Posted on 03/26/2013 9:50:57 PM PDT by Lorianne
We wrote earlier about the recent move by bankers — and the politicians who serve them — to unreform the derivatives market, to return it to its pre–Dodd-Frank, pre–Crash-of-2007 state. This is a serious move by banks and bank lobbyists, and it could well happen soon. The seven bills in the House package of “tweaks” — as the House Agriculture website dishonestly puts it — have cleared the committee with Democratic support and are headed to the House floor. In the meantime, there are companion bills in the Senate.
What will happen in the Senate? Well, Dick Durbin (always an Obama surrogate) famously said of the Senate that “the banks own the place.” And of course the White House has been notoriously bank-friendly since day 1. As a friend told me last week, “Bank lobbyists are good; they really earn their money.” Indeed.
Our earlier story focused on both aspects of this push — the “bad Dems” side and the derivatives side. Let’s now look at just the derivatives aspect.
What is a “derivative”?
While a general definition of a derivative in this context could be — “A financial product derived from another financial product” (for example, a futures contract tied to a stock index) — in practice, the term applies to a whole world of financial products that are written on a one-off basis between two entities called “counterparties,” as opposed to products that are traded on a broad, well-regulated market.
Standard futures contracts are bought and sold on large exchanges, for example, the Chicago Board of Trade (CBOT). If I buy a futures contract — for example, I go long (contract or agree to buy in the future) a million bushels of wheat, or barrels of oil, in the expectation that the future price will rise within the time limit of the contract — there will be a counterparty on the short, or selling side, but I have no idea who that is. In fact, in a well-regulated market, the contracts are all standardized; there are thousands of identical contracts in pairs (one on the long or buy side, and one on the short or sell side); and as long as there are the same number of identical contracts on each side, it makes no difference who’s on the other side of my personal contract. The exchange just matches up longs with shorts when they liquidate.
The contracts, as you can see, are created by the exchanges themselves (for example, by the CBOT); they keep the operation orderly; and there are rules, both by the exchanges and by the government, that prevent things (mostly) from running out of control. For example, I can indeed buy futures contracts on millions and millions of barrels of oil for delivery next July (say), and I can put up a tenth of the cost of these contracts, but if the market moves against me, I have to increase my margin (add to my escrow if you will) to protect my counterparties from my inability to pay. The exchange requires that, and if I don’t comply, I’m liquidated (at my expense) and kicked out.
Futures contracts are gambling — I can bet on the Dow to go down or up, for example — but trading in futures contracts is regulated gambling, in which winners are protected from losers, and in many cases, losers protected from themselves.
Not so, derivatives, in the usual meaning of the word. Derivatives in that sense are contracts between parties who want to trade risks, but they aren’t market-traded. They aren’t standardized. And counterparties aren’t vetted by any controlling institution.
In derivatives trading, the counterparties know each other, the contracts are one-off between the parties directly, and the only guarantee that either party will get paid is trust … or the naked belief that they just can’t lose on this one.
AIG wrote billions of dollars of CDS “insurance” against the mortgage market without having even a fraction of what it would take to pay off claims … in the naked belief that they could collect fees forever and never have to pay out once. When the whole thing collapsed, they were wiped out. And because their “insurance” was part of the balance sheet of AIG’s many counterparties (Goldman Sachs and everyone like them), Goldman Sachs would have been wiped out too by AIG’s failure (in effect, by their lies and deception).
That’s why the government bailed out AIG — and insisted on giving them 100 cents on the dollar — so that they could pay off Goldman et al. AIG was bailed out to bail out all their counterparties. (Our discussion of CDSs and their role as bets is here.)
How large is the derivatives market? $1.2 quadrillion in notional value; at least $12 trillion in cash at risk
You read that headine right. By at least one estimate, in 2010 there was a total of $12 trillion in cash tied up (at risk) in derivatives as defined above, all of which controlled contracts connected to assets valued at $1.2 quadrillion.
Here’s how we got those numbers — be sure to differentiate the two values, cash value vs. notional value, as explained below (h/t commenter BeccaM for the link; my emphasis):
Big Risk: $1.2 Quadrillion Derivatives Market Dwarfs World GDP
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.To understand the concept of “notional value,” it’s useful to have an example. Let’s say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.
You might be able to hedge this risk of a spike in interest rates by swapping that variable rate of interest for a fixed one. To do that you’d need to find a counterparty who has an asset with a fixed rate of return who believed that interest rates were going to fall and was willing to swap his fixed rate for your variable one.
The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the “notional” amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion — far smaller, but still 20% of the world economy.
To trust that lower number ($12 trillion), a lot depends on what’s being traded. In the example above — an “interest rate swap” — what’s being traded (swapped) is the risk of small interest rate changes on the $1 million you borrowed. It’s never the whole $1 million (the notional value).
But with a CDS — a “credit default swap” as discussed here — what’s traded is a fee paid by one side vs. the whole cost of the default paid by the other side. If I as an “insurer” sold a hedge fund a CDS on $20 million in GM bonds, and those bonds default, I’m on the hook for the whole $20 million, the “notional” value.
