OK, I figured out commoditized loans, and how that stupidity will be blowing a hole in the world financial system. I understand the roles of Fannie and Freddie, and how their enablement of the worldwide housing ponzi scheme came about. I also understand why the Arizona Cardinals will always be the worst football team in the land.
But for the life of me I can't make sense out of this derivatives explosion. Someone make sense of it to me por favor. Buffet tried awhile ago here, but I'm still unclear:
Buffet labels derivatives "time bombs, both for the parties that deal in them and the economic system" and "financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal".
From Mogambo's "Something Bad is Coming Soon" rant the other day:
"Derivatives Deluge Multiples Real Risks and Potential Profits" by Deepcaster.com reports that "262 trillion is the notional amount of OTC Interest Rate Derivatives which existed as of June, 2006. This figure was 24% higher than six months previously.
I gulp in dread. $262 trillion is about six times the entire yearly global output of all goods and services produced by everybody and every business on the entire freaking planet!
And in just six months these derivatives grew by more than the total of everything else on earth? And grew to that preposterous size by gaining another 24% in six months? Yow! I quickly check to make sure I am wearing my tin-foil hat and some artillery, because, brother, this is serious business here!
I think I might not be the only one in the room who doesn't understand what's happening out there with derivatives. The government, the media and 99.999999% of the world population is probably a bit foggy here too.
But I've got a hunch we'll all be hearing a lot more about 'em real soon...
December 08, 2006
I'm not smart enough to figure out what the heck is going on with this derivatives craziness. Someone explain it to me.
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Many derivatives are 'liquified' versions of corporate bonds. Bonds in the primary market (excepting Treasuries) are fairly illiquid.
So they make up these things such that one of these derivatives plus a treasury "equals" the supposed flows from a corporate bond.
Credit default swap. It lets you view a corporate bond as a Treasury (interest rates) plus some kind of credit event cash stream, and own them separately.
The central risk is the lack of a known-to-be-secure means of guaranteeing contract execution. On equity options (a derivative) on options exchanges, it is the Options Clearing Corporation which has this responsibility, and they Won't Be Allowed To Fail.
With these other 'o-t-c' (meaning unregulated) derivatives, who knows?
I think the gaudy number being pushed around is something inflated ridiculously. If you were to look at the cash FX market (closest to a pure financial instrument as any) the headline numbers look stupendous, but in the end people profit and loss is from things in the 3rd 4th and 5th decimal point. e.g. GBP/USD 1.9632 to 1.9714 is a big move in FX trading.
A basic derivative is used by farmers all the time...futures contracts on wheat, corn, soybeans, hogs, or whatever else they are raising. And it is very useful....setting a price for the sale of their goods at a certain price in the future. It removes the uncertainty of what the farmer will collect per quantity of whatever they are raising.
I'm not going to claim to understand derivatives, because I don't.
I grew up in Texas in the 1980's. I do remember the late 1980's when several Texas universities and the Texas Teachers Retirement Fund lost millions overnight because they had invested their endowments and pension funds in derivatives. I remember 60 Minutes doing a piece on derivatives and how these money managers lost millions for these universities. They said the really bad part of derivatives is that you are investing in nothing more than a mathamatical formula. This formula can cost you your entire investment if one of the derivative factors moves in the wrong direction.
One of the problems with financial markets reporting is that reporters don't understand financial markets. Derivitaves are inflated dramatically by lots of double counting.
Let's assume for a moment that there is security X (bond, stock, bushel of corn, whatever) valued at 100. In many cases that security will have one or more option contracts associated with it. Let's say that one guys feels that the price is too high and he buys a put (right to sell at a given price) against it. That derivative could be reported as worth the value of the underlyer - 100 -- even if it is only worth the value of the put itself, usually a tiny fraction. It could even be valued as the price of the underlyer PLUS the value of the option itself).
Another investor thinks the same security is cheap and buys a call (again valued as 100+ when the real cost and risk is tiny).
So far our underlying security has amassed related options reported as 200+% of the underlyer -- and many more such options could be written against the same thing, again and again and again. (it practically endless)
But financial markets are relatively efficient on these things. If more options are purchased implying an upside to the security then the price of the underlyer will rise... but that will lead to more options expressing a downside view putting pressure the other way... All along the options tend to provide some balance. The only thing at risk here are the small costs associated with the options themselves.
But it is not all peaches and cream. You can enter into option contracts with unlimited downside, but most investors do not do this, or they hedge such bets to limit that exposure (that's where we get the name hedge fund). And there is also the fact that there has been increasing leverage in the system meaning that lots of the bets are undertaken with borrowed money. Like with Long Term Capital, when your bets all go south and you've done it on someone else's dime, insolvency awaits.
