Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen
"We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."
That warning was in Buffett's 2002 letter to Berkshire shareholders. He saw a future that many others chose to ignore. The Iraq war build-up was at a fever-pitch. The imagery of WMDs and a mushroom cloud fresh in his mind.
Also fresh on Buffett's mind: His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared with the hundreds of billions of dollars of subprime-credit write-offs now making Wall Street's big shots look like amateurs.
Buffett tried to sell off Gen Re's derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a "financial weapon of mass destruction." That was 2002.
Derivatives bubble explodes five times bigger in five years
Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:
Sarbanes-Oxley increased corporate disclosures and government oversight
Federal Reserve's cheap money policies created the subprime-housing boom
War budgets burdened the U.S. Treasury and future entitlements programs
Trade deficits with China and others destroyed the value of the U.S. dollar
Oil and commodity rich nations demanding equity payments rather than debt
In short, despite Buffett's clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.
Data on the five-fold growth of derivatives to $516 trillion in five years comes from the most recent survey by the Bank of International Settlements, the world's clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier's window at a racetrack or casino, where you'd place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.
To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:
U.S. annual gross domestic product is about $15 trillion
U.S. money supply is also about $15 trillion
Current proposed U.S. federal budget is $3 trillion
U.S. government's maximum legal debt is $9 trillion
U.S. mutual fund companies manage about $12 trillion
World's GDPs for all nations is approximately $50 trillion
Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
Total value of the world's real estate is estimated at about $75 trillion
Total value of world's stock and bond markets is more than $100 trillion
BIS valuation of world's derivatives back in 2002 was about $100 trillion
BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion
Moreover, the folks at BIS tell me their estimate of $516 trillion only includes "transactions in which a major private dealer (bank) is involved on at least one side of the transaction," but doesn't include private deals between two "non-reporting entities." They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.
Also, keep in mind that while the $516 trillion "notional" value (maximum in case of a meltdown) of the deals is a good measure of the market's size, the 2007 BIS study notes that the $11 trillion "gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets."
Bubbles, domino effects and the 'bad 2%'
However, while that may be true as far as the parties to an individual deal, there are broader risks to the world's economies. Remember back in 1998 when LTCM's little $5 billion loss nearly brought down the world's banking system. That "domino effect" is now repeating many times over, straining the world's monetary, economic and political system as the subprime housing mess metastasizes, taking the U.S. stock market and the world economy down with it.
This cascading "domino effect" was brilliantly described in "The $300 Trillion Time Bomb: If Buffett can't figure out derivatives, can anybody?" published early last year in Portfolio magazine, a couple months before the subprime meltdown. Columnist Jesse Eisinger's $300 trillion figure came from an earlier study of the derivatives market as it was growing from $100 trillion to $516 trillion over five years. Eisinger concluded:
"There's nothing intrinsically scary about derivatives, except when the bad 2% blow up." Unfortunately, that "bad 2%" did blow up a few months afterwards, even as Bernanke and Paulson were assuring America that the subprime mess was "contained."
Bottom line: Little things leverage a heck of a big wallop. It only takes a little spark from a "bad 2% deal" to ignite this $516 trillion weapon of mass destruction. Think of this entire unregulated derivatives market like an unsecured, unpredictable nuclear bomb in a Pakistan stockpile. It's only a matter of time.
World's newest and biggest 'black market'
The fact is, derivatives have become the world's biggest "black market," exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today's slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.
Recently Pimco's bond fund king Bill Gross said "What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August." In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't "figure out" the world's $516 trillion derivatives.
Why? Gross says we are creating a new "shadow banking system." Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions.
BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic "shadow banking system" that has become the world's biggest "black market."
That's crucial, folks. Why? Because central banks require reserves like stock brokers require margins, something backing up the transaction. Derivatives don't. They're not "real money." They're paper promises closer to "Monopoly" money than real U.S. dollars.
And it takes place outside normal business channels, out there in the "free market." That's the wonderful world of derivatives, and it's creating a massive bubble that could soon implode.
Ludwig von Mises Institute, Tuesday, October 14, 2008
People should be free to use any money they can get each other to accept. More than that, people should be free to introduce new moneys based on gold or silver or any other commodity, and develop payment systems based on this, whether that means paper signifiers or digital goods.
For believers in liberty and sound economics, it has been a series of devastating weeks. The crisis of fiat money, long foretold by the Austrian school, finally came. But there turns out to be no great satisfaction in saying "I told you so."
