Monday, September 22, 2008

Derivatives: the "pub with no beer"

You could be forgiven for thinking that financial bloggers are hysterical and fantasy-ridden, far more so than the middlebrow newspapers that have only just caught on to the crisis.

Until you learn the facts.

The money system is so enormous and complex that nobody knows all the details, but it is estimated that in 2007, the entire world's GDP was equivalent to $54.35 trillion.

Derivatives - mutual insurance without the requirement on anybody to hold any assets - have recently been estimated by the Bank for International Settlements at over $1,000 trillion.
To put it visually (figures are in trillions of dollars):

And now a quotation on default rates - the percentage of bonds (promises to repay) that fail:

NEW YORK, Aug 1 (Reuters) - The U.S. junk bond default rate rose to 2.25 percent in July from 1.92 percent in June, as a credit crisis and sluggish economy pushed more companies into bankruptcy protection, according to data from Standard & Poor's released on Friday.

The default rate is likely to rise to 4.9 percent over the next year and could reach 8.5 percent if economic conditions are worse than expected, S&P said in its report.

Note that in the case of derivatives contracts, a default rate of less than 5.5% would equate to a wipeout of a whole year of the entire world's earnings.

No wonder that governments are absolutely determined that confidence in the system must be maintained, at whatever cost. It may take a long time to blow up a balloon, but it doesn't burst slowly.

And how do we get out of this threatening situation? How on earth, to use a different analogy, will the cat ever climb back down from so high a tree?


Nick Drew said...

a default rate of less than 5.5% would equate to a wipeout of a whole year of the entire world's earnings

its not at all as bad as that: first of all, see some of Mark W's posts on double- and triple-counting and more

also, and even more significant, the loss on a defaulted derivative is usually nowhere near its 'nominal' value: the relevant number is its current mark-to-market (replacement) value

(which, when the derivative is first entered into, will be close to zero)

of course in times like these, some MTM valuations are very high (or conversely low) which distorts what would normally be the rule-of-thumb arithmetic


Thanks, Nick. now, your best guess as to the true scale of this problem?

Nick Drew said...

in normal times, what with netting and zero-sum, I would be stabbing at $ 1 to 2 trillion, maybe 5 as the total absolute value of the derivs portfolio

in times like this:

(a) while credit risk is symmetrical in most derivatives, Sod's Law has it that the only time the bugger will go bust is when he owes you money; and ...

(b) factors that are normally uncorrelated suddenly become correlated (because they suddenly share a common cause, = meltdown), so generally-sound diversification principles let you down ...

so then we may be looking at something order-of-magnitude worse ...

a lot will hinge on whether netting continues to work effectively (because most of the derivs business will all be between a relatively finite pool of pros) - and it may break down in conditions of bankruptcy, due to legal asymmetries that creep in ...

blather blather, you have gathered I am reduced to telling you how difficult it all is ! oh I dunno ... OK *produces rabbit from hat* - let's say 10% of 20 trillion

Nick Drew said...

PS, just noticed that Peston quotes 'analyst estimates' at 2 trillion for the net value of outstanding CDS's alone. That is consistent with my 'maybe 5 trillion for the lot, in normal times' stab

Anonymous said...

I always thought of these things in the same way as credit default swaps (CDS) which is a form of credit derivative. You pay insurance in the form of a CDS on your investment and the investment goes pear-shaped but then the insurance turns out to be worthless. What it means is that you were sold a duffer in terms of the insurance originally and you were left with the same situation with regard to bad debt as if the insurance had not existed. This is the situation AIG has got itself into - basically it was selling insurance on investment products that it couldn't cover when things went sour. Should have been allowed to go to the wall really - people would have just taken out insurances with other companies.

So the upshot is that credit derivatives shouldn't have the massive impact on the ordinary man in the street that the headline numbers might suggest. If a rich man buys a £1million oil painting, but has it stolen and then his insurance doesn't pay up - does that hurt me? I doubt it. The big headline numbers suggest that the credit derivatives market was a massive bubble due to burst on its own.

However, the ordinary man in the street will feel some pain for sure. Some ways that the credit derivatives market might hurt the rest of us could be:

1] The credit derivative market helped to create "moral hazard" with regard to "junk" investments which are now subject to systemic risk with no viable insurance to back up the risk. Lets face it, there was a lot of "junk" investment going around in the last 5 years or so - not just mortgage deals but daft private equity deals too, and failing companies being bailed out with bank loans.

2] Some big players in this market are going to go bust and shed jobs.

3] The CDS market was probably propping up the daft investment strategies of a large number of big investment banks. Take that insurance away and the ability to continue to invest in daft ways goes too - many struggling companies may find they have cashflow problems once they can't insure their junk bonds.

4] It seems the investment banks were counting these derivatives as assets, allowing them to make loans against them. Another source of vanishing liquidity in that case.

5] Govermnents seem to like the idea of bailing out the players in this market - with our money.


Thanks ND asnd Anon - starting to get a hazy feel for it. From what you say, it seems like (a) the only thing real about this is the premiums paid, and (b) the fantasy world of derivatives has encouraged riskier investment strategies.

AntiCitizenOne said...

Does ANYONE online support the bailout?

Anonymous said...

I support the bailout on the grounds that a slowly deflating bubble is safer than a bursting bubble. There are too many Jeremiahs on the net that love the schadenfreude of their "told you so" predictions but actually have no other solutions than "do nothing" that would probably result in total collapse of the global economy maybe eventually global famine and world war.

There is a lot of pain to be had here, and it is best to spread it around until its nice and thin. Somebody said that we are playing jenga with the global economy. Problem is that if you remove an entire layer from the bottom of the Jenga tower then the tower collapses - that is the danger of letting the financial sector collapse. Ideally you want to replace the rotten Jenga blocks with something new - but that isn't a solution that can be taken in a short time.

The danger is that having used the printing of money as a "get out of jail free" card the Fed will simply go right ahead and blow up an even bigger bubble somewhere else.