So there are risks, but the headline numbers and the scope and nature of the real risks are terribly overstated in media.
I'll explain it to you Keith. Most recent mortgages originated in the U.S. are crap. Now, you take those crap mortgages and bundle them up and sell them to some fool down on Wall Street. He says hey, this bundle of crap is too risky so I am going to unbundle it and play a global game of pass the trash. Then I will rebundle, resecuritize, and finally resell this crap to my insurance agent. My insurance agent wants to hedge his investment so he goes and makes a currency play down at xyz hedge fund with leverage. Now, the whole world is in a housing bubble. The crap got passed. The worldwide financial implosion will be heard from outer space. The U.S. is the catalyst. Doomsday. The end.
Here's the key issue nobody has mentioned:
You know all those junk loans made to subprime borrowers? We think the instutitions who bought that debt were fools, right? Nope. They were smart. They bought 'insurance' (derivatives) such that if interest rates go up and the borrowers default, the insurance will protect them from massive defaults.
The only problem is that the companies writing derivatives against interest rate moves have no assets themselves. They are spreading the risk with other derivative purchases. Get the picture?
By analogy, it's like you buying $10M of insurance to drive your ferrari through downtown LA at 100 mph with the insurance companies not having the assets to pay off. If you don't hit anyone, the system remains intact, but if you wipe out a few dozen people, there's no money for hospital bills. (perhaps someone can find a better analogy)
Bottom line, the whole system is rigged to run perfectly, but if one big default happens, everyone down the chain needs to get paid, and there's no wealth there to back it up, just some digits in a computer.
Read how long it took Buffett to back out of his derivative contracts for just one company.
To add to the above comment:
Derivatives also give 'investors' the belief that they are protected against anything going wrong, hence they take on much more risk on dubious ventures.
***VICTORY LAP***
Remember "It's all about the derivative markets stupids!!!"
Well, look who got the wakeup call...
To quote Ray Patterson, Springfield's sanitation commissioner voted out when Homer Simpson "Made allot of crazy promises!", "You're all screwed!"
Derivitives were dreamed up to bring the world into a one world finanical system meltdown that will bring control to the few that sold the idea to the markets. Follow the trail to the one who dreamed it up and there is where you can begin to find your answers.
The funny thing is that the underlying asset that these tools are hedging is poop. When the housing bubble blows it will spatter the whole world. Then the gubbermint can print more money. Problem solved.
Keith,
I have your answer.
And in terms that everyone can understand.
But first, please allow me to clarify the number of outstanding derivatives positions:
The actual number is $370 trillion, not the $262 that Mogambo states.
The actual stats on worldwide derivatives can be found at:
www.bis.org.
The stats for U.S. based derivatives can be found at:
www.occ.gov (search "derivatives" for the latest report).
Now, for what "derivatives" are in this modern day,
Simply, put they are bets.
Bets between two parties on the future value of something.
That something might be an interest rate, a stock price, a commodity price, or whether someone will pay back a debt.
Some of these bets are traded on exchanges, but the vast, vast majority are not.
And like all bets, somebody wins and somebody loses.
The winner is supposed to collect from the loser.
Now, the REAL reason you are seeing the explosive, exponential growth in derivatives (especially in the "OTC" or off-exchange) bets is that the "winners" are allowing the "losers" to continue to "double down" on the bet.
And why would the winners allow this?
Because the losers can't pay.
And if the winners admit this, then the whole rickety edifice collapses.
Furthermore, the risk of derivatives is insanely concentrated in the U.S. in just THREE banks:
JPM
Bank of America
Citi
In fact, JPM is exposed at the rate of SEVEN-HUNDRED THIRTY PERCENT of what is called "risk-based" capital, in other words if just fifteen percent of JPMs bets go wrong, then their entire stockholder's equity is wiped out.
Finally, the other intent of derivatives is to hide losses, shift risk on to dumber parties, conceal profits, create phony revenue, and move money around to other entities for various tax and regulatory reasons.
So, there you have it. A simple, easy-to-understand explanation of derivatives.
Hope this helps.
A good article on derivatives
Correction: Mogambo was right, I did not carefully read that he was stating that INTEREST RATE derivatives were $262 trillion. However, I am also right about the TOTAL amount of derivatives postitions outstanding being $370 trillion worldwide.