As a result, I accept the $1.2 quadrillion notional value number. But I think the $12 trillion cash-at-risk number is way low. And “just” $12 trillion is, as they point out, still 20% of world GDP. Stunning.
And don’t forget, these are 2010 numbers. Banks have grown even fatter since then, even greedier, even riskier. And their push to gut the modest regulations put in place by Dodd-Frank declares their intentions to grow. Whatever the size of this market today, expect it to grow like a weed.
Again, House bill HR 992, one of the seven mentioned at the beginning of this piece, is the one that makes you, the taxpayer, even more on the hook for banker-losses than you were after the Dodd-Frank reform. For the banks, the high-priced lobbyists, and their paid, moderately-priced politicians, this is a Win-Win.
But for you, it’s a second trip to Bailout Village. As for the nation … well, I think there’s rebellion in the air if this happens twice. In this case, the hubris of our enemies is not our friend. Not our friend at all.
....
That’s all too complicated for me. I’m going to see if American Idol is on.
ping
Buy so bubble gum. Blow some bubbles. Have them pop all over your face. That pretty much sums up what is happening. ;-)
Buy so bubble gum. Blow some bubbles. Have them pop all over your face. That pretty much sums up what is happening. ;-)
Not a good image.
Whats another few zeros? /s
The only trouble is I’m a REALLY good bubble-gum chewer. And it is FUN to chew gum and blow bubbles. And they NEVER pop!
Add in all of the computerized trading and it gets really scary. Freeper LH shared the following link awhile ago on Stock Trading Algorithms. 15 minutes, but VERY interesting:
http://www.youtube.com/watch?v=TDaFwnOiKVE
Seems to me that this is a problem only to the extent that governments feel they need to bail them out... With numbers like this, they can’t. So who looses
Notional value - what somebody says something is worth. Documentation is not necessary.
My $25,000 Focus has a notional value of $1,000,000. However, because I’m such a nice guy, I will be willing willing to,sell it for half its notional value.
In other words, notional value is the same in saying the value is made up.
it’s all fake. it’s fake money based on non-existing products.
WOULD YOU PLEASE NOT USE THE WORD “QUADRILLION”. WHAT IF OBAMA FINDS OUT THAT THERE’S SOMETHING BIGGER THAN A TRILLION?
What is important to realize about all this is that the whole world, all the major economic powers and blocs are primed to blow up: China, Japan, the US, and Europe. It is not like some of these are acting as stabilizers for the others. They are all pursuing unsustainable courses and becoming increasingly unstable. The result is likely to be a cascading failure and mega-meltdown. There should be nothing surprising about this. None of the underlying problems have been fixed. They are all still there. They are getting worse and more problems are being added to them with each new crisis. Something will have to give. It is not a question of if but when, like a weak and poorly built dam holding back a 500 year flood, or like being in a munitions factory, gunpowder spilled all over the floor, and matches being flicked about. It will explode. The financial sector controls the economy and government. But it does not control the math, and in the end the math will win out.
Well said.
Methinks the house of cards is teetering....
Quadrillion?? That’s just enough for golf and dinner \Obama
I know this is simplistic but please follow my logic.
1. The raw materials are there.
2. The Workers are available.
3. The Factories are there.
4. Products can be made.
5. The transportation infrastructure is there.
6. The Stores are there.
7. The Customers are there.
So what completes it?
The medium that allows value to be transferred readily among all those factor and more. We call that money and it’s really useful because who want to carry around a Cow to trade for a tree to trade for a carpenter to make a house for example.
What is about to mess up not only our economy but the world economy is that a some people have decided to trade around money itself in ways that don’t actually have a real thing backing up it’s value.
What does that mean to me and most other people? These people aka Bankers are threatening that if they can’t have their illusionary profits then no one can have their real profits, (Backed by real things, Product or labor), then they’ll just take their ball and go home and oh yes, tear up the field, the bleachers and anything that catches their eyes. By the way, what group of people does that sound like by the way? Hint: We have been calling them various names, Takers, Feral Youts, etc.
And so it comes to the bottom line for the Economy. All economies rely upon one thing above all others. TRUST. And when the trust goes so does that economy. And frankly my FRiends the Trust has almost dried up for everyone in this economy. To many people have taken advantage of that trust, Bankers, Politicians and the Takers lead the list.
As my dad once told me when I was young and a friend refused to pay me back the money he had borrowed for ‘just until payday’, that I was to take it as a lesson. I could still be friends with that individual but I learned that I could not TRUST him with any money from then on.
And so it applies now to the Bankers and the others. So what does a person like me do? We withdraw as much as we can and try to minimize our exposure to effects of these people. And we watch, knowing that the whole house of cards is going to fall.
Trust... So hard to create, it’s a daily thing to create trust. Trust... So easy to destroy, all it takes is one thing to do so, and it can be just about anything too.
but honestly what happened in Cyprus where they took money wont happen anywhere else...honestly...
if this keeps up i might actually stop having faith in the banking system /end sarc
derivatives primer
Disclaimer: Opinions posted on Free Republic are those of the individual posters and do not necessarily represent the opinion of Free Republic or its management. All materials posted herein are protected by copyright law and the exemption for fair use of copyrighted works.