Yves here. Readers have asked us to write about the ginormous scale of the derivatives market. This article is a layperson-friendly discussion of bank efforts to stymie the not-onerous safeguards in Dodd Frank and why you should be up in arms about it. Derivatives, specifically credit default swaps, were the reason what would otherwise been a contained subprime crisis into a global financial meltdown. If you have not done so already, we strongly encourage you to call your Senator and Representative and tell them you are strongly opposed to this stealth effort by banks to keep taxpayers on the hook for the derivatives casino and allow it to continue to operate with minimal supervision.
By Gaius Publius. Cross posted from Americablog
We wrote earlier about the recent move by bankers — and the politicians who serve them — to unreform the derivatives market, to return it to its pre–Dodd-Frank, pre–Crash-of-2007 state. This is a serious move by banks and bank lobbyists, and it could well happen soon. The seven bills in the House package of “tweaks” — as the House Agriculture website dishonestly puts it — have cleared the committee with Democratic support and are headed to the House floor. In the meantime, there are companion bills in the Senate.
What will happen in the Senate? Well, Dick Durbin (always an Obama surrogate) famously said of the Senate that “the banks own the place.” And of course the White House has been notoriously bank-friendly since day 1. As a friend told me last week, “Bank lobbyists are good; they really earn their money.” Indeed.
Our earlier story focused on both aspects of this push — the “bad Dems” side and the derivatives side. Let’s now look at just the derivatives aspect.
What is a “derivative”?
While a general definition of a derivative in this context could be — “A financial product derived from another financial product” (for example, a futures contract tied to a stock index) — in practice, the term applies to a whole world of financial products that are written on a one-off basis between two entities called “counterparties,” as opposed to products that are traded on a broad, well-regulated market.
Standard futures contracts are bought and sold on large exchanges, for example, the Chicago Board of Trade (CBOT). If I buy a futures contract — for example, I go long (contract or agree to buy in the future) a million bushels of wheat, or barrels of oil, in the expectation that the future price will rise within the time limit of the contract — there will be a counterparty on the short, or selling side, but I have no idea who that is. In fact, in a well-regulated market, the contracts are all standardized; there are thousands of identical contracts in pairs (one on the long or buy side, and one on the short or sell side); and as long as there are the same number of identical contracts on each side, it makes no difference who’s on the other side of my personal contract. The exchange just matches up longs with shorts when they liquidate.
The contracts, as you can see, are created by the exchanges themselves (for example, by the CBOT); they keep the operation orderly; and there are rules, both by the exchanges and by the government, that prevent things (mostly) from running out of control. For example, I can indeed buy futures contracts on millions and millions of barrels of oil for delivery next July (say), and I can put up a tenth of the cost of these contracts, but if the market moves against me, I have to increase my margin (add to my escrow if you will) to protect my counterparties from my inability to pay. The exchange requires that, and if I don’t comply, I’m liquidated (at my expense) and kicked out.
Futures contracts are gambling — I can bet on the Dow to go down or up, for example — but trading in futures contracts is regulated gambling, in which winners are protected from losers, and in many cases, losers protected from themselves.
Not so, derivatives, in the usual meaning of the word. Derivatives in that sense are contracts between parties who want to trade risks, but they aren’t market-traded. They aren’t standardized. And counterparties aren’t vetted by any controlling institution.
In derivatives trading, the counterparties know each other, the contracts are one-off between the parties directly, and the only guarantee that either party will get paid is trust … or the naked belief that they just can’t lose on this one.
AIG wrote billions of dollars of CDS “insurance” against the mortgage market without having even a fraction of what it would take to pay off claims … in the naked belief that they could collect fees forever and never have to pay out once. When the whole thing collapsed, they were wiped out. And because their “insurance” was part of the balance sheet of AIG’s many counterparties (Goldman Sachs and everyone like them), Goldman Sachs would have been wiped out too by AIG’s failure (in effect, by their lies and deception).
That’s why the government bailed out AIG — and insisted on giving them 100 cents on the dollar — so that they could pay off Goldman et al. AIG was bailed out to bail out all their counterparties. (Our discussion of CDSs and their role as bets is here.)
How large is the derivatives market? $1.2 quadrillion in notional value; at least $12 trillion in cash at risk
You read that headline right. By at least one estimate, in 2010 there was a total of $12 trillion in cash tied up (at risk) in derivatives as defined above, all of which controlled contracts connected to assets valued at $1.2 quadrillion.
Big Risk: $1.2 Quadrillion Derivatives Market Dwarfs World GDP
One of the biggest risks to the world’s financial health is the $1.2 quadrillion derivatives market. It’s complex, it’s unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost — and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so. A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon’s), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world’s annual gross domestic product is between $50 trillion and $60 trillion. To understand the concept of “notional value,” it’s useful to have an example. Let’s say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.
You might be able to hedge this risk of a spike in interest rates by swapping that variable rate of interest for a fixed one. To do that you’d need to find a counterparty who has an asset with a fixed rate of return who believed that interest rates were going to fall and was willing to swap his fixed rate for your variable one.
The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the “notional” amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion — far smaller, but still 20% of the world economy.
To trust that lower number ($12 trillion), a lot depends on what’s being traded. In the example above — an “interest rate swap” — what’s being traded (swapped) is the risk of small interest rate changes on the $1 million you borrowed. It’s never the whole $1 million (the notional value).
But with a CDS — a “credit default swap” as discussed here — what’s traded is a fee paid by one side vs. the whole cost of the default paid by the other side. If I as an “insurer” sold a hedge fund a CDS on $20 million in GM bonds, and those bonds default, I’m on the hook for the whole $20 million, the “notional” value.
As a result, I accept the $1.2 quadrillion notional value number. But I think the $12 trillion cash-at-risk number is way low. And “just” $12 trillion is, as they point out, still 20% of world GDP. Stunning.
And don’t forget, these are 2010 numbers. Banks have grown even fatter since then, even greedier, even riskier. And their push to gut the modest regulations put in place by Dodd-Frank declares their intentions to grow. Whatever the size of this market today, expect it to grow like a weed.
Again, House bill HR 992, one of the seven mentioned at the beginning of this piece, is the one that makes you, the taxpayer, even more on the hook for banker-losses than you were after the Dodd-Frank reform. For the banks, the high-priced lobbyists, and their paid, moderately-priced politicians, this is a Win-Win.
But for you, it’s a second trip to Bailout Village. As for the nation … well, I think there’s rebellion in the air if this happens twice. In this case, the hubris of our enemies is not our friend. Not our friend at all.
I thought you should know this, though. We’re going to be covering the derivatives story to conclusion. Hopefully this post and the previous one will keep you oriented as the game moves forward. Quoting Congressman Grayson again:
“The road to hell is paved with these bills.”