Too Little, Too Late For Derivatives Oversight

As the Obama administration sets out to reform the over-the-counter (OTC) derivatives market, Wall Street is scrambling to protect its own profits and put a preemptive kibosh on any regulation that could reduce the lucrative transaction fees or expose criminal wrong-doing.

But no matter how many regulators gain oversight in the derivative markets, how successful the government is at putting in place rules to cage the beast, derivatives are a problem of breathtaking scale that cannot be cleaned up with a quick government fix.

It is currently estimated that there are $684 trillion in outstanding derivatives and another $800 trillion in "shadow" or off-balance-sheet derivatives (which are impossible to calculate because they are not reported), totaling well over $1.4 quadrillion.

This is roughly 27 times the global GDP at $55T, and 7 times aggregate global asset values (of stocks, real estate and private business) at $200T. Obviously, this total amount is not at risk, but the derivatives are based ultimately on underlying asset values or assumptions that if off by even 5%, could create a loss that well exceeds global GDP, and if off by 18% would wipe out global asset values.

Creating oversight now is like mandating that a sprinkler system be installed while the house is burning down, then asking the arsonist if he will choose, and then install the sprinklers. I question what good, if any, will come of the new derivatives regulations at the eleventh hour after the damage has been done, and enlisting the help of the same entities that caused the problem in the first place.

The spectacular scale of the unwinding of the derivatives market, the likes of which we have only seen the beginning, will dwarf the sub prime debacle. The sub-prime mortgage problem was a mere $850 billion. The much larger issue is ahead of us: The $3T commercial real estate CDO problem, followed by the Option ARM and Prime CDO bombs, estimated at $8T. Like a pyramid flipped upside down, balancing on its tip, sits the value of real assets. If the value of those real assets decline even slightly, the remaining portion of the pyramid (leverage) crashes down. This unravelling will take years from which to recover. It is pure fantasy that government oversight at this time will change this.

Surely if AIG was too big to fail, the other financial entities dealing in derivatives will also need rescuing. This will require an unending source of government funds in mammoth proportions as the Federal Reserve continues to buy defaulted derivatives. Since the central banks, including the U.S. Federal Reserve, are not accountable to any government, they are able to swap currency and quality assets for the toxic waste sitting on the books of the public banks. The toxic waste then disappears onto the Fed's balance sheet, booked at the price for which they were purchased. However, the purchase price is entirely arbitrary, since there is no market for these derivative products, and determined by the banks themselves. Since there is no visibility as to exactly what the Fed has on its balance sheet, nor whom it purchased those toxic assets from, those bad assets will just sit and fester outside of the inquisitive eyes of the public or any government body.

The toxic asset values are in the trillions. The BIS now estimates that total derivative banking losses will exceed $4.1 trillion. This is very conservative, and based on past underestimations, this number will likely surpass $10 trillion over the next year. The Fed has run out of assets to swap, so their only option is to purchase those assets with currency they print. If the bad assets were $100 billion, the system could afford this without a major impact on inflation. However, with the amounts now in the multiple trillions, the impact of "saving" the banks and monetizing all these bad assets will devastate the U.S. economy, and possibly destroy the U.S. dollar. The Fed is basically forcing the taxpayer, those holding U.S. Treasuries and U.S. dollars, and Joe Public to pay for this. Once again, the banks will succeed in privatizing profits and socializing losses.

Written by Jill Keto and Daniel Keto

Follow Jill Keto on Twitter: www.twitter.com/jillketo

Comments

[beaupritchard]

Well written

[jerichoj8]

Void all default swaps. They are utter bs. They are sham insurance or sham investments. We've paid to much to these thieves already.

[TJCole]

Let's Tax the Derivatives Market a 5% origination Tax, that would pay for the best Health Care reform you could imagine it would raise $3 Trillion ore more over the years...!

[funkalicious]

With the global nature of the derivative market the portion that the US has any control over is infinitesimal in the grand Scheme the quadrillion in notional in the offsetting house of cards is a ticking neutron bomb waiting to explode. The Keto's are right on point the horse is out of the barn and now it is Katy bar the door too wet to plow.

So far the TARP and bailout money has just put a finger in the dike that is about ready to burst.

I had this discussion with a friend before the blow up, he had written an influential white paper on derivative structuring back in 1993, he could not believe that any more than 5% of the notional value would ever be at risk. But what if one of the counter parties goes bankrupt I pressed...

