Skip to comments.The Horrific Derivatives Bubble That Could Destroy Entire World Financial System
Posted on 08/09/2010 6:07:25 PM PDT by Errant
Michael Snyder writes: Today there is a horrific derivatives bubble that threatens to destroy not only the U.S. economy but the entire world financial system as well, but unfortunately the vast majority of people do not understand it. When you say the word "derivatives" to most Americans, they have no idea what you are talking about. In fact, even most members of the U.S. Congress don't really seem to understand them. But you don't have to get into all the technicalities to understand the bigger picture.
Basically, derivatives are financial instruments whose value depends upon or is derived from the price of something else. A derivative has no underlying value of its own. It is essentially a side bet. Originally, derivatives were mostly used to hedge risk and to offset the possibility of taking losses. But today it has gone way, way beyond that. Today the world financial system has become a gigantic casino where insanely large bets are made on anything and everything that you can possibly imagine. The derivatives market is almost entirely unregulated and in recent years it has ballooned to such enormous proportions that it is almost hard to believe. Today, the worldwide derivatives market is approximately 20 times the size of the entire global economy.
Because derivatives are so unregulated, nobody knows for certain exactly what the total value of all the derivatives worldwide is, but low estimates put it around 600 trillion dollars and high estimates put it at around 1.5 quadrillion dollars.
Do you know how large one quadrillion is?
Counting at one dollar per second, it would take 32 million years to count to one quadrillion.
If you want to attempt it, you might want to get started right now.
To put that in perspective, the gross domestic product of the United States is only about 14 trillion dollars.
In fact, the total market cap of all major global stock markets is only about 30 trillion dollars.
So when you are talking about 1.5 quadrillion dollars, you are talking about an amount of money that is almost inconceivable.
So what is going to happen when this insanely large derivatives bubble pops?
Well, the truth is that the danger that we face from derivatives is so great that Warren Buffet has called them "financial weapons of mass destruction".
Unfortunately, he is not exaggerating.
It would be hard to understate the financial devastation that we could potentially be facing.
A number of years back, French President Jacques Chirac referred to derivatives as "financial AIDS".
The reality is that when this bubble pops there won't be enough money in the entire world to fix it.
But ignorance is bliss, and most people simply do not understand these complex financial instruments enough to be worried about them.
Unfortunately, just because most of us do not understand the danger does not mean that the danger has been eliminated.
In a recent column, Dr. Jerome Corsi of WorldNetDaily noted that even many institutional investors have gotten sucked into investing in derivatives without even understanding the incredible risk they were facing....
A key problem with derivatives is that in the attempt to reduce costs or prevent losses, institutional investors typically accepted complex risks that carried little-understood liabilities widely disproportionate to any potential savings the derivatives contract may have initially obtained.
The hedge-fund and derivatives markets are so highly complex and technical that even many top economists and investment-banking professionals don't fully understand them.
Moreover, both the hedge-fund and the derivatives markets are almost totally unregulated, either by the U.S. government or by any other government worldwide.
Most Americans don't realize it, but derivatives played a major role in the financial crisis of 2007 and 2008.
Do you remember how AIG was constantly in the news for a while there?
Well, they weren't in financial trouble because they had written a bunch of bad insurance policies.
What had happened is that a subsidiary of AIG had lost more than $18 billion on Credit Default Swaps (derivatives) it had written, and additional losses from derivatives were on the way which could have caused the complete collapse of the insurance giant.
So the U.S. government stepped in and bailed them out - all at U.S. taxpayer expense of course.
But the AIG incident was actually quite small compared to what could be coming. The derivatives market has become so monolithic that even a relatively minor imbalance in the global economy could set off a chain reaction that would have devastating consequences.
In his recent article on derivatives, Webster Tarpley described the central role that derivatives now play in our financial system....
Far from being some arcane or marginal activity, financial derivatives have come to represent the principal business of the financier oligarchy in Wall Street, the City of London, Frankfurt, and other money centers. A concerted effort has been made by politicians and the news media to hide and camouflage the central role played by derivative speculation in the economic disasters of recent years. Journalists and public relations types have done everything possible to avoid even mentioning derivatives, coining phrases like toxic assets, exotic instruments, and most notably troubled assets, as in Troubled Assets Relief Program or TARP, aka the monstrous $800 billion bailout of Wall Street speculators which was enacted in October 2008 with the support of Bush, Henry Paulson, John McCain, Sarah Palin, and the Obama Democrats.
