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Jim Sinclair does a good job of explaining the difference between the
notional and real value of derivatives, and how that real value comes to bear
on the financial system in the event of a default. You can read this here for a review of the basic concept if you do not understand it.
Within my own view of money, uncollateralized financial instruments like
derivatives are credits, or potential money. When an event triggers them so
that they become real, with a significant presence on the balance
sheet and the income statement, then they become money.
In the financial world we see the extraordinary growth of derivatives in
notional value, to almost unbelievable proportions. This mass of derivatives
facilitates the withdrawal of money from the real economy in the form of
wealth transferal, such as bonuses and commissions for example. But they do
not become actual money themselves until some trigger event. To perhaps
stretch our analogy to the physical world, it could be described as the
withdrawal of the ocean, as money is siphoned from the real economy by the
financial world, in advance of the arrival of a tsunami as derivatives start
hitting the balance sheets and are transformed into 'real money.'
This could be the cause of a hyperinflationary policy error which I have been
alluding to for the past several years. The policy error is not in the simple
setting interest rates, but the Fed's failure to regulate the banking system
and manage its risks. In this the Fed, particularly under Greenspan, was an
abysmal failure, and improvement has not been forthcoming.
The explosion of the realization of derivatives would create enormous
fortunes and unpayable debts. Depending on how the
monetary authorities deal with it, the potential for a Weimer experience is
there. Nationalizing the banks and canceling the transactions is one way out.
Attempting to sustain these mythical financial structures will take the
existing currency system down. That is the limit of the Fed's power.
Most theories and models are tested at the extremes of their limits, and I
suggest that the coming financial crisis will wash many of the current
economic and monetary models away, scouring the detritus of years of
conflicting interests and fanciful adornments down to their foundations. But
the responsible parties will all sit back and say, "We did not
know." But of course they did. They just did not care, as long as it
paid them handsomely.
Taking this discussion of derivatives an important step further, the most
significant elements of concern in derivatives are the same as they are in
all financial schemes: unsustainable leverage and the mispricing of risk.
In derivatives the unsustainable leverage arises from the fact that the
impact or risk magnitude of the derivatives, which
are often uncollateralized, are artificially reduced by the assumed effects
of 'netting.' And the risk is mispriced, not only in the terms of the
agreement itself, but in the failure to properly account for counterparty
risk as the instrument plays out in a larger risk portfolio. There is
individual contract risk, and then there is the cascading risk of a highly
compacted financial system.
We see situations today in which a single bank may have a hundred or more
trillion dollars of notional value in derivatives on their books, against
much less than a trillion in assets.
But the risk in such a large position is allowed because the banks can show
that they have supposedly 'netted out' the risk by making other derivative
arrangements that offset their own risk, in the manner of a hedge. As the amounts of derivative netting grows larger and more
intertwining, the secondary effects of counterparty risk become tightly
compressed.
What if a counterparty fails? Then all its own
agreements fail, many of which may be hedges that also fail, and a cascading
failure of these financial instruments in a tightly compressed and
overleveraged system becomes catastrophic.
In 2002 Warren Buffett famously referred to derivatives as 'financial weapons
of mass destruction.' But beyond that headline, few in the media took the
time to actually communicate what Buffett was really saying, and the risks
that the unregulated derivatives markets posed to the banking system.
The collapse of Lehman Brothers threatened to trigger a financial meltdown. A
panicked leadership of the country was able to stop it, but at the cost of
many trillions of dollars, and a distortion in the real economy that still
goes largely unmeasured. And this was by intent, because the leaders feared a
loss of confidence in the system. And so while the meltdown was averted, a credibility trap was
created that is the epitome of moral hazard.
The influence and knowledge, call it soft blackmail of mutually assured
destruction if you will, that the 'Too Big To Fail' banks obtained in this coverup of the depths of the fraud and mispricing of risk
in the financial system has given them enormous power over the political
process. It would have been more effective to have nationalized the banks and
cut the risk out at the source, but the new president Obama was badly advised
to say the least, by advisors he himself appointed, who were in fact long
time insiders in the creation of the risk situation itself.