If it would do any good, it would be worth it. But Treasury officials and central bankers are proceeding as if they had nothing to do with actually causing the bubble and the bursting of the bubble — acting, in fact, as if the old tale about the need to support prices to fix the recession were true. It is the perfect storm: the big banks loot us through government, while the academic economists approve it as applied science.
Moreover, there seems to be no test of whether or not what they are doing is a good thing. When the market responds negatively to a new infusion of cash, they say that it isn't enough. When the market responds positively, they take credit for fixing the problem. The state maintains the charade that it is the one infallible institution.
To top it off, the unreconstructed Keynesian Paul Krugman has won the Swedish central bank's Nobel Prize in economics. It wasn't for his reflationist views but for his trade theory; nonetheless, his overall oeuvre will receive new attention, and his views on the crisis are identical to the kind of fallacy-ridden central planning that caused the downturn of 1929 to turn into the Great Depression. Put his ideas in charge, and we are doomed.
Instead, of course, they should turn to those who both predicted this crisis and who offer a coherent explanation for it. The most important priority right now is dramatic monetary reform. In an ideal world, officials would follow the Mises/Rothbard strategy of defining the dollar as a weight of gold and permit all-around convertibility at all levels.
The immediate criticism is that this step would curb the power of central bankers and government to create money out of thin air to fix the crisis. But the criticism alone makes the point. It would indeed restrict their power, and that is precisely why it needs to be done. True liquidity is based on savings and capital; it cannot be created by decree. Decrees end up creating money out of thin air, which ends up overriding market preferences and generating inflation. Everything officials do to fix the crisis ends up prolonging it.
Here's the core problem of the gold-standard idea. It is indeed the best path. But the people charged with implementing it will invariably be the very people, advancement of whose interests has caused the current problem and have the least incentive to change the system. We've seen in the last several weeks how these people are willing to blow up the world rather than face liquidation. So the question becomes, how can we take steps toward sound money and banking without depending on the good will of the officials in charge?
The answer is provided in some of the writings of Jörg Guido Hülsmann and, before him, Hans Sennholz. Guido is a student of Rothbard's while Hans was a student of Mises's. Both agree on an alternative path forward that embraces radical decontrol of money and banking in the hope of a currency competition that will at least allow gold currency as an option. Guido's book on the topic will be appearing soon, and Hans Sennholz's relevant work here is Money and Freedom, which is newly available from Mises.org. (This is also the approach that Ron Paul, a longtime advocate of the gold standard, took during his campaign.)
Currently the government has in place severe restrictions on what currency you can use as legal tender. The courts do not enforce other kinds of monetary contracts. Anyone who comes up with alternative currency is going to face possible prosecution. For this reason, the dollar is mandatory. We will be stuck with it even as the feds are destroying it. There is no way out.
All these restrictions need to be repealed as a step toward monetary reform. People should be free to use any money they can get each other to accept. More than that, people should be free to introduce new moneys based on gold or silver or any other commodity, and develop payment systems based on this, whether that means paper signifiers or digital goods. The market is capable of policing this system the same way it does retail trade.
Money originated in market competition long before the age of the nation-state. It is a product of the market, not of state edict or some mythical "social compact." Nor is there a reason to put a stop to the competitive process once it has decided upon a single money. Money can and does fail, especially once it is nationalized and given over to a central bank to manage. Permitting freedom in money production and use amounts to permitting market forces to continue to select the most-serviceable alternative.
In many ways, this proposal finds support in the work of F.A. Hayek, who also advocated competitive currencies. But this one goes further in allowing a full free market in minting money by private firms.
There is historical precedent for this in George Selgin's Good Money. In England, early in the Industrial Revolution, the state also maintained a monopoly on money production but it failed to make enough small-denomination coins to meet the demand. Private button makers swung into action to make coins that were circulated widely. Their quality was controlled by market means, and they became far more desirable and widely circulated than government money.
What's interesting here is how the market appeared to violate what is called Gresham's Law, which asserts that "bad money" drives good money underground. But that is only true if the "bad money" is artificially overvalued. In settings in which the official currency is failing and alternatives are available, the process can work in the reverse, with good money replacing bad as the primary means of exchange.
Not only is the soundness of the world economy at stake; there is a matter of human rights: the rights to invent, trade, make contracts, and associate. The major strategic advantage of this program is that it is not asking the state to do anything positive with its monetary powers. A demand for monetary freedom — a repeal of legal-tender laws and the opening up of the banking system to private enterprise — is nothing more than the extension of freedom generally.
