Subprime mortgages? The real threat is credit derivatives.

Discussion in 'Economy' started by BaronVonBigmeat, Sep 17, 2008.

  1. BaronVonBigmeat
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    BaronVonBigmeat Senior Member

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    "AIG’s Dangerous Collapse" by Daniel R. Amerman, FSU Editorial 09/17/2008

    If you've never quite understood what derivatives were all about, this article does a pretty good job of explaining them.
     
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  2. gonegolfin
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    gonegolfin Member

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  3. Paulie
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    Paulie Platinum Member

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    Can you explain for all of us the specifics of the interest rate derivatives market, in relation to the "crisis" we're facing, and what the government is doing in their intervention efforts these days? At least, the efforts we're actually being TOLD about, anyway.

    I have a general idea, and I imagine that my "general idea" is probably light years beyond that of the understanding of most here on this board. I'd like for the posters who lurk and post in this subforum to understand what it is exactly that we are facing, beyond what the media sugarcoats for us.

    Laymans' terms, if possible. Thanks Brian.
     
    Last edited: Sep 18, 2008
  4. gonegolfin
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    gonegolfin Member

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    Well, I am also a lay person, so hopefully it is in layman's terms.

    I have written several times in the past about the large size of the derivatives market that is traded over-the-counter. As of the end of last year, the sum notional amount of the OTC derivatives market is nearly $600 trillion. The gross market value of the OTC derivatives market is over $14.5 trillion. I am sure we are well past both now.

    Reliable information is only updated once a year. You can go to the BIS (Bank of International Settlements) website to find a nice breakdown of the OTC derivatives market (http://www.bis.org/statistics/otcder/dt1920a.pdf). As I alluded to earlier, the Credit Default Swaps (CDS) market is small in comparison to the Interest Rate Derivatives market. The total notional amount of CDS was less than $57 trillion at the end of last year, with the gross amount at about $2 trillion. Meanwhile, Interest Rate Derivatives totaled over $393 trillion of notional value and nearly $7.2 trillion in gross market value.

    It should be noted that the notional amount is really used to provide a comparison of market size between related derivatives markets and does not provide a measure of counter-party risk. That is, it is not a measurement of exposure as principal payments are not made in derivatives transactions as they are with equities, bonds, loans, etc. But the periodic payments made in derivatives are based on the notional amount (the payments are not the notional amounts themselves). The gross market value refers to the replacement cost of the outstanding contracts at prevailing market prices.

    There are various types of Interest Rate Derivatives, the most popular being Interest Rate Swaps. There is also the Interest Rate Cap, Forward Rate Agreement, Interest Rate Swap Option and Bond Option, and good old Interest Rate Futures contracts (these are not included in the above numbers as they are traded on an exchange), among many more. It is probably best to focus on Interest Rate Swaps since they dominate not just the Interest Rate Derivatives market, but the Derivatives Market as a whole (using notional values).

    Interest Rate Swaps, like most derivatives, foremost are financial instruments used to hedge risk. But the rapid expansion of the derivatives markets in recent years and increased use of leverage has seen financial institutions increasingly (an understatement) use these instruments for simple naked profit as well. At a basic level, each counter-party agrees to the payment of a stream of income. One stream is based on a fixed rate and the other a variable rate. The floating rate is usually based off of LIBOR. The fixed rate is referred to as the swap rate. Here counter-parties can hedge their loan portfolio for example. But they can also use these derivatives to bet on the future of interest rates. All interest payments (payment streams) are settled in net, with the payments calculated using the interest rates (floating rate or swap rate, depending on the counter-party) applied against the notional amount. So, you can see why the notional amount does not provide the measure of counter-party risk.

    The problem with these derivatives is that the investor is exposed to counter-party risk. And when there are only a limited number of trading partners comprising the pool of investors for all of these derivatives, the counter-party risk is elevated considerably. Most all of the outstanding OTC derivatives are held by ten banks and primary dealers - JP Morgan I believe is the largest with about $100 trillion in notional value. The tangled web of counter-parties is so complex, that nobody understands the inherent risk in a particular party defaulting. As we have seen with the default of Lehman debt in the credit markets, it has already had a ripple effect in the money markets (look at the money market funds that have recently broken the sacred $1/share benchmark) as well as the credit default swaps on the balance sheets of these financial institutions. And now you can see that the size of the interest rate derivative market is substantially larger than the credit default swap market currently causing significant problems in our financial markets.

