Derivatives: The $600 Trillion Time Bomb That's Set to Explode October 12, 2011 By Keith Fitz-Gerald, Chief Investment Strategist, Money Morning Do you want to know the real reason banks aren't lending and the PIIGS have control of the barnyard in Europe? It's because risk in the $600 trillion derivatives market isn't evening out. To the contrary, it's growing increasingly concentrated among a select few banks, especially here in the United States. In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to a recent report from the Office of the Currency Comptroller. The four banks in question: JPMorgan Chase & Co. (NYSE: JPM), Citigroup Inc. (NYSE: C), Bank of America Corp. (NYSE: BAC) and Goldman Sachs Group Inc. (NYSE: GS). Derivatives played a crucial role in bringing down the global economy, so you would think that the world's top policymakers would have reined these things in by now - but they haven't. Instead of attacking the problem, regulators have let it spiral out of control, and the result is a $600 trillion time bomb called the derivatives market. Think I'm exaggerating? The notional value of the world's derivatives actually is estimated at more than $600 trillion. Notional value, of course, is the total value of a leveraged position's assets. This distinction is necessary because when you're talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30, or, in extreme cases, 100 times greater than investments that could be funded only in cash instruments. The world's gross domestic product (GDP) is only about $65 trillion, or roughly 10.83% of the worldwide value of the global derivatives market, according to The Economist. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble. Why Gold Will Beat the Market Manipulators Find out why gold is the one investment Wall Street manipulators can't touch in this free report. Enter Email Address Here: Cancel at any time | How it works Compounding the problem is the fact that nobody even knows if the $600 trillion figure is accurate, because specialized derivatives vehicles like the credit default swaps that are now roiling Europe remain largely unregulated and unaccounted for. Tick...Tick...Tick To be fair, the Bank for International Settlements (BIS) estimated the net notional value of uncollateralized derivatives risks is between $2 trillion and $8 trillion, which is still a staggering amount of money and well beyond the billions being talked about in Europe. Imagine the fallout from a $600 trillion explosion if several banks went down at once. It would eclipse the collapse of Lehman Brothers in no uncertain terms. A governmental default would panic already anxious investors, causing a run on several major European banks in an effort to recover their deposits. That would, in turn, cause several banks to literally run out of money and declare bankruptcy. Short-term borrowing costs would skyrocket and liquidity would evaporate. That would cause a ricochet across the Atlantic as the institutions themselves then panic and try to recover their own capital by withdrawing liquidity by any means possible. And that's why banks are hoarding cash instead of lending it. The major banks know there is no way they can collateralize the potential daisy chain failure that Greece represents. So they're doing everything they can to stockpile cash and keep their trading under wraps and away from public scrutiny. What really scares me, though, is that the banks think this is an acceptable risk because the odds of a default are allegedly smaller than one in 10,000. But haven't we heard that before? Although American banks have limited their exposure to Greece, they have loaned hundreds of billions of dollars to European banks and European governments that may not be capable of paying them back. According to the Bank of International Settlements, U.S. banks have loaned only $60.5 billion to banks in Greece, Ireland, Portugal, Spain and Italy - the countries most at risk of default. But they've lent $275.8 billion to French and German banks. And undoubtedly bet trillions on the same debt. There are three key takeaways here: There is not enough capital on hand to cover the possible losses associated with the default of a single counterparty - JPMorgan Chase & Co. (NYSE: JPM), BNP Paribas SA (PINK: BNPQY) or the National Bank of Greece (NYSE ADR: NBG) for example - let alone multiple failures. That means banks with large derivatives exposure have to risk even more money to generate the incremental returns needed to cover the bets they've already made. And the fact that Wall Street believes it has the risks under control practically guarantees that it doesn't. Seems to me that the world's central bankers and politicians should be less concerned about stimulating "demand" and more concerned about fixing derivatives before this $600 trillion time bomb goes off.
Sadly, I don't think this is exaggeration at all. You can tell that governments around the world are in near desperation mode. Markets continually fall for attempts at band aid solutions. The only people buying stocks are companies and institutions - eventually when things get really bad and earnings begin to falter, that will stop and the whole thing will implode because there won't be anyone left holding things up. The hope is that the economy will pick up and we can all be friends again and forget about it all, but the polarity among people is so intense that barring the messiah literally appearing from the sky, we are maybe two to three years away from world mass riots and I don't mean the tame ones we see now like OWS. Eventually, you are going to piss the wrong person off, and then nuclear warheads are going to get detonated. What is amazing to me is how many times we have to go through the same thing in history. Are two world wars not enough? It is an ever repeating cycle. Somehow, I think this may be the final one. Maybe in my lifteime I get to see true worldwide economy and government that understands the human condition, without ruining that which drives us to innovate and be creative. Remember, a lie is best hidden between two truths.
My question is when do the banks just hit the Re-Set button and throw the CDS contracts in the trash? Would that require a new currency? Is it really THAT damn bad?
The number is big, but the vast majority are swaps where you are really trading the change. So while the notional might be 1Bn the real risk is teh difference between two rates. If one of the counterparties were to go under, the other guy wouldn't lose 1Bn but really this rate difference which will be on the order of millions. That being said, the concentration is a problem and we saw what happens when LEH went under (and that was pretty orderly). Ken Griffin said it best. It's not too big to fail, but too interconnected to fail.
Risk is limited to the underwriters capital. Not the notional amount. Say an insurer writes 1 Trillion in policies, all of which come due, and the insurer is worth 20 Billion after liquidation = <20 Billion gets paid. That, or the Government nationalizes AIG and makes everyone whole
Here is the problem and it goes for the sovereigns as well, which is why we will probably see much worse things to come. There is no such thing as an orderly failure.
I am not exactly an expert on this subject but that answer seems to be terribly simplistic. I would think the result would depend entirely on the various financial regulations and governments financial insurance policy relative to each individual account holder which would end up relying on factors such the maximum coverage and account types.
when there is a crisis, replication cost of the other side of the trade is a lot higher because liquidity evaporates
What other Government-backed depositor insurance schemes do you know of besides FDIC and SIPC? The only other guarantee against counter-party loss is TBTF, which doesn't apply to anyone outside Federal Reserve shareholder banks. Ie, not you. Sorry. Options work the same way as insurance. Policy writers hold only a fraction of the capital needed to cover the net redemption value of their outstanding portfolio.