And one more point:
While those who "poo-poo" the notional amounts as being an overstatement of the risk in interest rate derivatives are correct (the actual exposure to the parties is about 5% overall, which is still HUGE when you are figuring 5% of $262 trillion), I can state with absolute certainty that the credit default swaps, currently at $6.5 trillion DO represent the actual amount at risk. If a credit event happens, the writer of the CDS "insurance" has to make the entire notional payment to the other party.
I trust Math ( I'll ignore the small problem of Godel's theorem) - I even trust statistics. I'm not privy to how the derivatives are constructed and therein lies the problem. Apart from the old style options and futures, the modern derivatives are not exchange traded so their value is completely opaque, nor are the marked to market every day, nor is margin requirement enforced on a daily basis, nor is TOTAL net market exposure for parties known, monitored.
If only they were transparent. Hell, if we could identify the assumptions ( for example if they are being as primitive as to assuming Gaussian -normal distributions in calculating volatility without incorporating modern fat tailed observed distributions ) and I suspect that's what happening since I have yet to see people using anything else than Black Scholes in public to value options then THERE IS hell to pay.
But we can't see what they use. So we have to rely on human nature. and I can just imagine what route those greedy theiving, "make a deal" people on BOTH sides of the transaction did.
-K
simple, buy GOLD
US Statesman and economist Lyndon H. LaRouche Jr. warned of the dangers of "derivatives" back in 1993. He proposed a "transaction tax" of 1/10th of 1 percent to dry up these parasitical financial claims.
Now there is an estimated $500 trillion (notional value)in derivatives, sitting in off balance sheet accounts of the world banking system.
Lyndon LaRouche wrote a major policy piece in 1994 titled "The coming distintegration of the financial system". Where he said this current IMF Floating exchange rate system was doomed. He called for an orderly bankruptcy reorganization writting off all derivative obligations and a return to the FDR Bretton Woods Monetary system of fixed exchange rates.
Instead of following LaRouche's advise the US went with the likes of Greenspan and his "derivative" protection rackett. Sending the world towards WWIII.
Hopefully, after the financial crash, ALL this financial mumbo-jumbo, such as derivatives, stocks, hell - the entire stock market - will be banned. Everyone will have to work and produce something materially to earn a living instead of making money by trading money.
"Hopefully, after the financial crash, ALL this financial mumbo-jumbo, such as derivatives, stocks, hell - the entire stock market - will be banned. Everyone will have to work and produce something materially to earn a living instead of making money by trading money."
Gosh, but then all of the off-balance sheet stuff would greatly reduce bonuses and we can't have that... and you'd have to clean your own house- people would just die... what crap could the pols pump then?!?
Keith,
Here's a very comprehensive article written by Mike Ruppert on the subject:
Global Economic Collapse Likely
Derivatives Bubble About to Burst -- Manipulated Gold Prices About to Explode
Can Wall Street Survive?
http://www.fromthewilderness.com/free/ww3/11_09_01_Derivatives.html
And from Wikipedia:
http://en.wikipedia.org/wiki/Derivative_(finance)
Theory of derivatives:
If you mix a teaspoon of sh_t in 1000 gallons of clean water, no one will notice.
The problem:
When you do the same thing to that 1000 gallons of clean water millions of times, the effect is less desireable. Bankers have learned to hold their noses...
Here is what is happening with increasing frequency since '87 but becoming the norm since 9/11.
In conjunction with commercials, investment banks, and brokers, the NY Fed is intervening by buying forward S&P futures and options on futures by temporary additions of reserves and via special drawing rights from the US Treasury. The NY Fed can turn the futures on a dime, literally, with as little as $12B-$15B of working capital at present at optimal technical junctures in the market. We are at or approaching one of those points as I type.
The primary instrument is the use of US Treasuries collateralized via an increasingly complex derivatives structure at what is theoretically infinite terms or durations, thus the dramatic increase in the "notational" value of derivatives in recent years.
Since The Crash and 9/11, the largest commercials and now hedge funds, a growing number of which are sponsored by commercials, have established intermediary firms or front companies offshore, largely in the Caribbean, to provide the means by which to execute the ongoing intervention to prop up the equity (and to a lesser extent the corporate bond and Treasury markets). The offshore firms and their transactions are totally unregulated and thus virutally invisible, which is why hedge funds are fighting vigorously not to be required to provide more disclosure.
Moreover, an additional factor has emerged since The Crash and 9/11: Proprietary Trading Firms or PTFs. These entities play a role today similar to the bucket shops of old, being used by large institutions in many cases, as well as by hedge funds to front run trades, pick off smaller traders (and push their positions to and past stops to take them out of their trades at will), and to take or unload large-block positions to avoid transparency of the transactions.