Europe stuns with €1.5 trillion bank rescue, as France plays role of saviour
Daily Telegraph, 14 Oct 2008
Germany, France, Italy, Spain, Holland and Austria have joined forces to launch the greatest bank bail-out in history, offering over €1.5 trillion in guarantees and fresh capital in a "shock and awe" blitz to halt the credit panic.
The move – unveiled simultaneously in the six states to maximise the show of unity – throws the full weight of the eurozone behind global efforts to stem the crisis.
The move gave a tremendous boost to bourses across Europe, lifting the Euro Stoxx index by 9.53pc in the biggest one-day rally ever.
The pan-European plan – totalling over $2 trillion, or £1.17 trillion – completes the third leg of a dramatic restructuring of finance across the Western world. Sovereign states have now absorbed the brunt of the credit risk in half the global economy.
"The greatest risk is inertia," said French President Nicolas Sarkozy, now basking in glory as the man who refused to give up after the first emergency summit of EU leaders ended in discord.
"The French state will not let a single bank fail. We have to unblock the interbank market because money has stopped circulating, but it is a reasonable bet that by offering this guarantee, it won't actually be needed," he said, unveiling a French package worth €320bn in guarantees for fresh interbank loans and a €40bn bank rescue fund.
Sarkozy has emerged as the statesman of the hour, shaping events as others dithered. He appears to have understood intuitively that credit paralysis would set off a dangerous downward spiral.
Germany's rescue package totals €500bn, far bigger in per capita terms than America's scheme. The bulk is to guarantee interbank lending, while €100bn is for a stabilisation fund to recapitalise banks and cover losses – with strict pay limits for executives.
"We have placed the first foundation stone of a new financial order," said chancellor Angela Merkel, underlining that nothing would ever be the same again in banking.
She also warned that the US government's "massive support" for the Detroit car industry would create a major headache for Germany's producers, who are already struggling. BMW said yesterday that it would idle plants in Leipzig, Regensburg and Munich as demand fell.
Italy's finance minister Giulio Tremonti said Rome would provide as much money "as necessary" to stabilise credit markets. Italy's plan includes the injection of up to €40bn in fresh capital into the banks on a "case by case" basis, through preference shares.
The Netherlands is offering a €200bn guarantee; Austria is putting up €100bn, as is Spain – as a "preventive measure". Debts issued before the end of next year will be guaranteed for five years under all the national plans.
Diplomats say the world owes a great deal to France's finance minister, Christine Lagarde. A former chair of the US law firm Baker McKenzie and a friend of US Treasury Secretary Hank Paulson, she has been a bridge between the EU and Washington, helping to end the transatlantic sniping that has damaged market confidence over the past year. The close co-operation is in stark contrast to the catastrophic rift in October 1931, when France set off a wave of US bank defaults by pulling its gold out of New York.
The Sarkozy accord was not enough to shield Société Générale yesterday, as reports circulated that it might be the first to tap into the French bank rescue fund, perhaps needing as much as €10bn. The share price collapsed 17pc at one point on fears of losses in its structured credit unit. Investors are concerned that it may suffer from exposure to Eastern Europe, where it has played a role in providing foreign currency mortgages. The shares ended down 2pc in Paris.
This week's dramatic action by the eurozone states has gone a long way to reassure investors that EMU can weather a severe crisis, even though it lacks an EU treasury or fully fledged lender-of-last resort. The EU Stability Pact rules on budget deficits have been shunted aside by invoking the "special circumstances" clause of the Maastricht treaty, opening the way for fiscal stimulus. The Dutch-Belgian rescue of Fortis and the French-Belgian rescue of Dexia were not without friction, but at the end of the day the system was able to come up with creative solutions.
IMF chair Dominique Strauss-Kahn said the monetary union had faced its "ordeal by fire" this week. With French leadership, it survived.
European Central Bank President Jean-Claude Trichet listens while attending the session 'System Financial Risk' at the World Economic Forum in Davos, January 24, 2008 :
"If the risks were not materializing [from time to time] you would not be in a free market economy, you would be in the Soviet Union."
The market is worth more than $516 trillion, (£303 trillion), roughly 10 times the value of the entire world's output: it's been called the "ticking time-bomb".
It's a market in which the lead protagonists – typically aggressive, highly educated, and now wealthy young men – have flourished in the derivatives boom. But it's a market that is set to come to a crashing halt – the Great Unwind has begun.
