Wait, the Derivatives market is worth $1,200 TRILLION dollars???

[Zalatix]

That's 20 times the world's GDP. Wow, Sauron has been pretty gosh darned busy conjuring up all that imaginary money. Who's going to cover this mess if it goes belly-up?

On a side note: I'm going to have to go back to economics class just to understand some of what is being said here.

http://www.dailyfinance.com/2010/06/09/risk-quadrillion-derivatives-market-gdp/

Big Risk: $1.2 Quadrillion Derivatives Market Dwarfs World GDP

By Peter Cohan
Posted 10:45AM 06/09/10
Posted under: Economy, Investing, Investing Basics

One of the biggest risks to the world's financial health is the $1.2 quadrillion derivatives market. It's complex, it's unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost -- and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.

A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world's leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon's), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world's annual gross domestic product is between $50 trillion and $60 trillion.

[99th_Monkey]

1. Clearly, the Have-Mores are having a heyday.

... Deliberately crashing and trashing the world financial systems,
like drunken sailor psychopaths, drunk on power and money, and
everyone else is supposed to not notice or care, until it's their
broke ass that's begging on the street, when it's already too late.

[jmowreader]

2. Economics class won't do it for ya

I think one of the big attractions of derivatives is that no one knows what the hell they are, including the people in the business. (We've run probably fifty articles about derivatives over the last year. In every instance when a complex derivative was named and described, the description was for the wrong derivative...in most cases, a "CDO-squared" (collateralized debt obligations created by tranching other CDOs) was called a "synthetic CDO" (a CDO created by tranching naked credit default swaps--these were the securities at the heart of the Goldman Sachs scandal). But you have to give them SOME credit--at least they didn't call them safe investments.)

The biggest problem in the credit derivatives market is the regulating body: there's a federal agency called the Commodity Futures Trading Commission, but credit derivatives would most properly be regulated by the Nevada Gaming Commission.

[Zalatix]

3. So we've created some kind of financial chimera whose DNA we can't even decode?

[jmowreader]

30. Precisely

It gets better: the huge financial services reform bill that was SUPPOSED to rein in the derivatives market still lets them do outrageous crap.

Let me tell you the best part: You know about the Goldman Sachs scandal, where John Paulson set up a billion-dollar bet against the housing market? Not only was what he did legal when he did it, it's still legal.

How the Goldman Sachs scandal worked: Goldman Sachs hired John Paulson, who has made billions of dollars as a short-seller, to make them a shitload of money. Paulson identified a billion dollars' worth of mortgages that he thought were going to default, and bought "naked credit default swaps" against them. A credit default swap is a bit like an insurance policy written against a credit account. It's only a bit like an insurance policy because the person who buys the CDS doesn't have to own what it's written against, and the person selling it doesn't have to own the money necessary to pay the buyer if the casualty being covered (the default of the underlying credit account) happens. After Paulson got the naked CDS, he then wrote bonds called "synthetic collateralized debt obligations" against them. A non-synthetic CDO is written against a basket of anything you want--you could bundle thirty mortgage-backed securities, fifteen credit card receivables asset-backed securities, a whole mortgage, nineteen car loans and a million-dollar "win" ticket on I'll Have Another in the Belmont, base a CDO on the bundle and people would buy the damn thing. Synthetic CDOs, OTOH, are written only against credit default swaps--usually, naked CDS.

They call the people involved in these transactions counterparties. Each of them has money in the deal. The person who created and sold the CDO, which we will call the "writer," makes money if the people way down at the bottom of this thing, the homeowners who bought the houses the mortgages on which John Paulson is betting against, lose their homes to foreclosure. Quite obviously, the more people default the more money he makes and if they all default he'll be out there dancing nekkid in the middle of the street with mango jelly all over him. The people who bought the CDO, who we will call the "marks," make money if the homeowners pay off their mortgages. John Paulson doesn't want the marks to make money, because the more they make the less he does. Hence the need to pick mortgages he absolutely knew would fail.

I read the prospectus. It specifically said the investment was a synthetic CDO, and this is how synthetic CDOs all work.

