NOTE: more recent at bottom of page
Derivatives ‘Mother of All Bubbles’ exploding
In 2003, Warren Buffett called
“financial weapons of mass destruction”
What are they about to destroy
a few charts to see magnitude
click on image to enlarge
and for more info see
Hedge Hogs; Gold Man’s Sacks; “financial terrorist attacks;” and the Obama sellout: > HERE
SUPER COMMITTEE BIG BANK ROBBERY and “this sucker” going down > HERE
Terrorism by Economic Collapse, debt bondage, money as debt on interest, etc > HERE
Derivatives ‘Mother of All Bubbles’ exploding > HERE
Super rich 1% vs 99 %; Terrorism Cycle: Guillotines: Occupy “ALL” streets > HERE
and so many more on those websites (under development with limited resources)
Great derivatives crash
“Mother of All Bubbles” Exploding,
Political Earthquakes Under Way
Warren Buffett’s Wall Street War (pdf)
TSF’s Dark Comedy Commentary October 20, 2009
by Janet Tavakoli
In a January 2009 interview with NBC’s Tom Brokaw, Warren Buffett criticized leveraging “to the sky,” and creating “phony instruments [RMBSs, CDOs, et al.] that fool other people so you stick money in your pocket.” In 2002, he claimed over-the-counter derivatives are “financial weapons of mass destruction” and participants who account for them have “enormous incentives to cheat.”
Warren Buffett, the blogosphere’s “Oracle of Omaha,” often chastises the financial community. If you cost him money, he’s liable to write an expose. He posts annual shareholder letters on a low-tech website and seems to labor under the assumption that rational people eagerly read his blog. Congress and regulators are dismissive of Buffett’s hyperbolic rhetoric; it is fit only for a banana republic.
Buffett called the crisis an economic Pearl Harbor. [Buffett is not calling for this, but… ] During World War II, we imposed an excess profits tax. We should impose a 95% excess profits tax—or windfall profits tax—on certain financial institutions (including Goldman Sachs) enriching themselves with ongoing low-cost Fed funding and debt guarantees.
End of Excerpt. Click above link for full commentary.
Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based firm that provides consulting to financial institutions and institutional investors. Ms. Tavakoli has more than 20 years of experience in senior investment banking positions, trading, structuring and marketing structured financial products. She is a former adjunct professor of derivatives at the University of Chicago’s Graduate School of Business. She is the author of:Credit Derivatives & Synthetic Structures (John Wiley & Sons, 1998, 2001), Structured Finance & Collateralized Debt Obligations (John Wiley & Sons, 2008).
Janet Tavakoli’s book on the global financial meltdown is Dear Mr. Buffett: What An Investor Learns 1,269 Miles From Wall Street (Wiley 2009)
Derivatives of Mass Destruction: From ‘Fat Man’ to ‘Fat Finger’
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I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones. — Albert Einstein
Deputy National Security Adviser John Brennan said Sunday that the White House does not believe Thursday’s Wall Street nosedive was the result of a cyberattack. — The Hill
Had Mr. Einstein lived long enough he would not have been ignorant of WWIII’s weapons- they are financial in nature, and, instead of “Fat Man” and “Little Boy“, modern WMDs are called Credit Default Swaps (CDS) and are ignited by a “Fat Finger“.
The need to hedge derivative portfolio “delta” (sometimes in amounts far exceeding the underlying security’s total value and often “computer driven”) makes financial markets very vulnerable to “Fat Finger” problems (or any multi-standard deviation price changes). It’s a WMD (not confined to CDS, hedging is common to all derivatives) waiting for a trigger.
We need to dismantle these WMD, instead of focusing all effort onstamping out the next lit fuse.
Unconvinced? Think I’m (falsely) “shouting fire in a crowded theater?”
In theory, CDS provide securities’ owners a means to cheaply insure against their default. By paying a small premium (or series of premiums) [usually far smaller than the security’s yield] the risk of default is swapped to the CDS seller.
In theory, as with all derivatives (in a former life I used to trade these things), sellers can instantaneously hedge (for instance, by selling the security issuer’s stock, bond, or currency) the assumed risks, deriving (sellers hope) profit from the received premiums less any hedging costs.
In practice, (as I learned, painfully) trying to maintain hedges in fast markets (and I traded foreign exchange–a pretty liquid arena) can be impossible. Worse, as price deviation from last hedged position grows, the amounts to hedge grow as well. A .5% move in the underlying might call for a 10% hedge, while a 2% move might call for 35% and so on.
Adding insult to injury, all those hedges may have to be unwound if prices come back to “normal.” Among traders, market chasing as described above is called hedging “bad gamma” (which is about as fun as having “bad karma”).
In practice, CDS are not primarily used as insurance. They are, more often, purchased “naked,”, not to hedge against a default, but to bet on it, and perhaps, as you’ll see, to actually accelerate it, particularly if one could, through naked purchases in greater amounts than existing underlying securities, force hedgers into selling over-drive.
I suspect events like last week’s panic in equity markets will become far more frequent so long as CDS use (in particular), and thus necessity of hedging thereof, continues to grow.
Warren Buffett (BRK.A) , before a Galileo-like recantation and rebaptism in the church of TBTF finance, was a pioneer in recognizing derivatives as financial weapons of mass destruction. Like the nuclear weapons of WWII, modern WMD are examples of tremendous leverage–tiny amounts of fissile material or premium, respectively, explode with enormous yield, wreaking horrific damage.
Unlike atomic weapons, whose direct effects are limited to a blast and radiation radius, modern WMD, like CDS, use high speed connectivity and computer driven hedging as transmission mechanisms. The “Fat Finger” ignites a “critical price deviation” forcing hedgers of naked CDS to (try to) sell what might be many multiples of available securities.
Fortunately, just as atomic weapons require radioactive cores, so too do our CDS WMD. In the latter case, the underlying core (financial entity) must be highly leveraged. Instability, either at an atomic or financial level, is key to explosive yield. Trying to force default in an unleveraged, highly solvent financial entity would be about as fun as using carbon-12 instead of uranium-235 in an atomic bomb.
In other words, while real world WMD deterrence might require a missile shield, financial WMD deterrence might require a solvency shield. The more solvent, and less leveraged a company becomes, the less it needs to respond to the whims of the markets. It can just go about its business.
Highly leveraged financial companies like Lehman (LEHMQ.PK) and Bear Stearns were prime “fissile” material–so unstable they needed daily financial stabilization. Unfortunately, there seems to me to be far more financially unstable material laying around than fissile isotopes–Wall Street finance being far more effective than, say, Iranian centrifuges.
On the bright side, fears of “Fat Fingers” igniting naked CDS into financial WMD might someday be seen in the same light as plans for mutually assured destruction (MAD) – as signs of the need to dismantle armaments. Perhaps Homeland Security should audit the Fed, and dismantle the highly leveraged and unstable financial cores we’ve strategically placed around the nation.
Either that or people of the future might visit New York as they now visit Hiroshima and Nagasaki, looking at a plaque commemorating the destruction caused by a “Fat Finger” instead of a “Fat Man” or a “Little Boy.”
Who knows, maybe in addition to Arms Control, Capital Control will be a national security matter.
More articles by Dave Lewis »
A £516 trillion derivatives ‘time-bomb’
Not for nothing did US billionaire Warren Buffett call them the real ‘weapons of mass destruction’
By Margareta Pagano and Simon Evans
The market is worth more than $516 trillion, (£303 trillion), roughly 10 times the value of the entire world’s output: it’s been called the “ticking time-bomb”.
It’s a market in which the lead protagonists – typically aggressive, highly educated, and now wealthy young men – have flourished in the derivatives boom. But it’s a market that is set to come to a crashing halt – the Great Unwind has begun.
Last week the beginning of the end started for many hedge funds with the combination of diving market values and worried investors pulling out their cash for safer climes.
Some of the world’s biggest hedge funds – SAC Capital, Lone Pine and Tiger Global – all revealed they were sitting on double-digit losses this year. September’s falls wiped out any profits made in the rest of the year. Polygon, once a darling of the London hedge fund circuit, last week said it was capping the basic salaries of its managers to £100,000 each. Not bad for the average punter but some way off the tens of millions plundered by these hotshots during the good times. But few will be shedding any tears.
The complex and opaque derivatives markets in which these hedge funds played has been dubbed the world’s biggest black hole because they operate outside of the grasp of governments, tax inspectors and regulators. They operate in a parallel, shadow world to the rest of the banking system. They are private contracts between two companies or institutions which can’t be controlled or properly assessed. In themselves derivative contracts are not dangerous, but if one of them should go wrong – the bad 2 per cent as it’s been called – then it is the domino effect which could be so enormous and scary.
Most markets have something behind them. Central banks require reserves – something that backs up the transaction. But derivatives don’t have anything – because they are not real money, but paper money. It is also impossible to establish their worth – the $516 trillion number is actually only a notional one. In the mid-Nineties, Nick Leeson lost Barings £1.3bn trading in derivatives, and the bank went bust. In 1998 hedge fund LTCM’s $5bn loss nearly brought down the entire system. In fragile times like this, another LTCM could have catastrophic results.
That is why everyone is now so frightened, even the traders, who are desperately trying to unwind their positions but finding it impossible because trading is so volatile and it’s difficult to find counterparties. Nor have the hedge funds been in the slightest bit interested in succumbing to normal rules: of the world’s thousands of hedge funds only 24 have volunteered to sign up to a code of conduct.
Few understand how this world operates. The US Federal Reserve chairman, Ben Bernanke, tapped up some of Wall Street’s best for a primer on their workings when he took the job a few years ago. Britain’s financial regulator, the Financial Services Authority, has long talked about the problems the markets could face on the back of derivative complexity. Unfortunately it did little to curb the products’ growth.
In America the naysayers have been rather more vocal for longer. Famously, Warren Buffett, the billionaire who made his money the old-fashioned way, called them “weapons of mass destruction”. In the late 1990s when confidence was roaring in the midst of the dotcom boom, a small band of politicians, uncomfortable with the ease with which banks would be allowed to play in these burgeoning markets, were painted as Luddites failing to move with the times.
Little-known Democratic senator Byron Dorgan from North Dakota was one of the most vociferous refuseniks, telling his supposedly more savvy New York peers of the dangers. “If you want to gamble, go to Las Vegas. If you want to trade in derivatives, God bless you,” he said. He was ignored.
What is a Derivative?
Warren Buffett, the American investment guru, dubbed them “financial weapons of mass destruction”, but for the once-great-and-good of Wall Street they were the currency that enabled banks, hedge funds and other speculators to make billions.
Anything that carries a price can spawn a derivatives market. They are financial contracts sold to pass on risk to others. The credit or bond derivatives market is one such example. It is thought that speculation in this area alone is worth more than $56 trillion (£33 trillion), although that probably underestimates the true figure since lax regulation has seen the market explode over the past two years.
At the core of this market is the credit derivative swap, effectively an insurance policy against the default in the interest payment on a corporate bond. One doesn’t even need to own the bond itself. It is like Joe Public buying an insurance policy on someone else’s house and pocketing the full value if it burns down.
As markets slid into crisis, and banks and corporations began to default on bond payments, many of these policies have proved worthless.
Emilio Botin, the chairman of Santander, the Spanish bank that has enjoyed phenomenal success during the credit crunch, once said: “I never invest in something I don’t understand.” A wise man, you may think.
Derivatives: Fiscal Weapons of Mass Destruction
Friday, 07 May 2010 12:28 PM
By Arnaud De Borchgrave
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Even the world’s most savvy stock market giants (e.g., Warren E. Buffett) have warned over the past decade that derivatives are the fiscal equivalent of a weapon of mass destruction, potentially lethal, and the consequences of such an explosion would make the recent global financial and economic crisis seem like penny ante.
But generously lubricated lobbyists for the unrestricted, unsupervised derivative markets tell congressional committees and government regulators to butt out.
While banks all over the world were imploding and some $50 trillion vanished in global stock markets, the derivatives market grew by an estimated 65 percent, the Bank for International Settlements said.
B.I.S. convenes the world’s 57 most powerful central bankers in Basel, Switzerland, for periodic secret meetings. Occasionally, they issue a cry of alarm. This time, derivatives had soared from $414.8 trillion at the end of 2006 to $683.7 trillion in mid-2008 — in 18 months time.
The derivatives market is estimated at $700 trillion (notional value, not market value). The world’s gross domestic product in 2009: $69.8 trillion; the United States': $14.2 trillion. The total market cap of all major global stock markets? A mere $30 trillion. And the total amount of dollar bills in circulation, most of them abroad: $830 billion (not trillion).
One of the Middle East’s most powerful bankers conceded to us recently that even after listening to experts explain the drill, he still doesn’t understand derivatives and therefore doesn’t trust them and won’t have anything to do with them. And when that weapon of mass destruction explodes, he explained, “Our bank’s customers, from all over the world, will be saved from the disaster.”
What’s so difficult to understand about derivatives? Essentially, they are bets for or against the house — red or black at the roulette wheel. Or betting for or against the weather in situations where the weather is critical (e.g., vineyards).
Forwards, futures, options, and swaps form the panoply of derivatives. Credit derivatives are based on loans, bonds, or other forms of credit. Over-the-counter derivatives are contracts that are traded and privately negotiated directly between two parties, outside of a regular exchange.
All of this is unregulated. What happens between two parties — notably hedge funds — is like what happens between two individuals who bet on the final score of a football or baseball game.
Congressional committees have been warned time and again about “ticking time bombs” and “financial weapons of mass destruction” — to no avail, demonstrating that both the U.S. government and the U.S. Congress are dysfunctional. The need for constitutional reform comes up frequently in Washington think tank discussions, only to end with the observation that Democrats and Republicans would never agree on anything that momentous.
On May 16, 2006, for example, Richard T. McCormack, vice chairman of Bank of America Merrill Lynch and former undersecretary of state for economic and agricultural affairs, told a Senate banking hearing on derivatives and hedge funds in 2006, when the derivative industry was in the $300 trillion range: “The increasing internationalization of finance and investment suggests the need for an ever more global approach to monitoring potentially dangerous problems.”
Derivatives played a key role in camouflaging the multibillion-dollar Enron scam in 2001. Similarly, the Long-Term Capital Management (LTCM) hedge fund debacle of 1998 almost slayed the global monetary system. Yet its trading loss was a mere $5 billion. But this derivative-driven collapse seriously threatened the soundness of financial markets.
When the Russian ruble suddenly nosedived without warning, LTCM found itself exposed with more than $1 trillion in foreign exchange derivatives. It couldn’t pay. The N.Y. Fed organized a consortium of companies (Bear Stearns, Merrill Lynch, Lehman Bros.) to buy out LTCM and cover its debts. LTCM shareholders were wiped out but none of the creditors took losses.
LTCM was a hedge fund with only 200 employees, but without the N.Y. Fed’s intervention, it would have caused a crash felt around the world.
McCormack pleaded with congressional banking experts to correct, if we can, any structural or technical problems that could increase the likelihood of systemic risk in the event of future shock to the financial system, such as the Russian default (i.e., debacle) in 1998. No response.
On Feb. 28, 2006, when he was president of the New York Federal Reserve, Treasury Secretary Timothy Geithner outlined challenges to financial stability posed by derivatives. No response.
The 2007 U.S. subprime mortgage global disaster was also derivatives-driven — and provoked the biggest financial and economic disaster since the Great Depression.
McCormack, then a senior fellow at the Center for Strategic and International Studies, explained to the banking committee how Italy secured entrance into the euro by purchasing exotic derivatives that “obscured the true financial condition of the country until after they were admitted” to the new European common currency. No reaction.
The same thing happened with Japan when some banks “purchased derivative instruments which disguised the actual catastrophic state of their balance sheets at the time.” No action.
Today’s massive new derivatives bubble is driving the domestic and global economies, far outstripping the subprime-credit meltdown.
Hopefully not belatedly, Congress is considering legislation to curb the use of derivatives and other methods that artificially boost returns. But 13 members of Congress or their wives used derivatives to magnify their daily moves. And one measure proposed by Sen. Blanche Lincoln, D-Ark., would bar banks from trading in derivatives. This, in turn, would push almost $300 trillion beyond the reach of regulators. And derivatives would become still more opaque. Some say abolish derivatives trading in the United States and push it offshore.
The now bloody Greek tragedy over its debt crisis is echoing through the Federal Reserve and the halls of Congress. Greece’s public debt exceeds 100 percent of its economy versus 90 percent (at $13 trillion) for the United States. If you add unfunded U.S. liabilities for Social Security, Medicare, Medicaid, the long-term shortfall is $62 trillion, or about $200,000 for each American. At least that’s the estimate of the Pete Peterson Foundation. And Pete Peterson himself says he’s now in the business of promoting awareness about public borrowing.
With possible trader error plunging the Dow Jones industrial average into a 1,000-point tailspin and back up in 16 minutes, economic and financial prognostication made astrology look respectable.
Could Greece be a harbinger of ugly things to come for the rest of the world? Prominent investor Marc Faber, Hedge fund manager Jim Chanos, and Harvard’s Kenneth Rogoff told Bloomberg News China’s economy will slow and possibly “crash” within a year as the nation’s property bubble is set to burst.
© Newsmax. All rights reserved.
Global Economic Collapse Likely
Derivatives Bubble About to Burst — Manipulated Gold Prices About to Explode
Can Wall Street Survive?
Michael C. Ruppert
FTW - A hearing to dismiss a suit by the Gold Ant-Trust Action Committee (GATA) is scheduled to begin in U.S. District Court on October 9th, 2001. That suit, based upon detailed research, alleges that a conspiracy has existed between the U.S. Treasury, The Federal Reserve, former Treasury Secretaries Robert Rubin and Lawrence Summers and major U.S. investment banks to illegally and covertly flood the world with literally twice the amount of gold permitted by a 1999 international treaty. The suit also threatens to publicly expose the artificial manipulation of gold prices going much further back.
In 1998 the collapse of Long Term Capital Management (LTCM), a New York based gold derivatives/futures trading operation, nearly brought about the implosion of the world economy. In order to save LTCM from an insolvency that would have exposed the secret manipulations of gold, the Treasury Secretary Robert Rubin, the Fed Chairman, Alan Greenspan and the Bank of International Settlements allegedly intervened to hide the crimes. They became known as “The Plunge Protection Team.”
One of the prime reasons for artificially suppressing gold prices was to preserve investor confidence in U.S. markets. Gold prices have traditionally been used as a gauge for investor confidence. Low gold prices traditionally mean that stock markets are healthy, good investments; that inflation is low; and that credit may be expanded. Throughout the late 90s as badly needed corrections in the markets failed to happen a monstrous bubble grew on Wall Street. That stock bubble has been threatening the imminent implosion of U.S. markets
Now another, even more terrifying, monster rears its ugly head. This “derivatives bubble” was widely known and discussed when I attend the global crisis economic conference in Moscow, Russia this March. Following is a bulletin I sent to subscribers just two days before the attacks on the World Trade Center and the Pentagon.
FTW, Sept. 9, 2001 – I cannot overstate the importance of this post in helping to understand the economic precipice on which we are all perched. More importantly, there is also a huge socio-political precipice that is just as dangerous because of the fact that trust in government institutions is at an all time low. Every time there is a police shooting these days, whether as corrupt as those revealed in Miami recently; as indicative of bad judgement and poor training as the one in Santa Clarita; or as justified as those in Indiana; the “automatic” reaction of many now is that the cops are always wrong. This “barometer” of public trust indicates that average people are beginning to have a first reaction that government and major institutions are “the enemy” rather than that they should be trusted. Right or wrong, the implications for society as a whole are ominous when emotion overrides reason.
“Let them eat cake.”
It is this mix of economic and socio/political nitroglycerin that scares me. I am joined by many “thinkers” now in sensing the possibility of a “Reign of Terror,” or mindless bloodletting. It would have nothing to do with justice, good and evil, right or wrong and it would not subside until the fear and revenge quotients just below the surface of the collective consciousness have spent themselves. This is especially true for the nations of the world whose populations have suffered under US economic bullying and globalization for many decades.
The sooner corrective action is taken the better. The more it is postponed, the more certain is the bloody abyss, as emotional and rational “account balancings” occur at the same time as the economic ones.
Read this posting carefully and then consider two points:
- Since the 1998 Russian economic collapse was triggered by the “looting” by Harvard and Goldman Sachs and THAT in turn triggered the collapse of LTCM, have we been looking at a system of greed out of control where competing pyramids fight each other for diminishing capital streams? Would Goldman and Harvard wage war against LTCM or JPMorganChase knowing that it could destroy the world economy and create a global depression? If true, that implies a pending financial and economic donnybrook, that could “Hiroshima” the economy of the entire planet. The lunatics are officially running the asylum now.
- As the DOW plummets – and I expect that it may be in the 8,000s or below by the end of October – I have now come to the conclusion that it is POSSIBLE, IF NOT LIKELY – that the Bowers shootdown in Peru this Spring was an intentional move. Reason: the immediate and total suspension of drug interdiction flights — an apparent easy capitulation by the CIA — that has since allowed drug smuggling to multiply in the intervening months. I have read some estimates indicating that cocaine smuggling to the U.S. is up 30% this year as a result. Add to that the fact that the eradication efforts in Colombia have not reduced coca production but have instead, increased it by 15-20% or more.
What better way to pour additional billions in drug money into markets on the brink of collapse while trying to maintain a public image that fewer and fewer people are buying anyway?
There’s a reason why people in this country no longer get motivated by individual cries for justice or any single human interest story, whether the victim lost a house or $250 million. In the panic of a fire in a crowded movie theater, no one gives a shit. We’re all going to burn.
“From The Wilderness”
On September 8, I received the following from my friend David Guyatt in London.
I have lifted the following from www.lemetropolecafe.com and hope they donÕt mind me posting it here in its entirety.
9/7 Adam Hamilton – The JPM Derivatives Monster
The JPM Derivatives Monster
Out of all the incredible financial developments of the 1990s, one of the most important fundamental structural changes in the nature of the operation and interaction of the global financial system was the literal explosion of the use of derivatives.
Derivatives are often highly complex financial instruments that “derive” their value from some other underlying asset. As the use of these instruments evolved and advanced to a stunning degree in the 1990s, an intriguing bifurcation of opinion on the merits of the hybrid instruments developed. Among the Wall Street power players and aggressive private speculators, derivatives were seen as a wonderful financial innovation that would lead to highly customizable risk management and a huge new profit stream for Wall Street.
Outside of the financial halls of power, however, derivatives began to acquire a reputation of being staggeringly risky financial instruments that could turn sour in a heartbeat and devour the financial wizards who created them like hungry sharks. Like the young sorcererÕs apprentice in Walt DisneyÕs classic 1940 masterpiece “Fantasia”, a general public perception of derivatives gradually evolved that perceived the growth of derivatives as a dangerous experiment being recklessly played out in the financial world. Like the sorcererÕs apprentice dabbling in powerful magic when the master was not around to manage the unleashed forces, derivatives creation was increasingly seen by the average investor as being hazardous attempts to harness enormous financial tides and forces that were simply too big and too complex to be decisively tamed.