Last week the beginning of the end started for many hedge funds with the combination of diving market values and worried investors pulling out their cash for safer climes.
Some of the world's biggest hedge funds – SAC Capital, Lone Pine and Tiger Global – all revealed they were sitting on double-digit losses this year. September's falls wiped out any profits made in the rest of the year. Polygon, once a darling of the London hedge fund circuit, last week said it was capping the basic salaries of its managers to £100,000 each. Not bad for the average punter but some way off the tens of millions plundered by these hotshots during the good times. But few will be shedding any tears.
The complex and opaque derivatives markets in which these hedge funds played has been dubbed the world's biggest black hole because they operate outside of the grasp of governments, tax inspectors and regulators. They operate in a parallel, shadow world to the rest of the banking system. They are private contracts between two companies or institutions which can't be controlled or properly assessed. In themselves derivative contracts are not dangerous, but if one of them should go wrong – the bad 2 per cent as it's been called – then it is the domino effect which could be so enormous and scary.
Most markets have something behind them. Central banks require reserves – something that backs up the transaction. But derivatives don't have anything – because they are not real money, but paper money. It is also impossible to establish their worth – the $516 trillion number is actually only a notional one. In the mid-Nineties, Nick Leeson lost Barings £1.3bn trading in derivatives, and the bank went bust. In 1998 hedge fund LTCM's $5bn loss nearly brought down the entire system. In fragile times like this, another LTCM could have catastrophic results.
That is why everyone is now so frightened, even the traders, who are desperately trying to unwind their positions but finding it impossible because trading is so volatile and it's difficult to find counterparties. Nor have the hedge funds been in the slightest bit interested in succumbing to normal rules: of the world's thousands of hedge funds only 24 have volunteered to sign up to a code of conduct.
Few understand how this world operates. The US Federal Reserve chairman, Ben Bernanke, tapped up some of Wall Street's best for a primer on their workings when he took the job a few years ago. Britain's financial regulator, the Financial Services Authority, has long talked about the problems the markets could face on the back of derivative complexity. Unfortunately it did little to curb the products' growth.
In America the naysayers have been rather more vocal for longer. Famously, Warren Buffett, the billionaire who made his money the old-fashioned way, called them "weapons of mass destruction". In the late 1990s when confidence was roaring in the midst of the dotcom boom, a small band of politicians, uncomfortable with the ease with which banks would be allowed to play in these burgeoning markets, were painted as Luddites failing to move with the times.
Little-known Democratic senator Byron Dorgan from North Dakota was one of the most vociferous refuseniks, telling his supposedly more savvy New York peers of the dangers. "If you want to gamble, go to Las Vegas. If you want to trade in derivatives, God bless you," he said. He was ignored.
What is a Derivative?
Warren Buffett, the American investment guru, dubbed them "financial weapons of mass destruction", but for the once-great-and-good of Wall Street they were the currency that enabled banks, hedge funds and other speculators to make billions.
Anything that carries a price can spawn a derivatives market. They are financial contracts sold to pass on risk to others. The credit or bond derivatives market is one such example. It is thought that speculation in this area alone is worth more than $56 trillion (£33 trillion), although that probably underestimates the true figure since lax regulation has seen the market explode over the past two years.
At the core of this market is the credit derivative swap, effectively an insurance policy against the default in the interest payment on a corporate bond. One doesn't even need to own the bond itself. It is like Joe Public buying an insurance policy on someone else's house and pocketing the full value if it burns down.
As markets slid into crisis, and banks and corporations began to default on bond payments, many of these policies have proved worthless.
Emilio Botin, the chairman of Santander, the Spanish bank that has enjoyed phenomenal success during the credit crunch, once said: "I never invest in something I don't understand." A wise man, you may think.
George Washington's Blog, Saturday, October 11, 2008
This essay is about future derivatives problems. But before we look to the future, let's recap what happened yesterday, to gain some perspective.
Post-Game Analysis on Lehman
As the Washington Post writes today about yesterday's auction of some $400 billion dollars in credit default swaps for Lehman:
'If we see defaults from the standpoint that protection sellers don't pay up, then we're going to have a huge problem in the market,' Telpner said. 'But we don't have any explicit evidence indicating that sellers ultimately are not going to be able to pay the amounts owed to buyers.'
And the Sunday Times writes today:
"The valuation leaves the insurers of the debt a bill of about $365 billion. It is not clear whether the insurers, which are required to settle the bill in the next two weeks, will be able to pay – a development that could further undermine increasingly stressed capital markets."
