It’s All About the Derivatives (Wait…What?)

With talk of financial regulation and fraud charges for Goldman Sachs in the air, this piece by Graham Summers via Automatic Earth gave me the spooks (scroll down the page).

The intro:

As we celebrate year three of the Great Financial Crisis with the first official bailout of an entire country (Greece), I’m still astounded and the complete and utter lack of coverage the underlying cause of this Crisis has received.

We’ve had tens of thousands, if not hundreds of thousands of articles and research reports have been written about the Crisis, and yet I would wager less than 1% of them actually bother talking about what caused it, let alone how the various efforts to stop it have in fact FAILED to address the key issues.

Remember back in 2007? At that time we were told it was all about Subprime mortgages. Then in 2008, we were told it was the investment banks, specifically Lehman Brothers’ failure and AIG’s credit default swaps. In 2009, we were told it was poor accounting standards and bad bets made by Wall Street. And here we are in 2010, and we’re still being told it was simply bad bets made by Wall Street.

All of these answers are partially right, but none of them are totally 100% accurate. Why? Because they fail to address the one underlying issue that links ALL of these items. I’m talking about the Black Hole of Finance: a bottomless pit that no official or regulator bothers mentioning in public because acknowledging it would mean acknowledging that all of the efforts to stop the Crisis are truly paltry.

What caused the Crisis?

Derivatives.

And:

Let’s do some quick math.

If you add up the value of every stock on the planet, the entire market capitalization would be about $36 trillion. If you do the same process for bonds, you’d get a market capitalization of roughly $72 trillion.

The notional value of the derivative market is roughly $1+ QUADRILLION.

I realize that number sounds like something out of Looney tunes, so I’ll try to put it into perspective.

$1+ Quadrillion is roughly:

  • 40 TIMES THE WORLD’S STOCK MARKET.
  • 10 TIMES the value of EVERY STOCK AND EVERY BOND ON THE PLANET
  • 23 TIMES WORLD GDP.

Or $190,000/per person on the planet according to this source.

And no regulator (that I’ve heard of) is talking about taking this black hole on.  [Maybe we  need magicians or sci-fi theorists to figure out how to fight a black hole].

The Goldman Sachs charge has to do with subprime mortgage credit default swaps.  Which sounds like a major push until you remember:

After all, in 2008 the Credit Default Swap (CDS) market (which incidentally is only 1/10th the size of the interest rate-based derivative market) nearly destroyed the entire financial system. One can only imagine what would happen if the interest rate-based derivative market (which is ten times as large) suffered a similar Crisis.

Update I:  Good news/bad news (from another pov).  Rick Bookstaber in another must read post, doesn’t see derivatives as the biggest threat in the near term, but rather municipal markets.  Though the distinction is not crystal clear (at least it isn’t to me) as bond derivatives make up a slice of the overall derivatives market.

Update II:  Greginak points to Obama’s announcement today that he will veto a financial regulation bill without derivatives regulation.  Which sounds good.  I’d like to hear details about how exactly to go about said regulation.  But given (yet again) total Republican opposition to dealing with the majority party, we’ll see what deals/compromises he might have to make to get any bill through.

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34 thoughts on “It’s All About the Derivatives (Wait…What?)

  1. I mean in the event some significant part of that goes down, doesn’t it seem like yeah, some of the counterparties will get something, but surely orders of magnitude less than what the contracts state? I mean, is there any doubt massive nullifications and rewrites would be the necessary course? Whatever has to happen to get through with some semblance of an economy, maybe even a banking system?

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    • @Michael Drew, that’s a good point. undoubtedly there will have to be write-offs. The question I think is more exposure and the inter-linking and cascades. Also I don’t see any evidence that we would be headed for anything other than another round of gov’t (i.e. tax payer sponsored) bailouts. But where is that going to come from?

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      • @Chris Dierkes, Totally still apocalyptic. But somehow those numbers have to get brought back out of the looneysphere by judicial fiat. Still a lot of people expecting to get paid — up to and including systemic failure, so it’s kind of irrelevant what I’m saying. You’d think the trading would be taking all that into account. Maybe it is. (Yikes!)