A string of massive derivatives debacles in the 1990s helped buttress this negative popular perception of derivatives and provided strong support for the “derivatives are very dangerous” side of the great derivatives debate.
In December 1993 the large German industrial conglomerate Metallgesellschaft AG reported huge derivates related losses racked up by its US subsidiary. Through an intricate hedging strategy involving heavy energy derivatives use that spun out of control, the US subsidiary of the German giant watched in horror as its complex custom-tailored financial instruments exploded in unforeseen market conditions. Total losses were originally estimated at $1b, enough to push Metallgesellschaft, GermanyÕs fourteenth largest industrial corporation, to the brink of bankruptcy. Metallgesellschaft eventually had to cough up $1.9b as a last-ditch rescue package to stave off bankruptcy. What was perhaps the first well-known large derivatives debacle in the 1990s was only a grim taste of things to come.
Unfortunately, the misfortune of Metallgesellschaft in attempting to conquer the brave new derivatives world proved to be only the tip of the iceberg in derivatives disasters of the 1990s. Cargill lost $100m playing with mortgage derivatives, Askin Securities lost $600m dabbling in mortgage-backed securities, US blue-chip Dow 30 company Procter & Gamble lost $157m hedging with currency derivatives, and Codelco Chile obliterated $200m on copper and precious metals futures. We could add Daiwa Bank of Japan, Sumitomo Corporation, Ashanti Goldfields, and the list goes on and on. And these are just a few of the less well-known derivatives debacles!
In 1994 the County Treasurer of one of the wealthiest counties in the United States, Orange County, California, brought the mighty county to its knees in bankruptcy. Robert Citron deployed risky exotic derivatives including reverse repurchase agreements to produce very high returns for the County Investment Pool he managed. Unfortunately, when the markets moved against his huge leveraged positions, the retirement funds under his custodianship quickly hemorrhaged $1.5b. In a hearing before the California State Senate in 1995, Citron said, “I must humbly state I certainly was not as sophisticated a treasurer as I thought I was.”
In February 1995 the proud and strong 223 year-old Barings Investment Bank of England, which even counted Queen Elizabeth as a client, was annihilated by unauthorized derivatives trading activity that imploded as the markets did not move as planned. Nicholas William Leeson, a 27-year old hotshot derivatives trader based in Singapore, managed to quickly lose $1.3b in the highly leveraged derivatives market before BaringsÕ management in London realized what was happening.
Rogue trader Nick Leeson was betting heavily on the future direction of the Japanese blue-chip Nikkei stock index using common options. He placed hundreds of millions of dollars at risk on the premise that the Nikkei was due for a major recovery in 1995. As we all know today as we watch the embattled Nikkei index rip through 17 year lows like a meteorite through a circus tent, Nick Leeson made the wrong bet. His personal derivatives debacle was so extreme that it killed the proud Barings Bank. Barings had been around for centuries and had even helped finance the rise of the great British Empire in the 19th century. A respected, conservative monolith of a British institution died at the hands of powerful and inherently uncontrollable forces unleashed by a young sorcererÕs apprentice halfway around the world in Singapore.
Derivatives disasters continued to blossom around the world like isolated mushroom clouds in the late 1990s, with the most memorable and dangerous being the catastrophic Long Term Capital Management debacle in 1998 on the heels of the Russian Debt Crisis, which we discuss further later in this essay. In light of the frightening record of the enormous risks and leverage of derivatives humbling the mighty in the 1990s, it is no surprise that most people today rightfully believe that derivatives are a highly risky and unforgiving high-stakes game.
As derivatives use continues to explode around the globe, it is prudent for investors to closely monitor derivatives and the companies dealing in them. The markets, if they have taught us anything in this chaotic past year, have certainly reinforced the historical truism that they are as unpredictable as ever over the short-term. Major discontinuities in price and unforeseen volatility events can erupt at any moment, potentially putting unfathomable structural stress on highly-leveraged derivatives portfolios.
As we plunge through the early years of our new millennium, any study of derivates in the United States among leading blue-chip financial institutions inevitably leads to one conclusion. Virtually all paths of derivatives inquiry lead to the same destination. Today, more than ever before in the short history of derivatives, one leading United States institution effectively IS the derivatives market. This company, as we will explore in this essay, is the American giant superbank JPMorganChase (www.JPMorganChase.com).
Before we begin our exploration of JPMorganChaseÕs (JPM-NYSE) mind-boggling exposure to the high-leverage high-risk global derivatives market, a quick and dirty explanation of derivatives is in order.
As we mentioned above, derivatives are simply financial instruments that derive their value from some other underlying asset. The term “asset” is employed rather loosely here, as in the derivatives world it can also include interest rates, currency exchange rates, stock indices, and other market indices. Common examples of derivatives include options, futures, forwards, swaps, and various combinations of these instruments.
The humble option is one of the simplest forms of derivatives. An option is simply the right to buy (call) or sell (put) a certain investment at a contractually set price for a limited time in the future. Options are also used as building blocks to assemble much more complex highly exotic derivatives instruments, kind of like the financial equivalent of the toy Lego blocks perpetually popular with children. Options are a fantastic tool to help comprehend and understand the enormous leverage inherent in derivatives and the huge risks that are shouldered when trading them. In order to wrap our minds around options, it is best to start our illustration with normal equity investing and then move to simple lone options.
Imagine you have saved up $5,000 of risk capital you want to sow into the markets in the hopes of reaping some profits. The conventional stock investing strategy is simply to find some undervalued stock and buy it. You do your due diligence, find an undervalued stock trading at a fair multiple with good future prospects, and you buy your shares of the company. For this exampleÕs sake, letÕs assume that your investment in “XYZ Company” was made at a share price of $50. Your $5,000 bought you 100 shares of XYZ Company.
Now that your capital has been successfully deployed, letÕs fast-forward six months into the future and examine two scenarios. In the “Win Scenario”, XYZ rallies 50% and you win some healthy capital gains on your investment. In the “Loss Scenario”, XYZ plunges 50% and you begin to feel like a typical NASDAQ investor today.
In the Win Scenario when you are simply buying stock outright, your gains are easy to calculate. Your 100 shares of XYZ that you purchased at $50 ran up 50% to $75, leaving you with an equity position worth $7,500, a straightforward $2,500 profit. In the Loss Scenario, XYZ plunged to $25, vaporizing one half of your original capital deployed. Your shares are still worth $2,500, however, even after the share price implosion of XYZ. This clear-cut equity example which we all intuitively understand is a pure unleveraged position that is most useful to contrast with the extraordinary risks and potential rewards/losses inherent in derivatives trading.
Next, letÕs warp back in time to your original decision to deploy your $5,000 of risk capital. LetÕs assume that the money is not super-important to you and that you have a very-high risk tolerance, so you decide to place the money in options instead of stock. You still like XYZ Company and its prospects but you crave higher leverage and you are willing to accept higher risks of loss to attain that leverage. You fully realize the risks in playing options are very high, but you will not shed any tears if your $5,000 speculation does not pay off. You do some research and find that you can buy a standard call option, the right to purchase, XYZ stock at a strike price of $55 for seven months into the future for $1 per option.
Each option contract on XYZ represents options on 100 shares, so at $1 per share a contract runs $100. With your $5,000 of risk capital you can buy 50 option contracts, yielding a total span of control of 5,000 shares. The enormous leverage inherent in derivatives such as options is immediately apparent. If you buy XYZ outright, you only can afford 100 shares with your $5,000. On the other hand, if you play the risky derivatives market through call options on XYZ, you can control the gains and losses on 5,000 shares, a staggering 50 times increase in absolute leverage. With leverage through derivatives comes the potential for far greater returns, but also far greater losses. Leverage is ALWAYS a sharp double-edged sword.
In the Win Scenario, XYZ rockets to $75 in six months. Your 50 contracts of XYZ call options at a $55 strike price are still one month from expiration and have grown very valuable. As each option grants you the contractual right to purchase a share of XYZ at $55 even though it is now trading at $75, the option on every individual share is now worth $20. The option, a derivative, derives its value from the movements in its underlying asset, the actual shares of XYZ. Since you bought 50 contracts each representing 100 shares worth of XYZ call options, your $5,000 speculation has grown into $100,000 in six months! Through the use of derivatives, your dramatic increase in leverage yielded an awesome $95,000 profit instead of the $2,500 you would have made through outright XYZ stock ownership. When the markets move your way, leverage attained through derivatives can be utterly exhilarating.
In the Loss Scenario, XYZ plummeted to $25 in six months, mimicking the 2001 action of the crippled NASDAQ. Because your options are now so far “out of the money”, they are nearly worthless. Even though there is one month left until they officially expire, no one in the market wants to buy your right to purchase XYZ at $55 when they can just go buy the actual stock at $25 in the open markets. In this scenario, your $5,000 of risk capital has been ground down into oblivion, a catastrophic 100% loss. If you had just bought the stock outright instead, at least you would still have $2,500 dollars left, but through deploying options you basically made an all-or-nothing bet that the XYZ stock price would rise over the limited time horizon of the options. When the markets move against your derivatives, your hard-earned capital can be literally obliterated in mere hours or days, a very difficult and excruciating experience.
Options, the simplest of derivatives, help illustrate the extraordinary leverage and the mega-risk that derivatives exposure entails. Amazingly, long options are one of the lowest risk forms of derivatives because one can never lose more capital than what they paid to purchase the options. Many other more exotic derivatives have dangerous unlimited loss potential and can ultimately destroy far, far more capital than what was actually paid for the financial instruments.
Another critical concept for understanding the strange world of derivatives is “notional value” or “notional amount”. This is a quasi-fictional number that illustrates how much capital a given derivative effectively controls. Although the notional amount does not change hands in a derivatives transaction, it is used to calculate the actual payments that must be made to one counterparty or the other in a derivatives transaction. Furthering our options example above, we can also gain a glimpse into the world of notionality in derivatives.
Although you only deployed $5,000 worth of risk capital in your XYZ call option purchase, you controlled the equivalent of 5,000 shares of stock since each option only cost $1. As the stock was trading at $50 when you originally purchased your options, you controlled a notional amount of XYZ stock worth $50 per share times 5000 shares, or $250,000. In the Win Scenario when XYZ rose 50%, the notional value of your options rose to $75 per share times 5000 shares, $375,000. By purchasing call options you harnessed the extreme leverage of derivatives to enable yourself to originally control the notional equivalent of $250,000 worth of XYZ stock while only risking $5,000 of your own capital.
Realize that the notional amount is not a real number but simply a descriptive fiction detailing how much of the equivalent underlying asset your derivatives position effectively “controls”. Notional amounts are used in the derivatives world to show the effective span of control that derivatives grant market participants over underlying assets at any given point in time. By comparing changing notional values over time, they can be used to measure and analyze positional changes in derivatives exposure over a given time horizon.
Also critical, realize that notional amounts are NOT volume or turnover data, but positional data points. A notional derivatives amount for the end of a given quarter is like a balance sheet presentation of potential exposure at that moment in time, NOT an income-statement like account of activity or turnover in a given quarter. Some prominent analysts have crossed this line out of reality and made the embarrassing public mistake of publishing research where they articulated the twisted fantasy that notional amounts are transactional and not positional. Notional derivatives amounts ARE positional, a snapshot of exposure at a single moment in time.
Although it has lately become somewhat popular on Wall Street and financial circles to claim that notional amounts of derivatives bear no relation to the risk of derivatives positions, we strongly disagree. The higher the notional amounts of an entityÕs total derivatives exposure, generally the higher the leverage it has used to pyramid its derivatives positions. The greater the leverage employed, the higher the aggregate risk of a derivatives portfolio. We will discuss this important concept in more detail further below.
In the United States, commercial banks and trusts are required to report their derivatives exposure once every quarter to the United States Comptroller of the Currency. The Office of the Comptroller of the Currency was founded in 1863 as a bureau of the US Treasury and has been responsible for ensuring a “stable and competitive national banking system”. Per the OCCÕs website atwww.occ.treas.gov , the OCC claims it has four objectives:
“To ensure the safety and soundness of the national banking system, to foster competition by allowing banks to offer new products and services, to improve the efficiency and effectiveness of OCC supervision, including reducing regulatory burden, and to ensure fair and equal access to financial services for all Americans.”
The OCC prepares a quarterly report called the “Bank Derivatives Report” which details general derivatives positions for all US commercial banks and trusts that operate in the derivatives market. US commercial banks and trusts are required by law to report their general derivatives positions to the OCC each quarter. Although the OCC Bank Derivatives Report does not include the derivatives positions of non-commercial bank entities like Goldman Sachs, which is an investment bank, the OCC report is still extremely useful in providing a sample or cross section of derivatives market activity and positions in general. We are not sure what percent of the total derivatives market that commercial banks and trusts represent, but we suspect it approaches a majority.
In this essay, all the derivatives data cited is directly from the latest available OCC Bank Derivatives Report, for the first quarter of 2001, available athttp://www.occ.treas.gov/ftp/deriv/dq101.pdf . All of our graphs and derivatives numbers are either lifted directly from or calculated directly from this important US government report. As the data we are reporting is so mind-blowing as to appear unbelievable, we strongly encourage you to check out this original OCC document with your own eyes. An analysis of this official report makes it quite evident that the enormous derivatives market is dominated by one US holding company, the elite blue-chip Dow 30 superbank JPMorganChase.
Our first graph was constructed using data from “Table 1″ of the OCC Q1 2001 Bank Derivatives Report. It clearly shows who the largest derivatives players are out of all the 395 US commercial banks and trusts that dabble in the derivatives market. The first point that leaps out of this pie graph like a central banker sitting on a thumbtack shows the overwhelming iron-fisted dominance that JPMorganChase (Chase Manhattan Bank and Morgan Guaranty together) exercises over the US derivatives market.
As we delve into the often cryptic world of derivatives, it rapidly becomes apparent that the amounts of dollars of capital effectively controlled through derivatives is absolutely staggering. The notional amount pie in our first graph above is a monstrous $43,922 billion, or almost $44 TRILLION dollars. Rarely at a loss for superlatives, we cannot even think of enough to describe how large these numbers truly are! It is virtually impossible for humans to grasp how big even one trillion is, so we are enlisting the help of the fascinating “MegaPenny Project” website which was created to illustrate enormous numbers.
The MegaPenny Project is located at http://www.kokogiak.com/megapenny/ and is designed to illustrate large numbers by stacking given numbers of common US one-cent pennies and showing the relative size of the stacks. We encourage you to take in the whole fascinating MegaPenny tour, but for this essay we are particularly interested in its two pages describing one trillion pennies, beginning at http://www.kokogiak.com/megapenny/thirteen.asp . The MegaPenny Project does a wonderful job graphically illustrating just how much space one trillion pennies would take up.
According to the fine folks at MegaPenny, a solid block of one trillion pennies tightly stacked on top of each other would create a cube 273 feet on each side, each axis of the cube almost as long as an American football field. For comparison purposes, remember that all the gold mined in the last six millennia would fit in a much, much smaller cube only 62 feet on each side! The cube of one trillion pennies would weigh an amazing 3,125,000 tons, almost half as much as the estimated entire weight of all the huge stones comprising the Great Pyramid on the Giza plateau in Egypt! If the trillion pennies were laid flat side-by-side instead of stacked, they would cover 89,675 acres, or over 140 square miles. Stacked on top of each other in a single mega-column, one trillion pennies would create a stack of pennies 986,426 miles high. The average distance from the Earth to the Moon is only around 238,866 miles, so one trillion pennies stacked could travel between the Earth and Moon over four times!
One trillion is a ridiculously large number and almost impossible to visualize in the abstract. Trillions of dollars of derivatives exposure blow the mind! According to MegaPenny, it would take 1.8t pennies to create an exact full-scale replica of the Empire State Building out of pennies. It would take 2.6t tightly stacked pennies to create a life-sized perfect replica of ChicagoÕs mighty SearÕs Tower.
It is very hard to believe that the total US notional derivatives positions of US commercial banks and trusts is $43.9 TRILLION dollars. By comparison, the US GDP, all the goods and services produced and consumed in our entire great nation by every single American each year, was only running $10.1t in the first quarter. The US M3 money supply, the broadest measure of money, was only $7.4t at the time. The 500 best and biggest companies in the United States, the S&P 500, were only worth $10.4t at the end of the first quarter. Clearly, the $43.9t dollars of the notional value of derivatives that a mere 395 commercial banks and trusts control is simply staggering as it far exceeds the entire US GDP, the entire broad US money supply, and the entire value of all the stocks traded in the United States! BIG, BIG, BIG numbers!
Of that huge $43.9t, JPMorganChase, a single holding company, controls a breathtaking $26.3t worth of derivatives in notional terms! JPM represents 59.8% of the total derivatives market controlled by US commercial banks and trusts per the OCC. Why on earth would one entity run up such gargantuan exposure to derivatives? Perhaps JPM controls nearly 60% of the commercial bank segment of the derivatives market because maybe it holds 60% of the commercial bank assets in the United States of America. We constructed the next graph from “Table 1″ of the Q1 2001 OCC Bank Derivatives Report as well to investigate this very question.
Although JPM is a very large commercial bank, it only represents around 12.6% of the total commercial bank assets in the United States per the Q1 OCC report. The pie size in this second graph is $4.9t. This number implies that, in general, the US commercial banking system has a derivatives notional value to assets ratio of 9 to 1, pretty extraordinary leverage when one realizes that a large portion of a given bankÕs assets are not usually the shareholdersÕ but represent funds entrusted to the bank by depositors in various forms. It is also pretty extraordinary gross leverage for an industry that prides itself in being “conservative”. A 9 to 1 implied leverage to assets achieved through derivatives sounds more like hedge fund territory than banking!
JPMorganChase controls 12.6% of the total commercial bank and trust assets in the United States, but a whopping 59.8% of the total commercial bank and trust derivatives market. JPMÕs implied derivatives leverage on assets ratio is a colossal 43 to 1. Why would one superbank risk such extreme derivatives exposure relative to its asset base?
Even more provocative and outright frightening is the ratio of the notional value of JPMÕs derivatives positions to its shareholder capital. Per JPMÕs latest 10-Q quarterly financial report filed with the US Securities and Exchange Commission available at www.jpmorganchase.com/pdfdoc/jpmchase/10Q2Q01.pdf , JPM reported a stockholdersÕ equity balance of $42b. $42b is a lot of capital and is nothing to scoff at, but when compared to an outstanding aggregate derivatives position with a notional value of $26,276b, JPMÕs implied leverage on stockholder equity is utterly mind-blowing. For every dollar that JPMÕs shareholders own free and clear, JPM management has pyramided on almost $626 worth of derivatives exposure in notional terms to the highly risky and highly volatile derivatives market! 626 to 1 implied leverage?!? Why, why, why?
While the latest JPM 10-Q was released in mid-August and pertains to Q2 while the latest OCC derivatives report is from Q1, this cross quarter comparison still accurately shows the hyper-extreme leverage inherent in JPMÕs aggregate derivatives exposure. If we instead use JPMÕs Q1 10-Q to ensure we are comparing apples to apples, the implied leverage on stockholdersÕ equity changes little to 611 to 1 on $43b of stockholdersÕ equity.
In financial circles 10 to 1 leverage is considered very aggressive, 100 to 1 is considered to be in the kamikaze realm, but we donÕt ever recall hearing about large-scale leveraged operations exceeding 100 to 1 outside of the horrible example of the doomed super hedge fund Long Term Capital Management. JPMÕs management may have effectively created the most leveraged large hedge fund in the history of the world by using $42b worth of shareholdersÕ equity to control derivatives representing a notional value of a staggering $26,276b. After we shook off the blunt shock of learning of an implied leverage of 626 to 1 by the United StatesÕ premier Wall Street bank and elite Dow 30 blue-chip company, we continued to dig deeper into the revealing OCC Bank Derivatives Report.
The next pie graph was constructed from “Table 8″, “Table 9″, and “Table 10″ of the OCC report. It shows a breakdown of how JPMÕs derivatives portfolio is comprised, of what classes of derivatives constitute the JPM Derivatives Monster. The total pie size in this graph is nine-tenths of one percent smaller than the earlier totals in the OCC report. The OCC explained this small delta in a footnote claiming it was caused by the exclusion of some credit derivatives as well as rounding differences. The large green slice of this pie is comprised of a small amount of credit derivatives and other derivatives of which the OCC does not require specific disclosure including “foreign exchange contracts with an original maturity of 14 days or less, futures contracts, written options, basis swaps, and any contracts not subject to risk-based capital requirements.”
Once again, this graph exclusively represents only JPMorganChaseÕs enormous $26t derivatives portfolio, no other banksÕ or trustsÕ data is included in this gargantuan pie. The sorcererÕs apprentice is playing with powerful financial magic indeed!
As the pie illustrates, JPMÕs largest position by far is in interest rate derivatives. The huge red king-sized slice of the pie graph represents interest rate derivatives with a notional amount of a staggering $17.7t!
In interest rate derivatives, the notional amount represents the implied principal of a debt on which interest rate derivatives are written. For instance, a debtor with $1m in debt and variable interest rate payments may contract with JPM to hedge its interest rate payments into a fixed interest rate scheme instead of a variable one. By having a fixed interest rate payment schedule, the debtor company will not have to worry about market fluctuations in interest rates as their counterparty JPMorganChase assumes that risk for a fee. Although the interest streams in this small $1m debt example are swapped, the actual cash changing hands may only be a few tens of thousands of dollars. The $1m in principal, however, is the notional amount for our interest rate derivatives example and provides a true picture of JPM positional exposure in the deal.
Gold investors may be surprised to see what a trivial portion of JPMÕs total derivatives portfolio is deployed in the gold market. Only two tenths of one percent of JPMÕs notional derivatives exposure is in gold. Of course, gold is an exceedingly small market compared to the huge debt or foreign exchange markets so JPMÕs position in gold derivatives is still quite large relative to the gold market itself. JPM reported $56.8b in gold derivatives in the Q1 2001 OCC report. By comparison, with only 2,500 metric tonnes of gold mined on the entire planet each year, the whole freshly mined annual world gold supply is only worth $22b at $275 per ounce.
JPM is controlling a notional amount of gold through derivatives equal to the value of every ounce of gold that will be mined in the entire world for the next two and a half years assuming gold production does not continue to plummet due to dismal gold prices, which it probably will.
Why is a sophisticated superbank like JPM even interested in the small and devastated gold market, let alone motivated enough to maintain derivatives exposure equal to more than 6,400 tonnes of gold? Why does JPM management want to maintain derivatives gold exposure worth 1.35 times the capital owned by the shareholders of the company? With Wall Street perpetually telling the world that gold is a “barbaric relic”, why does the premier Wall Street bank have such large gold derivatives positions? Ever more intriguing questions!
In the lower left corner of the graph above note the percentage of derivatives market shares that JPM controls out of the entire US commercial bank and trust derivatives universe. JPM is the utterly dominant player with 64% of the interest rate derivatives market, 49% of the foreign exchange market, 68% of the equity derivatives market, and 62% of the gold derivatives market among US commercial banks and trusts. JPMÕs management, for whatever reasons, has effectively built up a derivates powerhouse that has almost cornered the entire US commercial bank and trust derivatives market.