Will the "insurers" of Lehman's CDS be able to pay up? The big bank insurers to the Lehman swaps have been hoarding cash, and so can presumably pay.
The bigger question is whether the hedge funds - such as Citadel - will be able to pay up or will go belly up. The next couple of weeks will tell.
But even if no companies are wiped out by their Lehman CDS obligations, it is clear that yesterday was, indeed, a traumatic day for the world economy. As today's Sunday Times article put it:
"Lehman’s corporate debt default promises to increase the stress across global credit markets. Sean Egan, of the Egan-Jones ratings agency, said: 'This is a killer. Lehman said a month ago that it was in terrific shape and now you can’t even get ten cents on the dollar for its debt.
'It underscores the deep structural flaws in our financial system, knocks confidence in the financial markets and raises the cost of capital. It also demonstrates that we are experiencing not only a crisis of confidence, but a crisis.'"
Next Up: Automakers
The next phase of the derivatives wipeout will hit insurance companies and auto makers.
Initially, Standard and Poor's is saying that GM and Ford may very well go bankrupt.
As of 2004, "GM was among the five companies most frequently included in credit-derivatives contracts in 2004, along with Ford Motor Co., France Telecom SA, DaimlerChrysler AG and Deutsche Telekom AG, Fitch said."
Indeed, according to Fitch's, as of 2004 and 2005, there were perhaps billions of dollars in GM credit default swaps traded per day. Fitch's noted that "GM CDS are the second most included named in synthetic collateralized debt obligations (CDOs), behind Ford, as disclosed in several Fitch analyses of the CDS market."
On October 3rd, Bloomberg wrote:
General Motors Corp. saw its credit default swaps rise to a record after the automaker said Sept. 19 it was going to draw down the remainder of a $4.5 billion revolving credit line to preserve cash because of the instability in the financial markets. Detroit-based GM, the largest U.S. carmaker, has lost almost $70 billion since 2004.
As of June of this year, "The cost to insure GM's debt with credit default swaps rose to 33.5 percent upfront . . . plus annual payments of 500 basis points" and "Ford saw its credit default swap spread increased to 30.5 percent upfront, plus 500 basis points annually".
According to financial advisor Mike "Mish" Shedlock, there are appromixately one trillion dollars of credit default swaps for GM.
If GM goes bust, there would be huge credit default swap liability. While I have seen no estimates of the current amount of Ford CDS, it is probably also quite high, given that it was one of the most common CDS issued in 2004.
The insurance companies are also getting hit hard by CDS.
The October 3rd Bloomberg article states:
"The cost to protect against default by Hartford, Prudential Financial Inc. and MetLife Inc. soared to records and shares fell yesterday on speculation that turmoil in financial markets may be spreading to insurance companies."
As an article at Naked Capitalism explains:
First it was banks and securities firms, and now the focus of worry has widened to include insurance companies. Reader John referred us to a Reuters article that MetLife credit default swaps are now trading on an upfront basis, which means buyers of protection against the default of MetLife bonds must make an upfront payment as well as agreeing to periodic fees. Only companies seen as being in serious risk of failure trade on an upfront basis. Another story shows similar pricing of XL Capital CDS.
Concerns about MetLife became serious when the company announced it was writing down its investment portfolio and withdrew its 2008 earnings forecast.
Metlife Inc's credit default swaps on began trading on an upfront basis on Thursday, indicating perceptions that its credit quality is considered distressed.
The cost to insure Metlife's debt rose to around 10.5 percent the sum insured as an upfront sum, or $1.05 million to insure $10 million in debt for five years, in addition to annual premiums of 5 percent, according to Markit Intraday.
The swaps had closed on Wednesday at a spread of around 717 basis points, or $717,00 per year for five years to insure $10 million in debt, according to Markit.
The second Reuters story:
Credit default swaps on XL Capital Ltd [an insurance copmany] began trading on an upfront basis on Thursday, and its stock price plunged more than 37 percent.
The cost to insure XL's debt rose to around 12.5 percent the sum insured as an upfront sum, or $1.25 million to insure $10 million in debt for five years, in addition to annual premiums of 5 percent, according to Phoenix Partners Group....
The swaps had opened at a spread of around 750 basis points, or $750,00 per year for five years to insure $10 million in debt, according to Phoenix.
Instead of being the end of the derivatives bloodbath, Lehman was probably just the beginning.
