The $700 trillion elephant

[girl gone mad]

The $700 trillion elephant
Commentary: Gargantuan derivatives market weighs on all other issues
By Thomas Kostigen, http://www.marketwatch.com/news/story/700-trillion-elephant-room/story.aspx?guid={024DB809-8506-4AA9-83BB-B053FD4E1C11}&tool=1&dist=bigcharts&">MarketWatch

SANTA MONICA, Calif. (MarketWatch) -- 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.

Try as we might to salvage the residential real estate market, it's at best worth $23 trillion in the U.S. We're struggling to save the stock market, but that's valued at less than $15 trillion. And we hope to keep the entire U.S. economy from collapsing, yet gross domestic product stands at $14.2 trillion.

Compare any of these to the derivatives market and you can easily see that we are just closing the windows as a tsunami crashes to shore. The total value of all the stock markets in the world amounts to less than $50 trillion, according to the World Federation of Exchanges.

To be sure, the derivatives market is international. But much of the trouble we're in began with contracts "derived" from the values associated with U.S. residential real estate market. These contracts were engineered based on the various assumptions tied to those values.

Few know what derivatives are worth. I spoke with one derivatives trader who manages billions of dollars and she said she couldn't even value her portfolio because "no one knows anymore who is on the other side of the trade."

Derivatives pricing, simply put, is determined by what someone else is willing to pay for the contract. The value is based on an artificial scenario that "X" will be worth "Y" if "Z" happens. Strip away the fantasy, however, and the reality of the situation is akin to a game of musical chairs -- without any chairs.

So now the music has finally stopped.

http://www.marketwatch.com/news/story/700-trillion-elephant-room/story.aspx?guid={024DB809-8506-4AA9-83BB-B053FD4E1C11}&tool=1&dist=bigcharts&">More...

[GoesTo11]

1. How about if we bail out the losers of these bets to pay off the winners?

[BzaDem]

2. This is somewhat of an exaggeration.

Let's say Company A bets that the value of some security will go up. If the value goes up, Company B will pay Company A a million dollars. Otherwise, Company A will pay Company B a million.

At the same time, Company A bets that the value of that security will go down. Company C pays Company A a million if that happens, and A pays C if it doesn't.

So in reality, the total risk to Company A is 0 dollars. If the value goes up, A collects a million and loses a million, and if the value goes down, A loses a million and collects a million.

But on paper, the total risk to Company A is 2 million dollars; it has two bets going worth a million each (even though it couldn't possibly lose them both).

That's how you get these ridiculous figures like 700 trillion. That is the total value of all bets. But it is possible that all bets cancel each other out and the total risk to all companies is 0 dollars. We don't know, because we don't know who the bets are with and what they are.

So yes, the lack of regulation of derivatives is something that needs to be fixed right away, and is partly responsible for this mess. But I would take figures like "700 trillion" with a grain of salt.

[napi21]

3. You're right! As I read the OP, all I coult think was chicken little!

YES thing are bad right now, but not nearly as bad as the naysayers are saying.

[inna]

4. very good explanation and thanks for that....

... but still, it's an interesting article that is well worth reading, imo.

rec #6!

[Joanne98]

10. Bets that cancel each other out just show how the market is an insane casino.

I bought fifty lottery tickets last year and I won 50$. I'm even so why did I bother?

I think it's designed that way ON PURPOSE so all the thieves will have plenty of grass to hide in!

[autorank]

5. It's twice as bad as that.

These are "on the books." The off the books derivative contracts are about equal in size.

[A HERETIC I AM]

6. Nonsense.

It's not as if that figure or the one you contemplate represents debt instruments that will have to settle or be made whole.

Do you have car insurance? What is the total amount of coverage the insurance company has agreed on in your contract? If it is a typical car insurance policy with comprehensive and personal injury protection, it could well be into the several hundreds of thousands. What is the likelihood that insurance company will pay out every single dime in coverage on your policy as well as every other policy it has written?

"Remote" doesn't describe it.