    Finally, think about this ... if interest rates go hard one way (up significantly would be very, very bad), it will trigger a number of defaults on these contracts. As the financial world has learned, these "insurance" instruments work fine if the level of losses and default is reasonable. But if a significant portion of counter-parties cannot afford to "pay up", significant damage can be inflicted upon the financial system (the counter-party on the winning side of the contract does not get paid). Especially when you again consider the complex web of counter-party positions (small number of counter-parties, lots of contracts). This is exactly why Bear Stearns and AIG were rescued (avoid the domino effect at all costs). And as far as interest rates going up significantly ... folks, we are in a bond bubble. What do you think is going to happen with interest rates when foreigners finally get tired of accepting trash rates for their rapidly depreciating dollars (the printing presses are being warmed up)? They are going to demand higher rates. If the Treasury chooses not to pay these higher rates at auction, the Federal Reserve has no choice but to monetize its own debt. That is, purchase its own debt with money created out of thin air. Hello inflation and a vicious cycle.

    To date, the media has been focused on subprime and credit default swaps. Most of them do not know what interest rate derivatives are, nor do they understand the size of the market. Meanwhile, our government has absolutely been focused on keeping interest rates low. For many reasons.

    Brian
     
    Last edited: Sep 18, 2008
  5. midcan5
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    midcan5 liberal / progressive

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    I am always fascinated by the ways money can be made doing nothing but creating a sort of pyramid scheme that promises great things on paper. I promise to protect your investment and your risk if you pay me. Now extend this a few layers. We hope the people running these things are honest but without regulatory restraints who knows. And knowledge about the wagers and the soundness of all this invested (?) money is almost beyond the scope of regulatory institutions. The piece below may help explain some of the confusion.

    Derivatives Explained
     
  6. Paulie
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    Paulie Platinum Member

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    Not to blast you in a partisan way midcan, but your ideology of spending even more than we already do now, and just taking money from people's pockets to cover it is the kind of thing that EXACERBATES this type of problem. Right now people NEED their money. They need to pay their enormous debt off, not give it to the government.

    Yes, more people need healthcare. I understand that. But right now, we're on the brink of economic collapse not fathomed since the 30's. For a long time to come, this government is going to HAVE to reduce it's spending and pay off its debt. It needs to happen NOW. We simply can not afford to have our cake and eat it too. The only way to do so, is to continue printing more money, which is counter-productive because then consumers lose purchasing power. They can pay debt off easier, but they can't buy enough essentials in contrast, because the dollar is losing more value.

    I think liberals are going to have to start to understand that for a while to come, we simply can not afford to spend any more. And the conservatives are going to have to understand that we simply can not afford to continue running a worldwide military empire, spending nearly a Trillion dollars a year doing so. We're buried. We're so far buried, that if these bailouts didn't happen there probably would have been catastrophy. If that's not bad enough for BOTH sides to say the spending needs to stop, I don't know what ever will be.

    Can you understand my point?
     
  7. user_name_guest
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    user_name_guest Member

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    Imagine if our currency was gold, would that value presented in those charts be in the $50+ trillion category?
     
  8. Toro
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    Toro Diamond Member

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    Hence, the bailouts of Lehman and AIG
     
  9. Diuretic
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    Diuretic Permanently confused

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    Ross Gittins of the Sydney Morning Herald makes economics simple for dolts like me. I like reading him. You blokes who are knowledgeable in economics and business might like to read his latest piece.
    More at the link - Why governments bail out banks | smh.com.au
     
  10. Zoomie1980
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    Zoomie1980 Senior Member

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    This is something people need to realize in this election year. NEITHER President is going to be able to do ANYTHING about the economy. Presidents have virtually NO power over the economy anyway, Congress has taxing authority, but seldom if ever exercises it to a degree that matters. But now, they simply have NO power. ABSOLUTELY NONE. There is no money available for ANYTHING. No healthcare plan, no tax increases (Obama today is now admitting that most of his tax hikes on those over $250,000 aren't going to happen anytime soon if he wins because they would destroy the fragile economy!).

    So we are WASTING OUR TIME by worrying about what these two guys are going to do for the economy. They are going to do NOTHING. BOTH OF THEM!!! There is no money to do anything with!

    So move on to something they can control....foreign policy or something.
     

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