The myth has quickly taken hold that the global financial crash was caused by bad mortgages. This has allowed rightwing hatemongers to blame the meltdown on the "liberal" programs that encouraged home ownership among a small percentage of lower-income people (a poisonous canard that parts of the mainstream media have actually done a fairly good job of knocking down), while "progressives" of various stripes have denounced banks and other financial institutions for pushing over-easy credit on people who couldn't really afford it.
Unsustainable mortgages are a key factor in the global crash, of course. And many people (most of them white, by the way) did take out mortgages they would not be able to afford if the housing bubble ever burst, which it has, most spectacularly. And yes, it is undeniable that the financial services industry has been tempting people with easy credit like schoolyard pushers flashing reefers.
All of this was bound to end badly, and did. But this alone would not have been enough to threaten the destruction of the entire global financial system, nor cause the blind, screaming panic that has strangulated the financial markets, seized up the vital flow of money between banks, and caused the "free" market-worshipping governments of the Western world to carry out nationalizations and interventions that, in sheer numbers, dwarf anything ever seen following a Communist revolution. (As John Lancaster notes in the London Review of Books, the Bush Administration's takeover of Fannie Mae and Fannie Mac alone was "was, by cash value, the biggest nationalisation in the history of the world." And that was just the beginning.)
What has struck mortal fear in the heart of markets and governments is not bad mortgages, but the almost incomprehensibly huge and complex market for "derivatives," based in part on mortgage debt -- but also on a vast array of other sources that were "securitized," turned into tradable if ghostly commodities then sold off in a bewildering variety of increasingly arcane forms. This was accompanied by the expansion of yet another vast market in insurance mechanisms designed to protect these derivatives -- mechanisms which themselves became "securitized."
At the same time, the financial services industry used its paid bagmen in governments around the world to loosen almost all restrictions not only on securitization and the trading of derivatives, but also on the amount of debt that institutions could take on in order to play around in these vastly expanded and deregulated markets. For example, as Lancaster points out, UK's Barclays Bank had a debt-to-equity ratio of 63 to 1:
Imagine that for a moment translated to your own finances, so that you could stretch what you actually, unequivocally own to borrow more than sixty times the amount. (I'd have an island. What about you?)
The result of all this has been the construction of a gargantuan house of cards, based on next to nothing, and left alone in the shadow of building "perfect storm" of greed, deregulation and political corruption.
That storm has now struck. The house of cards has fallen down, and revealed a hole of derivatives-based debt that could not be filled, literally, by all the money in the world, much less by the mere trillions that national governments are frantically throwing at it today.
Yes, "mere" trillions. As Will Hutton explains in the Observer:
...the dark heart of the global financial system [is] the $55 trillion market in credit derivatives and, in particular, credit default swaps, the mechanisms routinely used to insure banks against losses on risky investments. This is a market more than twice the size of the combined GDP of the US, Japan and the EU. Until it is cleaned up and the toxic threat it poses is removed, the pandemic will continue. Even nationalised banks, and the countries standing behind them, could be overwhelmed by the scale of the losses now emerging.
Try to imagine that: a $55 trillion market now at risk of complete destruction. Even the derivative debt owed by individual institutions stands at nation-wrecking levels. For example, a single bank in Britain, Barclays again, holds more than $2.4 trillion in credit default swaps, the tradable "insurance" mechanism against securities default. This is more than the entire GDP of Great Britain. If all this paper goes bad, there are not enough assets in the entire country to pay it off. And that's just one bank, in one country.
Hutton gives the details:
This market in credit derivatives has grown explosively over the last decade largely in response to the $10 trillion market in securitised assets - the packaging up of income from a huge variety of sources (office rents, port charges, mortgage payments, sport stadiums) and its subsequent sale as a 'security' to be traded between banks.
Plainly, these securities are risky, so the markets invented a system of insurance. A buyer of a securitised bond can purchase what is in effect an insurance contract that will protect him or her against default - a credit default swap (CDS). But unlike the comprehensive insurance contract on your car which you have with one insurance company, these credit default contracts can be freely bought and sold. Complex mathematical models are continually assessing the risk and comparing it to market prices. If the risk falls, the CDSs are cheap; if the risk rises - because, say, a credit rating agency declares the issuing company is less solid - the price rises. Hedge funds speculate in them wildly.
