Derivatives, mother of all bubbles

Discussion in 'Economics' started by ljmlmvlhk, Sep 10, 2008.

  1. ljmlmvlhk

    ljmlmvlhk Guest

    Are derivatives another form of ponzi system ?
    Is there a risk one day this will implode ?

    The present market gyrations, will this cause more people to leave a buy and hold environment to grasp hedging strategies ?
    Then one day, the markets get the speed wobbles and literally melt from the weight of synthetic deals ?

    Just curious.
  2. That's sort of how Warren Buffett sees it and has warned about...
  3. Derivatives are not required or necessary to have a financial crisis. I recall reading that many of the current futures contracts did not exist at the time of the 1929 stock market crash.

    Derivatives are just another thing that are bought and sold.
  4. Indeed.

    Also Credit default swaps is a 45 trillion dollars /year market.

    Citi is holding over a trillion off balance sheet assets in derivatives/CDS.

    It is doomed... only in time.
  5. I remember Greenspan wringing his hands about it in front of some Congressional committee.

    I suspect he has an academic's understanding of derivatives, but still.

    Supposedly the use of futures as portfolio hedges was a factor that accelerated the downdraft in the 1987 crash.
  6. S2007S


    The Derivative market is just so great that its hard to place how many hundreds of trillions its actually worth, an article from MARCH 2008 states its a $500 TRILLION DOLLAR market.


    Derivatives the new 'ticking bomb'
    Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen
    By Paul B. Farrell, MarketWatch
    Last update: 7:31 p.m. EDT March 10, 2008

    ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe Berkshire should be a fortress of financial strength" wrote Warren Buffett. That was five years before the subprime-credit meltdown.
    "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.
    Comments? Yes, we want to hear your thoughts. Tell us what you think about derivatives: as "financial weapons of mass destruction;" as a "shadow banking system;" as a "black market;" as the next big bubble dangerously exposing us to that unpredictable "bad 2%."
  7. Not really, derivatives themselves are not dangerous, it's the margin that is dangerous. In 1929 a trader could buy $100 of stock with $10 or so. He could take possession of the shares, deposit them with a bank, borrow on them and go get $1000 worth. When the market crashed the loss was greater than all the money in circulation.
  8. achilles28


    Derivatives are the invention of Wallstreet and Large Banks that own the Federal Reserve.

    What happens when you sell premium on 45 Trillion worth of derivatives and the market goes the wrong way?

    You vote the FED (which you own) to bail the underwater bets out.

    That way, you don't owe squat. Still collect the premium and put the American Public on the hook for the difference via price inflation.

    Thats what derivatives are all about.

    Never in our day will we see a Citi or Bank of America go into full-fledged bankruptcy without some Treasury or Fed "Rescue" to prevent derivative trigger.

    And thats only one kind. Who knows what other chicanery they've levied on us.

    Americas Banking and Financial System is built on a Gigantic Moral Hazard.

    There is no penalty for taking bets that lose. Because the house always wins. And the sheeple always get fucked.
  9. achilles28


    1929 is a bad example.

    1929 saw industry wide margin calls across the board.

    This was entirely coordinated.

    Investors leveraged up to their eye-balls were forced to liquidate en masse, this dropped the market, then created panicked selling.

    The whole 1929 run up was created by cheap money. Just like 2000+.

    On the date of the crash, Banks and Brokerages effectively jacked rates by many percentages, thus crashing the market.
  10. Banjo