Subprime mortgages? The real threat is credit derivatives.

[BaronVonBigmeat]

The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.

Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. The chart below shows the relative size of the credit derivatives and subprime mortgage markets.

"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.

 

[gonegolfin]

"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.

Just wait until interest rate derivatives make the news when the bond bubble blows up.

Brian

 

[Paulie]

Just wait until interest rate derivatives make the news when the bond bubble blows up.

Brian

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.

 

[gonegolfin]

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.

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

 

[midcan5]

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

 

[Paulie]

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

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?

 

[user_name_guest]

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

 

[Toro]

Hence, the bailouts of Lehman and AIG

 

[Diuretic]

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.

How come conservative American politicians, avowed believers in the free market, are busy propping up investment banks and nationalising insurance companies?

Are they just helping out their rich buddies at taxpayers' expense? The old story of capitalising the profits and socialising the losses?

But, if so, how come they're letting some outfits go to the wall while bailing out others? And while we're on the subject, how come central banks that profess to be terribly worried about inflation - including our own - are flooding the market with liquidity?

More at the link - Why governments bail out banks | smh.com.au

 

[Zoomie1980]

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?

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.

 

[editec]

Fascinating.

Thanks ever so much for the link Baron.

I understood derevatives only so far as they were promises to cover risks, but I had no idea, none whatever!, that the drevivitive companies where themselves ALSO coving their asses from losses by derivitives.

The house of cards these genuises stacked up is far worse than even I imagined possible.

So much for the whole "Greed is Good" school of philosophy, eh?

If this doesn't convince our resident libertarians why individual Greed is NOT good for societies as a while, I'm not sure anything can.

The vast amjority of us who have had absolutely nothing to do with this orgy of risk taking, and who certainly haven't gained doodle-squat from the excesses of this gilded age, but whose gradual bankrupting has been our only reward from it, are about to suffer the consequences of the worshippers at the alter of mammon having gained complete control over our poltical process, our governments, our media and our banking and our indistrial systems.

Those of us who have been marginalized because we constituted a threat to public order by dint of our common sense (we loose cannons); those of us who have spoken out about this madness to the extent that we were driven from the fold of "reasonable men"; will of course, not be consulted while "The Plan" is being formulated this weekend.

The people in those corridors of power are exactly the same people who allowed and facilitated this disaster to develop.

I have no faith whatever that "the PLAN" will be effective in stopping the collapse of the world's economy.

They will, at ANY COST TO THIS NATION AND THE CITIZENS OF THE USA, seek to protect themselves from the consquences of their orgy of greed, and dump whatever debts they have on the taxpayers in the forms of treasury debts, and of course eventually, with specie with absolutely no value.

What a SNAFU.

What hubris our masters have shown us they suffered from.

Although the specifics are different in every case, this is how empires, like ours in the West, typically die.

Will the economic hard times bring us into a new golden age?

Possibly.

But the vast majority of us will have some mighty heavy swells crossing our bows before this nation finds that safe harbor, mates.