Their purpose was a market solution to make securitisation less risky; in fact, they make it more risky, as we are now witnessing. The collapse of Lehman Brothers - the refusal to bail it out has had cataclysmic consequences - means that it can no longer honour $110bn of bonds, nor $440bn of CDSs it had written. On Friday, the dud contracts were auctioned, with buyers paying a paltry eight cents for every dollar. Put another way, there is now a $414bn hole which somebody holding these contracts has to honour. And if your head is spinning now, add the three bust Icelandic banks. They can no longer honour more than $50bn of bonds, nor a mind-boggling $200bn of CDSs....
While every bank tries to pass the toxic parcel on to somebody else, the system has to find the money. So will compensation for the near valueless contracts and thus now uninsured debt ultimately be made - and by whom? And because nobody knows - not the regulators, banks or governments - who owns the swaps and whether they are credit-worthy, nobody can answer the question. Maybe holders of insurance policies will get the cash due to them, but will that weaken somebody else? The result - panic.
This is the ultra-dangerous downward vortex in which the system is locked. It is why share prices are plummeting. As recession deepens, there will be defaults on securitised bonds and the potential collapse of more banks outside the G7 ring-fence. Nobody knows what proportion of the $55 trillion of credit default contracts that have actually been written will be honoured and who might bear losses running into trillions of dollars.
This is the beast in the dark that is haunting the feckless leaders of the developed world: $55 trillion of unaccountable debt, and no way of knowing how much of it is even now being flushed down the toilet, taking the global economy with it.
The massive interventions we are seeing might stabilize the markets temporarily, or at least arrest their free fall long enough to come up with some kind of massive restructuring of the global financial system. Or they might not. For it is by no means certain that the wisdom, and the political courage, to come up with a more viable system can be found among the world's political leaders -- all of whom, as we noted here the other day, have risen within the present system and, to one degree or another, owe their own power and privilege to the "malefactors of great wealth" and the extremist cult of market fundamentalism. There is no indication anywhere that the circle of collusion and corruption between governments and Big Money has even lessened, much less been broken, by the economic catastrophe. All of the various bailout plans and "coordinated actions" still have as their chief aim the preservation of the malefactors in their current state of wealth, privilege and domination. As Jonathan Schwarz notes:
Still, U.S. elites will try to impose as much of a structural adjustment as they can get away with, in order to make the bottom 80% of America pay the price for the elites' spectacular screw-ups. The Washington Post has already started writing about how the current crisis demonstrates that we must cut Social Security. Look for much more of this to come.
The only slim hope we have for any genuine reform -- even an imperfect, conflicted, compromised reform, which is the only kind we will ever have in this world, until the lion lies down with the lamb -- is that the sheer scale of the real problem -- the $55 trillion beast, the very real potential for the complete destruction of the global economy, and the state power that depends upon it -- might force some politicians to turn apostate, renounce the market cult, and bite the hands that have fed them for so long.
Absent this near-miraculous possibility, we will be left with yet another rickety house of cards, slapped together on the fly -- largely at the malefactors' direction and for their benefit -- while the beast gapes wide his ponderous jaws, and prepares to swallow us whole.
Coming Soon: The 600 Trillion Derivatives Emergency Meeting
Seeking Alpha, October 13, 2008
Here is an update on the size of the derivatives market with the latest official figures (.pdf) from the Bank for International Settlements (BIS). Hold your breath, as we are not anymore talking paltry billions but TRILLIONS of whichever fiat currency.
Current emergency meetings on banks and markets are still only in the stage where politicians and central bankers are bickering over how to create a few more hundred billions Euros and FRNs. But toxic MBS pale in comparison to the mushrooming growth of the derivatives market. According to figures released in the quarterly review of the BIS (pp A103) in September the total notional amount of outstanding derivatives in all categories rose 15% to a mindboggling $596 TRILLION as of December 2007.
Two thirds of contracts by volume or $393 TRILLION fell into the category of interest rate derivatives. Credit Default Swaps had a notional volume of $58 TRILLION, seeing the sharpest relative increase after a volume of $43 TRILLION a year earlier.
Currency derivatives reached a volume of $56 TRILLION.
Oh, and every grand balance sheet comes with a trash can. Unallocated derivatives with a notional amount of $71 TRILLION are looming over the heads of the disintegrating investment community too.
However You Look At It, This Is an Accident Waiting To Happen
Don't lose your sleep because of these numbers that KO my desktop calculator. In an ideal world - in which we are not - long and short derivatives would net out each other, leaving only a fraction of risk. The BIS tries to assess this net risk with a total of $14.5 TRILLION (2006: 11.1 TRILLION) in gross market value for all contracts but comes up with a second figure.