None of this is illegal, technically, mind you, but it is occurring virtually without any visibility from the financial media. What it does clearly indicate is that the game has utterly changed since The Crash and 9/11. At least to a significant degree at present, the NY Fed, large institutions, and market makers have the ability in working together to turn the market and ramp it higher anytime they choose, squeezing shorts and allowing Wall-Streeters to prevent even a 10% correction to the major indices.
How long this can continue is anyone's guess, but these guys have far too much to lose in billions of dollars in fee income to allow the market to crater.
Will this ultimately be perceived as a scandal? I doubt it, as the people who have the most to gain or whose fat is being saved from the fire are the top 1-10% who own most of the equities and financial wealth of the US (85%). Why would they not use every means at their disposal to prop up the markets and preserve their wealth and status?
"I do remember the late 1980's when several Texas universities and the Texas Teachers Retirement Fund lost millions overnight because they had invested their endowments and pension funds in derivatives"
OK, now multiply this by a magnitude of a million and we begin to get an idea of what will happen in a derivatives meltdown. Pretty much the entire economy goes "poof" overnight and everybody will wonder what the hell happened to all of the money.
Some posters have questioned the validity of the headline number but it really doesn't matter once you get into tens and hundreds of trillions. It should be a giant wake-up call to everyone when these things are growing 20%+ every six months!!! Who cares if it's $85TR or $200TR or $370TR. That's like saying, "it's only a small nuclear war."
LTCM was just a TINY example of what is coming, and they needed a full-fledged FED bailout to contain that mess. And these were Nobel economists using their bulletproof models. I honestly don't see how the economy will survive a derivatives meltdown. There just isn't 1/1000th enough money to pay off all of the claims. IMHO, the housing bust will be the pin that pops the derivatives bubble.
Derivatives are just bets. If you have a million in life insurance, that's a "derivative" of sorts.
The totals aren't netted against each other. So if a market making co. has two bets which offset each other exactly, the figure they report is the total. So if they bet on the Patriots for 1 million and the Bears for 1 million (in a pats-bears game) they have no exposure...but they report 2M.
So the figures are wildly overstated.
Buffett is talking about the odd bets on esoteric things...companies can make a bet and report it as "profit" to its theoretical value. The other company can do the same thing (different theoretical value). Eventually the bet comes due...then what?
And what if a company loses big and can't pay? Domino effect.
Most of the bets are plain vanilla "interest rate swaps" etc. Most banks limit exposure to each end user client.
The fear is overstated for the most part.
Yes, they definitely do use things other than Black-Scholes on Gaussian processes for valuing these exotic derivatives, and they are aware of fat tails.
Various tail distributions get used, stable pareto, extreme value, q-gaussian.
Still the essential statistical problem is that it's hard to estimate probabilities where few data have been seen, so results depend very much on assumptions.
A quant nerd changes the basis functions for fitting a bit and expected tail losses (a decent modern measure of risk) can vary widely. Management says "ooh, number X will get us in big trouble, but number X', that's more like it, we'll be fine." Nerd: "So you're saying we're going for the q-gaussian and not pareto?" Managing director: "Well I'll put it this way: the wife 'needs' a 6 bedroom house when we go to the Hamptons not our 4 bedroom 'shack', and the mistress isn't going down until I drop some more bling, and well, you too 'need' your job to pay for your rental hovel....so figger it out Einstein"
No, i'm not a quant, I'm a physicist but I have read a couple of books and have some experience in statistical modeling.
"And these were Nobel economists using their bulletproof models. "
LOL. They were economists alright: in love with their classical theories.
They didn't hire enough physicists who knew about fat tails and such and had professional skepticism about data and models.
By the way, after LTCM collapsed they rebooted, improved their models, and have been making great profits.
THOSE NOBEL PRIZE WINNING FORECASTERS AT LONG TERM CAPITAL (REMEMBER THEM?} AND AT OTHER DERIVATIVE FIRMS HAVE FORGOTTEN THAT:
1+1= 2
0+0= 0
Thing are looking great...ya right!
http://tinyurl.com/yz686h
"The totals aren't netted against each other. So if a market making co. has two bets which offset each other exactly, the figure they report is the total. [...] So the figures are wildly overstated."
Technically, you are correct. But a precipitous event might require settlement of a significant fraction of those $200 trillion in derivatives contracts. Where would the liquidity come from? That's right, you would see cascading cross-defaults, and in an age of electronic money, the results would be widespread and bad.