In short, what you are looking at here is nothing more, and nothing less, than a $100,000 lottery ticket. The only real difference is, when you buy a $2 Powerball ticket on Saturday and it doesn't win--the usual performance of a Powerball ticket--you throw it in your recycling bin and wait till Wednesday to try again. When you buy a $100,000 Goldman Sachs ticket on Monday and it performed as well as the Powerball ticket you bought Saturday, you go to your congressman with a sad story and they have an investigation.

The Commodity Futures Modernization Act specifically says derivatives are not "gambling transactions." This is true. Casinos have rules.

[stevenleser]

33. Yep, I have a friend with a masters in math from MIT. He sat down and explained them to me

one day. I used to tutor Calculus I and II. I think I grasped it for a few minutes. An hour later I couldnt explain it at all. Suffice to say that the math involved is very complex.

Now the really bad part. When the math required just to understand derivatives is that tough, the math required to do a strong risk analysis of each derivative is several orders more difficult and it is VERY easy to fail to take something into account that blows the entire risk analysis out of the water.

My friend is one of those several hundred risk analysis people who failed to understand what might happen if real estate suddenly went south. He explained the mistake they all made there too.

Complex financial instruments should be banned.

[Zalatix]

34. Banned? Oh no don't do that, just because we silly mortals cannot understand it.

To do that would mean to imply that it's not our fault that we don't get it. Which would be a slap to the face of social Darwinism itself!

We deserve to be fleeced because we just. Don't. Get. It!

[TahitiNut]

4. Wendy Gramm

should be imprisoned for gross malfeasance in office, fraud, corruption, and being Phil Gramm's wife.

[salin]

8. Ding, Ding, Ding!

She is responsible, as her last act in office (I believe it was in the last couple of days), for quietly passing a rule that took derivatives OUT of regulatory reach.

The first public awareness (and severe economic calamity) was with the crash of Enron - and learning of the schemes used to game the energy market (and cause an economic crash in the economy of California). No correction was made and this havoc has grown to this absurd level.

Suddenly putting one's saving under the mattress almost starts to make sense.

[sendero]

12. "Almost"?

Why would you bother with a bank? they are giving you NOTHING for the use of your money.

IMHO everyone should have a portion, a large portion at that, of their funds in the Bank of Sealy. There is no downside other than physical loss or destruction (ie,e your house burns down).

[salin]

28. Not there yet, but have a good credit union

money isn't earning much of anything. But for now it is safe.

The whole CHASE debacle - I believe was backed by depositors money (if I read correctly) in which case - there really is no more value to having money in a bank. No interest on savings, and so safety of savings. The only value is exchanging a paper (or electronic) pay check into cash.

Makes the bank of Sealy look more appealing.

[unkachuck]

51. "...money isn't earning much of anything."

....the days of making money on deposits are gone....the sheep have to be driven to wall-street so they can be sheared....

[FarCenter]

19. What do you mean "no one knows what the hell they are"?

Read Sayajit Das', "The Swaps & Financial Derivatives Library: Products, Pricing, Applications and Risk Management, 3rd Edition Revised", 4 volumes, 4700 pages.

http://www.amazon.com/The-Swaps-Financial-Derivatives-Library/dp/0470821760/ref=ntt_at_ep_dpt_9

For a more fun read, there's his "Extreme Money: Masters of the Universe and the Cult of Risk".

http://www.amazon.com/Extreme-Money-Masters-Universe-Cult/dp/0132790076/ref=ntt_at_ep_dpt_1

[laundry_queen]

27. Pricey read that first one.

I'm going into a 3rd year of an applied degree in accounting (my courses are the equivalent of 4th year Bcom courses) and I know how to account for derivatives on the financial statements, but haven't learned anything else about them. Seeing as many of my courses are MBA transferable courses, I'm thinking even most MBAs don't REALLY know much about derivatives. I'd like to read that first book but it's more than the total I've paid for all my texts this term. I might have to read the second one though. Thanks for the links.

