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About those derivatives

Read this with Barry Ritholtz's excellent article in the Washington Post, "Credit default swaps are insurance products. It’s time we regulated them as such.

This subject is so complex that it helps to read (and reread) the meaning of terms while trying to understand the material. It's a lot like learning a foreign language. So here is some background information describing what derivatives are, how big the derivatives markets are, and why this is a problem. ~ Ilene

Terms and Definitions:

Derivatives – A derivative is a risk transfer agreement, the value of which is derived from the value of an underlying asset. The underlying asset may be an interest rate, a commodity, equity shares, an equiity index, a currency, or virtually any other tradable instrument upon which parties can agree.

According to Wikipedia, "A derivative instrument is a contract between two parties that specifies conditions (especially the dates, resulting values of the underlying variables, and notional amounts) under which payments, or payoffs, are to be made between the parties. 

"Under US law and the laws of most other developed countries, derivatives have special legal exemptions that make them a particularly attractive legal form through which to extend credit. However, the strong creditor protections afforded to derivatives counterparties, in combination with their complexity and lack of transparency, can cause capital markets to underprice credit risk. This can contribute to credit booms, and increase systemic risks. Indeed, the use of derivatives to mask credit risk from third parties while protecting derivative counterparties contributed to both the financial crisis of 2008 in the United States and the European sovereign debt crises in Greece and Italy.

"Financial reforms within the US since the financial crisis have served only to reinforce special protections for derivatives, including greater access to government guarantees, while minimizing disclosure to broader financial markets." More here. 

Credit Default Swaps (CDSs) - A type of derivative - a credit derivative contract between two counterparties. According to Wiki, "A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a loan default or other credit event. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults."

Thus, the buyer of the CDS receives a payoff from the seller IF the underlying financial instrument defaults or experiences a similar credit eventRead more here.

Collateralized debt obligations (CDOs)  - Another type of derivative. "CDOs are a type of structured asset-backed security (ABS) with multiple 'tranches' that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixed-income underlying assets… In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower layers (tranches) suffer losses first.

"CDOs can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000–2006, then declined dramatically in the wake of the subprime mortgage crisis, which began in 2007. Many of the assets held by these CDOs had been subprime mortgage-backed bonds. Global investors began to stop funding CDOs in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.

A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other ABSs, and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the subprime mortgage crisis in 2007, this view has gained substantial credibility. Credit rating agencies failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs with the highest possible grade. More here.

Articles

According to the Bank for International Settlement's (BIS) reports (OTC [over the counter] derivatives market activity in the first half of 2011 and Semiannual OTC derivatives statistics at end-June 2011), the size of the derivatives market now is in excess of $700 Trillion Dollars. 

Zero Hedge explains in,

"$707,568,901,000,000: How (And Why) Banks Increased Total Outstanding Derivatives By A Record $107 Trillion In 6 Months:"

While everyone was focused on the impending European collapse, the latest soon to be refuted rumors of a quick fix from the Welt am Sonntag notwithstanding, the Bank of International Settlements reported a number that quietly slipped through the cracks of the broader media. Which is paradoxical because it is the biggest ever reported in the financial world: the number in question is $707,568,901,000,000 and represents the latest total amount of all notional Over The Counter (OTC, read unregulated) outstanding derivatives reported by the world's financial institutions to the BIS for its semi-annual OTC derivatives report titled "OTC derivatives market activity in the first half of 2011."

Indicatively, global GDP is about $63 trillion if one can trust any numbers released by modern governments. Said otherwise, for the six month period ended June 30, 2011, the total number of outstanding derivatives surged past the previous all time high of $673 trillion from June 2008, and is now firmly in 7-handle territory: the synthetic credit bubble has now been blown to a new all time high. Another way of looking at the data is that one of the key contributors to global growth and prosperity in the past 10 years was an increase in total derivatives from just under $100 trillion to $708 trillion in exactly one decade. And soon we have to pay the mean reversion price…

Try not to laugh. Or cry. Or gloss over, because when it comes to visualizing $708 trillion most really are incapable of doing so.

Total outstanding gross market value by 6 month period:

 

Notice that the top chart is of the Total Over-The-Counter Outstanding Derivatives while the second chart is of the Gross Market Value of the Total Over-The-Counter Outstanding Derivatives? Zero Hedge explained the difference.

First, according to the BIS:

 
 

Notional amounts outstanding: Nominal or notional amounts outstanding are defined as the gross nominal or notional value of all deals concluded and not yet settled on the reporting date. For contracts with variable nominal or notional principal amounts, the basis for reporting is the nominal or notional principal amounts at the time of reporting.

