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Reply #84: His Discussion of Derivatives is Enlightening and Chilling at the Same time [View All]

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Demeter Donating Member (1000+ posts) Send PM | Profile | Ignore Thu Dec-01-11 12:26 PM
Response to Reply #78
84. His Discussion of Derivatives is Enlightening and Chilling at the Same time
ZeroHedge piece on derivatives :

$707,568,901,000,000: How (And Why) Banks Increased Total Outstanding Derivatives By A Record $107 Trillion In 6 Months

... the Bank of International Settlements reported a number that quietly slipped through the cracks of the broader media.

Which is paradoxical because it is the biggest ever reported in the financial world: the number in question is $707,568,901,000,000 and represents the latest total amount of all notional Over The Counter (read unregulated) outstanding derivatives reported by the world's financial institutions to the BIS for its semi-annual OTC derivatives report titled "OTC derivatives market activity in the first half of 2011."

Indicatively, global GDP is about $63 trillion if one can trust any numbers released by modern governments. Said otherwise, for the six month period ended June 30, 2011, the total number of outstanding derivatives surged past the previous all time high of $673 trillion from June 2008, and is now firmly in 7-handle territory: the synthetic credit bubble has now been blown to a new all time high.

Another way of looking at the data is that one of the key contributors to global growth and prosperity in the past 10 years was an increase in total derivatives from just under $100 trillion to $708 trillion in exactly one decade. And soon we have to pay the mean reversion price.

What is probably just as disturbing is that in the first 6 months of 2011, the total outstanding notional of all derivatives rose from $601 trillion at December 31, 2010 to $708 trillion at June 30, 2011. A $107 trillion increase in notional in half a year. Needless to say this is the biggest increase in history. So why did the notional increase by such an incomprehensible amount?

Simple: based on some widely accepted (and very much wrong) definitions of gross market value (not to be confused with gross notional), the value of outstanding derivatives actually declined in the first half of the year from $21.3 trillion to $19.5 trillion (a number still 33% greater than US GDP).

Which means that in order to satisfy what likely threatened to become a self-feeding margin call as the (previously) $600 trillion derivatives market collapsed on itself, banks had to sell more, more, more derivatives in order to collect recurring and/or upfront premia and to pad their books with GAAP-endorsed delusions of future derivative based cash flows...

There is much more than can be said on this topic, and has to be said, because an increase of that magnitude is simply impossible to perceive without alarm bells going off everywhere, especially when one considers the pervasive deleveraging occurring at every sector but the government. All else equal, this move may well explain the massive surge in bank profitability in the first half of the year.

It also means that with banks suffering massive losses, and rumors of bank runs and collateral calls, not to mention the aftermath of the MF Global insolvency, the world financial syndicate will have no choice but to increase gross notional even more, even as the market value continues to get ever lower, thus sparking the risk of the mother of all margin calls: a veritable credit fission reaction.

Ilargi: I may be wrong, but I still think I detect a notion of surprise and/or anguish in Tyler Durden's assessment. And as far as I can see, there is no need for any of that...Let's just stick with CDS for now. They're the proverbial only game left in town. CDS (and some other derivatives) were invented for one main reason: for financial institutions to hide their debt and losses (or risk). Whatever worthless paper they have in their books, they can take -virtually- out all the risk it poses by buying "insurance", for a fraction of the "value" of that paper. Works miracles for reserve requirements. That's why CDS exist. They free up "assets" to "invest" (take to the casino, everything on red). And why should the banks care about counterparty risk? That's for someone else to worry about (like the Fed and/or other regulatory bodies).

But yes, this game is running thin like so many others. Still, what can they do? Take all the crap on to their balance sheet? They don't have a choice. They need to keep on buying swaps, even if they highly doubt the solvability of the party they buy it from. That's not their responsibility: if the regulators allow that party to write the swaps, they're off the legal hook.

An underlying very interesting question is what part of existing swaps has been "solved". It can't be all that much. After all, the paper the swaps "insured" against will largely still be in the vaults; nobody wants it. Well, unless they sell it for a big loss. But that triggers all sorts of unintended consequences: increased reserve requirements, for one. Price discovery, for another. Better to hang on to the initial swap then. That is, until it expires. And then you buy a new one, even if it costs far more. It's all OTC, so your buddy next door will give you a good deal. What, me, worry? Most important: Look at what happened with AIG, and look at the numbers involved: nobody has that kind of money. Nobody. None of this stuff was ever issued with the idea in mind of an actual (forced) "credit event" pay-out. It was all just an accounting trick from the get-go. But in this case one that can blow the entire global financial system out of the water in one fell swoop. And in one fell day.

Meanwhile, as the mayhem increases, it hard to see how the OTC derivatives markets could be prevented from increasing with it. Simple, only game left in town.
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