He helped to invent them & wrote some of the
primary textbooks.

textbook

Traders, Guns, & Money

i understand a few of the derivatives, e.g. credit default insurance. what has happened with some of those is the seller of the derivative, in this case a form of insurance, is unable to honor their contract, so they are forced to go BK (i think this is part of what happened to AIG).

the problem is, a lot of large corporations have bought this form of "insurance", to protect themselves from risk (often related to a loan going bad). other corporations, including hedge funds, were only too glad to collect premiums, and then hedged themselves with a related derivative.

so basically all these large corporations have bought & sold insurance against credit defaults (and derivatives contract defaults), but their calculations do not allow for a "false black swan" event. what i mean by a black swan event is, (for example with car insurance) what if EVERYBODY had a fender bender today Saturday Oct. 18 ? well, last time i had a fender bender it cost my insurance company about $1000. i'm using this example to illustrate the case, using an insurance metaphor, where ALL (of most) of the contracts come due AT THE SAME TIME. now, we know we're not all going to have fender-bender's today, so Allstate & State Farm are safe (at least on that front).

what wasn't factored into the calculations of the credit derivatives was everybody defaulting on their loans, at once. however, in a cascading economic contraction, that's exactly what happens. i call it a "false black swan event" because the insurance sold was based on a false premise - that the economy would keep growing, that house prices would keep going up. so the corporations that sold these derivatives have $60 (or $600) trillion worth of contractual obligations which they will largely be unable to fulfill/ honor.

the goal - not having any financial dealings with any corporation that is RELYING on a credit derivative to protect them from financial risk. because the insurance will probably not be there when they need it.

the PROBLEM is - well, given that there's $60 (or $600) trillion of these contracts outstanding, they're "spread around". in pension funds, city coffers in Norway (one of the articles that came out about mortgage-backed securities was an interview with a mayor in Norway whose city lost a bunch of money on American mortgage-backed securities). possibly even CALPERS (isn't that the pension fund for California state employees).

so everybody who sold a credit derivative, and is unable to honor their contract, will be forced into bankruptcy. every counterparty, who depended on that insurance, will be finding themselves without the insurance payout on which they were counting.

i wish there was a Books on Tape version of Satyajit Das' books. his name sounds like some Indian swami.
 

chess9

Elite member
Apr 15, 2000
7,748
0
0
Originally posted by: wwswimming
Originally posted by: soccerballtux
The truly scary thing is nobody, and I mean nobody, knows what's going to happen, let alone what we should do to fix it, if it needs fixing. Economics is vastly more complicated than it was in the early 90's.
Satyajit Das knows. He helped to invent them & wrote some of the
primary textbooks.

textbook

Traders, Guns, & Money

i understand a few of the derivatives, e.g. credit default insurance. what has happened with some of those is the seller of the derivative, in this case a form of insurance, is unable to honor their contract, so they are forced to go BK (i think this is part of what happened to AIG).

the problem is, a lot of large corporations have bought this form of "insurance", to protect themselves from risk (often related to a loan going bad). other corporations, including hedge funds, were only too glad to collect premiums, and then hedged themselves with a related derivative.

so basically all these large corporations have bought & sold insurance against credit defaults (and derivatives contract defaults), but their calculations do not allow for a "false black swan" event. what i mean by a black swan event is, (for example with car insurance) what if EVERYBODY had a fender bender today Saturday Oct. 18 ? well, last time i had a fender bender it cost my insurance company about $1000. i'm using this example to illustrate the case, using an insurance metaphor, where ALL (of most) of the contracts come due AT THE SAME TIME. now, we know we're not all going to have fender-bender's today, so Allstate & State Farm are safe (at least on that front).

what wasn't factored into the calculations of the credit derivatives was everybody defaulting on their loans, at once. however, in a cascading economic contraction, that's exactly what happens. i call it a "false black swan event" because the insurance sold was based on a false premise - that the economy would keep growing, that house prices would keep going up. so the corporations that sold these derivatives have $60 (or $600) trillion worth of contractual obligations which they will largely be unable to fulfill/ honor.

the goal - not having any financial dealings with any corporation that is RELYING on a credit derivative to protect them from financial risk. because the insurance will probably not be there when they need it.

the PROBLEM is - well, given that there's $60 (or $600) trillion of these contracts outstanding, they're "spread around". in pension funds, city coffers in Norway (one of the articles that came out about mortgage-backed securities was an interview with a mayor in Norway whose city lost a bunch of money on American mortgage-backed securities). possibly even CALPERS (isn't that the pension fund for California state employees).

so everybody who sold a credit derivative, and is unable to honor their contract, will be forced into bankruptcy. every counterparty, who depended on that insurance, will be finding themselves without the insurance payout on which they were counting.

i wish there was a Books on Tape version of Satyajit Das' books. his name sounds like some Indian swami.
Good summary, but your writing sucks. ;) You must be an engineer.