 

Nominal or notional amounts outstanding provide a measure of market size and a reference from which contractual payments are determined in derivatives markets. However, such amounts are generally not those truly at risk. The amounts at risk in derivatives contracts are a function of the price level and/or volatility of the financial reference index used in the determination of contract payments, the duration and liquidity of contracts, and the creditworthiness of counterparties. They are also a function of whether an exchange of notional principal takes place between counterparties. Gross market values provide a more accurate measure of the scale of financial risk transfer taking place in derivatives markets.

Zero Hedge argued: "Well, no. It is logical that the BIS will advise everyone to ignore the bigger number and focus on the small one: just like everyone was told to ignore gross exposure and focus on net… until Jefferies had to dump all of its gross PIIGS exposure or stare bankruptcy in the face; so no – the correct thing to say is "gross market values provide a more accurate measure of the scale of financial risk transfer" if one assumes there is no counterparty risk. Because once the whole bilateral netting chain is broken, net becomes gross. And gross market value becomes total notional outstanding. And, to quote Hudson, it's game over.

As for the largely irrelevant gross market value, which is only relevant in as much as it will be the catalyst which will precipitate margin calls on the underlying notionals, all $700+ trillion of them (Quoting the BIS):

Gross positive and negative market values: Gross market values are defined as the sums of the absolute values of all open contracts with either positive or negative replacement values evaluated at market prices prevailing on the reporting date. Thus, the gross positive market value of a dealer’s outstanding contracts is the sum of the replacement values of all contracts that are in a current gain position to the reporter at current market prices (and therefore, if they were settled immediately, would represent claims on counterparties). The gross negative market value is the sum of the values of all contracts that have a negative value on the reporting date (ie those that are in a current loss position and therefore, if they were settled immediately, would represent liabilities of the dealer to its counterparties).

The term “gross” indicates that contracts with positive and negative replacement values with the same counterparty are not netted. Nor are the sums of positive and negative contract values within a market risk category such as foreign exchange contracts, interest rate contracts, equities and commodities set off against one another….

"And here again, what they ignore to add is that the measure of economic significance is only relevant in as much as the world's banks don't begin a Lehman-MF Global tango of mutual margin call annihilation. In that case, no. They are not measures of anything except for what some banks plug into some models to spit out a favorable EPS treatment at the end of the quarter.

"Expect to see gross market value declines persisting even as the now parabolic increase in total notional persists. At this rate we would not be surprised to see one quadrillion in OTC derivatives by the middle of next year.

"And, once again for those confused, the fact that notional had to increase so epically as market value tumbled most likely means that the global derivative pyramid scheme (no pun intended) is almost over."

*****

Back in 2008:

$596 Trillion!How can the derivatives market be worth more than the world's total financial assets? (Slate)

Excerpt: Iowa Sen. Tom Harkin issued a call on Tuesday for regulation of the "over the counter" derivatives market, which has an estimated size of about $596 trillion. By contrast, the value of the world's financial assets—including all stock, bonds, and bank deposits—was pegged at $167 trillion last year by McKinsey. How can the derivatives market be larger than the entire world's financial wealth?

Because the same assets might be involved in several different derivatives. A derivative is a financial instrument whose value depends on something else—a share of stock, an interest rate, a foreign currency, or a barrel of oil, for example. One kind of derivative might be a contract that allows you to buy oil at a given price six months from now. But since we don't yet know how the price of oil will change, the value of that contract can be very hard to estimate. (In contrast, it's relatively easy to add together the value of every share being traded on the stock market.)

The Monster That Ate Wall Street (The Daily Beast)

Excerpt: They're called "Off-Site Weekends"—rituals of the high-finance world in which teams of bankers gather someplace sunny to blow off steam and celebrate their successes as Masters of the Universe. Think yacht parties, bikini models, $1,000 bottles of Cristal. One 1994 trip by a group of JPMorgan bankers to the tony Boca Raton Resort & Club in Florida has become the stuff of Wall Street legend—though not for the raucous partying (although there was plenty of that, too). Holed up for most of the weekend in a conference room at the pink, Spanish-style resort, the JPMorgan bankers were trying to get their heads around a question as old as banking itself: how do you mitigate your risk when you loan money to someone? By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad. But what if JPMorgan could create a device that would protect it if those loans defaulted, and free up that capital?

What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices. While the concept had been floating around the markets for a couple of years, JPMorgan was the first bank to make a big bet on credit default swaps. It built up a "swaps" desk in the mid-'90s and hired young math and science grads from schools like MIT and Cambridge to create a market for the complex instruments. Within a few years, the credit default swap (CDS) became the hot financial instrument, the safest way to parse out risk while maintaining a steady return. "I've known people who worked on the Manhattan Project," says Mark Brickell, who at the time was a 40-year-old managing director at JPMorgan. "And for those of us on that trip, there was the same kind of feeling of being present at the creation of something incredibly important."

Like Robert Oppenheimer and his team of nuclear physicists in the 1940s, Brickell and his JPMorgan colleagues didn't realize they were creating a monster. 


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