Wednesday, September 02, 2009

The Fourth Horseman

Michael Panzner's prescient book "Financial Armageddon" listed four major threats to the economy: debt, retirement and healthcare benefits for the elderly, government bailouts, and financial derivatives. So far, three have exploded into public consciousness; but the fourth is still to come.

Some say that the derivatives market is now worth over $1 quadrillion, as compared with gobal GDP of some $55 trillion. For most people, these numbers mean nothing, so here's a graphic representation:

Supposedly, this shouldn't matter, since every bet involves two parties and so the sum total is zero. This ignores counterparty risk, i.e. the chance that the other person will fail to deliver when the time comes. It's the sort of thing that busted the UK's oldest bank, Barings.

From what little I understand, the derivatives market suffers from much the same complexity and obscurity as the packaged mortgage mess - the dealers are making loads of bets with loads of other people - so the misery could get spread around rather than just take down one or two incautious players.

If just 1% of the derivatives market fails, this equates to some 18% of global GDP. We in the UK are dealing with an economic contraction of less than 6% year-on-year, and that's causing paroxysms.

An argument for holding some emergency cash, away from the banks?


Anonymous said...

gold bugs creating a stir for financial armageddon again. "Buy gold now!".

Thing is that thew CDS market they talk about is bascially a bet on insurance. The bets are already paid for and if the insurance doesn't pay out what have you really lost? Only the money you paid for essentially worthless insurance. The "quadrillions" the market is allegedly worth only reflects the fact that layers and layers of this worthless insurance have built up in the system - which is itself a measure of its worthlessness. But since the insurance itself is not widely traded, only the underlying investment, it cannot even be considered as an asset. So basically you could revalue all the derivatives back down to zero and it wouldn't make any difference, except that a few companies that are active in the derivatives market would find themselves very redundant.

Sackerson said...

Hi, Anon:

1. I'm not a gold bug at these prices; though in some circumstances it may still lose less than holding cash or many other assets.

2. "a few companies that are active in the derivatives market would find themselves very redundant" - and unfortunately, deposit-takers have combined with investment banks, thanks to the repeal of the Glass-Steagall Act, so bad gambles by one side of the operation can cripple the other side, which in turn means either harm to depositors, shareholders and bondholders; or another heavy weight transferred to the taxpayers, now and future.