A $43 Trillion Dollar Market That Most People Have Never Heard Of

According to Bill Gross, a fixed income market guru, the size of the credit default swap market is "$43 trillion, more that half the size of the entire asset base of the global banking system." If that is not scary enough he goes on to tell is that "total derivatives amount to over $500 trillion, many of them finding their way"......................well, everywhere.

You are going to be hearing a lot more about these markets in coming weeks and months, which begs the question, why don't most people even know what they are? And more importantly, why should we care?

Bill Gross is a very senior guy at PIMCO, one of the largest fixed income managers in the world. They boast managing over $700 billion of assets, and in my experience as an ex-Goldman Sachs bond trader, they generally do it very well. Bill has been talking for a while now about the "Shadow Banking System" that has developed, which now dwarfs the traditional banking system. He describes how "our modern shadow banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever." Participants in this shadow banking system are in the business of making money, much like their more regulated cousins. They borrow money, leverage it up, and invest in assets to make a positive spread. Sounds simple, until things start to go wrong in the underlying asset, which of course is what is happening now.

At the center of this system is a product little known outside of the world of fixed income traders and investors, called Credit Default Swaps. According to Wikepedia, a "credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. Under a credit default swap agreement, a protection buyer pays a periodic fee to a protection seller in exchange for a contingent payment by the seller upon a credit event (such as a default or failure to pay) happening in the reference entity. When a credit event is triggered, the protection seller either takes delivery of the defaulted bond for the par value (physical settlement) or pays the protection buyer the difference between the par value and recovery value of the bond (cash settlement).

Credit default swaps resemble an insurance policy, as they can be used by debt owners to hedge against credit events. However, because there is no requirement to actually hold any asset or suffer a loss, credit default swaps can be used to speculate on changes in credit spread.

Credit default swaps are the most widely traded credit derivative product. The typical term of a credit default swap contract is five years, although being an over-the-counter derivative, credit default swaps of almost any maturity can be traded. "

Now what part of that description did you find the scariest? Was is the fact that this market is $43 trillion according to Gross? Or that all the contracts are based on the CREDIT of the underlying asset? Or the contingent payment based upon a credit event? Or the fact that in most cases the seller can ask for delivery of the defaulted bond? Or that there is no requirement to actually hold any asset or suffer a loss? Each of these questions could take pages and pages to dissect.

The whole system is obviously based on the assumption that your counter-party can in fact make good on the trade. That is why banks are moving quickly to check their counter-party risk and up shore up margin requirements. The prices of the underlying securities have been going down, making net net, some people winners, and some losers. It is the losers we need to worry about as they need to make good on their part of the trade, but will they have the money, the capital, to do so?

As an ex-trader I also find the part about the seller requesting delivery of the security to be particularly alarming. My old trader rule book tells me that you only sell (short) expensive bonds when you have locked up the borrowing, or else you get caught in something called a short squeeze. Knowing that these underlying bonds/loans can be synthetically created at a huge multiple of the underlying asset depending on demand for that asset, this could be really, really, really costly to many, and be very profitable for a few.

Given the size of the market, and the lack of transparency as to who owns what, we really have no idea about the financial impact caused by the deterioration of the underlying assets. This is why we care. One can not look at history to help figure this out either, as we have never had so much credit product outstanding. Where we are currently in the credit markets is fresh territory, uncharted waters, the wild west. The system is so complex and interconnected that it is absolutely impossible for anyone, any firm, any anything, to get their arms around it. Smart people are going to figure out a way to make money from this uncertainly, and less smart people are going to lose a lot.

Bill Gross is warning of the possibility of financial Armageddon as a result of this financial pyramid scheme, along the same line that George Soros, another billionaire who generally knows what he is talking about, came out about a few weeks ago. Both of these wizards of Wall Street have been known to talk to their position, but that does not mean they are not right.

I can't help but think of the movie, The Game, starring Michael Douglas as the playboy multi-millionaire, Nicholas. He thinks he is getting a present from his brother, a Game, that will change his life. "As the movie progresses, evidence mounts that the game is actually an elaborate scheme, but each time Nicholas thinks he has uncovered the truth, he finds a new layer of complexity has been revealed and that his previous assumptions were false."

Let's hope that enough pieces of this financial story get revealed in a timely way to prevent anyone from losing their faith in the overall system. There can be a happy ending, but like Nicholas, Bill, George and others, are having a hard time figuring it out.

Comments

[mrdontplay]

...money is the ROOT.

I think that has been proven true in how many civilizations and milliniums?

[NABNYC]

I know someone who sells 20-year annuities to seniors. Won't sell anything less than 20-years. Get these people to think it's a good deal to give him (and some insurance company) a big chunk of their money for 20 years.

The problem is that most people aren't in the position to give away their money for 20 years. When things go bad, such as their income drops because the feds slash interest rates, these old people need their money back.

The guy who sells the annuities makes huge commissions from selling the 20-year annuities. He sold a 20-year annuity to a lady who had just received a terrible health diagnosis, and who was dead in 5 months. This guy is rich. He's also a Christian. A Christian Minister. You want a good source of suckers? Start your own church.

Anyway, there's a new business field now, which is going around to those old people who gave someone $100,000, but now they need their money -- and buying it back from them for pennies on the dollar. Making money on both ends of the deal.

It's tragic the way theft is legalized by people called "financial advisors," who are really just thieves. Particularly when they shout hallelujah and wear a big crucifix around their neck.