Zeroing back in on the $17.7t in interest rate derivatives, we wonder why such enormous exposure to interest rates has been shouldered by JPMÕs management. In terms of interest rate derivatives alone, JPM has an implied leverage ratio of notional interest rate derivatives exposure to stockholdersÕ equity of 422 to 1. Are JPM shareholders aware of this? It is hard to fathom why anyone would want to have leveraged exposure to chaotic interest rates with 422 to 1 leverage, but an intriguing hypothesis has recently emerged that may illuminate the decision by JPM to dominate the enormous interest rate derivatives market. Here is a quick outline of this provocative theory.
As growing numbers of investors around the world realize, American attorney Reginald Howe filed a landmark complaint against the Swiss-based Bank for International Settlements on December 7, 2000. In his lawsuit, which is highly recommended reading and available for free download in PDF format atwww.zealllc.com/howepla.htm , Mr. Howe carefully builds the case that certain large banks that deal in gold derivatives were involved in an effort to actively manipulate the world gold market in violation of key United States laws. Shortly after Mr. Howe filed his complaint in United States District Court, we wrote a summary essay outlining his lawsuit called “Let Slip the Dogs of War” which also has further background information if you are interested in digging deeper.
In Howe v. BIS et al, both the pre-merger JP Morgan and Chase Manhattan were named as defendants with the BIS. In his complaint, Howe points out anomalous gold derivatives activity at both banks documented on earlier OCC bank derivatives reports that correlates extremely well with unusual activity in the gold markets and gold price. The evidence is highly suggestive that both banks, now a single entity, used carefully targeted strategic gold derivatives transactions to help rein in the out-of-control gold rally that was sparked in late 1999 after European central banks agreed to curtail their gold sales and leasing with the Washington Agreement.
Mr. HoweÕs complaint filed in the federal court elaborates on this odd activity by the two banks that have since merged to form superbank JPMorganChase. Interestingly, Mr. HoweÕs case will soon be heard before a federal judge in Boston, Massachusetts on October 9, 2001, when defendants will present their arguments in support of their Motions to Dismiss.
With both ancestor banks of the new JPMorganChase already documented as having well-timed anomalous gold derivatives activity prior to their merger, chances are the banks had some level of insider-type knowledge of what was really transpiring in the gold market. There is no way that JPM management would have acquired gold derivatives with a notional value worth 1.35 times the total of their entire shareholdersÕ equity base unless they knew and intimately understood the gold market.
On May 30, 2001, ace researcher and analyst Michael Bolser and GATA Chairman Bill Murphy co-published an analysis of JPMorganChaseÕs interest rate derivatives in Mr. MurphyÕs “Midas” column at the excellentwww.LeMetropoleCafe.com contrarian investing website. Mr. Bolser titled his research “GoldGateÕs Real Motive?”. Current subscribers towww.LeMetropoleCafe.com can see this analysis in the archives of the “James Joyce” table at LeMetropoleCafe. In his analysis, Mr. Bolser pointed out that JPMorganChase had $16t worth of notional interest rate derivatives exposure at the time and how incredible this fact was. He noted that JPMÕs interest rate derivatives notional amounts had doubled since the middle of 1998, an astronomical increase given the absolute amounts of dollars involved.
Mr. Bolser offered the stunning tentative conclusion that perhaps a suppressed or shackled-down gold price was a necessary prerequisite to JPM assuming enormous amounts of interest rate derivatives, as a managed gold price would ratchet down inflationary expectations and make interest rate positions much less volatile and risky than in a truly free market. Mr. Bolser planned to continue his research and was seeking earlier OCC reports to model JPMÕs derivatives trading activities and exposures further back in time.
After Mr. BolserÕs interest rate derivatives report revealing JPMÕs enormous and massively out-of-proportion derivatives positions, there were a few tangential comments made about this hypothesis over the summer by various market analysts, but for the most part it remained an obscure area of inquiry that appeared to generate little popular interest.
Then, just a few weeks ago on August 13, 2001, Reginald Howe published a fascinating commentary entitled “GibsonÕs Paradox Revisited: Professor Summers Analyzes Gold Prices” available at www.GoldenSextant.com . In his essay Mr. Howe quotes a 1988 academic paper from the Journal of Political Economy co-written by President Bill ClintonÕs future third Secretary of the Treasury, Lawrence Summers. Among other things, Mr. Howe discusses Mr. SummersÕ interpretation of an observation by the famous economist John Maynard Keynes on the behavior of gold prices and real interest rates. Lord Keynes called the relationship “GibsonÕs Paradox”.
As Mr. Howe points out, per Lord Keynes, GibsonÕs Paradox, the solid relationship between price levels including gold and interest rates under a gold standard regime was, “one of the most completely established empirical facts in the whole field of quantitative economics.” Mr. Howe shows, using the writings of Professor Lawrence Summers and legendary economist John Maynard Keynes that there is a rock-solid inverse relationship between gold and real interest rates in a free market. We investigated this phenomenon as well in our essay “Real Rates and Gold”. In effect, real interest rates could be used to predict inverse moves in the price of gold or gold could be used to predict inverse moves in the real interest rates.
For us, HoweÕs fantastic “GibsonÕs Paradox Revisited” essay finally lit the proverbial lightbulbs above our heads that triggered a solid understanding of Michael BolserÕs shrewd earlier hypothesis on JPMÕs enormous interest rate derivatives exposure! GibsonÕs Paradox helped to reconcile the puzzle and answer nagging questions about JPMÕs gargantuan interest rate derivatives position and how it could relate to the active management of the price of gold.
If factions of the US government in the Clinton years from 1995 to late 2000 were really actively manipulating the gold price (as the latest amazing research of government records by James Turk and Reginald Howe certainly strongly suggests through ever-increasing evidence), and if JPM really had inside knowledge of some of these operations as its anomalous gold derivatives activity seems to imply, then it is only a short logical step to assume that a possible catalyst for the explosion in JPMÕs interest rate derivatives operations was the artificially pegged price of gold!
GibsonÕs Paradox, defined by Lord Keynes, effectively claims that under a fixed gold price regime real interest rates remain predictable. If JPM top management was participating in any US efforts to cap gold, they had full knowledge that a de facto fixed gold price regime had been stealthily established and they would have had a carte blanche to massively balloon potentially highly lucrative interest rate derivatives exposure. After all, if JPM was convinced gold was under control, and that gold prices were a prime driver of real interest rates, then what better time to become the king of the interest rate derivates world than when gold was being quietly hammered down through massive sales of official sector gold from Western central banksÕ coffers?
Our superficial presentation here certainly does not do this startling hypothesis justice, but the JPMorganChase interest rate derivatives explosion due to JPM upper management knowledge of and possible involvement in stealthy government machinations in the gold markets is a very intriguing hypothesis that definitely warrants further investigation and discussion. We may write a future essay on this topic alone after we dig deeper, and we certainly hope other analysts and researchers follow Michael BolserÕs original lead and do some serious investigating.
Back to the JPMorganChase Derivatives Monster for now, we have to wonder how many JPM shareholders realize just how incredibly leveraged their superbank has become. Do they think they are holding a safe conservative blue-chip elite Wall Street bank, or do the average shareholders desire to hold a hyper-leveraged mega hedge fund with 600+ times implied leverage on stockholdersÕ equity? Do JPM shareholders understand how dangerous large derivatives positions have proven historically for other companies?
JPM currently has something like 2,700 large institutional shareholders who hold almost 61% of its common stock. Do the managers of these mutual funds and pension funds understand that JPM management has built the biggest most highly-leveraged derivatives pyramid in the history of the world per US government OCC reports? Do fund managers understand the inherent risks in leveraging capital hundreds of times over? These are important questions that ALL JPM investors should carefully consider, especially in this incredibly turbulent and volatile market environment we are experiencing today.
One of the most dangerous possible events for high derivatives exposure is unforeseen market volatility, especially that caused by unusual and unexpected major discontinuities in market pricing. The following graph is also shamelessly taken from the OCC report, “Graph 5C”, which shows the “charge-offs” taken on derivatives written off in each quarter since 1996 by commercial banks and trusts alone. Note the enormous loss that occurred in the third quarter of 1998 coincident with the Russian Debt Crisis/LTCM debacle and the large losses in late 1999 following the Washington Agreement gold spike.
When a non-linear market event that is inherently unpredictable like the Russian Debt Crisis occurs, its effects on carefully crafted derivatives portfolios can be catastrophic. Long Term Capital Management folded during the 1998 crisis. It was an elite hedge fund run by some of the most brilliant market geniuses of the entire last century. The all-star brain trust at LTCM could probably have helped put men on Mars, as the stellar IQs and acclaim of the founders were without equal in the financial world. The gentlemen helping to build the sophisticated computer derivatives trading models for LTCM were Nobel-prize winning economists who understood more about markets and volatility than pretty much everyone else on the planet. Here are a few paragraphs on LTCM from an earlier essay we penned on gold derivatives volatility titled, “Gold Delta Hedge Trap (Part 2)”.
“LTCM employed ScholesÕ and MertonÕs work to hedge and protect its bets. Through Black and Scholes based hedging strategies, LTCM became one of the most highly leveraged hedge funds in history. It had a capital base of $3b, yet it controlled over $100b in assets worldwide, and some reports claim the total notional value of its derivatives exceeded an incredible $1.25 TRILLION. LTCM used extraordinarily sophisticated mathematical computer models to predict and mitigate its risks.”
“In August 1998, an unexpected non-linearity occurred that made a mockery of the models. Russia defaulted on its sovereign debt, and liquidity around the globe began to rapidly dry up as derivatives positions were hastily unwound. The LTCM financial models told the principals they should not expect to lose more than $50m of capital in a given day, but they were soon losing $100m every day. Four days after the Russian default, their initial $3b capital base lost another $500m in a single trading day alone!”
“As LTCM geared up to declare bankruptcy, the US Federal Reserve believed LTCMÕs highly leveraged derivatives positions were so enormous that their default could wreak havoc throughout the entire global financial system. The US Fed engineered a $3.6b bailout of the fund, creating a major moral hazard for other high-flying hedge funds. (Expecting the government or counterparties will bail them out of bad bets once they get too large, why not push the limits of safety and prudence as a hedge fund manager?)”
Long Term Capital Management had $3b in capital allegedly supporting $1,250b of derivatives notional value, an implied leverage ratio of 417 to 1. JPMorganChase, per its own reports filed with the US government, has $42b supporting $26,276b of derivatives notional value. Incredibly, JPMÕs implied capital leverage on its derivatives is far, far higher than LTCMÕs at 626 to 1. IsnÕt it disconcerting to realize JPM management has further leveraged its shareholder equity than even the infamous Long Term Capital Management?
LTCM had the best economic minds in the world running the fund, unlimited brain and computer power, but still an unpredictable volatility event spurred by the Russian Debt Crisis caused their painstakingly developed computer derivatives models to blow up. By many reports, including from the Federal Reserve, the LTCM failure was so dangerous it threatened to take the whole financial system down if LTCMÕs obligations to its counterparties were defaulted upon.
We are NOT suggesting that JPM is another LTCM. We know that the men and women running JPM are very intelligent and have a deep understanding of the global markets in which their company operates. We know they have cross-hedged and carefully modeled their enormous derivatives portfolio to try and make it net market neutral and therefore resilient to shocks. But, just as a tiny imperfection can cause a massive hardened-steel shaft connected to a nuclear aircraft carrierÕs propeller to vibrate uncontrollably until it shatters, even a “balanced” net derivatives portfolio of massive size is highly vulnerable to market shocks that can push it out of proper equilibrium and spin the computer hedging models out of control far faster than derivatives can be unwound.
There comes a point when leverage becomes so extreme that even a tiny unforeseen event can break down the complex contractual glue that holds the various components and players of the convoluted derivatives world together and cause the whole structure to shake or crumble.
We believe that JPMÕs management is taking a mammoth gamble with the wealth of its shareholders by supporting derivatives with a notional value of over $26 TRILLION dollars with a relatively trifling $42 billion of shareholder equity. Any discontinuous market volatility event that is unforeseen and beyond JPM managementÕs control could conceivably cause this immense pyramid to rapidly unwind, utterly annihilating the companyÕs capital in a matter of days or weeks.
Also, JPM, just by virtue of having extreme leverage, is placing itself at risk for a Barings Bank type scenario, where a rogue trader hid derivatives trading activities from management until it was too late and the damage was irreparable. What if some twenty- or thirty-something derivatives trader working for JPM accidentally makes a big mistake in his or her trading and destroys that fragile balance supporting the whole massive JPM derivatives pyramid and the whole structure comes crashing down?
By its own reporting to the US government, JPMorganChase has shown itself to have evolved into a real-life Derivatives Monster. Derivatives offer extreme leverage and the potential for mega-profits, but with that they carry commensurate extreme risks. Until the JPM Derivatives Monster begins to deflate its leverage and exposure, we believe individual and institutional investors alike should be very careful in assessing the potential extreme risk of holding JPM stock.
We canÕt help but feeling that essentially unlimited leverage is the modern financial equivalent of Walt DisneyÕs sorcererÕs apprentice in “Fantasia” unleashing forces he couldnÕt possibly hope to control.
Adam Hamilton, CPA, MCSE
7 September 2001
Copyright 2000 – 2001 Zeal Research
Copyright 1999, 2000 Le Metropole Cafe. All rights reserved
Derivatives: A $700+ Trillion Bubble Waiting to Burst
31 comments | April 19, 2009
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In the past three years, while banks all over the world and Wall Street were imploding, while some $40-$50 trillion of capital was being destroyed in global stock markets, one financial market kept growing. That market is the financial derivatives market.
According to the Bank for International Settlements [BIS], the global Over the Counter [OTC] derivatives market has grown almost 65% from $414.8 trillion in December, 2006 to $683.7 trillion in June of 2008. On the BIS’s own website, there are no updated figures for the notional derivatives market since June 2008, so we can likely assume, with some margin of safety, that this market has now grown to more than $700 trillion. Comparatively speaking, the total market cap of all major global stock markets is approximately $30 trillion.
Before I discuss how financial products could grow more than 65% during a time period when financial companies were imploding all over the world, let’s review the definition of a derivative, because this will explain how this market of financial products keeps becoming more valuable at a time when the value of many capital assets are sinking like a rock in an ocean.
According to Wikipedia:
Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else (known as the underlying). The underlying value on which a derivative is based can be an asset (e.g., commodities, equities (stocks), residential mortgages, commercial real estate, loans, bonds), an index (e.g., interest rates, exchange rates, stock market indices, consumer price index [CPI] — see inflation derivatives), weather conditions, or other items. Credit derivatives are based on loans, bonds or other forms of credit. The main types of derivatives are forwards, futures, options, and swaps.
Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet. Over-the-counter [OTC] derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds…Because OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.
There are two key phrases to note in the above explanation of the financial derivatives markets-
(1)The notional value of derivatives is recorded OFF the balance sheet of an institution, although the market value of derivatives is recorded ONthe balance sheet; and
(2)OTC derivatives are not traded on an exchange, there is no central counterparty. Therefore, they are subject to counterparty risk, like an ordinary contract, since each counterparty relies on the other to perform.
As I’ve noted before, the $700 trillion global derivatives market is the notional value of this market, not the market value of these derivatives. The Bank for International Settlements compiles the notional value of this market worldwide from reported figures by Central Banks of the G10 countries and Switzerland. Thus, if the off-balance sheet assets of major international banks are growing so rapidly in the form of their notional values of their held financial derivative products, how can so many of these banks be in trouble?
The answer, quite simply, is that the market value of these derivatives is nowhere near the notional values of these derivatives maintained and reported by these banks, and that the global derivatives market is in serious trouble. Because derivative products are subject to counterparty risks as well, this means that the failure of one major financial institution could cause the evaporation of assets for many other financial institutions that have derivative products with exposure to that one financial institution. In other words, when the notional values of a good percent of these financial derivative products start evaporating into thin air, and they will, it will have a negative domino effect on the balance sheet of not just one major financial institution, but many.
Of course, when FASB suspended mark-to-market accounting rules recently, major international banks were allowed to re-value some of their derivative products closer to their notional value on their books to pad their balance sheets. Due to this change in accounting law, I can almost guarantee you that before market open Friday, Citigroup will announce better than expected financial results as they carried huge amounts of illiquid mortgages and financial derivatives on their balance sheets. [Editor’s note: Article was written prior to earnings announcement on 4/17/09]
Though many people argue that only the market value of these derivatives, and not their notional values, is ultimately important, this would have only been valid if FASB hadn’t suspended mark-to-market accounting rules. The types of derivative products most likely to continue to blow up are Credit Default Swaps [CDS], and indeed, it wasAIG’s exposure to Credit Default Swaps that caused it to collapse.
In reality, the market value of financial derivatives is only a fraction of its $700 trillion notional value; however the reality is that the potential losses from bad Credit Default Swaps can also be much more than their notional value. For example, consider a scenario where Company ABC underwrites a CDS in which they will receive $100,000 of payments from Company X in return for guaranteeing a $1,000,000 bond issued by Company Z. If all goes well, and the bond performs, then company ABC makes $100,000 in profit. However, if company Z fails, then Company ABC may now have to pay Company X $1,000,000. This is a scenario in which the losses from financial derivative products can be very real and very large. Though many analysts harp on the fact that the $700+ trillion notional figure of the derivative market is not real, it is not realistic either to only consider the much smaller market value of these derivatives as the above example illustrates.
Since it is now likely that the balance sheets of many financial institutions have been quickly “nursed back to health” by returning the book value of OTC financial derivative products to some fantasyland notional value versus their true market value, the collapse of the notional value of the $700+ trillion derivative market will indeed have future devastating consequences for global economies.
The Horrific Derivatives Bubble That Could One Day Destroy The Entire World Financial System
Today there is a horrific derivatives bubble that threatens to destroy not only the U.S. economy but the entire world financial system as well, but unfortunately the vast majority of people do not understand it. When you say the word “derivatives” to most Americans, they have no idea what you are talking about. In fact, even most members of the U.S. Congress don’t really seem to understand them. But you don’t have to get into all the technicalities to understand the bigger picture. Basically, derivatives are financial instruments whose value depends upon or is derived from the price of something else. A derivative has no underlying value of its own. It is essentially a side bet. Originally, derivatives were mostly used to hedge risk and to offset the possibility of taking losses. But today it has gone way, way beyond that. Today the world financial system has become a gigantic casino where insanely large bets are made on anything and everything that you can possibly imagine.
The derivatives market is almost entirely unregulated and in recent years it has ballooned to such enormous proportions that it is almost hard to believe. Today, the worldwide derivatives market is approximately 20 times the size of the entire global economy.
Because derivatives are so unregulated, nobody knows for certain exactly what the total value of all the derivatives worldwide is, but low estimates put it around 600 trillion dollars and high estimates put it at around 1.5 quadrilliondollars.
Do you know how large one quadrillion is?
Counting at one dollar per second, it would take 32 million years to count to one quadrillion.
If you want to attempt it, you might want to get started right now.
To put that in perspective, the gross domestic product of the United States is only about 14 trillion dollars.
In fact, the total market cap of all major global stock markets is only about 30 trillion dollars.
So when you are talking about 1.5 quadrillion dollars, you are talking about an amount of money that is almost inconceivable.
So what is going to happen when this insanely large derivatives bubble pops?
Well, the truth is that the danger that we face from derivatives is so great that Warren Buffet has called them “financial weapons of mass destruction”.
Unfortunately, he is not exaggerating.
It would be hard to understate the financial devastation that we could potentially be facing.
A number of years back, French President Jacques Chirac referred to derivatives as “financial AIDS”.
The reality is that when this bubble pops there won’t be enough money in the entire world to fix it.
But ignorance is bliss, and most people simply do not understand these complex financial instruments enough to be worried about them.
Unfortunately, just because most of us do not understand the danger does not mean that the danger has been eliminated.
In a recent column, Dr. Jerome Corsi of WorldNetDaily noted that even many institutional investors have gotten sucked into investing in derivatives without even understanding the incredible risk they were facing….
A key problem with derivatives is that in the attempt to reduce costs or prevent losses, institutional investors typically accepted complex risks that carried little-understood liabilities widely disproportionate to any potential savings the derivatives contract may have initially obtained.
The hedge-fund and derivatives markets are so highly complex and technical that even many top economists and investment-banking professionals don’t fully understand them.
Moreover, both the hedge-fund and the derivatives markets are almost totally unregulated, either by the U.S. government or by any other government worldwide.
Most Americans don’t realize it, but derivatives played a major role in the financial crisis of 2007 and 2008.
Do you remember how AIG was constantly in the news for a while there?
Well, they weren’t in financial trouble because they had written a bunch of bad insurance policies.
What had happened is that a subsidiary of AIG had lost more than $18 billion on Credit Default Swaps (derivatives) it had written, and additional losses from derivatives were on the way which could have caused the complete collapse of the insurance giant.
So the U.S. government stepped in and bailed them out – all at U.S. taxpayer expense of course.
But the AIG incident was actually quite small compared to what could be coming. The derivatives market has become so monolithic that even a relatively minor imbalance in the global economy could set off a chain reaction that would have devastating consequences.
In his recent article on derivatives, Webster Tarpley described the central role that derivatives now play in our financial system….
Far from being some arcane or marginal activity, financial derivatives have come to represent the principal business of the financier oligarchy in Wall Street, the City of London, Frankfurt, and other money centers. A concerted effort has been made by politicians and the news media to hide and camouflage the central role played by derivative speculation in the economic disasters of recent years. Journalists and public relations types have done everything possible to avoid even mentioning derivatives, coining phrases like “toxic assets,” “exotic instruments,” and – most notably – “troubled assets,” as in Troubled Assets Relief Program or TARP, aka the monstrous $800 billion bailout of Wall Street speculators which was enacted in October 2008 with the support of Bush, Henry Paulson, John McCain, Sarah Palin, and the Obama Democrats.
But wasn’t the financial reform law that Congress just passed supposed to fix all this?
Well, the truth is that you simply cannot “fix” a 1.5 quadrillion dollar problem, but yes, the financial reform law was supposed to put some new restrictions on derivatives.
And initially, there were some somewhat significant reforms contained in the bill. But after the vast horde of Wall Street lobbyists in Washington got done doing their thing, the derivatives reforms were almost completely and totally neutered.
So the rampant casino gambling continues and everybody on Wall Street is happy.
One day some event will happen which will cause a sudden shift in world financial markets and trillions of dollars of losses in derivatives will create a tsunami that will bring the entire house of cards down.
All of the money in the world will not be enough to bail out the financial system when that day arrives.
The truth is that we should have never allowed world financial markets to become a giant casino.
But we did.
Soon enough we will all pay the price, and when that disastrous day comes, most Americans will still not understand what is happening.
