Saturday, September 27, 2008

Over One Quadrillion Dollars in Derivatives

That is greater than the value of all things on Earth.

The unravelling of these derivatives could eat up all wealth.

And the $700 billion bailout now before Congress will be a joke if this derivatives bubble were to suddenly burst.

The Bank of International Settlements recently reported that the amount of
outstanding derivatives has now reached the $1.14 quadrillion mark ($548
Trillion in listed credit derivatives plus $596 trillion in notional [or face
value] OTC derivatives)....

Derivatives, as you may know, are essentially unregulated, high-risk credit bets. Unlike the earnest farmer who might employ a futures contract to hedge the price of the beans he’s worked so hard to grow, many of today’s institutions use futures, forwards, options, swaps, swaptions, caps, collars and floors—any kind of leverage device they can cook up—to bet the hell out of virtually anything.

What drives derivatives, at their very roots (if you can somehow get back that far), are base assets that get leveraged to a demented degree. Martin Mayer writing for the Brookings Institute, said, “the receiver of the payments on these loans or securities has bought the securities for the duration of the swap on 95% margin, even though the law says nobody can buy securities without putting up half the price.”

Extrapolated, $1.14 quadrillion in assets “owned” on something like 95% margin has to be one of the scariest phenomena in economic history....

Eventually, shockingly, something will happen. Some bank will slip up, some mathematician will miscalculate or the Fed just won’t react fast enough, and the whole [$1.14] quadrillion derivative complex will come tumbling down around our feet. Only it might not be [$1.14] quadrillion by then. It might be a whole lot more.

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