As a poster above suggested, that $700 trillion dollar figure needs to be taken with a big grain of salt and even if it is somewhat accurate, the overwhelming majority of the various contracts and instruments that figure represents will either expire worthless or never settle.

[autorank]

7. How did the "insurance" police work with subprimes. Credit swaps are much worse

That means that the proportional impact of credit swaps will be like a nuclear payload compared
to a conventional one.

Take a look at this. The Money Party (6): Meltdown Perpetrators Position Themselves

Gross size of the Over the Counter Derivatives Market & Growth

In Billions:
==========================
6/6/2006--------$370,178
12/1/2006-------$$414,845
6/1/2007--------$$516,407
12/1/2007-------$$595,341
6/1/2008--------$$683,725
Semiannual OTC derivatives statistics at end-June 2008
Bank for International Settlements (BIS)
http://www.bis.org/statistics/derstats.htm

BIS estimates that the the market beyond OTC derivatives is over 1 Quadrillion.

Somewhere in that fantasy world of 'notational values' for derivatives is the subprime
market, the one that cashed our economy. There is risk in these instruments and it's outlined
here http://interfluidity.powerblogs.com/posts/1176870506.shtml

But the real risk is having a market where people bet madly on just about anything WITHOUT
regulation or even real visibility.

But the credit swaps are much bigger (keep in mind the "World Domestic Product", like our GDP
was $65 Trillion in 2007.

Here's what it looks like in graphic form.

Subprime derivatives were the cause of our crisis. Look at the size of that derivatives market compared to credit derivatives.


(Subprimes, left; Credit, center; World economy, right)
Chart & great article: http://sayanythingblog.com/readers/entry/credit_derivatives_the_economic_crisis_which_pisses_on_sub_prime/

So the risk insured in the subprimes, the risk that is crushing us, is tiny compared to the
the credit derivatives.

Leverage Madness

Derivatives, as you may know, are essentially unregulated, high-risk credit bets. Unlike the earnest farmer who might employ a futures contract to hedge the price of the beans he’s worked so hard to grow, many of today’s institutions use futures, forwards, options, swaps, swaptions, caps, collars and floors—any kind of leverage device they can cook up—to bet the hell out of virtually anything.

What drives derivatives, at their very roots (if you can somehow get back that far), are base assets that get leveraged to a demented degree. Martin Mayer writing for the Brookings Institute, said, "the receiver of the payments on these loans or securities has bought the securities for the duration of the swap on 95% margin, even though the law says nobody can buy securities without putting up half the price."

============

There's a private market for derivatives. Maybe that's where the banks dumped all that money
the Fed gave them last year, you know the $3.2 trillion.

FINALLY:

http://interfluidity.powerblogs.com/posts/1176870506.shtml

Question: Do we need to worry that the "notional principal" of derivatives outstanding is several times the wealth of the entire world? Isn't "notional principal" meaningless, since actual cash flows between parties are mere fractions of this principal?

It is true that, when everything goes right, most derivatives compel cash flows that are small fractions of notional principal per year. But some common and ever-more-popular derivatives (e.g. CDSs, forwards and futures) can provoke sharp cash flows whose magnitude approaches the notional liabilities. More importantly, even "balanced" derivatives like vanilla fixed/floating interest rate swaps can subject parties to liability for the full notional principal, should one party default and enter bankruptcy, if the lawyers haven't been careful to write watertight "netting" agreements. Even where the legalese is solid, the credit-risk assumed by the "in-the-money" party to a derivative contract is proportional to notional principal. The hazard associated with a large notional principal is not primarily associated with the cash-flows that would be triggered by parties fulfilling their contractual obligations. Notional principal is a measure of the mayhem that would result should counterparties fail to meet their obligations in significant numbers.

[HamdenRice]

8. A trivial, make believe problem important mainly to those who don't know what derivatives are

There are big problems in the economy. The total value of all derivative contracts isn't one of them.

[girl gone mad]

9. About as deep as your TARP analysis was.