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Derivatives: The Quadrillion Dollar Financial Casino Completely Dominated By The Big International Banks
If you took an opinion poll and asked Americans what they considered the biggest threat to the world economy to be, how many of them do you think would give “derivatives” as an answer? But the truth is that derivatives were at the heart of the financial crisis of 2007 and 2008, and whenever the next financial crisis happens derivatives will undoubtedly play a huge role once again. So exactly what are “derivatives”? Well, derivatives are basically financial instruments whose value depends upon or is derived from the price of something else. A derivative has no underlying value of its own. It is essentially a side bet. Today, the world financial system has been turned into a giant casino where bets are made on just about anything you can possibly imagine, and the major Wall Street banks make a ton of money from it. The system is largely unregulated (the new “Wall Street reform” law will only change this slightly) and it is totally dominated by the big international banks.
Nobody knows for certain how large the worldwide derivatives market is, but most estimates usually put the notional value of the worldwide derivatives market somewhere over a quadrillion dollars. If that is accurate, that means that the worldwide derivatives market is 20 times larger than the GDP of the entire world. It is hard to even conceive of 1,000,000,000,000,000 dollars.
Counting at one dollar per second, it would take you 32 million years to count to one quadrillion.
So who controls this unbelievably gigantic financial casino?
Would it surprise you to learn that it is the big international banks that control it?
The New York Times has just published an article entitled “A Secretive Banking Elite Rules Trading in Derivatives“. Shockingly, the most important newspaper in the United States has exposed the steel-fisted control that the big Wall Street banks exert over the trading of derivatives. Just consider the following excerpt from the article….
On the third Wednesday of every month, the nine members of an elite Wall Street society gather in Midtown Manhattan.
The men share a common goal: to protect the interests of big banks in the vast market for derivatives, one of the most profitable — and controversial — fields in finance. They also share a common secret: The details of their meetings, even their identities, have been strictly confidential.
Does that sound shady or what?
In fact, it wouldn’t be stretching things to say that these meetings sound very much like a “conspiracy”.
The New York Times even named several of the Wall Street banks involved: JPMorgan Chase, Goldman Sachs, Morgan Stanley, Bank of America and Citigroup.
Why does it seem like all financial roads eventually lead back to these monolithic financial institutions?
The highly touted “Wall Street reform” law that was recently passed will implement some very small changes in how derivatives are traded, but these giant Wall Street banks are pushing back hard against even those very small changes as the article in The New York Times noted….
“The revenue these dealers make on derivatives is very large and so the incentive they have to protect those revenues is extremely large,” said Darrell Duffie, a professor at the Graduate School of Business at Stanford University, who studied the derivatives market earlier this year with Federal Reserve researchers. “It will be hard for the dealers to keep their market share if everybody who can prove their creditworthiness is allowed into the clearinghouses. So they are making arguments that others shouldn’t be allowed in.”
So why should we be so concerned about all of this?
Well, because the truth is that derivatives could end up crashing the entire global financial system.
In fact, the danger that we face from derivatives is so great that Warren Buffet once referred to them as “financial weapons of mass destruction”.
In a previous article, I described how derivatives played a central role in almost collapsing insurance giant AIG during the recent financial crisis….
Most Americans don’t realize it, but derivatives played a major role in the financial crisis of 2007 and 2008.
Do you remember how AIG was constantly in the news for a while there?
Well, they weren’t in financial trouble because they had written a bunch of bad insurance policies.
What had happened is that a subsidiary of AIG had lost more than $18 billion on Credit Default Swaps (derivatives) it had written, and additional losses from derivatives were on the way which could have caused the complete collapse of the insurance giant.
So the U.S. government stepped in and bailed them out – all at U.S. taxpayer expense of course.
As the recent debate over Wall Street reform demonstrated, the sad reality is that the U.S. Congress is never going to step in and seriously regulate derivatives.
That means that a quadrillion dollar derivatives bubble is going to perpetually hang over the U.S. economy until the day that it inevitably bursts.
Once it does, there will not be enough money in the entire world to fix it.
Meanwhile, the big international banks will continue to run the largest casino that the world has ever seen. Trillions of dollars will continue to spin around at an increasingly dizzying pace until the day when a disruption to the global economy comes along that is serious enough to crash the entire thing.
The worldwide derivatives market is based primarily on credit and it is approximately ten times larger than it was back in the late 90s. There has never been anything quite like it in the history of the world.
So what in the world is going to happen when this thing implodes? Are U.S. taxpayers going to be expected to pick up the pieces once again? Is the Federal Reserve just going to zap tens of trillions or hundreds of trillions of dollars into existence to bail everyone out?
If you want one sign to watch for that will indicate when an economic collapse is really starting to happen, then watch the derivatives market. When derivatives implode it will be time to duck and cover. A really bad derivatives crash would essentially be similar to dropping a nuke on the entire global financial system. Let us hope that it does not happen any time soon, but let us also be ready for when it does.
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The Size of Derivatives Bubble = $190K Per Person on Planet
Posted by Tom Foremski – October 16, 2008
More must read financial analysis from DK Matai, Chairman of the ACTA Open.
The Invisible One Quadrillion Dollar Equation — Asymmetric Leverage and Systemic Risk
According to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland — the central bankers’ bank — the amount of outstanding derivatives worldwide as of December 2007 crossed USD 1.144 Quadrillion, ie, USD 1,144 Trillion. The main categories of the USD 1.144 Quadrillion derivatives market were the following:
1. Listed credit derivatives stood at USD 548 trillion;
2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:
a. Interest Rate Derivatives at about USD 393+ trillion;
b. Credit Default Swaps at about USD 58+ trillion;
c. Foreign Exchange Derivatives at about USD 56+ trillion;
d. Commodity Derivatives at about USD 9 trillion;
e. Equity Linked Derivatives at about USD 8.5 trillion; and
f. Unallocated Derivatives at about USD 71+ trillion.
Quadrillion? That is a number only super computing engineers and astronomers used to use, not economists and bankers! For example, the North star is “just” a couple of quadrillion miles away, ie, a few thousand trillion miles. The new “Roadrunner” supercomputer built by IBM for the US Department of Energy’s Los Alamos National Laboratory has achieved a peak performance of 1.026 Peta Flop per second — becoming the first supercomputer ever to reach this milestone. One Quadrillion Floating Point Operations (Flops) per second is 1 Peta Flop/s, ie, 1,000 Trillion Flops per second. It is estimated that all the data found on all the websites and stored on computers across the world totals more than One Exa byte of memory, ie, 1,000 Quadrillion bytes of data.
Whilst outstanding derivatives are notional amounts until they are crystallised, actual exposure is measured by the net credit equivalent. This is normally a lower figure unless many variables plot a locus in the wrong direction simultaneously. This could be because of catastrophic unpredictable events, ie, “Black Swans”, such as cascades of bankruptcies and nationalisations, when the net exposure can balloon and become considerably larger or indeed because some extremely dislocating geo-political or geo-physical events take place simultaneously. Also, the notional value becomes real value when either counterparty to the OTC derivative goes bankrupt. This means that no large OTC derivative house can be allowed to go broke without falling into the arms of another. Whatever funds within reason are required to rescue failing international investment banks, deposit banks and financial entities ought to be provided on a case by case basis. This is the asymmetric nature of derivatives and here lies the potential for systemic risk to the global economic system and financial markets if nothing is done.
Let us think about the invisible USD 1.144 quadrillion equation with black swan variables — ie, 1,144 trillion dollars in terms of outstanding derivatives, global Gross Domestic Product (GDP), real estate, world stock and bond markets coupled with unknown unknowns or “Black Swans”. What would be the relative positioning of USD 1.144 quadrillion for outstanding derivatives, ie, what is their scale:
1. The entire GDP of the US is about USD 14 trillion.
2. The entire US money supply is also about USD 15 trillion.
3. The GDP of the entire world is USD 50 trillion. USD 1,144 trillion is 22 times the GDP of the whole world.
4. The real estate of the entire world is valued at about USD 75 trillion.
5. The world stock and bond markets are valued at about USD 100 trillion.
6. The big banks alone own about USD 140 trillion in derivatives.
7. Bear Stearns had USD 13+ trillion in derivatives and went bankrupt in March. Freddie Mac, Fannie Mae, Lehman Brothers and AIG have all ‘collapsed’ because of complex securities and derivatives exposures in September.
8. The population of the whole planet is about 6 billion people. So the derivatives market alone represents about USD 190,000 per person on the planet.
The Impact of Derivatives
1. Derivatives are securities whose value depends on the underlying value of other basic securities and associated risks. Derivatives have exploded in use over the past two decades. We cannot even properly define many classes of derivatives because they are highly complex instruments and come in many shapes, sizes, colours and flavours and display different characteristics under different market conditions.
2. Derivatives are unregulated, not traded on any public exchange, without universal standards, dealt with by private agreement, not transparent, have no open bid/ask market, are unguaranteed, have no central clearing house, and are just not really tangible.
3. Derivatives include such well known instruments as futures and options which are actively traded on numerous exchanges as well as numerous over-the-counter instruments such as interest rate swaps, forward contracts in foreign exchange and interest rates, and various commodity and equity instruments.
4. Everyone from the large financial institutions, governments, corporations, mutual and pension funds, to hedge funds, and large and small speculators, uses derivatives. However, they have never existed in history with the overarching, exorbitant scale that they now do.
5. Derivatives are unravelling at a fast rate with the start of the “Great Unwind” of the global credit markets which began in July 2007 and particularly after the collapse of Freddie Mac and Fannie Mae in September this year.
6. When derivatives unravel significantly the entire world economy would be at peril, given the relatively smaller scale of the world economy by comparison.
7. The derivatives market collapse could make the housing and stock market collapses look incidental.
Three Historical Examples
1. The so-called rogue trader Nick Leeson who made a huge derivatives bet on the direction of the Japanese Nikkei index brought on the collapse of Barings Bank in 1995.
2. The collapse of Long Term Capital Management (LTCM), a hedge fund that had a former derivatives and bond dealer from Salomon Brothers and two Nobel Prize winners in Economics as principals, collapsed because of huge leveraged bets in currencies and bonds in 1998.
3. Finally, a lot of the problems of Enron in 2000 were brought on by leveraged derivatives and using derivatives to hide problems on the balance sheet.
The single conceptual pitfall at the basis of the disorderly growth of the global derivatives market is the postulate of hedging and netting, which lies at the basis of each model and of the whole regulatory environment hyper structure. Perfect hedges and perfect netting require functioning markets. When one or more markets become dysfunctional, the whole deck of cards could collapse swiftly. To hope, as US Treasury Secretary Mr Henry Paulson does, that an accounting ruse such as transferring liabilities, however priced, from a private to a public agent will restore the functionality of markets implies a drastic jump in logic. Markets function only when:
1. There is a price level at which demand meets supply; and more importantly when
2. Both sides believe in each other’s capacity to deliver.
Satisfying criterion 1. without satisfying criterion 2. which is essentially about trust, gets one nowhere in the long term, although in the short term, the markets may demonstrate momentary relief and euphoria.
In the context of the USD 700 billion rescue plan — still being finalised in Washington, DC — the following is worth considering step by step. Decision makers are rightly concerned about alleviating immediate pressure points in the global financial system, such as, the mortgage crisis, decline in consumer spending and the looming loss of confidence in financial institutions. However, whilst these problems are grave, they are acting as a catalyst to another more massive challenge which may have to be tackled across many nation states simultaneously. As money flows slow down sharply, confidence levels would decline across the globe, and trust would be broken asymmetrically, ie, the time taken to repair it would be much longer. Unless there is government action in concert, this could ignite a chain-reaction which would swiftly purge trillions and trillions of dollars in over-leveraged risky bets. Within the context of over-leverage, the biggest problem of all is to do with “Derivatives”, of which CDSs are a minor subset. Warren Buffett has said the derivatives neutron bomb has the potential to destroy the entire world economy, and is a “disaster waiting to happen.” He has also referred to derivatives as Weapons of Mass Destruction (WMD). Counting one dollar per second, it would take 32 million years to count to one Quadrillion. The numbers we are dealing with are absolutely astronomical and from the realms of super computing we have stepped into global economics. There is a sense of no sustainability and lack of longevity in the “Invisible One Quadrillion Dollar Equation” of the derivatives market especially with attendant Black Swan variables causing multiple implosions amongst financial institutions and counterparties! The only way out, albeit painful, is via discretionary case-by-case government intervention on an unprecedented scale. Securing the savings and assets of ordinary citizens ought to be the number one concern in directing such policy.
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We welcome your thoughts, observations and views. Thank you.
Chairman, ATCA Open
– ATCA, The Philanthropia, mi2g, HQR –
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The original ATCA — Asymmetric Threats Contingency Alliance — is a philanthropic expert initiative founded in 2001 to resolve complex global challenges through collective Socratic dialogue and joint executive action to build a wisdom based global economy. Adhering to the doctrine of non-violence, ATCA addresses asymmetric threats and social opportunities arising from climate chaos and the environment; radical poverty and microfinance; geo-politics and energy; organised crime & extremism; advanced technologies — bio, info, nano, robo & AI; demographic skews and resource shortages; pandemics; financial systems and systemic risk; as well as transhumanism and ethics. Present membership of the original ATCA network is by invitation only and has over 5,000 distinguished members from over 120 countries: including 1,000 Parliamentarians; 1,500 Chairmen and CEOs of corporations; 1,000 Heads of NGOs; 750 Directors at Academic Centres of Excellence; 500 Inventors and Original thinkers; as well as 250 Editors-in-Chief of major media.
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The Bi-Polar Moving Bretton Woods Meetings
1. Bretton Woods was folded.
2. The floating exchange rate system is about to be folded.
3. By default or design we are going to a one-world currency and a one-world central bank of central banks.
4. For Portugal, Ireland, Italy, Greece or Spain to break off from the euro would be an expansion of the floating exchange rate system under present conditions.
5. There are presently 3 major currencies. That is the US dollar, the euro and gold.
6. The SDR was an attempt to form a single reserve currency that never took flight.
7. The SDR is an accounting unit made up of an index of currencies much like the USDX.
There is no immunity now from the size of funds seeking to speculate or manipulate markets. This type of money is attacking the debt of the weaker euro states by intention or coincidence. Their success in the Iceland situation was only the first chapter of a multi chapter play.
Central bankers fear that this type of action, most certainly if it is as successful as it was on Iceland, succeeding against the weaker euro states could easily attack the present functional reserve currencies, the US dollar and the euro.
There is an implicit fear that if the ECB refuses to or cannot sustain the debt of Portugal, Ireland, Italy, Greece and Spain the next to fall will be both the US dollar and the euro.
The states of the US are no different, in form or short opportunity, than weak members of the euro. Already major money is short California, New York and Pennsylvania debt. A pounding of state debt is as easy as the pounding of the weaker members of the euro.
Attack of a currency is primarily an attack of the debt representing that currency.
Central banks are run by bankers who used to measure their capital in millions only a few years ago. After the invention of the OTC derivative they measured their capital as today in billions. They now imagine measuring their capital both of their banks and personally in the trillions as they challenge nations, not companies.
China knows this and is insulating itself from this.
To accomplish this end whilst maintaining and increasing the value of hard assets ( assets of major players) a new single reserve currency must be functionally initiated either by default or by design.
A singular world currency must be an index of many currencies adjusted from time to time. Adjustment within its membership is the key to a common currency that the EU forgot about.
Whatever institution manages that index becomes the central bank of central banks able to create artificial money according to its allocation of the single currency index. This is what was desired of the SDR originally.
The chances of reverting to a Bretton Woods or increasing the Floating Exchange rates are unlikely.
A collapse of the weaker states of the euro would be an expansion of the floating exchange rate strengthening the market forces that will attack all nations one by one after their success in Iceland. The weakest will be the first to go, but none are safe.
The chance of an abrupt change to something new now, as above, is unlikely. The probability of moving towards a one world currency in stages over the next 5 years is a reality.
In order to make that transition a method of raising the status of the IMF and the SDR would be most likely. Such a transition would be for this entity to assist in sustaining the weaker states of the euro and the USA as the states of the USA are now rolling over harder, balance sheet wise, than the weaker states of the euro
The debt of nations is not immune to the tsunami of these speculative and manipulative funds attacking by design or coincidence, focusing on a market all on one side – short.
OTC derivatives are being used in the strategy to collapse the weaker states of the euro.
OTC derivatives are the cause of this entire trauma by design or coincidence.
Nothing has been done to curtail or reduce the ever-growing mountain of these instruments.
All that has occurred is the new means of valuation as value to maturity, and the collapse of FASB requiring market valuation. Both items repaired the appearance of the balance sheet of the financial entities by allowing a cartoon of valuations to re-enter the system.
The decision will take place that is in the best interest of the majority power of four groups ruling these bi-polar central bank meetings. Those groups are the banksters, bankers, Daddy Warbucks and politicians.
1. Gold will progressively lock price-wise in the inverse to the SDR or similar item.
2. An exchange will soon begin to trade a virtual SDR or similar item just as they trade a virtual dollar as the USDX or virtual gold as a paper gold.
3. The USDX will become redundant.
4. The ability to pay off the debt of previous reserve currencies with market de-valued paper is facilitated.
5. Currencies as a whole will decline.
6. That decline will be the SDR versus the gold price.
7. The method of attacking a currency is inherent in attacking its debt.
The answer is simple even though the problem is complex.
Reduce all your currency positions into strength. Buy gold in all its forms other than US or Euro based in weakness.
Gold will trade at $1650 and above. The US dollar continues its march in phases towards worth-less and worthlessness.
Derivatives and the Recession
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Foreclosure Scandal Exposes
Systemic Derivatives Fraud
by John Hoefle
[PDF version of this article]
The foreclosure scandal making headlines across the country is sounding the death knell of the derivatives markets. This sign in Leesburg, Va., was from the very beginning of the wave of foreclosures, in February 2007.
October 9, 2010 — Filing false documents in courts to obtain illegal foreclosures, breaking into homes and changing the locks while the residents are still legally living there, and even foreclosing on homes which have no mortgages—these are just some of the things the derivatives arms of the giant banks are doing, as they throw people to the wolves in a vain effort to stop their own collapse into oblivion. We are not at all surprised that the derivatives banks are acting this way—in fact, we would be a bit surprised if they didn’t, given the criminal nature of the financial markets. It would be nice to be able to say that we are surprised that the Federal regulators are letting them get away with it, but that one won’t fly. Under the Obama regime, with the help of Speaker of the House Nancy Pelosi, and “Bailout” Barney Frank and Chris Dodd of the House and Senate banking committees, the banks have gotten pretty much whatever they wanted. If that includes your house, too bad for you.
Fortunately, a number of state officials have more backbone and morality than the sellouts in Washington, and are beginning to take steps to rein in some of these abuses. Their actions have forced at least four banks—JP Morgan Chase, Bank of America, PNC, and Ally Financial (née GMAC), to temporarily suspend foreclosures—in the 23 states which require court approval in the case of home foreclosures (Bank of America has frozen foreclosures in all 50 states). Attorneys general in a number of states have already launched investigations into the actions of the banks, with more expected. The magnitude of the problem, and the number of banks involved, have only begun to surface.
The state actions have prompted weak cover-your-mustache posturing from Obama, Pelosi, and company, in a desperate effort to hide their abject subservience to the British Empire and the Inter-Alpha Group. No one is buying it.
The banks, for their part, are covering up this scandal as fast as they can, and with the help of compliant media such as the New York Times and Washington Post, are attempting to cast it as a story of “shoddy paperwork by low-level nobodies,” whose errors are now “jeopardizing the fragile recovery.” In effect, these bankers are brazenly threatening us yet again—even as they destroy the nation trying to bail them out. “Stop us from taking what we want,” they’re saying, “and we’ll make you pay.” What unmitigated gall!
Well, we’ve got a hot news flash for these arrogant bastards: You are already way beyond bankrupt, the economy is already collapsing, and we are through capitulating to your suicidal demands. This time, we’re going to shut your derivatives market down, and save ourselves. Enough is enough!
The horror show playing out before our eyes in the foreclosure markets, is the continuing collapse of perhaps the greatest financial swindle in the history of mankind: the derivatives markets. The story revolves around the way that derivatives were used to create a giant pool of fictitious capital, nominally based on home mortgages, and the way that the banks are now attempting to seize the homes to turn their funny money into hard assets.
What is absolutely clear, is that the mortgage system—which was run by and for the big derivatives players—systematically ignored legal requirements for the conveyance of promissory notes and mortgages, as they engaged in this giant scam. Individual mortgages were sold by their originators, and combined into pools, which were, in turn, used as the basis for the issuance of mortgage-backed securities (MBS). These MBS were then sliced and diced into pieces, and sold. Then many of these pieces were combined into new pools, against which new derivatives were created and sold, ad nauseam.
Rather than record these sales with county courts, as required by state real estate laws, the bankers created a giant database called MERS, to keep track of the sales. This allowed the banks to save billions of dollars in time and money on court filings, and made the whole train-wreck run more smoothly—for a while.
The problems for the bankers began in mid-2007, when the mortgage-derivatives market collapsed. Panic set in after the collapse of two Bear Stearns hedge funds, and with good reason: The pyramid scheme had collapsed. Speculators suddenly retrenched into survivalist mode, thereby killing the flow of funds into the mortgage market, and sending property values plunging.
Now the foreclosures have begun to accelerate, as the derivatives-holders try to seize real homes to cover their fictitious claims. The problem they face is that, having ignored real estate filing laws, they are now finding it difficult to prove they are the legal owners of the mortgages/notes, and thus have the legal standing to foreclose.
As a result, the banks acting on behalf of their derivatives pools have resorted to faking the paperwork, filing false affidavits with the courts, and other unsavory actions. They have become so blatant in their criminality and contempt for the law, and for the welfare of the people, that they have triggered a revolt by the public, and the state regulators and courts.
Prosecution of the individuals and institutions that knowingly violated the law is certainly warranted, but that is not sufficient to deal with the problem. If we fine the banks, they will just pay us back with our own bailout money. So people need to go to jail, and institutions need criminal convictions. We must teach the British Empire that violating U.S. laws has serious consequences. No more slaps on the wrist (especially when accompanied by cash under the table).
We must finally recognize that this financial crisis—from the so-called “subprime crisis” to the “foreclosure crisis” and everything in-between, has been the result of a derivatives market which has turned the global financial system into a giant, and completely bankrupt casino, and that the attempt to bail out this casino by sticking the public with the bill is killing us all. If we are to survive, we must shut down the derivatives markets, declaring all existing derivatives contracts null and void, and prohibiting them in the future. Wall Street will howl, but that’s just a sign something right is being done. If they’re not howling, we’re not doing enough.
Get Back On Track
Putting the nation back on track requires a fundamental change in policy, starting with the reinstatement of Franklin Roosevelt’s Glass-Steagall law. We must separate out and protect real banking, of the sort needed to keep a proper economy functioning, from the speculations of the casino. We will honor legitimate debts, but not derivatives claims and other casino chips. We will put the Federal Reserve into receivership, go back to a Hamiltonian credit system, return to a Bretton Woods-style fixed exchange rate, and launch an infrastructure Renaissance in the style of Lyndon LaRouche’s NAWAPA/Mars concept.