[willo]

Now if some nefarious source inside or outside the USA was contemplating it's destruction what better way of doing it. Either through massive incompetence, stupidity or malice this thing is unfolding. We have a corporate media whose main job is to obfuscate what is actually happening. We are all along for the ride, good luck.
Thanks congress for letting our country be ruined. May you reap what you have sown.

[mbaty]

Oh money! You make us all crazy.
If only we were crazy enough to create a system that worked for all of us...what would that even look like?

[Kantinflas]

Notice something? Only a couple of dozen comments on the ticking time bomb which might trigger the Second Great Depression. Whereas reports on HuffPo's political pages that Hillary changed her lipstick or Barack scuffed a shoe will draw three or four thousand comments. Is ignorance really bliss?

[mrdontplay]

...institu­tionalized ignorance

[FreedomCorpse]

They let the patients run the insane asylum with deregulation. What does anyone expect?

[rationalcon]

I continue to find it interesting that the size and breadth of the derivatives market is being treated as new information. In 1998 a relatively small derivative position gone bad at LTCM "almost" resulted in the total collapse of the world banking system. The Fed and Treasury knew at that time that unbridled use of derivatives to reduce risk was in fact an exceedingly risky approach. So why did they turn a blind eye as the "quants" fixed their models and the worldwide derivatives market exploded - so much so that it's tentacles reach into almost everyone's pockets in the world?

I ask myself this question daily, and I can't come up with any rational answer except short term greed at the expense of long term well being.

Many backwater financial pundits have been raising the alarm about the insidious derivatives market for many years, and anyone that is just now discovering the problem just hasn't been paying attention. Hopefully, (yes, that would be an invocation of faith) some adults will prevail and reign this in for a highly controlled unwinding of these positions.

I'm not optimistic. The spectre of an uncontrolled unwinding (crash) of these securities is real, but the odds of our elected officials doing anything until after the event is zero.

I weep for the future of my young sons.

[midtown]

They knew in 1998. Clinton got rid of the 1933 Glass-Steagall Act and replaced it with the Financial Services Modernization Act, also known as Gramm-Leach-Bliley (GLB). Glass-Steagall, actually two acts, was created after the financial scams of the 1920s.

Read this:

http://minneapolisfed.org/pubs/region/00-03/bush.cfm

And take note of where the Woodstock Institute is. That's why I trust Obama far more than Hillary to even understand what is going on. She thinks her husband left this country in good shape. Look around you. We wouldn't have a subprime mess if Glass-Steagall was still in place.

[realitytrumpsbull]

I think this sounds like some sort of invitation to grand larceny, sort of a 'get a taste/share the profits/(share the blame)' type of arrangement. Guilty conscience, perhaps?
I hope the whole mortgage-backed bullshit festival hits a pretty good speed bump at full gallop, and knocks a couple windows out, and wakes all the people up that are on that particular ride. Numbers, it's all numbers, but the number of people that have the time or the mental capacity or inclination to play these games is probably pretty small, and seeing as how there's already a lot of evidence of people doing all SORTS of crafty rackets in the general vicinity of our government and its' offices and subsidiaries and so forth that doesn't sound very much like Honest Work('cause it's not), well, I guess I'm glad to see the career money crooks finally coughing up the Real Story, here, but I also question whether any such activities have really been subjected to any serious and critical public oversight in years past. I also don't want any part of it.
That's my view, for what it's worth. I just want to understand why a standard paycheck is subjected to an effective 30% tax rate(combining state, federal, local withholdings and mediscam/h­ealthscare payments). I just want a job where you don't have to be an algebra whiz to buy your groceries, week to week. Can you do that? Thanks. In other words, do something useful besides play a numbers game against the public.

[WIpatriot]

Jacki, your last paragraph concerns me. What kind of "happy ending" can you envision? The "pros" don't see one; the "joes" don't see one. When the truth comes out, faith gets erased. Ergo, the end of the "faith based economy."

[curiousasheck]

Considering that in the 1930's the U.S.A. had plenty of mineral resources, lots of trained-an­d-regiment­ed manpower, millions of productive family farms, factories that were practically new, and more than 90 percent left of the greatest petroleum reserve anywhere in the world and we still ended up with a great depression I'm not very optimistic all of these bales of worthless paper in 2008 are going to do much for our plight.

[outnow]

Deregulation of financial markets was not a good idea. Globalization is not without costs. We are in uncharted waters. If Soros says it's true, then it is probably true.

[Henry]

A fool and his money soon go separate ways!
This CDS has nothing to do with the market, it is gambling.
The issue is liquidity. Capital is a meaningless abstraction without liquidity.
The lack of reserves you talk about are moot, as this is not a bank, there is no deposit, therefore no legal reserve requirement. Credit Reserve provisions are liquidless and must appear on any GAAP audited statement.
(As we all know, "when the shit hits the fan, reserves are meaningless!")
The invisible hand of the market place has the prescription for this illness. It's not pretty. Let the games begin. (high ground, middle of the crowd, head low)

[kellygrrrl]

wouldn't a more appropriate Co. name be PimPco --

[WIpatriot]

Cute.

[wiseapple]

Shouldn't there be ground rules (safeguards) set out by the Securities and Exchange Commission to eliminate this type of over-speculation? Where's the oversight and auditing of these wheeler-dealers?

[WIpatriot]

Faith-based economic system...what's not to love?

[mrcontinental]

Pretty much looks that way doesn't it?

[Rule Of Law]

I....Have.­...Been...­.Healed! Thankyou Jesusaaah!