AIG insured many of the CDSs, and they are belly up, or were. How much can they handle now? Maybe a few billion....

Iceland is similarly screwed. Their country is damned near bankrupt thanks to Wall Street idiots (helped by Icelandic idiots)

-Robert
 

MadRat

Lifer
Oct 14, 1999
11,668
46
91
They used to call things like derivatives by colorful phrases such as "Pyramid" schemes.
 

GeezerMan

Platinum Member
Jan 28, 2005
2,103
6
81
I just have an amateur understanding in these matters. My thinking is that the bankers are not stupid, just greedy. They must have known long ago that this game of musical chairs can't be saved, and that a printing press bailout can't work. A bailout might work if one has trillions of dollars stored up in real, not fiat, money. So, the bankers planned to just save themselves. If I were them, I would dump my toxic "investments" on taxpayers, and go buy some tangible property.

China knows this too, but like the rest of the world is scared to death on what a collapse would mean globally.
The U.S. has to go into debt and sell bonds to pay for the bailout, and our creditors are thinking they are damned if they do, and damned if they don't buy them.


.
 

ICRS

Banned
Apr 20, 2008
1,328
0
0
Originally posted by: MadRat
They used to call things like derivatives by colorful phrases such as "Pyramid" schemes.
Derivatives are nothing like Pyramid schemes.

The vast majority of derivatives are simple interest swaps.

This is what most derivatives are:

Party A: Pays Party B X% a Year based on the Notional Outstanding.
Party B: Pays Party A Z% of an Index + K spread based on the Notional Outstanding.

This is a float to fixed swap, this most common derivative.
 

Thump553

Lifer
Jun 2, 2000
11,968
1,307
126
Sixty Minutes had a fascinating episode about derivatives and credit swaps two weeks ago. One of the more bizarre factoids they popped out that the Wall Street imported physicists to design the formulas for subprime deriviatives, and apparently the goal was to make them so complicated that noone could understand them.
 

ICRS

Banned
Apr 20, 2008
1,328
0
0
Also many derivatives have a mandatory reduction schedules which reduces the applicable amount of the notional amount. I wonder when BIS calculates the Notional Outstanding if they are including the mandatory reduction schedules.
 

LegendKiller

Lifer
Mar 5, 2001
18,256
68
86
Originally posted by: MadRat
They used to call things like derivatives by colorful phrases such as "Pyramid" schemes.
They used to call people like this by colorful phrases such as "ignorant", "stupid", "moronic", "knuckle dragger", now they just call them "MadRat", or "davemcowen".

 

LegendKiller

Lifer
Mar 5, 2001
18,256
68
86
Originally posted by: GeezerMan
I just have an amateur understanding in these matters. My thinking is that the bankers are not stupid, just greedy. They must have known long ago that this game of musical chairs can't be saved, and that a printing press bailout can't work. A bailout might work if one has trillions of dollars stored up in real, not fiat, money. So, the bankers planned to just save themselves. If I were them, I would dump my toxic "investments" on taxpayers, and go buy some tangible property.

China knows this too, but like the rest of the world is scared to death on what a collapse would mean globally.
The U.S. has to go into debt and sell bonds to pay for the bailout, and our creditors are thinking they are damned if they do, and damned if they don't buy them.


.
Printing press bailout? Borrowing money is not a printing press.

What is "real" money? It's nothing more than money tied to an arbitrarily market valued asset, just like what we have now.
 

LegendKiller

Lifer
Mar 5, 2001
18,256
68
86
Originally posted by: Thump553
Sixty Minutes had a fascinating episode about derivatives and credit swaps two weeks ago. One of the more bizarre factoids they popped out that the Wall Street imported physicists to design the formulas for subprime deriviatives, and apparently the goal was to make them so complicated that noone could understand them.
The 60min episode was ridiculous. What "subprime" derivatives? RMBS? It doesn't take a physicist to understand how RMBS works.
 

LegendKiller

Lifer
Mar 5, 2001
18,256
68
86
Originally posted by: ICRS
Also many derivatives have a mandatory reduction schedules which reduces the applicable amount of the notional amount. I wonder when BIS calculates the Notional Outstanding if they are including the mandatory reduction schedules.
People prattle on about notional, but it's really a meaningless amount.