To succeed, we must break the power of the British Empire and its Rothschild-run Inter-Alpha Group over the world economy, and, in particular, the U.S. economy. We are at war with the empire, and our very survival is on the line. The actions we see in the foreclosure process are just a small part of the financial warfare directed against us. The empire’s puppets—from Obama on down, in Washington, and virtually all of Wall Street and the Boston Vault—must go. We must return to the concept of “of, by, and for the People.”
We had a chance in 2007 and 2008 with LaRouche’s Homeowners and Bank Protection Act, which would have stopped the foreclosures, and ripped legitimate banking functions from the clutches of the speculators. That effort, which had considerable public support, was sabotaged by “Bailout” Barney Frank and others. Had it passed, we would not be in the mess we are today. Those who blocked the HBPA on behalf of the empire, committed treason, if not by the letter of the law, then by the intent of the Constitution. They are not fit for public office—even in sanitation. They’re so corrupt they would probably contaminate the sewers.
What was a financial crisis, having been made far worse by the bailout scheme, has turned into a full-fledged breakdown crisis. We must bust up the imperial crime wave via Glass-Steagall. That will clean up the mess, but it still leaves us with a dying economy, which is where NAWAPA (the North Amerian Water and Power Alliance) and LaRouche’s “platform” concept come in. Nothing less will work, anything less is a waste of time.
Finally, in closing, we have a suggestion for all the investigators looking into the foreclosure crisis. The devil is not in the details, but in the nature of the now-dead financial system. You are looking at a vast criminal conspiracy intended to destroy the United States, and the nation-state system itself, in favor of the re-establishment of the British Empire on a global scale.
You should also consider the possibility that the deliberate failure to follow legal document-recording standards has to do with more than just saving time and money. We suspect, knowing the nature of the empire, that what they were really doing is selling the same assets to more than one buyer. They will gladly take “paperwork” fines, to hide that. Don’t let them get away with it.
So, put away your Sherlock Holmes, and turn off “CSI,” and read Edgar Allan Poe’s “The Purloined Letter.” That is the method you will need to get to the bottom of these crimes. Look with your mind, not your senses.
END-GAME IS ON: Getting Out in Time! by Lyndon H. LaRouche, Jr.
Obama Out To Kill Glass-Steagall, While Pushing Weimar Hyperinflation by Lyndon H. LaRouche, Jr.
A Glass-Steagall for Europe: Outlaw Currency Speculation by Helga Zepp-LaRouche
Federal Reserve Sparks Hyperinflation: Implement Glass-Steagall in September! by Helga Zepp-LaRouche
An Appeal for a Two-Tier Banking System: Europe Will Go Under Without Global Glass-Steagall June 2010 by Helga Zepp-LaRouche
There Is No `Greek’ Crisis: It’s the Euro That Has Failed May 2010 by Helga Zepp-LaRouche
EU Opens the Floodgates For Hyperinflation April 2010 by Helga Zepp-LaRouche
Lyndon H. LaRouche Emergency Address September 1, 2007 (MP3 audio)
The Schiller Institute
PO BOX 20244
Washington, DC 20041-0244
Systemic Uneconomics: Financial Crisis Root Causes: Part III
Submitted by Scott Cleland on Thu, 2010-01-21 16:03
To discern the real “root” causes of the financial crisis of 2008, one must probe beneath the surface and examine the health of the “root system” of our capital markets “forest.” The roots of the capital markets forest are sound economics; the natural market function of automatically equilibrating supply and demand and risk and reward, that is commonly appreciated as Adam’s Smith’s “invisible hand.” We generally assume that the natural market strength of the capital market forest’s root system ensures that all the trees are not in danger of being blown over in the crisis of a storm.
In the fall of 2008, we all were shocked to learn that the root system of our capital markets, that we had always assumed was healthy and strong, was actually frighteningly weak and brittle requiring the slapdash reinforcement of multi-trillion dollar emergency scaffolding of whatever material was close at hand, a TARP, bailout lifelines, capital sandbags, etc. — to buttress the main market “trees” from toppling over, trees that the Government judged to big to be allowed to fall.
With the financial storm clouds apparently passed for now, many are becoming complacent, because the old adage is true — out of sight out of mind. Moreover, everyone desperately wants and needs to be able to assume that the essential root system that they cannot see is fine and nothing to worry about. That’s because if people knew the root system was weak with root rot, systemic uneconomics, they would have less confidence in the capital markets forest or the fledgling economic recovery.
So many are myopically focusing on structurally preventing the trees from falling down, largely by packing tens of billions of dollars of additional capital “soil” around the base of the trees to try and reinforce them. More capital “soil” to reinforce the trees makes good sense. However, it totally covers up the most important point — that the capital markets forest must have a healthy root system so that the market’s trees can stand by themselves long-term. If the health of the root system is not restored with sound economics, it won’t be able to withstand future storms/crises that will surely come, if the future is anything like the past three decades.
Unfortunately, we also know that another old adage is true: what we don’t know can hurt us.
The real problem is neither the market nor economics, but the irresponsible proliferation of inherently uneconomic financial instruments that undermine the ability of natural market economics to function. It is common sense that if enough inherently uneconomic activity is introduced, condoned, and allowed to spread broadly and deeply into the public capital markets system, public markets deteriorate from being systemically economic to being systemically uneconomic; in other words the systemically dysfunctional mess we witnessed in the dismal fall of 2008.
More specifically, the root system rot of uneconomics comes from introducing a variety of inherently uneconomic derivative financial instruments into the public capital markets system, that inherently undermine, weaken and destabilize the market’s (or invisible hand’s) natural ability to equilibrate: supply and demand; risk and reward; the borrower and lender relationship; the balance between short and long term horizons; and the economic equation between risk and insurance.
Let me be crystal clear, financial derivatives themselves are not the problem because derivatives can be economic and have many legitimate and valuable benefits. As I explained in Part II of this series, “Systemic Risk Laundering,” the problem is an unaccountable, out-of-control derivative system where derivatives are all assumed to be systemically benign and allowed to destroy the underlying public asset they are derived from. Central to accountability is the fundamental question: is a particular derivative financial instrument economic or uneconomic when integrated into the overall capital market system? In other words, are particular derivative instruments constructive or destructive to the core economic linkage of: supply and demand? Risk and reward? Borrower and lender? Short term and long term? Risk and insurance? To carry the root metaphor deeper, do the particular derivative instruments impede, block, or distort the root system’s natural ability to absorb and benefit from the water and nutrients in the soil?
So what are the uneconomic derivative financial instruments that create systemic risk and systemic uneconomic dysfunction?
First, employee stock options (in stark contrast to actual employee stock grants) are inherently uneconomic because they pervasively disconnect risk from reward and supply from demand. Stock options are the market equivalent of something for nothing, an opportunity to gain with no offsetting opportunity to lose. Stock options, unlike stock grants or the buying or selling of stock, are one-way upside potential with no potential downside risk. The tech bubble taught us that too much personal financial opportunity divorced from any personal financial risk encourages unwarranted risk taking with other peoples’ money. Typical of the system, not enough was done after the tech bubble to address the inherent uneconomic nature of stock options, so they continue to rot away the market’s natural strength to this day.
Second, indexing financial instruments are inherently uneconomic because pervasive indexing is inherently destabilizing, anti-capital formation, speculative, and hyper-stressing of the financial system, as I described inPart I of this series: “Indexing into the Ditch.” Indexing naturally impedes the market’s ability to reach equilibrium by exacerbating market volatility because it artificially creates a massive one-sided economic market. It generates substantial supply with no offsetting demand in a down market; and it generates substantial demand with no offsetting supply in an up market. Indexing fosters a market momentum dynamic which means a dominant segment of the market does not care about economics: price, fundamentals or time horizon — at all. Therefore prices can never be too high or too low for an indexer because economics have absolutely nothing to do with indexing.
Third, off-exchange derivatives often are destructively uneconomic, because like indexing, they can subordinate the first purpose of an underlying publicly-traded asset by advantaging the second purpose of the derivative ahead of the first purpose of the publicly traded asset — the quintessential tail wagging the dog. Credit default swap derivative instruments were dangerously uneconomic in that they perverted the essential equilibrium of borrower and lender and the concept that insurance is only economically viable for quantifiable risk. New experiments with “life settlements” derivatives assuredly will end badly because they mix the economic concept of insurance for highly-quantifiable risk with markets with inherently unquantifiable risks, rewarding speculative arbitrage, manipulation and fraud.
Almost by definition, the second purposes of derivative instruments are different from the first purpose financial instruments, and that difference can either be benign and productive or uneconomic and destructive. Returning to the root system metaphor, many derivatives are akin to introducing untested synthetic bacteria or virus into the capital market’s forest ecosystem. The current near-total lack of accountability for many off-exchange derivatives means that anyone can dump in the capital market forest whatever they can convince or trick someone into buying.
Finally, computer-automated program trading, or more simply algorithmic trading, is rapidly becoming the market norm because it offers efficiencies, mostly centered on substantially lowering transaction and management costs, which can contribute to better net performance. However, the much under-appreciated problem here is the inherent uneconomic “short-termism” effect of pervasive algorithmic trading in capital markets. The obsession, trend, and technology arms race to achieve ever faster, more complex, and more comprehensive automated trading is tautologically short-term focused. This is essentially devolving into a counter-productive race where artificial intelligence portfolio management arbitrages new information faster and faster (now measured in milliseconds and soon in nanoseconds), rather than compete for long-term investment returns — the universal goal of most investors, pensioners, and companies that are supposedly the true customers of the public capital markets system.
I call this pervasive and corrosive technological dynamic “algorithmia.” At core, algorithmia is a technological downward spiral to achieve a relative mili-second edge and is all about extremely short-term arbitrage, often less than a day. The flood of investable resources into immediate-term algorithmia only exacerbates the distortion and destabilization for the rest of the market that is trying to investment optimize for various long-term investment horizons that investors, pensioners and companies need.
Why algorithmia is profoundly uneconomic is that it powerfully disconnects the market’s natural function of reaching equilibrium by matching buyers and sellers via different investment horizons. If most liquid investable resources are inherently immediate-term focused, even if they are masquerading as having a longer term investment horizon, the long-term capital market purposes of capital formation, economic growth and investment simply cannot function economically. Algorithmia is not about investing at all, but about constant arbitrage within and between asset classes. In the virtual mathematical world of algorithmia, what happens in the real world that’s not readily quantifiable, other than infrequently reported official numbers, is largely irrelevant.
Like indexing, algorithmia is inherently a momentum dynamic too, because what drives all of these algorithms is the same basic official input data. Once the market adjusts to new information the algorithmic task then shifts to see how the next piece of information will change the relative arbitrage equation competition based on what just happened, so this process is inherently sequential and cumulative, and hence momentum driven, not driven by economic fundamentals.
The 2008 Financial Crisis was a perfect and ominous example of the perils of algorithm-dominated markets. Algorithmia becomes a problem for the market when something happens that the programmers did not anticipate. Much of the market froze in fear in the fall of 2008 precisely because the established momentum of the market broke so unpredictably that many of the programs could not function as designed. In other words they worked when everything went according to plan, but they could be disastrous if and when the market behaved in an unanticipated or uneconomic way.
The scariest part of algorithmia is that almost by definition oversight and regulators will be lagging and reactive. Algorithmia also only increases the knowledge and sophistication gap between industry practitioners and regulators. Common sense suggests that, at a minimum, there needs to be an accountability system where all the algorithmic decisions and changes are at least subject to audit and re-creation by law enforcement, because without that deterrence and accountability, algorithmia, like off-exchange derivatives, will become a safe haven for speculators, market manipulators and fraudsters.
In sum, a primary root cause of the Financial Crisis of 2008 was systemic uneconomics: the ever-increasing accumulation of trillions of dollars of inherently uneconomic derivative financial instruments rotting out the root system of the capital markets forest. No amount of surface reinforcement or capital soil piled on the top of the big trees in the capital markets forest will enable the trees to stand on their own during the next big storm if their root systems continue to rot away from systemic uneconomics.
The best way to avert another financial crisis is stop the root rot in the capital markets forest. The best way to do that is to apply an “Accountability Framework Checklist” (like the one recommended below) to discern which derivative financial instruments and algorithmic practices are inherently economic and productive and which are inherently uneconomic and destructive. If the overall economic purposes of capital markets are capital formation, economic growth and investment, all the roots of the capital markets system need to be based on sound economics and not arbitrage, manipulation and fraud.
Note: Don’t miss Part I & II of this research series:
- “Systemic Risk Laundering — Financial Crisis Root Causes — Part II” Click here.
- “Indexing into the Ditch – Financial Crisis Root Causes – Part I” Click here.
Scott Cleland is President of Precursor LLC, an industry research and consulting firm, and was the Founding Chairman of the Investorside Research Association. Click here for Cleland’s Biography.
Systemic Risk Prevention Framework & Derivative Accountability Checklist
(Same Recommended Framework as in Part II of the series)
All of the thousands of new derivative financial instruments and systemic practices that have emerged over the last decade since the CFMA created a safe harbor from accountability need to be audited and evaluated for unaccountable systemic risk, fraud and uneconomics.
- What asset, instrument, or market is the derivative dependent or predicated upon?
- Does the derivative’s second purpose conflict with, or undermine, the first purposes/value of the underlying public asset, instrument, or market that the derivative is derived from?
- How is the derivative interconnected with other assets, instruments, markets or counterparties? And to what extent is that interconnectedness reasonably transparent and known by all the affected parties?
- What are the side effects, externalities, and long-term/cumulative effects of the derivative?
- Does the derivative enhance or detract from the underlying asset, instrument, or market?
- Does the derivative undermine or break any linkage/relationship/balance between:
- Supply and demand?
- Risk and reward?
- Borrower and lender?
- Short and long term?
- Risk and insurance?
- As the derivative scales in usage could it foster systemic:
- Market momentum?
- Market speculation?
- Front running?
- Is the derivative’s effect prone to undermining or discouraging capital formation?
- Is the derivative’s effect prone to undermining market efficiency in reaching price equilibrium?
- How could the derivative be susceptible to fraud or manipulation?
- Does the derivative transfer risk transparently and with fair representation?
- Does the derivative have independent research coverage?
- How is the derivative accountable and to what/whom?
- What are the accountability measures, (audit, internal controls, etc.) for the derivatives algorithms or quant models?
- What independent third party audits and creates accountability for ensuring integrity of the algorithms and computer code that undergird these virtual derivative exchanges/systems?
Wiki accessed oct 13 2011-10-13
Credit default swap
From Wikipedia, the free encyclopedia
|This article may be too technical for most readers to understand. Please help improve this article to make it understandable to non-experts, without removing the technical details. The talk page may contain suggestions. (November 2010)|
If the reference bond performs without default, the protection buyer pays quarterly payments to the seller until maturity
If the reference bond defaults, the protection seller pays par value of the bond to the buyer, and the buyer physically delivers the bond to the seller
Sovereign credit default swap prices of selected European countries from June 2010 till September 2011. The left axis issiis points; a level of 1,000 means it costs $1 million to protect $10 million of debt for five years.
A credit default swap (CDS) is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default. Generally, this involves an exchange or “swap” of the defaulted loan instrument (and with it the right to recover the default loan at some later time) for immediate money – usually the face value of the loan.
However, there is a significant difference between a traditional insurance policy and a CDS. Anyone can purchase a CDS, even buyers who do not hold the loan instrument and may have no direct “insurable interest” in the loan. The buyer of the CDS makes a series of payments (the CDS “fee” or “spread”) to the seller and, in exchange, receives a payoff if the loan defaults.
Credit default swaps have existed since the early 1990s, and increased in use after 2003. By the end of 2007, the outstanding CDS amount was $62.2 trillion, falling to $26.3 trillion by mid-year 2010.
Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA), although some are tailored to meet specific needs. CDSs have many variations. In addition to the basic, single-name swaps, there are basket default swaps (BDSs), index CDSs, funded CDSs (also called a credit-linked notes), as well as loan-only credit default swaps (LCDS). In addition to corporations and governments, the reference entity can include a special purpose vehicleissuing asset backed securities.
CDSs are not traded on an exchange and there is no required reporting of transactions to a government agency. During the2007-2010 financial crisis the lack of transparency became a concern to regulators, as was the multi-trillion dollar size of the market, which could pose a systematic risk to the economy.
Credit default swaps and other derivatives are unusual–and potentially dangerous–in that they combine priority in bankruptcy with a lack of transparency. In March 2010, the DTCC Trade Information Warehouse (see Sources of Market Data) announced it would voluntarily give regulators greater access to its credit default swaps database.
A number of financial professionals, regulators, and the media have begun using credit default swap pricing as a gauge of the riskiness of corporate and sovereign borrowers, and U.S. Courts may soon be following suit. 
Buyer purchased a CDS at time t0and makes regular premium payments at times t1, t2, t3, and t4. If the associated credit instrument suffers no credit event, then the buyer continues paying premiums at t5, t6 and so on until the end of the contract at time tn.
However, if the associated credit instrument suffered a credit event at t5, then the seller pays the buyer for the loss, and the buyer would cease paying premiums to the seller.
A CDS is linked to a “reference entity” or “reference obligor”, usually a corporation or government. The reference entity is not a party to the contract. The buyer makes regular premium payments to the seller, the premium amounts constituting the “spread” charged by the seller to insure against a credit event. If the reference entity defaults, the protection seller pays the buyer the par value of the bond in exchange for physical delivery of the bond, although settlement may also be by cash or auction. A default is often referred to as a “credit event” and includes such events as failure to pay, restructuring and bankruptcy, or even a drop in the borrower’s credit rating. Most CDSs are in the $10–$20 million range with maturities between one and 10 years. Five years is the most typical maturity.
A holder of a bond may “buy protection” to hedge its risk of default. In this way, a CDS is similar to credit insurance, although CDS are not subject to regulations governing traditional insurance. Also, investors can buy and sell protection without owning debt of the reference entity. These “naked credit default swaps” allow traders to speculate on the creditworthiness of reference entities. CDSs can be used to create synthetic long and short positions in the reference entity. Naked CDS constitute most of the market in CDS. In addition, CDSs can also be used in capital structurearbitrage.
A “credit default swap” (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults or experiences a similar credit event. The CDS may refer to a specified loan or bond obligation of a “reference entity”, usually a corporation or government.
As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor—the buyer of protection—will make regular payments to AAA-Bank—the seller of protection. If Risky Corp defaults on its debt, the investor receives a one-time payment from AAA-Bank, and the CDS contract is terminated. A default is referred to as a “credit event” and include such events as failure to pay, restructuring and bankruptcy. CDS contracts on sovereign obligations also usually include as credit events repudiation, moratorium and acceleration.
If the investor actually owns Risky Corp’s debt (i.e., is owed money by Risky Corp), a CDS can act as a hedge. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky Corp (see Uses).
If the reference entity (i.e., Risky Corp) defaults, one of two kinds of settlement can occur:
- the investor delivers a defaulted asset to Bank for payment of the par value, which is known as physical settlement;
- AAA-Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if Risky Corp defaults there is usually some recovery, i.e., not all the investor’s money is lost), which is known as cash settlement.
The “spread” of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or Risky Corp defaults. Payments are usually made on a quarterly basis, in arrears.
All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison. Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be the best indicators of the likelihood of sellers of CDSs having to perform under these contracts.
CDS contracts have been compared with insurance, because the buyer pays a premium and, in return, receives a sum of money if one of the events specified in the contract occurs. However, there are a number of differences between CDS and insurance, for example:
- The buyer of a CDS does not need to own the underlying security or other form of credit exposure; in fact the buyer does not even have to suffer a loss from the default event. In contrast, to purchase insurance, the insured is generally expected to have an insurable interest such as owning a debt obligation;
- the seller doesn’t have to be a regulated entity;
- the seller is not required to maintain any reserves to pay off buyers, although major CDS dealers are subject to bank capital requirements;
- insurers manage risk primarily by setting loss reserves based on the Law of large numbers, while dealers in CDS manage risk primarily by means of offsetting CDS (hedging) with other dealers and transactions in underlying bond markets;
- in the United States CDS contracts are generally subject to mark-to-market accounting, introducing income statement and balance sheet volatility that would not be present in an insurance contract;
- Hedge accounting may not be available under US Generally Accepted Accounting Principles (GAAP) unless the requirements of FAS 133 are met. In practice this rarely happens.
However the most important difference between CDS and insurance is simply that an insurance contract provides an indemnity against the losses actually suffered by the policy holder, whereas the CDS provides an equal payout to all holders, calculated using an agreed, market-wide method.
There are also important differences in the approaches used to pricing. The cost of insurance is based on actuarial analysis. CDSs are derivatives whose cost is determined using financial models and by arbitrage relationships with other credit market instruments such as loans and bonds from the same ‘Reference Entity’ the CDS contract refers to.
Further, to cancel the insurance contract the buyer can simply stop paying premium whereas in case of CDS the protection buyer may need to unwind the contract, which might result in a profit or loss situation.
Insurance contracts require the disclosure of all known risks involved. CDSs have no such requirement. Most significantly, unlike insurance companies, sellers of CDSs are not required to maintain any capital reserves to guarantee payment of claims.
- The buyer takes the risk that the seller may default. If AAA-Bank and Risky Corp. default simultaneously (“double default”), the buyer loses its protection against default by the reference entity. If AAA-Bank defaults but Risky Corp. does not, the buyer might need to replace the defaulted CDS at a higher cost.
- The seller takes the risk that the buyer may default on the contract, depriving the seller of the expected revenue stream. More important, a seller normally limits its risk by buying offsetting protection from another party — that is, it hedges its exposure. If the original buyer drops out, the seller squares its position by either unwinding the hedge transaction or by selling a new CDS to a third party. Depending on market conditions, that may be at a lower price than the original CDS and may therefore involve a loss to the seller.
In the future, in the event that regulatory reforms require that CDS be traded and settled via a central exchange/clearing house, such as ICE TCC, there will no longer be ‘counterparty risk’, as the risk of the counterparty will be held with the central exchange/clearing house.
As is true with other forms of over-the-counter derivative, CDS might involve liquidity risk. If one or both parties to a CDS contract must post collateral (which is common), there can be margin calls requiring the posting of additional collateral. The required collateral is agreed on by the parties when the CDS is first issued. This margin amount may vary over the life of the CDS contract, if the market price of the CDS contract changes, or the credit rating of one of the parties changes. Many CDS contracts even require to pay an upfront at the beginning (also referred to as “initial margin”).
Another kind of risk for the seller of credit default swaps is jump risk or jump-to-default risk. A seller of a CDS could be collecting monthly premiums with little expectation that the reference entity may default. A default creates a sudden obligation on the protection sellers to pay millions, if not billions, of dollars to protection buyers. This risk is not present in other over-the-counter derivatives.
Sources of market data
Data about the credit default swaps market is available from three main sources. Data on an annual and semiannual basis is available from the International Swaps and Derivatives Association (ISDA) since 2001 and from the Bank for International Settlements (BIS) since 2004. The Depository Trust & Clearing Corporation (DTCC), through its global repository Trade Information Warehouse (TIW), provides weekly data but publicly available information goes back only one year. The numbers provided by each source do not always match because each provider uses different sampling methods.
According to DTCC, the Trade Information Warehouse maintains the only “global electronic database for virtually all CDS contracts outstanding in the marketplace.”