[jmowreader]

31. Okay, Sayajit Das knows what the hell they are

Read this:

http://www.politicsdaily.com/2010/04/20/goldman-sachs-scandal-fabulous-fab-and-masters-of-the-universe/

Fabrice Tourre, John Paulson's contact at Goldman, sent this email:

"The whole building is about to collapse anytime now...Only potential survivor, the fabulous Fab...standing in the middle of all these complex, highly leveraged, exotic trades that he created without necessarily understanding all the implications of these monstrosities!!!"

Read that again.

What these guys were doing was the financial equivalent of selling coal trucks with the air brake chambers removed, without understanding the implications of selling 60-ton trucks with no brakes to people who work in the mountains.

[coalition_unwilling]

43. That is a powerful metaphor, I hope you will consider building an OP

Last edited Mon May 21, 2012, 03:10 AM - Edit history (1)

around its themes. The people who work in the mountains were not allowed to seek legal redress for a defective product from those who sold them said coal trucks.

[jmowreader]

50. Nor were the people whose houses were flattened...

because coal trucks that can't stop also can't turn, and if your house just happens to be at the bottom of a mountain...

[Zalatix]

35. 4700 PAGES!!! That's 3x as long as War and Peace!!!

[FarCenter]

39. According to Malcolm Gladwell, it takes 10,000 hours to master something

Derivatives or Russian literature -- take your pick.

[coalition_unwilling]

42. Actually, the CFTC does not have regulatory authority over many of the

derviatives currently traded (like credit default swaps). Back when it might have helped, its head, Brooksley Born, called for giving the CFTC authority to regulate, but her call was stuffed by parasites like Alan Greenspan, Hank Paulson, Geithner, et. al

http://www.washingtonpost.com/wp-dyn/content/article/2009/05/25/AR2009052502108.html

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

[Jack Rabbit]

48. Yes, I'd like to see the derivitives market regulated by the Nevada Gaming Commission

The Nevada Gaming Commission would shut it down.

The Nevada Gaming Commission takes a dim view of a game where the house plays and doesn't reveal to the other players that it is playing or how it is betting. One might think such a game is rigged.

[jmowreader]

49. There's a more important NCG rule

According to "Ocean's Eleven" (the Clooney version, haven't seen the Rat Pack one, sorry), the Nevada Gaming Commission requires that a casino hold enough cash in its vault to cover every chip in play on the floor.

There is not enough money in the world, by a factor of about 25, to cover all the derivatives outstanding.

[Jack Rabbit]

54. You're right. That is more important.

However, Dr. Bernanke is printing the money to cover for the house it as fast as he can. Pay no attention to that hyperinflation behind the curtain.

[Waiting For Everyman]

5. Yup, and it needs to be declared void for the fraud that it is.

It'll come to that sooner or later. It's asinine to even try to pay that. And why? It's fictional "debt" anyway.

Imo those who spun the webs should be left to take the loss and let the chips fall where they may... Iceland-style. By global agreement if need be. It'll come to that anyway someday because there's nothing else that can be done with it.

[hifiguy]

22. Indeed. This is nothing more than Monopoly money.

No real asset is behind any of this toxic horseshit and it is worthless. Declare every dime of it worthless and wipe it from the face of the earth and start over again.

[FBaggins]

6. The key here is to understand that "notional value" isn't real.

You can swap the interest payment on a billion dollars worth of treasuries without owning the actual treasuries. The notional value involved in that swap (on your end) is a billion dollars, but there's no actual billion involved.

[sendero]

13. Not only that..

.. but a certain amount of this is negated by the fact that one bet is just against another.

That is not to say that this is not a serious problem, it is and the deregulation of these instruments was the beginning of the end of our financial system. Warren Buffett didn't call them "financial weapons of mass destruction" for nothing.

What many of these are used for is to create the illusion of "insurance" or "hedge" against loss. Only problem is I could write an insurance policy for $100 million but if the loss even occured I could not pay off. Same with this crap.

[FBaggins]

15. That's certainly correct.

There are a group of financial institutions who made the same amount of money that JPM lost.

That is not to say that this is not a serious problem

Right. But the problem isn't that derivatives exist. They're actually a very good idea that reduces risk when used properly. The problem is when they're used to make large bets.

