PAUL B. FARRELL
Derivatives the new ‘ticking bomb’
Buffett and Gross warn: $516 trillion bubble
is a disaster waiting to happen
Today 11.13.08 Total Derivatives Over $600 Trillion
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:
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Sarbanes-Oxley increased corporate disclosures and government oversight
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Federal Reserve’s cheap money policies created the subprime-housing boom
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War budgets burdened the U.S. Treasury and future entitlements programs
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Trade deficits with China and others destroyed the value of the U.S. dollar
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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:
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U.S. annual gross domestic product is about $15 trillion
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U.S. money supply is also about $15 trillion
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Current proposed U.S. federal budget is $3 trillion
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U.S. government’s maximum legal debt is $9 trillion
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U.S. mutual fund companies manage about $12 trillion
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World’s GDPs for all nations is approximately $50 trillion
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Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
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Total value of the world’s real estate is estimated at about $75 trillion
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Total value of world’s stock and bond markets is more than $100 trillion
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BIS valuation of world’s derivatives back in 2002 was about $100 trillion
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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%.”
![[George Soros]](http://s.wsj.net/public/resources/images/OB-CR128_soros__D_20081113124153.jpg)
Reuters
When you buy a derivative you are buying a contract that is similar to an insurance policy. Unlike a futures contract in which you agree to pay a certain price for future delivery of gold, corn, or whatever, nothing is ever delivered in a derivatives contract - except a payment from the seller of the contract to the buyer should the contract described event happen such as the default of a particular bond. Derivatives are essentially just highly speculative bets that are not secured by anything tangible and this is what makes then so dangerous and volatile - especially in highly volatile markets.
The Wikipedia definition of Derivatives is as follows:
“Derivatives are financial instruments whose values depend on the value of other underlying financial instruments. The main types of derivatives are futures, forwards, options, and swaps.
The main use of derivatives is to reduce risk for one party. The diverse range of potential underlying assets and pay-off alternatives leads to a wide range of derivatives contracts available to be traded in the market. Derivatives can be based on different types of assets such as commodities, equities (stocks), bonds, interest rates, exchange rates, or indexes (such as a stock market index, consumer price index (CPI) — see inflation derivatives — or even an index of weather conditions, or other derivatives). Their performance can determine both the amount and the timing of the pay-offs.”
http://en.wikipedia.org/wiki/Derivative_(finance)
The single biggest problem with derivatives is that most all derivatives contracts are UNLISTED PRIVATE CONTRACTS BETWEEN COUNTERPARTIES and there is thus no way to establish “market value” of derivatives. They are not trades on exchanges and are essential subjectively valued “Level 3″ assets that only have value if another party can be found to buy them. If derivatives were required to be STANDARDIZED AND LISTED ON OTC EXCHANGES they would not be such a danger to the economic system as there would be “market value” and they would become much more “fungible” like commodities (which are totally fungible) and there would be transparency.
If you really want to understand why derivatives are so impossible to value and so complex, try reading an actual sample derivaties contract:
ABD AGREEMENT OTC-DERIVATIVES
http://print.onecle.com/contracts/navteq/abn-amro.derivatives.2004.shtml
You will quickly see, even if you are an experience financial person or lawyer, why derivatives are so impossible to value because of their vast incomprehensible complexity with a “trigger” hinged on uncertain external financial events - and that is the most fundamental problem related to the whole $500 billion to $1 quadrillion nominal value derivatives nightmare.
The derivatives bubble is the single biggest credit bubble in the world with some estimates putting the total nominal amount of $1 quadrillion. By the most conservative BIS estimates it is well over $600 trillion. However, there is a huge difference between the actual amount of money involved in the derivatives misadventure and the “nominal” value which is like the face value on a life insurance policy. The actual money involved is more like the premiums paid on a term life insurance policy and is probably no more than 2% of the nominal value. Even at 2% that still means that there are over $12 trillion involved in the derivatives betting game. There is no question but that the derivatives gambling casino will go bust.
GTM
The best solution is to simply void all derivatives contracts and return the premiums paid on them and unwind the entire derivatives markets in its entirety. All it is financially is a betting parlor with best on which way indexes, or interest rates, or whatever will move. There is no financial value in such arrangements and all is does is to create vast risk of losses (in the guise of doing exactly the opposite by “hedging them”) and this entire derivatives market worldwide should be unwound and shut down in an orderly fashion before it implodes or explodes.