The so called Gross Credit Exposure appears almost moderate at $3.256 TRILLION after $2.672 TRILLION a year earlier.
Even when taking the lowest of these figures shudders run down my spine. All emergency talks have so far focused on a few hundred billions in fiat currencies, but the current nervousness demonstrated by hectic talks of finance ministers and central bankers all over the globe should give everybody a vague idea that something here may blow up any day. This pool of so far silent derivatives without a major bust can come to life any day with the failure of a multinational financial firm.
The BIS review is a good way to grasp the dimensions long term monetary expansion has brought upon us. A net risk of $14 TRILLION compares with the annual GDP of the USA. Nobody, absolutely nobody can afford this tab in the case of an unorderly unwinding of this market that is roughly 12 times the size of the global economy. I conclude a lot more paper promises will be burnt in the coming derivatives tsunami. As a reminder, most of these contracts have been moved off balance sheets into under capitalized subsidiaries that profited from the good rating of the parent company. But in case of a default it is this nasty, nasty huge notional amount that becomes a liability.
As the vast majority of these contracts have no market, failure will come in the form of counterparty risk. This makes all the current emergency meeting a bit more understandable if politicians are already aware of the biggest bubble that may find no other way of deflation than a sudden burst. I base my sense of urgency on the rapid growth of the net risk in only one year, rising a stunning 30% at a time when the first signs of the credit crunch appeared.
German chancellor Angela Merkel said ahead of an emergency meeting with French president Nicolas Sarkozy in a TV interview that she would present a rescue package for German banks on Monday. This is also expected from several other European countries. Italian president Silvio Berlusconi went so far as to suggest a concerted stock exchange holiday. It would fit the other crooked nails in the coffin of free markets.
Falls in the value of financial assets worldwide might have reached more than $50,000bn, equivalent to a year’s global economic output, the Asian Development Bank will warn on Monday.
The World Bank report said $2,500bn-$3,000bn in public and private debt in emerging markets needed to be rolled over in 2009, most of it denominated in foreign currencies. This would put pressure on developing country governments, many of which had inadequate reserves to help their banks and companies refinance, the bank said.
Although the bank itself and other official institutions such as the International Monetary Fund have been increasing their lending, even at the lower end of the $270bn-$700bn range “existing resources of international financial institutions would appear inadequate to meet financing needs this year”, it said.
Financial Derivatives -The $700 Trillion Elephant
March 6, 2009, Market Watch
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.
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.
That's why stabilizing the housing market will do little to take the sting out of the snapback we are going through on Wall Street. Once people's mortgages were sold off to secondary buyers, and then all sorts of crazy types of derivative securities were devised based on those, and those securities were in turn traded on down the line, there is now little if any relevance to the real estate values on which they were pegged.
It isn't the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to sway attention away from the place where greed truly flourished -- trading phony instruments to the tune of $700 trillion.
AIG Warned of 'Crisis' if Government Didn't Help
March 9, 2009, ABC News
An AIG report to the Treasury Department last month warned that if the government didn't come to its rescue again, its collapse would trigger a "chain reaction of enormous proportion" that would "potentially bankrupt or bring down the entire system" and make it impossible for AIG to repay the billions it already owed the U.S. government.
A draft of the report, obtained by ABC News, was marked "strictly confidential." It said, "The failure of AIG would cause turmoil in the U.S. economy and global markets and have multiple and potentially catastrophic unforeseen consequences."
The draft was dated Feb. 26. On March 2, the Treasury Department and the Federal Reserve system announced that AIG, which lost $61.7 billion in the fourth quarter of 2008, would receive $30 billion in new government help.
AIG warns in its report of the "systemic risk" that a potential collapse posed. It describes a "systemic risk" as one that "could potentially bankrupt or bring down the entire system or market."
The company said, "What happens to AIG has the potential to trigger a cascading set of further failures, which cannot be stopped except by extraordinary means."
The company points out in the report that it operates in 140 countries and is the largest insurer in the Mideast, Southeast Asia, Hong Kong, the Philippines, Thailand and Japan. It argues that its failure would create a "crisis of confidence" worldwide.
"Permitting AIG to fail would be even more serious today than in September, especially in view of the support of the U.S. government," the report said. "Public confidence in financial institutions is at a nadir and it is questionable whether the economy could tolerate another shock to the system that a failure of AIG would produce."