What many of these are used for is to create the illusion of "insurance" or "hedge" against loss.

Wait... now we disagree. There's no illusion there. They are insurance and they do provide an appropriate hedge against loss. The problem begins when they aren't used that way.

A much simplified example is home insurance. If you own a home it's entirely reasonable to hedge the risk of its loss by purchasing homeowners insurance. That's a highly-leveraged investment that returns zero in most cases but a ton in certain rare events. What is not appropriate is purchasing insurance on the property down the street for which you have no ownership interest.

It gets worse when you purchase insurance on lots of homes you don't own. Then take it to the next level and imagine a company that does this for profit... and you purchase options on the stock of that company (layering more leverage onto those insurance contracts).

If JPM morgan had a large loan portfolio that behaved in the opposite direction from the swaps they puchased... there would be zero problem. They would be exchanging a small portion of possible gain for an insurance policy against a large loss. But buying that same investment "uncovered" is an inappropriate risk which should not be permissible for that type of institution any more than I should be able to take out a life insurance policy on you.

[sendero]

16. I'll have to disagree .

... on my main point. Credit Default Swaps are all over the place, written by institutions that absolutely could not cover the loss should it occur. This is what brought down AIG.

[coalition_unwilling]

44. There are two problems actually. Your problem is one of them, in that

those writing and selling credit default swaps (like AIG) were not required to maintain sufficient reserves to pay them off. But the flip side is that organizations like Goldman Sachs could buy credit default swaps without having an 'insurablity interest.' (I got this idea from Joseph Stiglitz' magisterial Freefall, btw.)

To illustrate, if you buy an insurance policy against your neighbor's house burning down, suddenly you have acquired a fiduciary interest in seeing your neighbor's house burn down (so you get paid). As complicated and arcane as the math behind these dervivatives can be, it cannot mask the greed and corruption at the root.

[TrollBuster9090]

7. Magic Economics. Nice work if you can get it.

1. Create massive amounts of IMAGINARY wealth.
2. Trade it back and forth for REAL bonuses that are proportional to the imaginary wealth.
3. When the balloon bursts, and the imaginary wealth is exposed as being imaginary, you rob the taxpayers of REAL wealth to make sure the people who had the IMAGINARY wealth are not the ones who'll end up getting screwed.

This is way beyond VooDoo Economics. This is magic faerie dust economics. A lot of real risk and real debt and real hazard are created, but the only real wealth that's created is the wealth that's raked in by the traders.

[Zalatix]

9. Ah, I see. I wasn't getting it because it's not even real.

Jim Jones never made purple kool-aid as strong as the shit these guys in the derivatives market are passing around!

[MadHound]

10. The funny thing is, every empire of note,

From Rome to Britain, Spain to Holland, eventually wound up devoting the largest part of their economy to the financial sector. Sadly, as soon as that happened, the financial sector would blow up and either severely weaken, or take down that empire. We are following that same path, and doing so in a much more spectacular pattern, using magic markets such as derivatives, so that financial frauds who call it real can make obscene amounts of money while the rest of us suffer.

[DetlefK]

14. Rome is a bad example.

Their whole financial system was unsustainable to begin with: The main chunk of the money that was spent by the empire didn't come from taxes but from pillage.
Invading other nations and stealing their resources (gold, slaves, marble...) was the main income of the Roman Empire. Until one day a limit was reached, where the empire was too big and maintaining the borders too expensive. Additionally, there were no rich neighbors left to rob. (The british tribes were too poor and the kingdoms of the Middle-East too far away.)
Unable to keep the state running and under pressure by the migrating populations of northern and eastern europe, the empire finally collapsed.

[magical thyme]

26. and the main chunk of money funding this empire is pillage

stolen from the working and middle classes. Gutting companies that produce real wealth, firing workers, raiding 401Ks, going after the social security fund. Stealing entire countries (read: Greece, next up Portugal?)

And a limit is being reached where there is no working or middle class left to plunder.

With nothing left to steal from Peter and Paul (and Dick and Jane and Harry and Sally), this too shall pass...