The Office of the Comptroller of the Currency publishes quarterly credit derivative data about insured U.S commercial banks and trust companies.
Credit default swaps allow investors to speculate on changes in CDS spreads of single names or of market indices such as the North American CDX index or the European iTraxx index. An investor might believe that an entity’s CDS spreads are too high or too low, relative to the entity’s bond yields, and attempt to profit from that view by entering into a trade, known as abasis trade, that combines a CDS with a cash bond and an interest-rate swap.
Finally, an investor might speculate on an entity’s credit quality, since generally CDS spreads increase as credit-worthiness declines, and decline as credit-worthiness increases. The investor might therefore buy CDS protection on a company to speculate that it is about to default. Alternatively, the investor might sell protection if it thinks that the company’s creditworthiness might improve. The investor selling the CDS is viewed as being “long” on the CDS and the credit, as if the investor owned the bond. In contrast, the investor who bought protection is “short” on the CDS and the underlying credit. Credit default swaps opened up important new avenues to speculators. Investors could go long on a bond without any upfront cost of buying a bond; all the investor need do was promise to pay in the event of default. Shorting a bond faced difficult practical problems, such that shorting was often not feasible; CDS made shorting credit possible and popular. Because the speculator in either case does not own the bond, its position is said to be a synthetic long or short position.
For example, a hedge fund believes that Risky Corp will soon default on its debt. Therefore, it buys $10 million worth of CDS protection for two years from AAA-Bank, with Risky Corp as the reference entity, at a spread of 500 basis points (=5%) per annum.
- If Risky Corp does indeed default after, say, one year, then the hedge fund will have paid $500,000 to AAA-Bank, but then receives $10 million (assuming zero recovery rate, and that AAA-Bank has the liquidity to cover the loss), thereby making a profit. AAA-Bank, and its investors, will incur a $9.5 million loss minus recovery unless the bank has somehow offset the position before the default.
- However, if Risky Corp does not default, then the CDS contract runs for two years, and the hedge fund ends up paying $1 million, without any return, thereby making a loss. AAA-Bank, by selling protection, has made $1 million without any upfront investment.
Note that there is a third possibility in the above scenario; the hedge fund could decide to liquidate its position after a certain period of time in an attempt to realise its gains or losses. For example:
- After 1 year, the market now considers Risky Corp more likely to default, so its CDS spread has widened from 500 to 1500 basis points. The hedge fund may choose to sell$10 million worth of protection for 1 year to AAA-Bank at this higher rate. Therefore, over the two years the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but receives 1 * 15% * $10 million = $1.5 million, giving a total profit of $500,000.
- In another scenario, after one year the market now considers Risky much less likely to default, so its CDS spread has tightened from 500 to 250 basis points. Again, the hedge fund may choose to sell $10 million worth of protection for 1 year to AAA-Bank at this lower spread. Therefore over the two years the hedge fund pays the bank 2 * 5% * $10 million = $1 million, but receives 1 * 2.5% * $10 million = $250,000, giving a total loss of $750,000. This loss is smaller than the $1 million loss that would have occurred if the second transaction had not been entered into.
Transactions such as these do not even have to be entered into over the long-term. If Risky Corp’s CDS spread had widened by just a couple of basis points over the course of one day, the hedge fund could have entered into an offsetting contract immediately and made a small profit over the life of the two CDS contracts.
Credit default swaps are also used to structure synthetic collateralized debt obligations (CDOs). Instead of owning bonds or loans, a synthetic CDO gets credit exposure to a portfolio of fixed income assets without owning those assets through the use of CDS. CDOs are viewed as complex and opaque financial instruments. An example of a synthetic CDO is Abacus 2007-AC1, which is the subject of the civil suit for fraud brought by the SEC against Goldman Sachs in April 2010. Abacus is a synthetic CDO consisting of credit default swaps referencing a variety of mortgage backed securities.
Naked credit default swaps
In the examples above, the hedge fund did not own debt of Risky Corp. A CDS in which the buyer does not own the underlying debt is referred to as a naked credit default swap, estimated to be up to 80% of the credit default swap market. There is currently a debate in the United States and Europe about whether speculative uses of credit default swaps should be banned. Legislation is under consideration by Congress as part of financial reform.
Critics assert that naked CDS should be banned, comparing them to buying fire insurance on your neighbor’s house, which creates a huge incentive for arson. Analogizing to the concept of insurable interest, critics say you should not be able to buy a CDS—insurance against default—when you do not own the bond. Short selling is also viewed as gambling and the CDS market as a casino. Another concern is the size of CDS market. Because naked credit default swaps are synthetic, there is no limit to how many can be sold. The gross amount of CDS far exceeds all “real” corporate bonds and loans outstanding. As a result, the risk of default is magnified leading to concerns about systemic risk.
Financier George Soros called for an outright ban on naked credit default swaps, viewing them as “toxic” and allowing speculators to bet against and “bear raid” companies or countries. His concerns were echoed by several European politicians who, during the Greek Financial Crisis, accused naked CDS buyers of making the crisis worse.
Despite these concerns, Secretary of Treasury Geithner and Commodity Futures Trading Commission Chairman Gensler are not in favor of an outright ban of naked credit default swaps. They prefer greater transparency and better capitalization requirements. These officials think that naked CDS have a place in the market.
Proponents of naked credit default swaps say that short selling in various forms, whether credit default swaps, options or futures, has the beneficial effect of increasing liquidity in the marketplace. That benefits hedging activities. Without speculators buying and selling naked CDS, banks wanting to hedge might not find a ready seller of protection.Speculators also create a more competitive marketplace, keeping prices down for hedgers. A robust market in credit default swaps can also serve as a barometer to regulators and investors about the credit health of a company or country.
Despite politicians’ assertions that speculators are making the Greek crisis worse, Germany’s market regulator BaFin found no proof supporting the claim. Some suggest that without credit default swaps, Greece’s borrowing costs would be higher.
Credit default swaps are often used to manage the risk of default that arises from holding debt. A bank, for example, may hedge its risk that a borrower may default on a loan by entering into a CDS contract as the buyer of protection. If the loan goes into default, the proceeds from the CDS contract cancel out the losses on the underlying debt.
There are other ways to eliminate or reduce the risk of default. The bank could sell (that is, assign) the loan outright or bring in other banks as participants. However, these options may not meet the bank’s needs. Consent of the corporate borrower is often required. The bank may not want to incur the time and cost to find loan participants. If both the borrower and lender are well-known and the market (or even worse, the news media) learns that the bank is selling the loan, then the sale may be viewed as signaling a lack of trust in the borrower, which could severely damage the banker-client relationship. In addition, the bank simply may not want to sell or share the potential profits from the loan. By buying a credit default swap, the bank can lay off default risk while still keeping the loan in its portfolio. The downside to this hedge is that without default risk, a bank may have no motivation to actively monitor the loan and the counterparty has no relationship to the borrower.
Another kind of hedge is against concentration risk. A bank’s risk management team may advise that the bank is overly concentrated with a particular borrower or industry. The bank can lay off some of this risk by buying a CDS. Because the borrower—the reference entity—is not a party to a credit default swap, entering into a CDS allows the bank to achieve its diversity objectives without impacting its loan portfolio or customer relations. Similarly, a bank selling a CDS can diversify its portfolio by gaining exposure to an industry in which the selling bank has no customer base.
A bank buying protection can also use a CDS to free regulatory capital. By offloading a particular credit risk, a bank is not required to hold as much capital in reserve against the risk of default (traditionally 8% of the total loan under Basel I). This frees resources the bank can use to make other loans to the same key customer or to other borrowers.
Hedging risk is not limited to banks as lenders. Holders of corporate bonds, such as banks, pension funds or insurance companies, may buy a CDS as a hedge for similar reasons. Pension fund example: A pension fund owns five-year bonds issued by Risky Corp with par value of $10 million. To manage the risk of losing money if Risky Corp defaults on its debt, the pension fund buys a CDS from Derivative Bank in a notional amount of $10 million. The CDS trades at 200 basis points (200 basis points = 2.00 percent). In return for this credit protection, the pension fund pays 2% of $10 million ($200,000) per annum in quarterly installments of $50,000 to Derivative Bank.
- If Risky Corporation does not default on its bond payments, the pension fund makes quarterly payments to Derivative Bank for 5 years and receives its $10 million back after five years from Risky Corp. Though the protection payments totaling $1 million reduce investment returns for the pension fund, its risk of loss due to Risky Corp defaulting on the bond is eliminated.
- If Risky Corporation defaults on its debt three years into the CDS contract, the pension fund would stop paying the quarterly premium, and Derivative Bank would ensure that the pension fund is refunded for its loss of $10 million minus recovery (either by physical or cash settlement — see Settlement below). The pension fund still loses the $600,000 it has paid over three years, but without the CDS contract it would have lost the entire $10 million minus recovery.
In addition to financial institutions, large suppliers can use a credit default swap on a public bond issue or a basket of similar risks as a proxy for its own credit risk exposure on receivables.
Although credit default swaps have been highly criticized for their role in the recent financial crisis, most observers conclude that using credit default swaps as a hedging device has a useful purpose.
Capital Structure Arbitrage is an example of an arbitrage strategy that utilizes CDS transactions. This technique relies on the fact that a company’s stock price and its CDS spread should exhibit negative correlation; i.e., if the outlook for a company improves then its share price should go up and its CDS spread should tighten, since it is less likely to default on its debt. However if its outlook worsens then its CDS spread should widen and its stock price should fall. Techniques reliant on this are known as capital structure arbitrage because they exploit market inefficiencies between different parts of the same company’s capital structure; i.e., mis-pricings between a company’s debt and equity. An arbitrageur attempts to exploit the spread between a company’s CDS and its equity in certain situations. For example, if a company has announced some bad news and its share price has dropped by 25%, but its CDS spread has remained unchanged, then an investor might expect the CDS spread to increase relative to the share price. Therefore a basic strategy would be to go long on the CDS spread (by buying CDS protection) while simultaneously hedging oneself by buying the underlying stock. This technique would benefit in the event of the CDS spread widening relative to the equity price, but would lose money if the company’s CDS spread tightened relative to its equity.
An interesting situation in which the inverse correlation between a company’s stock price and CDS spread breaks down is during a Leveraged buyout (LBO). Frequently this leads to the company’s CDS spread widening due to the extra debt that will soon be put on the company’s books, but also an increase in its share price, since buyers of a company usually end up paying a premium.
Another common arbitrage strategy aims to exploit the fact that the swap-adjusted spread of a CDS should trade closely with that of the underlying cash bond issued by the reference entity. Misalignments in spreads may occur due to technical reasons such as:
- Specific settlement differences
- Shortages in a particular underlying instrument
- Existence of buyers constrained from buying exotic derivatives.
The difference between CDS spreads and asset swap spreads is called the basis and should theoretically be close to zero. Basis trades can aim to exploit any differences to make risk-free profit.
Forms of credit default swaps had been in existence from at least the early 1990s, with early trades carried out by Bankers Trust in 1991. J.P. Morgan & Co. is widely credited with creating the modern credit default swap in 1994. In that instance, J.P. Morgan had extended a $4.8 billion credit line to Exxon, which faced the threat of $5 billion inpunitive damages for the Exxon Valdez oil spill. A team of J.P. Morgan bankers led by Blythe Masters then sold the credit risk from the credit line to the European Bank of Reconstruction and Development in order to cut the reserves that J.P. Morgan was required to hold against Exxon’s default, thus improving its own balance sheet. In 1997, JPMorgan developed a proprietary product called BISTRO (Broad Index Securitized Trust Offering) that used CDS to clean up a bank’s balance sheet. The advantage of BISTRO was that it used securitization to split up the credit risk into little pieces that smaller investors found more digestible, since most investors lacked EBRD’s capability to accept $4.8 billion in credit risk all at once. BISTRO was the first example of what later became known as synthetic collateralized debt obligations (CDOs).
Mindful of the concentration of default risk as one of the causes of the S&L crisis , regulators initially found CDS’s ability to disperse default risk attractive. In 2000, credit default swaps became largely exempt from regulation by both the U.S. Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). The Commodity Futures Modernization Act of 2000, which was also responsible for the Enron loophole , specifically stated that CDSs are neither futures nor securities and so are outside the remit of the SEC and CFTC.
At first, banks were the dominant players in the market, as CDS were primarily used to hedge risk in connection with its lending activities. Banks also saw an opportunity to free up regulatory capital. By march 1998, the global market for CDS was estimated atabout $300 billion, with JP Morgan alone accounting for about $50 billion of this. The high market share enjoyed by the banks was soon eroded as more and more asset managers and hedge funds saw trading opportunities in credit default swaps. By 2002, investors as speculators, rather than banks as hedgers, dominated the market. National banks in the USA used credit default swaps as early as 1996. In that year, the Office of the Comptroller of the Currency measured the size of the market as tens of billions of dollars. Six years later, by year-end 2002, the outstanding amount was over $2 trillion. Although speculators fueled the exponential growth, other factors also played a part. An extended market could not emerge until 1999, when ISDA standardized the documentation for credit default swaps.Also, the 1997 Asian Financial Crisis spurred a market for CDS in emerging market sovereign debt. In addition, in 2004, index trading began on a large scale and grew rapidly.
The market size for Credit Default Swaps more than doubled in size each year from $3.7 trillion in 2003. By the end of 2007, the CDS market had a notional value of $62.2 trillion.But notional amount fell during 2008 as a result of dealer “portfolio compression” efforts (replacing offsetting redundant contracts), and by the end of 2008 notional amount outstanding had fallen 38 percent to $38.6 trillion.
Explosive growth was not without operational headaches. On September 15, 2005, the New York Fed summoned 14 banks to it offices. Billions of dollars of CDS were traded daily but the record keeping was more than two weeks behind. This created severe risk management issues, as counterparties were in legal and financial limbo. U.K. authorities expressed the same concerns.
Market as of 2008
Composition of the United States 15.5 trillion US dollar CDS market at the end of 2008 Q2. Green tints show Prime asset CDSs, reddish tints show sub-prime asset CDSs. Numbers followed by “Y” indicate years until maturity.
Proportion of CDSs nominals (lower left) held by United States banks compared to all derivatives, in 2008Q2. The black disc represents the 2008 public debt.
Since default is a relatively rare occurrence (historically around 0.2% of investment grade companies default in any one year), in most CDS contracts the only payments are the premium payments from buyer to seller. Thus, although the above figures for outstanding notionals are very large, in the absence of default the net cash flows are only a small fraction of this total: for a 100 bp = 1% spread, the annual cash flows are only 1% of the notional amount.
Regulatory concerns over CDS
In the days and weeks leading up to Bear’s collapse, the bank’s CDS spread widened dramatically, indicating a surge of buyers taking out protection on the bank. It has been suggested that this widening was responsible for the perception that Bear Stearns was vulnerable, and therefore restricted its access to wholesale capital, which eventually led to its forced sale to JP Morgan in March. An alternative view is that this surge in CDS protection buyers was a symptom rather than a cause of Bear’s collapse; i.e., investors saw that Bear was in trouble, and sought to hedge any naked exposure to the bank, or speculate on its collapse.
In September, the bankruptcy of Lehman Brothers caused a total close to $400 billion to become payable to the buyers of CDS protection referenced against the insolvent bank. However the net amount that changed hands was around $7.2 billion This difference is due to the process of ‘netting’. Market participants co-operated so that CDS sellers were allowed to deduct from their payouts the inbound funds due to them from their hedging positions. Dealers generally attempt to remain risk-neutral, so that their losses and gains after big events offset each other.
Also in September American International Group (AIG) required a federal bailout because it had been excessively selling CDS protection without hedging against the possibility that the reference entities might decline in value, which exposed the insurance giant to potential losses over $100 billion. The CDS on Lehman were settled smoothly, as was largely the case for the other 11 credit events occurring in 2008 that triggered payouts. And while it is arguable that other incidents would have been as bad or worse if less efficient instruments than CDS had been used for speculation and insurance purposes, the closing months of 2008 saw regulators working hard to reduce the risk involved in CDS transactions.
In 2008 there was no centralized exchange or clearing house for CDS transactions; they were all done over the counter (OTC). This led to recent calls for the market to open up in terms of transparency and regulation. In November, DTCC, which runs a warehouse for CDS trade confirmations accounting for around 90% of the total market, announced that it will release market data on the outstanding notional of CDS trades on a weekly basis. The data can be accessed on the DTCC’s website here: The U.S. Securities and Exchange Commission granted an exemption for IntercontinentalExchange to begin guaranteeing credit-default swaps.
The SEC exemption represented the last regulatory approval needed by Atlanta-based Intercontinental. Its larger competitor, CME Group Inc., hasn’t received an SEC exemption, and agency spokesman John Nester said he didn’t know when a decision would be made.
Market as of 2009
The early months of 2009 saw several fundamental changes to the way CDSs operate, resulting from concerns over the instruments’ safety after the events of the previous year. According to Deutsche Bank managing director Athanassios Diplas “the industry pushed through 10 years worth of changes in just a few months”. By late 2008 processes had been introduced allowing CDSs that offset each other to be cancelled. Along with termination of contracts that have recently paid out such as those based on Lehmans, this had by March reduced the face value of the market down to an estimated $30 trillion. The Bank for International Settlements estimates that outstanding derivatives total $592 trillion. U.S. and European regulators are developing separate plans to stabilize the derivatives market. Additionally there are some globally agreed standards falling into place in March 2009, administered by International Swaps and Derivatives Association (ISDA). Two of the key changes are:
1. The introduction of central clearing houses, one for the US and one for Europe. A clearing house acts as the central counterparty to both sides of a CDS transaction, thereby reducing the counterparty risk that both buyer and seller face.
2. The international standardization of CDS contracts, to prevent legal disputes in ambiguous cases where what the payout should be is unclear.
Speaking before the changes went live , Sivan Mahadevan, a derivatives strategist at Morgan Stanley in New York, stated
|“||A clearinghouse, and changes to the contracts to standardize them, will probably boost activity. … Trading will be much easier…. We’ll see new players come to the market because they’ll like the idea of this being a better and more traded product. We also feel like over time we’ll see the creation of different types of products.||
In the U.S., central clearing operations began in March 2009 , operated by InterContinental Exchange (ICE). A key competitor also interested in entering the CDS clearing sector is CME Group.
In Europe, CDS Index clearing was launched by ICE’s European subsidiary ICE Clear Europe on July 31. It launched Single Name clearing in Dec 2009. By the end of 2009, it had cleared CDS contracts worth EUR 885 billion reducing the open interest down to EUR 75 billion 
By the end of 2009, banks had reclaimed much of their market share; hedge funds had largely retreated from the market after the crises. According to an estimate by the Banque de France, by late 2009 the bank JP Morgan alone now had about 30% of the global CDS market.
Government approvals relating to Intercontinental and its competitor CME
The SEC’s approval for ICE’s request to be exempted from rules that would prevent it clearing CDSs was the third government action granted to Intercontinental in one week. On March 3, its proposed acquisition of Clearing Corp., a Chicago clearinghouse owned by eight of the largest dealers in the credit-default swap market, was approved by the Federal Trade Commission and the Justice Department. On March 5, the Federal Reserve Board, which oversees the clearinghouse, granted a request for ICE to begin clearing.
Clearing Corp. shareholders including JPMorgan Chase & Co., Goldman Sachs Group Inc. and UBS AG, received $39 million in cash from Intercontinental in the acquisition, as well as the Clearing Corp.’s cash on hand and a 50-50 profit-sharing agreement with Intercontinental on the revenue generated from processing the swaps.
SEC spokesperson John Nestor stated
|“||For several months the SEC and our fellow regulators have worked closely with all of the firms wishing to establish central counterparties…. We believe that CME should be in a position soon to provide us with the information necessary to allow the commission to take action on its exemptive requests.||
Other proposals to clear credit-default swaps have been made by NYSE Euronext, Eurex AG and LCH.Clearnet Ltd. Only the NYSE effort is available now for clearing after starting on Dec. 22. As of Jan. 30, no swaps had been cleared by the NYSE’s London- based derivatives exchange, according to NYSE Chief Executive Officer Duncan Niederauer.
Clearing house member requirements
Members of the Intercontinental clearinghouse will have to have a net worth of at least $5 billion and a credit rating of A or better to clear their credit-default swap trades. Intercontinental said in the statement today that all market participants such as hedge funds, banks or other institutions are open to become members of the clearinghouse as long as they meet these requirements.
A clearinghouse acts as the buyer to every seller and seller to every buyer, reducing the risk of a counterparty defaulting on a transaction. In the over-the-counter market, where credit- default swaps are currently traded, participants are exposed to each other in case of a default. A clearinghouse also provides one location for regulators to view traders’ positions and prices.
Terms of a typical CDS contract
A CDS contract is typically documented under a confirmation referencing the credit derivatives definitions as published by the International Swaps and Derivatives Association. The confirmation typically specifies a reference entity, a corporation or sovereign that generally, although not always, has debt outstanding, and a reference obligation, usually an unsubordinated corporate bond or government bond. The period over which default protection extends is defined by the contract effective date and scheduled termination date.
The confirmation also specifies a calculation agent who is responsible for making determinations as to successors and substitute reference obligations (for example necessary if the original reference obligation was a loan that is repaid before the expiry of the contract), and for performing various calculation and administrative functions in connection with the transaction. By market convention, in contracts between CDS dealers and end-users, the dealer is generally the calculation agent, and in contracts between CDS dealers, the protection seller is generally the calculation agent. It is not the responsibility of the calculation agent to determine whether or not a credit event has occurred but rather a matter of fact that, pursuant to the terms of typical contracts, must be supported by publicly available information delivered along with a credit event notice. Typical CDS contracts do not provide an internal mechanism for challenging the occurrence or non-occurrence of a credit event and rather leave the matter to the courts if necessary, though actual instances of specific events being disputed are relatively rare.
CDS confirmations also specify the credit events that will give rise to payment obligations by the protection seller and delivery obligations by the protection buyer. Typical credit events include bankruptcy with respect to the reference entity and failure to pay with respect to its direct or guaranteed bond or loan debt. CDS written on North American investment gradecorporate reference entities, European corporate reference entities and sovereigns generally also include restructuring as a credit event, whereas trades referencing North American high yield corporate reference entities typically do not. The definition of restructuring is quite technical but is essentially intended to respond to circumstances where a reference entity, as a result of the deterioration of its credit, negotiates changes in the terms in its debt with its creditors as an alternative to formal insolvency proceedings (i.e., the debt is restructured). This practice is far more typical in jurisdictions that do not provide protective status to insolvent debtors similar to that provided by Chapter 11 of the United States Bankruptcy Code. In particular, concerns arising out of Conseco‘s restructuring in 2000 led to the credit event’s removal from North American high yield trades.
Finally, standard CDS contracts specify deliverable obligation characteristics that limit the range of obligations that a protection buyer may deliver upon a credit event. Trading conventions for deliverable obligation characteristics vary for different markets and CDS contract types. Typical limitations include that deliverable debt be a bond or loan, that it have a maximum maturity of 30 years, that it not be subordinated, that it not be subject to transfer restrictions (other than Rule 144A), that it be of a standard currency and that it not be subject to some contingency before becoming due.