But wasn't the financial reform law that Congress just passed supposed to fix all this?
Well, the truth is that you simply cannot "fix" a 1.5 quadrillion dollar problem, but yes, the financial reform law was supposed to put some new restrictions on derivatives.
And initially, there were some somewhat significant reforms contained in the bill. But after the vast horde of Wall Street lobbyists in Washington got done doing their thing, the derivatives reforms were almost completely and totally neutered.
So the rampant casino gambling continues and everybody on Wall Street is happy.
One day some event will happen which will cause a sudden shift in world financial markets and trillions of dollars of losses in derivatives will create a tsunami that will bring the entire house of cards down.
All of the money in the world will not be enough to bail out the financial system when that day arrives.
The truth is that we should have never allowed world financial markets to become a giant casino.
But we did.
Soon enough we will all pay the price, and when that disastrous day comes, most Americans will still not understand what is happening.
The sky is falling!
This is the sort of article that gives fear mongering a bad name.
He does not clearly explain the difference between the notional value of derivatives and the actual amount of money that can be gained or lost.
For example, suppose I bet you a dollar that the Dow Jones Industrials will go down tomorrow. The notional value of this contract would be the amount of money spent buying and selling the 30 Dow stucks, which is billions of dollars even for one day. However, the most I can make or lose on this contract is one dollar.
Now let’s try a real-world example. When Lehmann failed, it failed for $380 billion. There were in fact CDOs outstanding on this debt several times over, or more than a trillion dollars worth of CDOs. However, when the 300-odd major holders of these derivative positions met to settle up, only about $18 billion in actual cash had to be paid out, since each position was heavily hedged.
....And "SubPrime" was "contained"......
I knew there was a Liberal in the woodpile somewhere... Nobody EVER explains what that nasty "triggering" event would be. Just like TARP... the sky is falling so pass this crazy legislation that you don;t understand and didn't bother to read. I think this threat is nuts... how many bets on tonight's baseball game? Who knows? But, when the game is over, the market clears real fast...
Or... I’m totally wrong and this is really scary!
So we’re only looking at about a 27 trillion dollar pay out? That makes me feel a lot better. Thanks!
Actually, there aren’t 1.5 quadrillion dollars in existence so somebody got snookered...
So - I have been hearing about these things for quite awhile. Why are all governments continuing with them. Why not reel them in, starting like tomorrow? Why do things have to burst? Where are the adults?
Can someone take the Market Oracle out back and shoot it, please?
I swear, it pains me to see otherwise sane people becoming as deranged as the “Oh my God, a car backfired, it’s a sign of the apocalypse!” types. It’s a sickness.
It won't be the first time! Ducking & lol...
The US economy is not the financial system.
The financial system is ALREADY destroyed, and the sooner it collapses, the better.
The end of this big con won’t destroy the real economy, it will liberate it.
They have been unable or unwilling to regulate them it seems.
Yes, it's 999,999,999,999,999,999 more than the number of brain cells possessed by the average Market Oracle writer.
I have news for you, subprime mortgages are not derivatives.
A bank loan is not a derivative.
A covered call is a derivative, and selling covered calls is one of the safest investments you can make. In fact, it's safer than buying a stock without selling the call. But unless you know what derivatives are and how they can be used, you are fooled by all the references to big numbers in this article.
Here, you do it... http://www.marketoracle.co.uk :)
The incentives for mischief here are enormous. I doubt it means the end of the world if they all blow up. More likely, Michelle Obama will only be able to take 7 vacations next summer instead of 8.
1. Listed credit derivatives stood at USD 548 trillion;
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:
a. Interest Rate Derivatives at about USD 393+ trillion;
b. Credit Default Swaps at about USD 58+ trillion;
c. Foreign Exchange Derivatives at about USD 56+ trillion;
d. Commodity Derivatives at about USD 9 trillion;
e. Equity Linked Derivatives at about USD 8.5 trillion; and
f. Unallocated Derivatives at about USD 71+ trillion.
Not counting 32 million years of interest!
350 Million Americans could be eating nothing but rice and MO would still take her vacations.
I guess it's all insured, another impossibility...