[bhikkhu]

32. Rome is a bad example there too

...as it enjoyed 200 years of relative peace and stability (the Pax Romana - http://simple.wikipedia.org/wiki/Pax_Romana ) after it grew close to its largest extent in 27 BC. Not much war or pillage, but things were pretty good for a long time. I don't know much about its financial systems, but what brought it down was a whole complex of other things.

[coalition_unwilling]

45. At least the Roman empire created some great art and philosophy that

outlasted it, as compared to our Golden Arches and "Bay Watch" (I tried to think of the absolutely worst TV show I possibly could and this one popped into my head for some reason).

I know, I know, that cultural legacy is and was small comfort to the slaves of the Roman Empire. But still . . .

[onethatcares]

38. that sounds vaguely similar to

this country I live in. The one between the Pacific and Atlantic Oceans with Canada at the northern edge.

[Blue_Tires]

36. +1

[DetlefK]

11. What's the difference between this and counterfeiting money? Please explain!

Money is a nothing more than an I.O.U.
"If you wanted to, you could exchange this piece of paper and this piece of metal for a specified amount of goods." That's the promise and it is kept by the national banks. That's why inflation and deflation are bad: The amount of money has to be equal to the amount of goods, otherwise trade collapses (consumer-wise or market-wise).

Counterfeiting money is similar to inflation: The additional money is not backed up by real-life goods or by some financial entity big enough to keep the promise in all situations.

And derivatives are similar to counterfeiting money: A bank creates a piece of currency and assigns a greater value to it than it is actually worth.




BTW: My cousin just finished his business-degree and he told me exactly that. And he's a mere student.
EVERYBODY IN THE BANKING SECTOR KNOWS THAT THE DERIVATIVES MARKET IS JUST MADE-UP VALUE! EVERYBODY!
And everybody trots along quietly, ignoring it and hoping that nothing bad will happen.

[coalition_unwilling]

46. You are conflating currency (a physical form that money takes) and money (the

abstract store of value, typically represented numerically).

So how is money created? At its simplest, money is created when a bank makes a loan. You have a checking account with $0 in it and the bank approves your loan and you now have $1,000 in it. The bank has 'created' money where before none existed. (The government requires the bank to maintain some reserves, let's say 10%, on its books from depositors for any loans it makes. So the bank in this hypothetical example is required to attract $100 in deposits in order to create the $1,000 of money.)

[PA Democrat]

17. Warren Buffett was sounding the alarm on derivatives way back in 2002 when

the "value" of the derivatives market was a fraction of what it is today.

There is a reason that people call derivatives trading the "shadow banking system" or the "dark market" and a reason why Wall Street wants to keep it that way. The Feds can't regulate or monitor what they can't see and that's the way Wall Street wants to keep it.

[econoclast]

18. No. Notional is not "worth"

Broadly speaking, a derivative is any financial instrument that DERIVES its value from some other, underlying financial instrument. The NOTIONAL value is just the nominal value of the underlying thing and has NO relevance to the value or risk of the derivative.

Example. Suppose you and I make a 20 dollar bet about whether or not the NY Yankees win the world series this year. Ok. How much money is at risk? 20 bucks. But, our bet is a derivative. The underlying thing is the NY Yankees. Including the YES tv network the Yanks are valued at about a billion dollars. So the NOTIONAL value of our 20 dollar bet is a cool billion!

Whenever somebody trots out the Notinal value of the Derivative market they are most likely trying to bamboozle you about something.

Which is not to say that there is not a lot of risk in the derivatives market, or that it can't get hellishly complicated. But NOTIONAL value gives no indication of how big that risk or complexity is.

[FarCenter]

20. The other reason that the total notional is so high is that it is cumulative

If a financial institution sells a derivative on an underlying asset with customer A and then buys a derivative on the underlying asset with customer B, the notional values are added together, since both derivative contracts are active.

This is different from trading in stocks and bonds where ownership of the underlying asset is transfered.

