08/17/2009 05:12 am ET Updated May 25, 2011

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