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  2. Well, I understand foreclosures, bad gummint policy requiring banks to make absurd loans, etc., but, frankly, I haven’t gotta clue as to what a derivative is or how to get one or lose a quad-trillion of them?

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    • @Bob Cheeks, Super simply (I don’t know the technicalities), it’s like this. I offer that in exchange for a dollar, I’ll write a contract saying I’ll pay you like ten grand if thing X happens (which I take to be something like a one-in-a-million shot). We both think the other’s a sucker. The reality in the world is that times a billion. Doomsday Scenario: I’m the sucker.

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      • @Michael Drew, Thanks Michael, that’s helpful, but damn that sounds a lot like gambling and not financing, or lending or borrowing or building widgets or anything to do with economy? If we want to regulate against that then that should be a simple matter of forbidding it? Oui vey sounds like George Soros time!

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        • @Bob Cheeks, Of course, whe you then turn around and buy insurance (aka derivatives) on the ones you just sold because you actually knew all along they were likely to go down, and have a paper trail to show you knew that, you get charged with fraud. Failing that, though, I’d be interested to hear what the house libertarians, or whatever they’re calling themselves these days, have to say about regulating derivatives.

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            • @Bob Cheeks, Believe so, at least that’s the story I’m telling. But it’s not traded and it’s sort of off-the books. Like a side bet sort of. So my wondering above about why the numbers aren’t traded down out of the likelihood of rewrites is I guess null&void(?). I’m outside my lane pretty good now.

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              • @Michael Drew, there is precedent in contract law to deal with contracts that you could perhaps have fulfilled if entered into individually, but that collectively become impossible. It might apply here, but I admit that I do not know the law well enough to say for sure. I also have much to write and read in the next few weeks, and this isn’t closely related, unfortunately. It would be an interesting issue to consider, preferably with the aid of an actual lawyer, which I am not.

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              • @Michael Drew,

                Here’s one possible question. It’s by no means sufficient, but it’s certainly necessary to ask if we’re going to approach the issue from a libertarian standpoint: Which current regulations helped to get us into the mess? Often, in such complex and already highly regulated policy areas, this is a fruitful question. I’m thinking particularly of health insurance, where one can make a plausible case that nearly all of the trouble stems from bad existing regulations.

                Whether or not this is true of derivatives trading, I admit I have no idea. But the question should be asked.

                One other thing I’d add to the discussion: I do not follow how the total “value” of the derivative market is indicative of the problem. This isn’t a “value” in the conventional sense at all, is it? At any rate, it’s almost entirely unrealized.

                What benefit do we get from bringing it up, other than scaremongering? (ZOMG WTF QUADRILLIONZ!!!) I’m not sure I see it.

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              • @Michael Drew, It’s always a good question to ask. The thing with derivatives as far as I understand is that it’s something like analogous to what happened with subprimes, CDOs, and default swaps. Which is to say, the downside was an unrealized theoretical number until it became clear that the unthinkable was happening (in that case the housing bubble popping). In that case, however, many claim that the relevant regulations were on the books, but the regulators were simply incompetent, though probably some regulations that had been relaxed, such as leverage limits, contributed. In the case of derivatives, my understanding is it’s really pretty Wild-Westish out there. But then I’m not sure what the likely precipitating event is suggested to be. You might be right that short of an event that would have massive consequences all by itself, these bets are just not going to go the unexpected direction in large numbers all at once.

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              • @Jason,

                In regards to why bring it up I don’t think it’s scaremongering so much as (for me anyway) another data point in the ongoing inquiry as to whether financial capitalism is creating real wealth. Begging the question of course what is real wealth, but when we’ve reached a place where we’re betting on bets worth a Quadrillion, what does that even mean? Have these economic transactions reached such a de-materialized position that they aren’t really connected to any physical, tangible, of human benefit–that is until they sink and bring other markets down with them.

                If it were to go systemic, then given the order of its greater magnitude in comparison to CDOs, CDS, etc., it is worth considering the ramifications. I think at least.

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              • @Chris Dierkes , The complexity serves two purposes, and its helpful to be clear about this. Some of it serves to move money from people who have it to people who need it, which to my mind is socially useful. Some of it simply serves to circumvent regulation, and much of it does both.