The global financial system is like a nuclear bomb. At its center are at most
ten banks whose financial posture is overleveraged and interdependent not
only amongst themselves but also with their national economies. It is not a
question of 'if' they fail, but 'when,' and what is done about it.
The bailouts become geometrically larger given the size and interwoven
complexity of the bets. The only feasible solution is to nationalize the
banks, keep the real parts of the economy whole, and restart the system in a
more sustainable manner. This is essentially what Franklin Roosevelt did in 1933, and to a more limited extent what J.P. Morgan did
with the NY banks in 1907. In both instances they dictated terms and made the
banks sign to preserve the system.
In the case of the 2008-9 crisis, Bush-Obama failed to dictate terms, and
essentially allowed the banks to do whatever they wished to keep going
without reforming the system, taking huge sums of money and paying off their
bets while maintaining their bonuses and most of their positions. And this
was a monumental political failure indeed, and history will probably not be
kind.
When the next crisis occurs, there are still a variety of responses. The monied interests will wish to promote another bailout,
with harsh terms being dictated to the public, rather than to the banks. This
is what is happening in Greece. The terms will be so draconian and
unsustainable that state fascism is the most likely longer term outcome.
Germany is struggling with that decision today, in light of bad results in
their last two experiences along those lines.
I am not hopeful that the leaders of the political world will have the
resolve to do what it takes to bring the banks back under control,
given the power that big money has obtained over our worldly leaders.
Following are edited excerpts from the Berkshire Hathaway annual report for
2002.
I
view derivatives as time bombs, both for the parties that deal in them and
the economic system.
Basically these instruments call for money to change hands at some future
date, with the amount to be determined by one or more reference items, such
as interest rates, stock prices, or currency values. For example, if you are
either long or short an S&P 500 futures contract, you are a party to a
very simple derivatives transaction, with your gain or loss derived from
movements in the index. Derivatives contracts are of varying duration,
running sometimes to 20 or more years, and their value is often tied to
several variables.
Unless derivatives contracts are collateralized or guaranteed, their
ultimate value also depends on the creditworthiness of the counter-parties to
them.
But before a contract is settled, the counter-parties record profits and
losses – often huge in amount – in their current earnings
statements without so much as a penny changing
hands. Reported earnings on derivatives are often wildly overstated.
That’s because today’s earnings are in a significant way based on
estimates whose inaccuracy may not be exposed for many years.
The errors usually reflect the human tendency to take an optimistic view of
one’s commitments. But the parties to derivatives also have enormous
incentives to cheat in accounting for them. Those who trade derivatives
are usually paid, in whole or part, on “earnings” calculated by
mark-to-market accounting. But often there is no real market, and
“mark-to-model” is utilized. This substitution can bring on
large-scale mischief.
As a general rule,
contracts involving multiple reference items and distant settlement dates
increase the opportunities for counter-parties to use fanciful assumptions.
The two parties to the contract might well use differing models allowing both
to show substantial profits for many years.
In extreme cases, mark-to-model degenerates into what I would call
mark-to-myth.
I can assure you that the marking errors in the derivatives business have not
been symmetrical. Almost invariably, they have favored either the trader
who was eyeing a multi-million dollar bonus or the CEO who wanted to report
impressive “earnings” (or both). The bonuses were paid, and the
CEO profited from his options. Only
much later did shareholders learn that the reported earnings were a sham.
Another problem about derivatives is that they can exacerbate trouble that
a corporation has run into for completely unrelated reasons. This pile-on
effect occurs because many derivatives contracts require that a company
suffering a credit downgrade immediately supply collateral to
counter-parties. Imagine then that a company is downgraded because of general
adversity and that its derivatives instantly kick in with their requirement,
imposing an unexpected and enormous demand for cash collateral on the
company.
