Monday, September 7, 2009

Our loss, your problem

This is an article that makes my blood run cold.

As it turns out, a year ago, the ESTIMATED worldwide potential liability for derivatives was $60 TRILLION. Now it is at least $100 trillion. It can only be estimated because the derivatives market is unregulated and unsupervised... many times each business day, contracts for over $100 million are done with a text message to a cell phone.

This story about potential default is very significant...
1. the reason for the Wall Street bailout was strictly because of derivatives. The bad mortgages packaged into the derivative packages were only a tiny portion of the worldwide problem.
2. politicians refuse to regulate this very lucrative money making derivative tool because the Wall Streets of the world won't let them. The money made by selling derivative instruments is what funds the politicians' campaigns and lines their pockets.
3. If any nation does what this article says China contemplates doing and defaults, the lights will go out around the world relatively quickly. The total worldwide risk for derivatives is probably may multiples of worldwide annual productivity... hard to know due to under reporting.

As bad as things are now in the US and the Common Market, it would have resulted in "lights out" this year if any country allowed default. While we can't easily measure the benefits... or, even the true costs... of the US financial bailout, the default of any country on their derivative contracts would have set the entire worldwide house of cards to tumble.

These jerks are so arrogant and so desperate to generate sales that in the absence of a mortgage derivative market, they are offering older folks money for up to 80% of the value of their life insurance contracts so when the original policyholder dies, the insurance company pays the financial investor. The financial guys want to package these contracts into tranches of $100 million each and sell derivatives based on these same contracts.

Gold and silver and other noble metal investments look a lot better now than they did before I read this article.

Suerte -CapnRick

Derivatives contracts in China

Our loss, your problem

Sep 3rd 2009 | HONG KONG
From The Economist print edition
China considers bailing out of costly futures contracts

GIVEN its vast reserves and seemingly healthy economy, a default by China’s government or one of its tentacles should be one of the lesser concerns for international markets. This perception was jolted on August 28th by reports that the State-owned Assets Supervision and Administration Commission (SASAC) might endorse a move by large state-controlled enterprises under its umbrella to break derivatives contracts that were purchased last year from international banks to protect them from rising commodity prices.

Details, inevitably, are fuzzy. There is no official comment; terrified international bankers are silent. But reports in the local press and some elaboration by participants suggest that efforts by the country’s large shippers, airlines and power companies to cope with high oil prices by taking out futures contracts produced steep losses as the market reversed and prices fell.

That apparently prompted SASAC to launch an investigation, in part to find out if its wards were engaged in outright speculation, rather than hedging, but also to determine if a bail-out could be arranged. The bluntest remedy would be to break the contracts entirely; another, to force contracts to be rewritten and losses reduced. Either outcome would be costly for the foreign banks, in the short run through lost profits and in the long run because a growing business in derivatives would be badly undermined.

For China, too, the consequences would hurt. Counterparties would presumably charge more in future to offset the risk of being stiffed. There would be legal fallout as well. If the contracts were arranged outside China through subsidiaries in Hong Kong, Singapore or London, which is common, then they were almost certainly done under non-Chinese laws that are unlikely to be sympathetic to deliberate deadbeats. Given the direct ties these companies have to the state, a default could in theory trigger a sovereign credit failure and the legitimate seizure of state-owned assets (though it is a stretch to believe that any bank with interests in China would push a case that far). If the contracts were arranged inside China, the companies might claim to have lacked the authority to have engaged in them, but that would undermine their ability to do business abroad.

One theory is that Beijing is trying to squeeze foreign banks out of the derivatives business. That would accord with rules recently put into effect that restrict the ability of foreign firms to develop derivatives. China, it is said, would like its own banks to gain expertise and, if profits must be made, have them benefit. If so, independent pricing of risk, which is what derivatives are meant to be about, would be the real casualty.


Anonymous said...

From what I gather, derivates are basically just insurance on an investment (bet.) You can pay a little insurance on a big fat policy, for an investment you don't even own. Basically, I can open a little insurance policy on 10,000 shares of Coca-Cola (expecting the stock to tank.) When it tanks, I collect all that insurance -- since i never actually owned the stock, that money doesn't cover my loss.. its a profit I just pocket.

Companies/people held these derivatives and counted them as an investment, as expected profit. That was AIG's big game, for instance (a small division of it, that got it into trouble.) So when that division's bad business practice caught up with them, then these betters weren't getting paid, and their profits tanked. I was imaginary money, and all the money was just being sucked up from developing nation economies, who bank-rolled US lenders, who gave bad loans to bad US borrowers. Borrowers couldn't pay, obviously, and it worked its way up the chain... To make the imaginary money real now, we bailed out the derivatives issuers (and the lenders.) The lender's threat was, "you make that money real, so we don't have to foot the bill, or we'll just sit on our purse and not lend." No lending, no economic growth.

It was imaginary money

Anonymous said...

Are we talking estimated liability only or total holdings. US banks have an aggregate total of 200 Trillion in derivatives exposure, and I think there's approximately 1 Quadrillion worth of exposure worldwide (estimates vary).

Admittedly, this isn't the same as liability and under some circumstances make the net gain/loss is neutral.

But not always. The danger with this mass of derivatives is amplification. A downturn can trigger contractual derivative obligations (i.e. immediate payment) that in turn depresses the economy, which triggers more contractual based payments, turning what would have been a small downturn into a big problem, like say, with AIG.

Anonymous said...

There is only a tiny fraction of assets backing up the value of any derivates contract. If the global derivates market is worth 750 trillion, that would be the value of all the world's real estate and GDP. It must be unraveled very very slowly.

If the public understood the risk of an imploding global depravities market, attitudes would be much different. One could wonder if hyper inflating the dollar would help mitigate the risk and if that is exactly how they figure it. There are many reasons for the Fed and Treasury to go ahead and hyper inflate.

The simple fact that the dollar is loosing it's World Reserve Currency status will kill the value of the dollar and cause import prices to rise significantly. We don't make much here, and that means most things, especially essentials, will go up in price kicking in the justification politicians will use to spend, spend, spend to bailout everyone who could vote for them.

I'm giving the idea of immigrating to Sweden a lot of thought. I don't know whether I should go or tough it out. At least here I know the terrain, or do I? It's not like Sweden won't be untouched. Jobs could be harder to find there as this thing unfolds and Europe is dragged down. Europe should however recover much faster the the States