The first warning most people would have is an ATM machine or gas pump rejecting their debit/credit card transaction. We haven't had a bank holiday in this country for quite some time - perhaps this new generation needs to see firsthand what it's all about.
very simple.
derivatives are a Ponzi scheme married to a game of musical chairs in reverse.
The last Wall Streeter holding the bag (or chair) pulls a Ken Lay, Bush pardons the sucker posthumously, and a million million-dollar FBs swim with the fishes.
Dave is the new Mogambo.
Keep it up Dave.
"Anything that would divert the country's brainpower from financial gimickery to, say, alternative energy research would be a good thing in my book."
The answer to that is very simple.
Pay the smartest people in the graduating class $200K a year, which plausibly goes up to $500k (as derivative trading can do, if not much more), and they'll be working like dogs on alternate energy.
The reality is that those guys spend aeons slugging it out in grad school, then work hard for a postdoc, and then find that getting a "real" job is incredibly hard for which they can slave long hours and just barely attempt to get grants which have a 90%+ rejection ratio. This, as they see their classmates in law, MBA, finance and sometimes medicine come to 15 year reunions already vice presidents, with fancy houses, bodacious wives {remember talking scientists here, 90% men), and a great future ahead of them. And they are worried that they can't even get health insurance, knowing how much any illness might cost.
But in real real reality there is no conservation of money, if the finance is squashed by regulation, there is nothing to ensure that it goes into hard engineering things like alternative energy. US Companies will continue to outsource and delete their R&D departments and invest only in near term opportunities. Government would rather give tax cuts to rich and will barely be holding on after the HousingPanic.
Notice something: today, Germany had a record trade surplus in high-tech manufacturing goods. And then some economist said that it's time for wages to increase to get a balance in GDP.
Notice in the US it is always reported as "wage *COSTS*" as if the money is flowing to Saudi Arabia or something, and certainly something very very bad to be avoided. No, these are paychecks of many people.
How is it that those supposedly coddled unionised German workers with high wages, universal health care and 6 weeks of vacation can lead the planet in export of high-end high-tech manufacturing, and in the US those are somehow 'dying' industries?
And the only export which has industrial support in the USA is either low tech agriculture (please), or high tech killing machines?
Everything else is left to wither at the whim of the supposedly "free" market---no many decisions are actively made to destroy US jobs needlessly because of ideology and greed. These ideologues actively dislike normal people being prosperous unless they are the tiny %age of the business elite.
LaRouche is a nut but he is onto something here. Most activity on "the Street" is churn and market manipulation, not real investment. Anything that would divert the country's brainpower from financial gimickery to, say, alternative energy research would be a good thing in my book.
Friday, December 08, 2006 8:14:14 PM
===================================
Anyone who thinks LaRouche is a nut job is likely the nut job.
John Hoefle(EIR Economics staff) gave testimony to the House Banking Committee under the chairmanship of the late congressman from TX Gonzales in 1993/1994 period. Gonzales thanked Hoefle and LaRouche for illuminating the risk of derivatives.
LaRouche's call for a transaction tax against derivatives @ 1/10th of one percent was his own policy and not Tobin's.
Back in 1993 when LaRouche first called for this tax, derivatives claims were probably in the area of $25 trillion where today they could be as high as $700 trillion.
And how could anyone refer to LaRouche as a nut job while living in a culture that would accept "derivatives" as acceptable and proper behavior? It's suicide.
TWO SUB-PRIME MORTGAGE LOAN COMPANIES SHUT DOWN THIS PAST
WEEK; TUMULT IN DERIVATIVES MARKET. Carrollton, Texas-based
Sebring Capital Partners, and Agura Hills, California-based Ownit
Mortgage Solutions, shut their doors for good, on Dec. 4 and Dec.
6, respectively. They were both active in the sub-prime mortgage
lending market, with Ownit Mortgage being the eleventh largest
wholesale sub-prime mortgage lender.
This created tumult in the derivatives market: the cost of
credit default swaps to protect against default on $10 million
worth of BBB-rated sub-prime mortgage bonds, jumped from $310,000
to $389,000. At the same time, the underlying bonds floated
against sub-prime mortgages, suffered their greatest weekly loss
of the year. What may be in the works is the same degree of
losses that the derivatives market experienced during May and
June of 2005 when the Ford and General Motors bonds plunged, and
the derivatives issued against these bonds (known as Collateral
Debt Obligations) experienced reportedly hundreds of billions of
dollars of losses.
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