The premium payments are generally quarterly, with maturity dates (and likewise premium payment dates) falling on March 20, June 20, September 20, and December 20. Due to the proximity to the IMM dates, which fall on the third Wednesday of these months, these CDS maturity dates are also referred to as “IMM dates”.
Physical or cash
As described in an earlier section, if a credit event occurs then CDS contracts can either be physically settled or cash settled.
- Physical settlement: The protection seller pays the buyer par value, and in return takes delivery of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. In the event of a default, the bank pays the hedge fund $5 million cash, and the hedge fund must deliver $5 million face value of senior debt of the company (typically bonds or loans, which are typically worth very little given that the company is in default).
- Cash settlement: The protection seller pays the buyer the difference between par value and the market price of a debt obligation of the reference entity. For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. This company has now defaulted, and its senior bonds are now trading at 25 (i.e., 25 cents on the dollar) since the market believes that senior bondholders will receive 25% of the money they are owed once the company is wound up. Therefore, the bank must pay the hedge fund $5 million * (100%-25%) = $3.75 million.
The development and growth of the CDS market has meant that on many companies there is now a much larger outstanding notional of CDS contracts than the outstanding notional value of its debt obligations. (This is because many parties made CDS contracts for speculative purposes, without actually owning any debt that they wanted to insure against default.) For example, at the time it filed for bankruptcy on September 14, 2008, Lehman Brothers had approximately $155 billion of outstanding debt but around $400 billion notional value of CDS contracts had been written that referenced this debt. Clearly not all of these contracts could be physically settled, since there was not enough outstanding Lehman Brothers debt to fulfill all of the contracts, demonstrating the necessity for cash settled CDS trades. The trade confirmation produced when a CDS is traded states whether the contract is to be physically or cash settled.
When a credit event occurs on a major company on which a lot of CDS contracts are written, an auction (also known as a credit-fixing event) may be held to facilitate settlement of a large number of contracts at once, at a fixed cash settlement price. During the auction process participating dealers (e.g., the big investment banks) submit prices at which they would buy and sell the reference entity’s debt obligations, as well as net requests for physical settlement against par. A second stage Dutch auction is held following the publication of the initial mid-point of the dealer markets and what is the net open interest to deliver or be delivered actual bonds or loans. The final clearing point of this auction sets the final price for cash settlement of all CDS contracts and all physical settlement requests as well as matched limit offers resulting from the auction are actually settled. According to the International Swaps and Derivatives Association (ISDA), who organised them, auctions have recently proved an effective way of settling the very large volume of outstanding CDS contracts written on companies such as Lehman Brothers and Washington Mutual.
Below is a list of the auctions that have been held since 2005.
Final price as a percentage of par
|2005-06-14||Collins & Aikman – Senior||43.625|
|2005-06-23||Collins & Aikman – Subordinated||6.375|
|2005-10-11||Delta Air Lines||18|
|2006-11-28||Dura – Senior||24.125|
|2006-11-28||Dura – Subordinated||3.5|
|2008-10-06||Fannie Mae – Senior||91.51|
|2008-10-06||Fannie Mae – Subordinated||99.9|
|2008-10-06||Freddie Mac – Senior||94|
|2008-10-06||Freddie Mac – Subordinated||98|
|2008-11-04||Landsbanki – Senior||1.25|
|2008-11-04||Landsbanki – Subordinated||0.125|
|2008-11-05||Glitnir – Senior||3|
|2008-11-05||Glitnir – Subordinated||0.125|
|2008-11-06||Kaupthing – Senior||6.625|
|2008-11-06||Kaupthing – Subordinated||2.375|
|2008-12-09||Masonite  – LCDS||52.5|
|2008-12-17||Hawaiian Telcom – LCDS||40.125|
|2009-01-06||Tribune – CDS||1.5|
|2009-01-06||Tribune – LCDS||23.75|
|2009-01-14||Republic of Ecuador||31.375|
|2009-02-03||Millennium America Inc||7.125|
|2009-02-03||Lyondell – CDS||15.5|
|2009-02-03||Lyondell – LCDS||20.75|
|2009-02-05||Sanitec  – 1st Lien||33.5|
|2009-02-05||Sanitec  – 2nd Lien||4.0|
|2009-02-09||British Vita  – 1st Lien||15.5|
|2009-02-09||British Vita  – 2nd Lien||2.875|
|2009-04-21||Charter Communications CDS||2.375|
|2009-04-21||Charter Communications LCDS||78|
|2009-05-13||General Growth Properties||44.25|
|2009-06-09||HLI Operating Corp LCDS||9.5|
|2009-06-10||Georgia Gulf LCDS||83|
|2009-06-11||R.H. Donnelley Corp. CDS||4.875|
|2009-06-12||General Motors CDS||12.5|
|2009-06-12||General Motors LCDS||97.5|
|2009-06-18||JSC Alliance Bank CDS||16.75|
|2009-06-24||RH Donnelley Inc LCDS||78.125|
|2009-07-09||Six Flags CDS||14|
|2009-07-09||Six Flags LCDS||96.125|
|2009-11-10||METRO-GOLDWYN-MAYER INC. LCDS||58.5|
|2009-11-20||CIT Group Inc.||68.125|
|2009-12-16||NJSC Naftogaz of Ukraine||83.5|
|2010-01-07||Financial Guarantee Insurance Compancy (FGIC)||26|
|2010-04-15||McCarthy and Stone||70.375|
|2010-04-22||Japan Airlines Corp||20.0|
|2010-06-04||Ambac Assurance Corp||20.0|
|2010-07-15||Truvo Subsidiary Corp||3.0|
|2010-09-09||Truvo (formerly World Directories)||41.125|
|2010-09-21||Boston Generating LLC||40.75|
|2010-12-09||Anglo Irish Bank||18.25|
|2010-12-10||Ambac Financial Group||9.5|
Pricing and valuation
There are two competing theories usually advanced for the pricing of credit default swaps. The first, referred to herein as the ‘probability model’, takes the present value of a series of cashflows weighted by their probability of non-default. This method suggests that credit default swaps should trade at a considerably lower spread than corporate bonds.
- the “issue premium”,
- the recovery rate (percentage of notional repaid in event of default),
- the “credit curve” for the reference entity and
- the “LIBOR curve”.
If default events never occurred the price of a CDS would simply be the sum of the discounted premium payments. So CDS pricing models have to take into account the possibility of a default occurring some time between the effective date and maturity date of the CDS contract. For the purpose of explanation we can imagine the case of a one year CDS with effective date t0 with four quarterly premium payments occurring at times t1, t2, t3, and t4. If the nominal for the CDS is N and the issue premium is c then the size of the quarterly premium payments is Nc / 4. If we assume for simplicity that defaults can only occur on one of the payment dates then there are five ways the contract could end:
- either it does not have any default at all, so the four premium payments are made and the contract survives until the maturity date, or
- a default occurs on the first, second, third or fourth payment date.
To price the CDS we now need to assign probabilities to the five possible outcomes, then calculate the present value of the payoff for each outcome. The present value of the CDS is then simply the present value of the five payoffs multiplied by their probability of occurring.
This is illustrated in the following tree diagram where at each payment date either the contract has a default event, in which case it ends with a payment of N(1 − R) shown in red, whereR is the recovery rate, or it survives without a default being triggered, in which case a premium payment of Nc / 4 is made, shown in blue. At either side of the diagram are the cashflows up to that point in time with premium payments in blue and default payments in red. If the contract is terminated the square is shown with solid shading.
The probability of surviving over the interval ti − 1 to ti without a default payment is pi and the probability of a default being triggered is 1 − pi. The calculation of present value, givendiscount factor of δ1 to δ4 is then
Premium Payment PV
Default Payment PV
|Default at time t1|
|Default at time t2|
|Default at time t3|
|Default at time t4|
The probabilities p1, p2, p3, p4 can be calculated using the credit spread curve. The probability of no default occurring over a time period from t to t + Δt decays exponentially with a time-constant determined by the credit spread, or mathematically p = exp( − s(t)Δt / (1 − R)) where s(t) is the credit spread zero curve at time t. The riskier the reference entity the greater the spread and the more rapidly the survival probability decays with time.
To get the total present value of the credit default swap we multiply the probability of each outcome by its present value to give
In the ‘no-arbitrage’ model proposed by both Duffie, and Hull-White, it is assumed that there is no risk free arbitrage. Duffie uses the LIBOR as the risk free rate, whereas Hull and White use US Treasuries as the risk free rate. Both analyses make simplifying assumptions (such as the assumption that there is zero cost of unwinding the fixed leg of the swap on default), which may invalidate the no-arbitrage assumption. However the Duffie approach is frequently used by the market to determine theoretical prices. Under the Duffie construct, the price of a credit default swap can also be derived by calculating the asset swap spread of a bond. If a bond has a spread of 100, and the swap spread is 70 basis points, then a CDS contract should trade at 30. However there are sometimes technical reasons why this will not be the case, and this may or may not present an arbitrage opportunity for the canny investor. The difference between the theoretical model and the actual price of a credit default swap is known as the basis.
Critics of the huge credit default swap market have claimed that it has been allowed to become too large without proper regulation and that, because all contracts are privately negotiated, the market has no transparency. Furthermore, there have even been claims that CDSs exacerbated the 2008 global financial crisis by hastening the demise of companies such as Lehman Brothers and AIG.
In the case of Lehman Brothers, it is claimed that the widening of the bank’s CDS spread reduced confidence in the bank and ultimately gave it further problems that it was not able to overcome. However, proponents of the CDS market argue that this confuses cause and effect; CDS spreads simply reflected the reality that the company was in serious trouble. Furthermore, they claim that the CDS market allowed investors who had counterparty risk with Lehman Brothers to reduce their exposure in the case of their default.
Credit default swaps have also faced criticism that they contributed to a breakdown in negotiations during the 2009 General Motors Chapter 11 reorganization, because bondholders would benefit from the credit event of a GM bankruptcy due to their holding of CDSs. Critics speculate that these creditors were incentivized into pushing for the company to enter bankruptcy protection. Due to a lack of transparency, there was no way to find out who the protection buyers and protection writers were, and they were subsequently left out of the negotiation process.
It was also reported after Lehman’s bankruptcy that the $400 billion notional of CDS protection which had been written on the bank could lead to a net payout of $366 billion from protection sellers to buyers (given the cash-settlement auction settled at a final price of 8.625%) and that these large payouts could lead to further bankruptcies of firms without enough cash to settle their contracts. However, industry estimates after the auction suggested that net cashflows would only be in the region of $7 billion. This is because many parties held offsetting positions; for example if a bank writes CDS protection on a company it is likely to then enter an offsetting transaction by buying protection on the same company in order to hedge its risk. Furthermore, CDS deals are marked-to-market frequently. This would have led to margin calls from buyers to sellers as Lehman’s CDS spread widened, meaning that the net cashflows on the days after the auction are likely to have been even lower.… Senior bankers have argued that not only has the CDS market functioned remarkably well during the financial crisis, but that CDS contracts have been acting to distribute risk just as was intended, and that it is not CDSs themselves that need further regulation, but the parties who trade them.
Some general criticism of financial derivatives is also relevant to credit derivatives. Warren Buffett famously described derivatives bought speculatively as “financial weapons of mass destruction.” In Berkshire Hathaway‘s annual report to shareholders in 2002, he said, “Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses—often huge in amount—in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen).” To hedge the counterparty risk of entering a CDS transaction, one practice is to buy CDS protection on one’s counterparty. The positions are marked-to-market daily and collateral pass from buyer to seller or vice versa to protect both parties against counterparty default, but money does not always change hands due to the offset of gains and losses by those who had both bought and sold protection. Depository Trust & Clearing Corporation, the clearinghouse for the majority of trades in the US over-the-counter market, stated in October 2008 that once offsetting trades were considered, only an estimated $6 billion would change hands on October 21, during the settlement of the CDS contracts issued on Lehman Brothers’ debt, which amounted to somewhere between $150 to $360 billion. Despite Buffett’s criticism on derivatives, in October 2008 Berkshire Hathaway revealed to regulators that it has entered into at least $4.85 billion in derivative transactions. Buffett stated in his 2008 letter to shareholders that Berkshire Hathaway has no counterparty risk in its derivative dealings because Berkshire require counterparties to make payments when contracts are inititated, so that Berkshire always holds the money. Berkshire Hathaway was a large owner of Moody’s stock during the period that it was one of two primary rating agencies for subprime CDOs, a form of mortgage security derivative dependant on the use of credit default swaps.
The monoline insurance companies got involved with writing credit default swaps on mortgage-backed CDOs. Some media reports have claimed this was a contributing factor to the downfall of some of the monolines. In 2009 one of the monolines, MBIA, sued Merrill Lynch, claiming that Merill had misrepresented some of its CDOs to MBIA in order to persuade MBIA to write CDS protection for those CDOs.
The risk of counterparties defaulting has been amplified during the 2008 financial crisis, particularly because Lehman Brothers and AIG were counterparties in a very large number of CDS transactions. This is an example of systemic risk, risk which threatens an entire market, and a number of commentators have argued that size and deregulation of the CDS market have increased this risk.
For example, imagine if a hypothetical mutual fund had bought some Washington Mutual corporate bonds in 2005 and decided to hedge their exposure by buying CDS protection from Lehman Brothers. After Lehman’s default, this protection was no longer active, and Washington Mutual’s sudden default only days later would have led to a massive loss on the bonds, a loss that should have been insured by the CDS. There was also fear that Lehman Brothers and AIG’s inability to pay out on CDS contracts would lead to the unraveling of complex interlinked chain of CDS transactions between financial institutions. So far this does not appear to have happened, although some commentators[who?] have noted that because the total CDS exposure of a bank is not public knowledge, the fear that one could face large losses or possibly even default themselves was a contributing factor to the massive decrease in lending liquidity during September/October 2008.
Chains of CDS transactions can arise from a practice known as “netting”. Here, company B may buy a CDS from company A with a certain annual premium, say 2%. If the condition of the reference company worsens, the risk premium rises, so company B can sell a CDS to company C with a premium of say, 5%, and pocket the 3% difference. However, if the reference company defaults, company B might not have the assets on hand to make good on the contract. It depends on its contract with company A to provide a large payout, which it then passes along to company C. The problem lies if one of the companies in the chain fails, creating a “domino effect” of losses. For example, if company A fails, company B will default on its CDS contract to company C, possibly resulting in bankruptcy, and company C will potentially experience a large loss due to the failure to receive compensation for the bad debt it held from the reference company. Even worse, because CDS contracts are private, company C will not know that its fate is tied to company A; it is only doing business with company B.
As described above, the establishment of a central exchange or clearing house for CDS trades would help to solve the “domino effect” problem, since it would mean that all trades faced a central counterparty guaranteed by a consortium of dealers.
Tax and accounting issues
The U.S federal income tax treatment of credit default swaps is uncertain. Commentators generally believe that, depending on how they are drafted, they are either notional principal contracts or options for tax purposes, but this is not certain. There is a risk of having credit default swaps recharacterized as different types of financial instruments because they resemble put options and credit guarantees. In particular, the degree of risk depends on the type of settlement (physical/cash and binary/FMV) and trigger (default only/any credit event). If a credit default swap is a notional principal contract, periodic and nonperiodic payments on the swap are deductible and included in ordinary income. If a payment is a termination payment, its tax treatment is even more uncertain. In 2004, the Internal Revenue Service announced that it was studying the characterization of credit default swaps in response to taxpayer confusion, but it has not yet issued any guidance on their characterization. A taxpayer must include income from credit default swaps in ordinary income if the swaps are connected with trade or business in the United States.
The accounting treatment of Credit Default Swaps used for hedging may not parallel the economic effects and instead, increase volatility. For example, GAAP generally require that Credit Default Swaps be reported on a mark to market basis. In contrast, assets that are held for investment, such as a commercial loan or bonds, are reported at cost, unless a probable and significant loss is expected. Thus, hedging a commercial loan using a CDS can induce considerable volatility into the income statement and balance sheet as the CDS changes value over its life due to market conditions and due to the tendency for shorter dated CDS to sell at lower prices than longer dated CDS. One can try to account for the CDS as a hedge under FASB 133 but in practice that can prove very difficult unless the risky asset owned by the bank or corporation is exactly the same as the Reference Obligation used for the particular CDS that was bought.
A new type of default swap is the “loan only” credit default swap (LCDS). This is conceptually very similar to a standard CDS, but unlike “vanilla” CDS, the underlying protection is sold on syndicated secured loans of the Reference Entity rather than the broader category of “Bond or Loan”. Also, as of May 22, 2007, for the most widely traded LCDS form, which governs North American single name and index trades, the default settlement method for LCDS shifted to auction settlement rather than physical settlement. The auction method is essentially the same that has been used in the various ISDA cash settlement auction protocols, but does not require parties to take any additional steps following a credit event (i.e., adherence to a protocol) to elect cash settlement. On October 23, 2007, the first ever LCDS auction was held for Movie Gallery.
Because LCDS trades are linked to secured obligations with much higher recovery values than the unsecured bond obligations that are typically assumed the cheapest to deliver in respect of vanilla CDS, LCDS spreads are generally much tighter than CDS trades on the same name.
Bill failed to limit CDS used for speculation
It is widely accepted that naked CDS are not used for hedging but for speculation. A bill was distributed in U.S. Congress that would give a public authority the power to limit the use of CDS other than for hedging purposes, but the bill did not become law.
- Bucket shop (stock market)
- Constant maturity credit default swap
- Credit default option
- Credit default swap index
- CUSIP Linked MIP Code Reference Entity Code(CLIP)
- Inside Job (film), a 2010 Oscar-winning documentary film about the financial crisis of 2007–2010 by Charles H. Ferguson
- Recovery swap
- Toxic security
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|Look up credit default swap in Wiktionary, the free dictionary.|
- Barroso considers ban on speculation with banning purely speculative naked sales on credit default swaps of sovereign debt
- “Systemic Counterparty Confusion: Credit Default Swaps Demystified”. Derivative Dribble. October 23, 2008.
- CBS ’60 minutes’ video on CDS
- 2003 ISDA Credit Derivatives Template. International Swaps and Derivatives Association
- BIS – Regular Publications. Bank for International Settlements.
- A Beginner’s Guide to Credit Derivatives – Nomura International Probability.net
- “A billion-dollar game for bond managers”. Financial Times.
- John C. Hull and Alan White. “Valuing Credit Default Swaps I: No Counterparty Default Risk”. University of Toronto.
- Hull, J. C. and A. White, Valuing Credit Default Swaps II: Modeling Default Correlations. Smartquant.com
- Elton et al., Explaining the rate spread on corporate bonds
- Warren Buffett on Derivatives – Excerpts from the Berkshire Hathaway annual report for 2002. fintools.com
- The Real Reason for the Global Financial Crisis. Financial Sense Archive
- Demystifying the Credit Crunch. Private Equity Council.
- The AIG Bailout William Sjostrom, Jr.
- Standard CDS Pricing Model Source Code – ISDA and Markit. CDSModel.com
- List of CDS premiums of various countries in English translation from German
- Zweig, Phillip L. (July 1997), BusinessWeek New ways to dice up debt – Suddenly, credit derivatives-deals that spread credit risk–are surging
- Goodman, Peter (Oct 2008) New York Times The spectacular boom and calamitous bust in derivatives trading
- Pulliam, Susan and Ng, Serena (January 18, 2008), Wall Street Journal: “Default Fears Unnerve Markets“
- Das, Satayjit (February 5, 2008), Financial Times: “CDS market may create added risks“
- Morgenson, Gretchen (February 17, 2008), New York Times: “Arcane Market is Next to Face Big Credit Test“
- March 17, 2008 Credit Default Swaps: The Next Crisis?, Time
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- Evans, David (May 20, 2008), Bloomberg: “Hedge Funds in Swaps Face Peril With Rising Junk Bond Defaults“
- van Duyn, Aline (May 28, 2008), Financial Times: “Moody’s issues warning on CDS risks“
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- Dizard, John (October 23, 2006). “A billion dollar game”. Financial Times. Retrieved October 19, 2008.
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- Boumlouka, Makrem (April 8, 2009), Wall Street Letter: “Credit Default Swap Market: “Big Bang”? “.
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Eco The Dumbest Idea In The World Maximizing Shareholder Value
Steve Denning, Contributor
RADICAL MANAGEMENT: Rethinking leadership and innovation
11/28/2011 @ 1:19PM |9,713 views
About the book:
Fixing the Game bubbles crashes … Roger Martin
There is only one valid definition of a business purpose: to create a customer.
Peter Drucker, The Practice of Management
“Imagine an NFL coach,” writes Roger Martin, Dean of the Rotman School of Management at the University of Toronto, in his important new book, Fixing the Game, “holding a press conference on Wednesday to announce that he predicts a win by 9 points on Sunday, and that bettors should recognize that the current spread of 6 points is too low. Or picture the team’s quarterback standing up in the postgame press conference and apologizing for having only won by 3 points when the final betting spread was 9 points in his team’s favor. While it’s laughable to imagine coaches or quarterbacks doing so, CEOs are expected to do both of these things.”
Imagine also, to extrapolate Martin’s analogy, that the coach and his top assistants were hugely compensated, not on whether they won games, but rather by whether they covered the point spread. If they beat the point spread, they would receive massive bonuses. But if they missed covering the point spread a couple of times, the salary cap of the team could be cut and key players would have to be released, regardless of whether the team won or lost its games. Suppose also that in order to manage the expectations implicit in the point spread, the coach had to spend most of his time talking with analysts and sports writers about the prospects of the coming games and “managing” the point spread, instead of actually coaching the team.
It would hardly be a surprise that the most esteemed coach in this world would be a coach who met or beat the point spread in forty-six of forty-eight games—a 96 percent hit rate. Looking at these forty-eight games, one would be tempted to conclude: “Surely those scores are being ‘managed’?”
Suppose moreover that the whole league was rife with scandals of coaches “managing the score”, for instance, by deliberately losing games (“tanking”), players deliberately sacrificing points in order not to exceed the point spread (“point shaving”), “buying” key players on the opposing team or gaining access to their game plan.
If this were the situation in the NFL, then everyone would realize that the “real game” of football had become utterly corrupted by the “expectations game” of gambling. Everyone would be calling on the NFL Commissioner to intervene and ban the coaches and players from ever being involved directly or indirectly in any form of gambling on the outcome of games, and get back to playing the game.
Which is precisely what the NFL Commissioner did in 1962 when some players were found to be involved betting small sums of money on the outcome of games. In that season, Paul Hornung, the Green Bay Packers halfback and the league’s most valuable player (MVP), and Alex Karras, a star defensive tackle for the Detroit Lions, were accused of betting on NFL games, including games in which they played. Pete Rozelle, just a few years into his thirty-year tenure as league commissioner, responded swiftly. Hornung and Karras were suspended for a season.
As a result, the “real game” of football in the NFL has remained quite separate from the “expectations game” of gambling. The coaches and players spend all of their time trying to win games, not gaming the games.