[dmallind]

21. Only if you think tomorrow's Powerball drawing is worth 2 Quadrillion

They sell roughly 20 million tickets with a payout of $100mm notional each, after all

Absurd? Yes - and every reason you can think of why it is absurd applies to your number-porn too.

[Taitertots]

25. Your analogy doesn't work because they divide the winnings for Powerball

If anything it shows how insane derivatives are because it would be similar to having a lottery where everyone who won could get 100,000,000 and spending all the money they gave you.

[Javaman]

23. isn't that 1.2 gazillion? nt

[eppur_se_muova]

24. Actually, it might be a Brazillion. nt

[aint_no_life_nowhere]

29. Might as well be Triskellian Quatloons

as far as my ability to understand that figure. In fact, maybe the traders are tossing around trillions as though they were Quatloons.

[Bigmack]

37. Quick... before this thread goes south...

I understand... for the moment... naked CDOs, naked short-selling, and derivatives.

I think it's a house of cards.

But..

What I want to know is how the house of cards can fall. If only 1/10th of the value of the derivatives is "lost"... whatever the hell that means.... Exactly how will it crash the economy of the world...or the US?

Isn't it all paper?

Help a non-business, non-math Major out here... please.

[bemildred]

40. It will fall when it can't grow any more.

Like all Ponzis. What would halt it's growth, I couldn't say, but something will, Ponzis need new money all the time, they have effects in the real world, make demands in the real world, sooner or later there are not enough willing new suckers.

[bemildred]

41. Here, this might do it:

http://www.democraticunderground.com/1002707207

[coalition_unwilling]

47. Here's a good example from real life: AIG sold credit default swaps against

the possiblity that bonds on mortgages would suffer defaults if the real estate bubble popped. Of course, few at the time ever thought that real estate prices would stop ascending (despite the fact that the real estate boom-bust cycle occurs almost as regularly as clockwork).

So AIG was legally required to pay out if the real estate bubble burst. But (and here's the big BUT): AIG was not legally required to maintain adequate reserves against the possibility that the real estate bubble would burst. So when the real estate bubble burst and AIG was required to pay out on all the CDSes it had sold, it did not have the funds to pay out. Instead, the taxpayers had to bail it out. Note that a sizable portion of those bailout funds were direct pass-throughs to Goldman Sachs (which had bought massive amounts of AIG's CDSes), even though Goldman Sachs had little or no insurablitiy interest (meaning GS held no underlying assets that required it to hedge with CDSes).

If AIG could not pay off on its CDSes, then GS would go belly-up because AIG did not pay. If GS went belly up, that might trigger the entire house of cards to come crashing down.

That's as near as I can come to providing a simple explanation of how a crash could occur.

[Zanzoobar]

52. It's stupendously simple

I will bet you that an apple will cost 5 bucks next year.

Will you take the bet?

If you take the bet, that is what the future price of an apple is next year.

It has very little to do with what an apple will be priced at next year.

That is how the market values everything. That is what is reported. The true number is not reported until the day the bet is settled, which is generally far from the future bet originally made. Thus, the people who made the original bets may sell their positions based on daily fluctuations, or again, future projections.

From there it's a formulaic matter to leverage massive bets against future prices based on technical indicators. Often, those technical indicators are directly derived from the ability of a massive financial institution to manipulate the bid and ask using their specialists, or market makers.

[pa28]

53. I think it's a very big deal indeed.

Most derivatives cancel each other out and are adequately collateralized but let's just say that 1% of these instruments are floating around based on fraudulent collateral. Based on the malfeasance we've seen that's probably not a really big stretch is it?

Sounds like a reasonable risk but that adds up to 12 trillion and quite of few of these instruments are being held by too big to fail banks. When another financial crisis comes along the bad will show up overnight and the bills will have to be paid.

The US public has allowed all of our skin to be hung on a hook for these people. Our reaction in terms of new regulation, enforcement and prosecution seems absurd in the face what we've committed ourselves to. You've got to laugh really because this problem needed to be addressed while the iron was hot in 2008 and 2009.

People who made a sincere attempt at exposing taxpayer risk were dismissed as anti-capitalist losers who probably lived under a bridge.