This makes Vegas look like a truckstop casino...
What the taxpayer (without consent) bailed out were the counter-parties to the AIG bets. Had AIG failed, and the counter-parties suffered losses, as they should have, the derivatives market would have shrunken pretty fast as the "Oh my God, look at what we lost" factor was appreciated.
Yup. It's always something....
If you're ready for doomsday for one reason, I've found that it requires little modification for all other possible reasons.
So...let her rip!
Okay. I'll agree that 600 trillion dollars is a frightening number and a quadrillion dollars is a horrifying number. But how does this particular bubble go "pop"? What is the triggering mechanism? What does it look like? How will it play out when it happens?
Alright, your post goes a long way toward putting the actual risk into proper context. The question remains, if this really is a “bubble,” how will it pop?
With all the doom and gloom going on, what would actually happen should this take place? I am tired of everyone scaring the beejeezes out of me and then not telling me how it will affect little old me in Kentucky.
I hear you. I have the same question.
Stupid article because derivatives are zero sum. Sure, they can break one guy...but that only moves the loser’s money over to the winner.
The same money overall still remains in the economy; it just moved.
Thus, derivatives can’t break the economy....just the losers.
Ever hear of the phrase "Too Big to Fail"?
That means when when a "Too Big to Fail" (like AIG) fails, the government borrows the money (Billions and billions of dollars for AIG) and pays off their gambling debt. The losers in this case are the pensioners, 401K holders, you and I and our children and grandchildren and great grandchildren. The increase in national debt limits our ability to provide things like defense, roads and bridges, social security, and etc and etc. Under the right circumstances, this market collapsing could be disastrous as it would trigger a collapse of our debt bubble, currency and economy. And not just us, but many other countries in the same boat as us.
The point of the article is about derivatives. Well, all that derivatives can do is to move money from a loser to a winner.
The same money stays in the economy. Sure, the loser of a derivatives transaction can be broken by the contract, but his money simply enriches the winner.
For every job lost by a derivatives loser, a new job will be created by a derivatives winner.
That may create some chaos, but it won’t break an economy.
I'm sure there are experts on FR who can provide much more detail.
Not really. Due to leverage, the loser who had only 1 job to bet, probably bet 10 jobs but borrowed the 9 which he didn't have. Because he is too big to fail, the government makes a deal and only takes 5 jobs from your company and gives them to the winner in China who just had 100 workers enter the job market. Meanwhile, the value of our jobs continue to decline due to the excess of illegal immigrants (monetizing of the debt). Now your company is at an unfair advantage because of an artificial market, goes bust and you suffer a heart attack and die from all the stress.
Nope. You are confusing bailouts (which happen even without derivatives, see GM & Chrysler) with derivatives.
Derivatives are economically neutral. Derivatives are like making a bet with a buddy. One of you will win, the other will lose, so money will flow from the loser to the winner to cover the bet.
That’s economically neutral because the “bet” merely moved money from one person to the other...no new money was created...no old money was destroyed.
Same with derivatives.
One person wins, the other person loses each derivatives bet.
Money moves between those two people, but money is neither created nor destroyed by the derivative.
So the broader economy sees the same amount of money left in it.
That’s economically neutral. Zero sum.
That means that derivatives can’t cause an economic crash.
Oh sure, derivatives can break a company...but one company’s loss is another company’s gain.
This nets out.
To the economy at large, derivatives are harmless. That’s why you can have multi-Trillions of them (and we’ve had them for years).
He’s blaming Sarah Palin for the Bail-out? Really?? How exactly does that work?
No I'm not, every example I gave you was based around "bailouts". I agree that minor derivative transactions doesn't mean collapse of the financial system.
What I failed to convey to you was my agreement with the author that the size of the market, lack of controls and exposure to manipulation could create a dangerous situation. Such an event might be the trigger that causes the collapse of most of the worlds financial systems. Many of which are already under a great deal of strain.
I guess I thought you realized this. I should have been more detailed in my example of AIG.
This thread is about derivatives. You’re railing about bailouts.
Two different things.
The *derivatives* are economically harmless. They are financially neutral. For every company that they kill, that much wealth is transfered to another.
That just moves money around...it doesn’t...and can’t...cause an economic collapse.
Tell that to AIG!