But the 5% is the worlds GDP I said while I drank his wine and his wife smiled on in his pied-a-terre in Madrid, not wanting to be an ungrateful house guest I deffered to his expertise I am just a humble carpenter after all. (an honest days work for small pay)

I may not know much, But I do know that a great notion can become bankrupt real quick,and if someone is paying for your vacation house and feeding you and pouring you wine you keep your pie hole shut. Kinda like Senators are doing now.

[mbaty]

Did you know that over 96% of all of our currency in circulation is in digital form only? It only exists in a computer. We are making this all up, you know. Currency is a form of universal value exchange. And while it may be true that the entire "fantasy finance" system of hedges and subprimes and default swaps will crumble into nothing, intrinsically things will still have value. And we will still need to trade those things. Based upon numbers, things look pretty bleak, and especially in comparison to the economy we have all become accustomed to, but the reality is that our economy is wildly, hugely, transparently out of balance. It is a system of inequity, a system where wealth becomes pooled in the hands of a few on the backs of the many. Such a system has no integrity. And when a structure has no integrity it collapses. If we want an economy of integrity, the old economy has to be radically restructured. The longer these inequalities go unbalanced, the sooner the system will fail. And all of us will still need to be sheltered and fed and have access to clean water and healthcare. We will still need to get from point A to point B. Money or not, we are still human beings, and that, intrinsically, is still worth something.

[pragmaticdallasite]

Indeed. Great post.

[DiogenesOfAlaska]

This is a quite pessimistic assessment from a usually upbeat person. Interesting. How come?

[drymartini1]

who said anything about "fictional wealth" or just plain wealth regarding derivatives.

there are different types of derivatives that are used for differnent purposes by different players. some use it for hedging, some use it for speculation, some use it for risk management.

I agree that all derivatives should have been only allowed in exchanges (hence regulated). but that doesnt mean that derivatives are not needed or useless.

[pragmaticdallasite]

Nobody said that, indeed they play an important role and have for years. But the recent expansion and sheer volume of the assets tied to these derivatives is the issue.

[Indra]

Sounds like a financial Tsunami. I am heading for the exit door as fast as possible. Excellent analysis. Thank you.

[DiogenesOfAlaska]

Let me know when you've found the exit door.

[KillTheMessenger]

Yawn. The size of derivatives has nothing to do with the underlying fundamentals. They are essentially side bets. Tim can bet with Tom tomorrow for a quadrillion gazillion dollars. No matter who wins, neither can pay out more than they have. If that's ten bucks, the total value of the bet is, at most, ten bucks.

The commercial real estate etc. time bombs we will, unfortunately, have to pay out. But in return we will get ownership of a lot of beautiful empty buildings that will stay empty and beautiful for a long, long time.

:-)

[drymartini1]

in addition to that, next time i hear someone about the size of the derivatives market I will barf.

The notional amount of a derivative trade MEANS NOTHING !! Most transactions are netted against each other and there are thousands of participants that have transactions with each other. You cant add that up to tell thats the size of the derivatives market.

ugggh !!

[FogBelter]

"The notional amount of a derivative trade MEANS NOTHING !! Most transactions are netted against each other and there are thousands of participants that have transactions with each other. You cant add that up to tell thats the size of the derivatives market."

You can add that up and tell the amount of fictitious wealth that was created through massive, unregulated, institutional fraud ... that is what the Notational Value of derivatives represents.

[DiogenesOfAlaska]

Well, it's not THAT simple.

Even if they are 'side bets' and even if a lot of them cancel out, the fact remains that a small error in valuations can wipe out large parts of the financial sector. That's the 'level 3' assets problem. It's not a small one. And because of bankruptcy costs, external effects in bankruptcy and knock-on-effects it's also not an accounting problem. It's a real problem to a considerable extent.

[funkalicious]

The problem is when one side of the trade goes belly up and the trade is called.
when notional becomes real.

What most of the Quants who failed at becoming rocket scientists they never realized X can equal a real number.

The only way these bankers can hold their mud is if they all keep standing. When Lehman bros and Bear went belly up all of those CDO's and CDS's derivatives automatically became real losses. On paper the sub prime problem should not have overwhelmed the system.

[RoloTomassi]

As with all delusional, happy-go-lucky claims issued from Wall St. on-high, such uninformed bad press means nothing...­until it does.

No doubt there are derivatives that will fair just fine in retaining their value, but it is well known by many economists that there is a plethora of real estate-based derivatives [estimated to be in the trillions] that are essentially worthless.

This "other shoe" will drop, like it or not, and in the meantime just keep on thinking happy thoughts..­..