For example, I almost did a deal with a canadian company, denominated in CAD, but with the bond having to be transacted in USD, with the money initially borrowed in EUR.

So, this $200MM deal had...

1. EUR to USD EURIBOR to USLIBOR interest rate swap.
2. USD to CAD BA to USLIBOR interest rate swap.
3. USD to CAD principal differential swap.
4. USD to EUR principal differential swap.
5. USD to CAD basis risk swap (to cover USLIBOR/USABCP rate differentials)

Then, swap 2,3,4,5 were laid off in a back-to-back swap with somebody on the "street", who might have also laid off the risk.

That means that there were 9 swaps, at a minimum, on a $200MM exposure, all at a notional balance of $200MM. The net swap payments would amount to less than $100K per month on average, yet the total notional of all of the swaps was at least $1.8BN.

VAR is the right risk measurement, not notional. Nobody measures that.
 

ICRS

Banned
Apr 20, 2008
1,328
0
0
Originally posted by: LegendKiller
Originally posted by: ICRS
Also many derivatives have a mandatory reduction schedules which reduces the applicable amount of the notional amount. I wonder when BIS calculates the Notional Outstanding if they are including the mandatory reduction schedules.
People prattle on about notional, but it's really a meaningless amount.

For example, I almost did a deal with a canadian company, denominated in CAD, but with the bond having to be transacted in USD, with the money initially borrowed in EUR.

So, this $200MM deal had...

1. EUR to USD EURIBOR to USLIBOR interest rate swap.
2. USD to CAD BA to USLIBOR interest rate swap.
3. USD to CAD principal differential swap.
4. USD to EUR principal differential swap.
5. USD to CAD basis risk swap (to cover USLIBOR/USABCP rate differentials)

Then, swap 2,3,4,5 were laid off in a back-to-back swap with somebody on the "street", who might have also laid off the risk.

That means that there were 9 swaps, at a minimum, on a $200MM exposure, all at a notional balance of $200MM. The net swap payments would amount to less than $100K per month on average, yet the total notional of all of the swaps was at least $1.8BN.

VAR is the right risk measurement, not notional. Nobody measures that.
Yep, and Mark to Market which this article mention is so volatile right now that it doesn't mean much. Two months ago our Mark-to-Market on our derivatives was over 300 billion, and now it is under 200 billion. While our Notional has remained the same. Nothing about our swaps changes, just the market yield curves have changed.
 

Jhhnn

No Lifer
Nov 11, 1999
62,364
14,616
136
The problem with derivatives is that they often leverage rather than insure. If I feel that I'm insured against loss on a particular deal, then I can engage in other deals that my capitalization wouldn't otherwise support. Spread that sort of thinking industry-wide, and the risk becomes systemic. Everybody's depending on everybody else to pay off when things get ugly, but nobody really has the money to cover. I depend on party A to pay me, he depends on party B, who depends on party Z, who depends on me...

It's all peachy on the way up- being leveraged at 30:1 means I can make $30M from a deal that would otherwise only net $1M, and it also means I can lose $30M... except I never had $30m in the first place... neither did the guys who insured me, either...

The whole concept of leveraged hedging has been likened to picking up pennies in front of a steamroller, lots of pennies. If you slip a little, or if the steamroller gains speed unexpectedly, you're a goner...
 

GeezerMan

Platinum Member
Jan 28, 2005
2,103
6
81
Originally posted by: LegendKiller
Originally posted by: GeezerMan
I just have an amateur understanding in these matters. My thinking is that the bankers are not stupid, just greedy. They must have known long ago that this game of musical chairs can't be saved, and that a printing press bailout can't work. A bailout might work if one has trillions of dollars stored up in real, not fiat, money. So, the bankers planned to just save themselves. If I were them, I would dump my toxic "investments" on taxpayers, and go buy some tangible property.

China knows this too, but like the rest of the world is scared to death on what a collapse would mean globally.
The U.S. has to go into debt and sell bonds to pay for the bailout, and our creditors are thinking they are damned if they do, and damned if they don't buy them.


.
Printing press bailout? Borrowing money is not a printing press.

What is "real" money? It's nothing more than money tied to an arbitrarily market valued asset, just like what we have now.
What? No name calling for me? I feel left out.
How about at least having a good enough economy to support the massive influx of dollars
I think it''s likely our creditors will slow down or stop buying our bonds, and then the Fed will just print away.
 

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