                For example, mortgage backed securities came to be because few organizations have the resources to lend money for 30 years. Which is fair enough. However, banks came to favour them because they were preferred by the Basle accords which count debt from Fannie and Freddie favourably when computing bank’s capital ratios.

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          • @Michael Drew, I, likewise, am going to have to ask for a pass. For professional reasons, my ability to comment on anything pertaining to the financial crisis is limited to begin with (not that this would provide me with any special insight – it doesn’t), but beyond that, this is one thing where my level of understanding is too low to even have an opinion. I just wind up deferring to Br. Dave.

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    • @greginak, well that’s good, but the question is how exactly to control/regulate them? This isn’t a derivatives only question given that we have massive instantaneous global flows 24/7….how does a national gov’t regulate such a reality?

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  3. A derivative is any contract where the thing being exchanged has its value derived from some other source.

    A huge percentage of the total amount of derivatives being traded is interest rate swaps — fixed for variable. As these contracts, by definition, net out to zero, they do not pose a significant risk to the global financial system.

    Where things went badly wrong is (a) complex and (b) still hotly disputed. The simple version is as follows:

    1. loans were made to people who couldn’t pay them back. These loans were secured by mortgages. So many loans were made that the value of land securing the mortgages started to rise purely as a function of the money flooding into the mortgage market, which in turn brought more people into the market to borrow money, which in turn raised the value of land, etc. (a bubble).

    2. Because so many bad loans were made all at the same time, they all went bad about the same time, starting in early 2007. As the foreclosure wave started to hit, two things happened: no one new came into the market to support the prices, because there wasn’t anyone left to do so, and people started leaving the market. This combination drove prices down sharply, which meant that when the bank foreclosed on its security (the land and the house) then resold it, the bank incurred a substantial loss.

    3. But it wasn’t a bank holding the loan, it was a trust organized by an investment bank that had issued securities backed by pools of these mortgages (1st level derivative) to other financial institutions all around the world. So all of a sudden, given the immense amount of leverage (borrowed money) underpinning these trusts, billions upon billions of dollars of securities were suddenly worth much less. How much less? Very hard to tell. In many cases the holder of the security will need to wait to maturity to find out whether there’s ever a default. But there have also been plenty of defaults where AAA securities are now actually worthless.

    4. One way these trusts lured in investors was to buy insurance, a credit default swap (2nd level derivative). AIG was the big issuer of credit default swap insurance, but not the only one. None of the insurers set aside adequate reserves to cover their losses. So when the trusts started to call on their insurance policies, Uncle Sam had to step in and prop up AIG just to keep the financial system afloat. Another thing that’s weird is that even someone who doesn’t own the underlying security can buy a credit swap on it. (You cannot do this in traditional insurance; you need to have what’s called an insurable interest. It helps keeps incentives aligned. ) There are now more dollars in credit default swaps outstanding than there are on the underlying mortgage-backed securities. This makes the financial system incredibly unstable, as every default on a mortgage security causes a cascade of calls on credit default swaps.

    5. The primary social purpose of an investment bank, like Lehman, is to serve as a clearinghouse for the enormous volumes of money sloshing around every day. They make their money for their shareholders, however, by essentially placing enormous bets on the various trades that come through the market every day. But as a clearinghouse, you’re only as good as your reputation. If your reputation suffers only a little, no one will trade with you. They’ll go to GS, or Chase. Lehman made some bad bets, people got wind of it and in a matter of days were forced to close their doors.

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  4. Francis, dude, your above explanation of the ‘derivative’ problem is worth a bachelor’s in economics. That’s one of the most erudite things I’ve read on this site…congratulations.

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  5. What I would add is:

    1. Regarding credit default swaps, the other major issue was not just the volume but the lack of transparency in that there was no way to monitor the build up of risk in the system. This exacerbated the problem with counterparty risk in light of the bailout of AIG. Take AIG out of the equation and every counterparty to AIG that was long a CDS contract through AIG was in deep trouble. Given offsetting positions, investor exposure went from nearly negligible to profound.