The need to meet this demand can then throw the company into a liquidity
crisis that may, in some cases, trigger still more downgrades. It all becomes
a spiral that can lead to a corporate meltdown.
Derivatives also create a daisy-chain risk that is akin to the risk run by
insurers or reinsurers that lay off much of their business with others.
In both cases, huge receivables from many counter-parties tend to build up
over time. A participant may see himself as prudent, believing his large
credit exposures to be diversified and therefore not dangerous. However under
certain circumstances, an exogenous event that causes the receivable from
Company A to go bad will also affect those from Companies B through Z.
In banking, the recognition of a “linkage” problem was one of the
reasons for the formation of the Federal Reserve System. Before the Fed was
established, the failure of weak banks would sometimes put sudden and
unanticipated liquidity demands on previously-strong banks, causing them to
fail in turn. The Fed now insulates the strong from the troubles of the weak.
But there is no central bank assigned to the job of preventing the dominoes
toppling in insurance or derivatives. (Such
as in the case of AIG for example - Jesse) In these industries,
firms that are fundamentally solid can become troubled simply because of the
travails of other firms further down the chain.
Many people argue that derivatives reduce systemic problems, in that
participants who can’t bear certain risks are able to transfer them to
stronger hands. These people believe that derivatives act to stabilize the
economy, facilitate trade, and eliminate bumps for individual participants. (This is the Greenspan argument for
example, but he and others went further in fighting any sort of regulation in
this area. - Jesse)
On a micro level, what they say is often true. I believe, however, that the
macro picture is dangerous and getting more so. Large amounts of risk,
particularly credit risk, have become concentrated in the hands of relatively
few derivatives dealers, who in addition trade extensively with one other.
The troubles of one could quickly infect the others.
On top of that, these dealers are owed huge amounts by non-dealer
counter-parties. Some of these counter-parties, are
linked in ways that could cause them to run into a problem because of a
single event, such as the implosion of the telecom industry. Linkage, when
it suddenly surfaces, can trigger serious systemic problems.
The derivatives genie is now well out of the bottle, and these instruments
will almost certainly multiply in variety and number until some event makes
their toxicity clear. Central banks and governments have so far found no
effective way to control, or even monitor, the risks posed by these
contracts. In my view, derivatives are financial weapons of mass destruction,
carrying dangers that, while now latent, are potentially lethal.
As an endnote, it appears that the money in derivatives was too good for even
Mr. Warren Buffett to pass up. Berkshire Profit Falls 30% On
Insurance, Derivatives.
Netting
Here is a fairly simple financial industry explanation of 'netting.'
 
"Rather
than execute a disastrously complicated web of transactions, swap dealers,
and ordinary banks, use clearing houses to do exactly what we just did above,
but on a gigantic scale. Obviously, this is done by an algorithm, and not by
hand. Banks, and swap dealers, prefer to strip down the number of
transactions so that they only part with their cash when absolutely
necessary. There are all kinds of things that can go wrong while your money
spins around the globe, and banks and swap dealers would prefer, quite
reasonably, to minimize those risks. (Presumably
by assuming them away, as in the case of Black-Scholes. Except the
assumptions made in netting as compared to the risk handwave
in Black-Scholes seem like planet killer class ordnance compared to conventional
bunker busters. - Jesse)
An Engine Of Misunderstanding
As you can see from the transactions above, the total amount of outstanding
debts is completely meaningless. That complex web of relationships between A,
B, and C, reduced to 1 transaction worth $1. Yet, the media would have
certainly reported a cataclysmic 2 + 3 + 4 + 5 + 2 + 6 = $22 in total debts.
(But borrowing from
Sinclair's description, if a major counterparty in this daisy chain fails,
the notional netting can become 'cataclysmic,' and enormous losses can be
realized, especially if there are linkages to the commercial credit and
banking systems. And this is where 'mark-to-myth' and bailouts come in. -
Jesse)
Charles Davi, Netting Demystified
Here is a visual representation of what a Lehman size failure would look like
in today's financial markets.
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