    If you had a $50 million CDS contract with AIG that pays you upon default and you were short a CDS contract with, say, North, that would require you to pay him $50 million upon default and AIG can’t meet its obligation, you are still on the hook for that $50 million to North and if you are a highly leveraged investor, you will be forced to raise cash through the sale of assets in the market. Enough of this and the bottom starts to fall out on prices.

    2. I would also add, similar to his comments on CDS, that another reason why losses have exceeded the volume of mortgages is because of the various types of synthetic CDOs that Wall Street was creating when they did not have the physical assets to structure a CDO. If the value of a synthetic CDO is based on an underlying CDO (or a number of them) and those CDOs go belly up, the effect cascades as well.

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  6. Jason,

    Which current regulations helped to get us into the mess? Often, in such complex and already highly regulated policy areas, this is a fruitful question.

    The Cato Institute has done this:

    http://www.cato.org/pubs/policy_report/v32n1/cpr32n1-1.html

    Libertarians ought to ask themselves if private sector profit-seeking behavior and/or areas where regulation was lacking (i.e. nondepository finance companies responsible for the majority of subprime mortgage originations) may have had a factor as well and balance those insights against the public policy insights and develop an opinion accoringly.

    The Cato report is Exhibit A as to why I am skeptical that libertarians have done this. It is as if every private sector action that could have contributed to the crisis only took place based because it was an unintended consequence of some government policy (no matter how far removed from that actual policy).

    Take away the regulations and people were still going to do whatever they could do to make as much money as they possibly could. Government greased the wheels to some degree and then profit seeking individuals and institutions did the rest.

    Looking at the political spectrum, more people on the Left understand this than the Right.

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  7. This just seems to be more of the “here’s a very large number, are you scared yet?” school of financial reporting. What this and almost every other piece misses is how derivatives/subprime/securitization/whatever managed to result in a systemic meltdown. All of these things are too small in and of themselves if disrupt the whole system.

    The only person who seems to have explains this is Gary Gorton, and his version shows that there are some subtleties that require ALL of these things to have played a role. In particular:

    1. Subprime is important because unlike a normal mortgage, if you invest in a subprime loan you are taking a long position on the housing market. There’s not just credit risk, but also asset value risk involved. This is not the case with regular prime mortgages (much).

    2. Securitization matters because its the key enabler of the “shadow banking system”. The shadow banking system consistents of repurchase agreements, where, for example, a pension fund lends money to an investment bank at a low rate overnight, and the loan is collateralized with a collection of bonds valued at the value of the loan. Investment banks rely on overnight repo for most of their funding, but lend on longer terms – that’s how banks make money.

    3. Derivatives are important because they allow restructuring of risk and payments. There simply isn’t enough truly safe debt around to enable all the repo agreements people want to make, so unsafe debts and even non-debt instruments get restructured or insured to make them look like safe debt.

    One of the many things that were restructured to make them look like safe debt were sub-prime mortgages, which involve a long position on the housing market. When the housing market starts to fall and that fact starts to come home to investors – they took a while to realize – the value of the products derived from them starts to fall.

    So as the values of those products falls, repo lenders start to look at their balance sheets and realize that the collateral is no longer worth as much as it was, and start forcing the borrowers – Lehman, Goldman, etc – to write the debt down and provide more collateral. Of course they don’t have the money to do this, so they have to start to sell other assets, most really solid genuinely AAA rated assets, and of course as they do so the values of those assets also fall, and lenders force them to take further haircuts.

    It was, in fact, a classic bank run, but one that relied on several layers on complexification that serve to disguise what happens. Its an error in my view to blame the complexities, rather than simply recognising the underlying structure that’s repeated again and again in every crisis. Its just as much of a mistake to say “this time its different” during the crash as it is during the boom.

    The basic problem is that lenders/depositors want safe, short-term assets. Banks don’t have enough safe assets to invest in, so they invest in unsafe assets and absorb the risk, and take the risk premium as profit. This is as true in the shadow banking system as it is in the conventional one. But the system is inherently unstable – on a sniff of a problem depositors can withdraw their money, which then creates more doubt causing more depositors to withdraw their money, and so on …

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