The real market vs the expectations market
In the today’s paradoxical world of maximizing shareholder value, which Jack Welch himself has called “the dumbest idea in the world”, the situation is the reverse. CEOs and their top managers have massive incentives to focus most of their attentions on the expectations market, rather than the real job of running the company producing real products and services.
The “real market,” Martin explains, is the world in which factories are built, products are designed and produced, real products and services are bought and sold, revenues are earned, expenses are paid, and real dollars of profit show up on the bottom line. That is the world that executives control—at least to some extent.
The expectations market is the world in which shares in companies are traded between investors—in other words, the stock market. In this market, investors assess the real market activities of a company today and, on the basis of that assessment, form expectations as to how the company is likely to perform in the future. The consensus view of all investors and potential investors as to expectations of future performance shapes the stock price of the company.
“What would lead [a CEO],” asks Martin, “to do the hard, long-term work of substantially improving real-market performance when she can choose to work on simply raising expectations instead? Even if she has a performance bonus tied to real-market metrics, the size of that bonus now typically pales in comparison with the size of her stock-based incentives. Expectations are where the money is. And of course, improving real-market performance is the hardest and slowest way to increase expectations from the existing level.”
In fact, a CEO has little choice but to pay careful attention to the expectations market, because if the stock price falls markedly, the application of accounting rules (regulation FASB 142) classify it as a “goodwill impairment”. Auditors may then force the write-down of real assets based on the company’s share price in the expectations market. As a result, executives must concern themselves with managing expectations if they want to avoid write-downs of their capital.
In this world, the best managers are those who meet expectations. “During the heart of the Jack Welch era,” writes Martin, “GE met or beat analysts’ forecasts in forty-six of forty-eight quarters between December 31, 1989, and September 30, 2001—a 96 percent hit rate. Even more impressively, in forty-one of those forty-six quarters, GE hit the analyst forecast to the exact penny—89 percent perfection. And in the remaining seven imperfect quarters, the tolerance was startlingly narrow: four times GE beat the projection by 2 cents, once it beat it by 1 cent, once it missed by 1 cent, and once by 2 cents. Looking at these twelve years of unnatural precision, Jensen asks rhetorically: ‘What is the chance that could happen if earnings were not being “managed’?”’ Martin replies: infinitesimal.
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In such a world, it is therefore hardly surprising, says Martin, that the corporate world is plagued by continuing scandals, such as the accounting scandals in 2001-2002 with Enron, WorldCom, Tyco International, Global Crossing, and Adelphia, the options backdating scandals of 2005-2006, and the subprime meltdown of 2007-2008. The recent demise of MF Global Holdings and the related ongoing criminal investigation are further reminders that we have not put these matters behind us.
“It isn’t just about the money for shareholders,” writes Martin, “or even the dubious CEO behavior that our theories encourage. It’s much bigger than that. Our theories of shareholder value maximization and stock-based compensation have the ability to destroy our economy and rot out the core of American capitalism. These theories underpin regulatory fixes instituted after each market bubble and crash. Because the fixes begin from the wrong premise, they will be ineffectual; until we change the theories, future crashes are inevitable.”
“A pervasive emphasis on the expectations market,” writes Martin, “has reduced shareholder value, created misplaced and ill-advised incentives, generated inauthenticity in our executives, and introduced parasitic market players. The moral authority of business diminishes with each passing year, as customers, employees, and average citizens grow increasingly appalled by the behavior of business and the seeming greed of its leaders. At the same time, the period between market meltdowns is shrinking, Capital markets—and the whole of the American capitalist system—hang in the balance.”
How did capitalism get into this mess?
Martin says that the trouble began in 1976 when finance professor Michael Jensen and Dean William Meckling of the Simon School of Business at the University of Rochester published a seemingly innocuous paper in the Journal of Financial Economics entitled “Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure.”
The article performed the old academic trick of creating a problem and then proposing a solution to the supposed problem that the article itself had created. The article identified the principal-agent problem as being that the shareholders are the principals of the firm—i.e., they own it and benefit from its prosperity, while the executives are agents who are hired by the principals to work on their behalf. The principal-agent problem occurs, the article argued, because agents have an inherent incentive to optimize activities and resources for themselves rather than for their principals.
Ignoring Peter Drucker’s foundational insight of 1973 that the only valid purpose of a firm is to create a customer, Jensen and Meckling argued that the singular goal of a company should be to maximize the return to shareholders. To achieve that goal, they academics argued, the company should give executives a compelling reason to place shareholder value maximization ahead of their own nest-feathering.
Unfortunately, as often happens with bad ideas that make some people a lot of money, the idea caught on and has even become the conventional wisdom. During his tenure as CEO of GE from 1981 to 2001, Jack Welch came to be seen–rightly or wrongly–as the outstanding exemplar of the theory, as a result of his capacity to grow shareholder value at GE and magically hit his numbers exactly. When Jack Welch retired from GE, the company had gone from a market value of $14 billion to $484 billion at the time of his retirement, making it, according to the stock market, the most valuable and largest company in the world. In 1999 he was named “Manager of the Century” by Fortune magazine. Since Welch retired in 2001, however, GE’s stock price has not fared so well: GE has lost around 60 percent of the market capitalization that Welch “created”.
Before 1976, professional managers were in charge of performance in the real market and were paid for performance in that real market. That is, they were in charge of earning real profits for their company and they were typically paid a base salary and bonus for meeting real market performance targets.
The change had the opposite effect from what was intended
The proponents of shareholder value maximization and stock-based executive compensation hoped that their theories would focus executives on improving the real performance of their companies and thus increasing shareholder value over time.
Yet, precisely the opposite occurred. In the period of shareholder capitalism since 1976, executive compensation has exploded while corporate performance has declined. “Maximizing shareholder value” turned out to be the disease of which it purported to be the cure.
Between 1960 and 1980, CEO compensation per dollar of net income earned for the 365 biggest publicly traded American companies fell by 33 percent. CEOs earned more for their shareholders for steadily less and less relative compensation. By contrast, in the decade from 1980 to 1990 , CEO compensation per dollar of net earnings produced doubled. From 1990 to 2000 it quadrupled.
Meanwhile real performance was declining. From 1933 to 1976, real compound annual return on the S&P 500 was 7.5 percent. Since 1976, Martin writes, the total real return on the S&P 500 was 6.5 percent (compound annual). The situation is even starker if we look at the rate of return on assets, or the rate of return on invested capital, which according to a comprehensive study by Deloitte’s Center For The Edge are today only one quarter of what they were in 1965.
Although Jack Welch was seen during his tenure as CEO of GE as the heroic exemplar of maximizing shareholder value, he came to be one of its strongest critics. On March 12, 2009, he gave an interview with Francesco Guerrera of the Financial Times and said, “On the face of it, shareholder value is the dumbest idea in the world. Shareholder value is a result, not a strategy… your main constituencies are your employees, your customers and your products. Managers and investors should not set share price increases as their overarching goal. … Short-term profits should be allied with an increase in the long-term value of a company.”
The shift to delighting the customer
What to do? Given the numbers of the people and the amount of money involved, rescuing capitalism from these catastrophically bad habits won’t be easy. For most organizations, it will take a phase change. It means rethinking the very basis of a corporation and the way business is conducted, as well as the values of an entire society.
“We must shift the focus of companies back to the customer and away from shareholder value,” says Martin. “The shift necessitates a fundamental change in our prevailing theory of the firm… The current theory holds that the singular goal of the corporation should be shareholder value maximization. Instead, companies should place customers at the center of the firm and focus on delighting them, while earning an acceptable return for shareholders.”
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If you take care of customers, writes Martin, shareholders will be drawn along for a very nice ride. The opposite is simply not true: if you try to take care of shareholders, customers don’t benefit and, ironically, shareholders don’t get very far either.
In the real market, there is opportunity to build for the long run rather than to exploit short-term opportunities, so the real market has a chance to produce sustainability. The real market produces meaning and motivation for organizations. The organization can create bonds with customers, imagine great plans, and bring them to fruition.
“The expectations market,” says Martin, “generates little meaning. It is all about gaining advantage over a trading partner or putting two trading partners together, then tolling them for the service. This structure breeds a kind of amorality in which information is withheld or manipulated and trading partners are treated as vehicles from which to extract money in the short run, at whatever the cost to the relationship.”
By contrast, the real market contributes to a sense of authenticity for individuals. Because individuals can find meaning in their jobs. They are not playing a zero-sum game. They are doing something real and positive for society.
Examples of the shift
Martin cites three examples of firms that are, even within the legal limits of today’s world, focused on the real world of customers and products more than gaming the stock market.
One is Johnson & Johnson [JNJ]. In 1982, when the Tylenol poisonings occurred, “J&J was in a terrible bind. Tylenol represented almost a fifth of the company’s profits, and any decline in its market share would be difficult to reclaim, especially in the face of rampant fear and rumor. Yet, rather than attempt to downplay the crisis—it was after all, likely the work of an individual madman in one tiny part of the country—J&J did just the opposite. Chairman James Burke immediately ordered a halt to all Tylenol production and advertising, distributed warnings to hospitals across the country, and within a week of the first death, announced a nationwide recall of every single bottle of Tylenol on the market. J&J went on to develop tamper-proof packaging for its products; an innovation that would soon become the industry standard.” Burke’s actions were not the heroic act of a single individual, says Martin. The actions flowed from the company credo which is engraved in granite at the entry to company headquarters, which makes crystal clear that customers are first, then employees, and shareholders absolutely last.
Martin contrasts J&J’s handling of the Tylenol crisis with the handling of the Deepwater Horizon oil spill in 2010 by BP [BP], which he sees as driven by a short-term concern for BP’s profits.
A second example is Procter & Gamble [PG] which “declares in its purpose statement: ‘We will provide branded products and services of superior quality and value that improve the lives of the world’s consumers, now and for generations to come. As a result, consumers will reward us with leadership sales, profit and value creation, allowing our people, our shareholders and the communities in which we live and work to prosper.’ For P&G, consumers come first and shareholder value naturally follows. Per the statement of purpose, if P&G gets things right for consumers, shareholders will be rewarded as a result.”
A third example is Apple [AAPL]. “Apple’s CEO, Steve Jobs, seems to delight in signaling to shareholders that they don’t matter much and that they certainly won’t interfere with Apple’s pursuit of its original customer-focused purpose: ‘to make a contribution to the world by making tools for the mind that advance humankind.’ Jobs’s feisty, almost combative demeanor at shareholder meetings is legendary. At the meeting in February 2010, one shareholder asked Jobs, “What keeps you up at night?” Jobs quickly responded, ‘Shareholder meetings.’”
Making needed legal changes
Admonishing CEOs (and investors) to ignore the expectations market and refocus on delighting the customer isn’t going to work, says Martin. It’s as likely to be “as effective as admonishing frat boys to stop chasing girls.” For CEOs, there are massive incentives for staying attuned to it and severe punishments for ignoring it. Investors, analysts, and hedge funds continue to reward firms that meet expectations and punish those that do not. Missing expectations, a dropping stock-price, and real-asset write-downs can together create an unstoppable downward spiral. In the current environment, to simply ignore the expectations market is to court disaster.
One of the great values of the Martin’s book is that he puts his finger on the needed legal changes that can help shift the dynamic of business away from gaming the expectations market and back to doing the real job of delighting customers.
- One is the repeal of 1995 Private Securities Litigation Reform Act, which contains what has become known as the “safe harbor” provision. “To move ahead productively,” he writes, “the safe harbor provision should simply be repealed. Executives and their companies should be legally liable for any attempt to manage expectations. Without the safe harbor provisions, there would be no earnings guidance and that would be a great thing.” Making this change would immediately bring the practice of giving guidance to the stock market, and so gaming expectations, to a screeching halt. There is, says Martin, simply no societal value to earnings guidance. The market will know exactly what earnings are going to be at the end of the quarter, in just three or fewer months. Society is not better off to have an executive publicly guess at what that number is going to be. We need to turn executives from the useless, vapid task of managing expectations to the psychologically and economically rewarding business of creating value.
- A second is the elimination of regulation FASB 142 which forces the real write-downs of real assets based on the company’s share price in the expectations market. The current rule forces executives to concern themselves with managing expectations in order to avoid write-downs. Changing the rule would remove the major sanction that now exists for executives who ignore the expectations market.
- A third is to restore the focus of executives on the real market and on an authentic life by eliminating the use of stock-based compensation as an incentive. This doesn’t mean that executives shouldn’t own shares. If an executive wants to buy stock as some sort of bonding with the shareholders or for whatever other reasons, that’s just fine. However, executives should be prevented from selling any stock, for any reason, while serving in that capacity—and indeed for several years after leaving their posts. Stock based compensation is a very recent phenomenon, one associated with lower shareholder returns, bubbles and crashes, and huge corporate scandals. In 1970, stock based compensation was less than 1 percent of compensation. By 2000, it was around half of compensation. For the last 35 years, stock-based compensation has been tried. It had the opposite effect of what was intended. We should learn from experience and discontinue it.
Other needed changes
Martin also argues for associated changes:
- We must restore authenticity to the lives of our executives. The expectations market generates inauthenticity in executives, filling their world with encouragements to suspend moral judgment. They receive incentive compensation to which the rational response is to game the system. And since they spend most of their time trading value around rather than building it, they lose perspective on how to contribute to society through their work. Customers become marks to be exploited, employees become disposable cogs, and relationships become only a means to the end of winning a zero-sum game.
- We need to address board governance. Boards have become complicit in gaming the expectations market, and the associated inflation of executive compensation.
- We need to regulate expectations market players, most notably hedge funds. Net, hedge funds create no value for society. They have huge incentives to promote volatility in the expectations market, which is dangerous for us but lucrative for them. So, we need to rein in the power of hedge funds to damage real markets.
In a book that offers so much, one is tempted to ask for more. Perhaps in subsequent writings, Martin will expand and carry his thinking forward.
In future writings, he might document more of the economically disastrous practices that enable firms to meet their quarterly targets, such as looting the firm’s pension fund or cutting back on worker benefits or outsourcing production to a foreign country in ways that further destroy the firm’s ability to innovate and compete.
He might also spell out the specific management changes that are necessary to delight the customer. The command-and-control management of hierarchical bureaucracy is inherently unable to delight anyone–it was never intended to. To delight customers, a radically different kind of management needs to be in place, with a different role for the managers, a different way of coordinating work, a different set of values and a different way of communicating. This is not rocket science. It’s called radical management.
He might also show how the shift from maximizing shareholder value to delighting the customer involves a major power shift within the organization. Instead of the company being dominated by salesmen who can pump up the numbers and the accountants who can come up with cuts needed to make the quarterly targets, those who add genuine value to the customer have to re-occupy their rightful place.
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He might also build on the theme that the shift from maximizing shareholder value to delighting the customer doesn’t involve sacrifices for the shareholders, the organizations or the economy. That’s because delighting the customer is not just profitable: it’s hugely profitable.
Bottom-line: capitalism is at risk
American capitalism hangs in the balance, writes Martin. His book gives a clear explanations as to why this is so and what should be done to save it.
A large number of rent-collectors and financial middlemen making vast amounts of money are keeping the current system in place. The fact that what they are doing is destroying the economy will not sway their thinking. As Upton Sinclair noted, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it.”
Is change possible? Martin believes so, quoting Vince Lombardi: “We would accomplish many more things if we did not think of them as impossible.”
Other “impossible” changes have been accomplished. “Not long ago, it seemed fanciful that public smoking would be restricted and tobacco companies would sponsor public service ads that discourage smoking,” wrote Deepak Chopra and David Simon in 2004. “But this shift in awareness occurred when a critical mass of people decided they would no longer tolerate a behavior that harmed many while benefited a few.”
For instance, the Aspen Institute’s Corporate Values Strategy Group has been working on promoting long-term orientation in business decision making and investing. In 2009, twenty-eight leaders representing business, investment, government, academia, and labor (including Warrent Buffett, CEO of Berkshire Hathaway [BRK.A, BRK.B], Lou Gerstner, former CEO of IBM [IBM] and Jim Wolfensohn, former president of the World Bank) joined with the Institute to endorse a bold call to end the focus on value-destroying short-term-ism in our financial markets and create public policies that reward long-term value creation for investors and the public good.
Ultimately, the change will happen, not just because it’s right, but because it makes more money. Once investors realize what is going on, the economics will drive the change forward.
The recognition that maximizing shareholder value is the dumbest idea in the world is an obvious but still a radical idea. Like all obvious, radical ideas, in the first instance it will be rejected. Then it will be ridiculed. Finally it will be self-evident and no one will be able to remember why anyone ever thought otherwise.
Buy the Martin’s book. Read it. Implement it. The very future of our society “hangs in the balance”.
Roger L. Martin: Fixing the Game: Bubbles, Crashes, and What Capitalism Can Learn from the NFL. Harvard Business Review Press 2011.
Steve Denning’s most recent book is: The Leader’s Guide to Radical Management (Jossey-Bass, 2010).
Follow Steve Denning on Twitter @stevedenning
HOLY BAILOUT – Federal Reserve Now Backstopping $75 Trillion Of Bank Of America’s Derivatives Trades
UPDATE – Chcek out regulator William Black’s blistering reaction to this story HERE.
This story from Bloomberg just hit the wires this morning. Bank of America is shifting derivatives in its Merrill investment banking unit to its depository arm, which has access to the Fed discount window and is protected by the FDIC.
This means that the investment bank’s European derivatives exposure is now backstopped by U.S. taxpayers. Bank of America didn’t get regulatory approval to do this, they just did it at the request of frightened counterparties. Now the Fed and the FDIC are fighting as to whether this was sound. The Fed wants to “give relief” to the bank holding company, which is under heavy pressure.
This is a direct transfer of risk to the taxpayer done by the bank without approval by regulators and without public input. You will also read below that JP Morgan is apparently doing the same thing with $79 trillion of notional derivatives guaranteed by the FDIC and Federal Reserve.
What this means for you is that when Europe finally implodes and banks fail, U.S. taxpayers will hold the bag for trillions in CDS insurance contracts sold by Bank of America and JP Morgan. Even worse, the total exposure is unknownbecause Wall Street successfully lobbied during Dodd-Frank passage so that no central exchange would exist keeping track of net derivative exposure.
This is a recipe for Armageddon. Bernanke is absolutely insane. No wonder Geithner has been hopping all over Europe begging and cajoling leaders to put together a massive bailout of troubled banks. His worst nightmare is Eurozone bank defaults leading to the collapse of the large U.S. banks who have been happily selling default insurance on European banks since the crisis began.
Bank of America Corp. (BAC), hit by a credit downgrade last month, has moved derivatives from its Merrill Lynch unit to a subsidiary flush with insured deposits, according to people with direct knowledge of the situation.
The Federal Reserve and Federal Deposit Insurance Corp. disagree over the transfers, which are being requested by counterparties, said the people, who asked to remain anonymous because they weren’t authorized to speak publicly. The Fed has signaled that it favors moving the derivatives to give relief to the bank holding company, while the FDIC, which would have to pay off depositors in the event of a bank failure, is objecting, said the people. The bank doesn’t believe regulatory approval is needed, said people with knowledge of its position.
Three years after taxpayers rescued some of the biggest U.S. lenders, regulators are grappling with how to protect FDIC- insured bank accounts from risks generated by investment-banking operations. Bank of America, which got a $45 billion bailout during the financial crisis, had $1.04 trillion in deposits as of midyear, ranking it second among U.S. firms.
“The concern is that there is always an enormous temptation to dump the losers on the insured institution,” said William Black, professor of economics and law at the University of Missouri-Kansas City and a former bank regulator. “We should have fairly tight restrictions on that.”
The Moody’s downgrade spurred some of Merrill’s partners to ask that contracts be moved to the retail unit, which has a higher credit rating, according to people familiar with the transactions. Transferring derivatives also can help the parent company minimize the collateral it must post on contracts and the potential costs to terminate trades after Moody’s decision, said a person familiar with the matter.
Keeping such deals separate from FDIC-insured savings has been a cornerstone of U.S. regulation for decades, including last year’s Dodd-Frank overhaul of Wall Street regulation.
Bank of America benefited from two injections of U.S. bailout funds during the financial crisis. The first, in 2008, included $15 billion for the bank and $10 billion for Merrill, which the bank had agreed to buy. The second round of $20 billion came in January 2009 after Merrill’s losses in its final quarter as an independent firm surpassed $15 billion, raising doubts about the bank’s stability if the takeover proceeded. The U.S. also offered to guarantee $118 billion of assets held by the combined company, mostly at Merrill.
Bank of America’s holding company — the parent of both the retail bank and the Merrill Lynch securities unit — held almost $75 trillion of derivatives at the end of June, according to data compiled by the OCC. About $53 trillion, or 71 percent, were within Bank of America NA, according to the data, which represent the notional values of the trades.
That compares with JPMorgan’s deposit-taking entity, JPMorgan Chase Bank NA, which contained 99 percent of the New York-based firm’s $79 trillion of notional derivatives, the OCC data show.
Moving derivatives contracts between units of a bank holding company is limited under Section 23A of the Federal Reserve Act, which is designed to prevent a lender’s affiliates from benefiting from its federal subsidy and to protect the bank from excessive risk originating at the non-bank affiliate, said Saule T. Omarova, a law professor at the University of North Carolina at Chapel Hill School of Law.
“Congress doesn’t want a bank’s FDIC insurance and access to the Fed discount window to somehow benefit an affiliate, so they created a firewall,” Omarova said. The discount window has been open to banks as the lender of last resort since 1914.
- How Hank Paulson Warned Hedge Funds In Advance
- The Unbearable Lightness Of TARP Reporting
- 60 Minutes – Congress Trading On Inside Information
- MUST SEE – Bernanke’s Stealth Bailout For Wall Street Kept Secret From Congress
- Jamie Dimon Loves Bernanke’s Stealth Bailout Sugar
- Secret Fed Loans Helped Banks Net $13 Billion
- Site Update: We Will Resume Normal Publishing Today
- Jim Grant: “Central Banks Are Insolvent”
- Dr. Russ Roberts: “I Want My Country Back!”
- The Fed Under Fire: The Federal Reserve Is The Black Hole In American Democracy (Phenomenal 8-Minute Short Film)
- Inside Job Wins The Oscar: “Not A Single Financial Executive Has Gone To Jail, And That’s Wrong”
- Pissed Off Irishman Talks Bankster Bailouts: “Greed, Greed, Cheap Money, And More F**king Greed”
- Max Keiser Short Film On Greece – Here’s What Happens When Your Country Goes Broke
- Michael Lewis: Beware of Greeks Bearing Bonds
- “When Irish Eyes Are Crying”: Michael Lewis For Vanity Fair
Thursday, December 1, 2011
As the Super Committee failed to agree on a measly $1 trillion in budget cuts, Bloomberg recently reportedyet another secret bank bailout totaling $7.7 trillion courtesy of the private Federal Reserve bank. This disclosure is in addition to the first-ever Congressional audit of the Fed that revealed a startling $16 trillion in secret bailouts.
This brings the grand total of previously unknown theft to $23.7 trillion which, interestingly enough, is the exact figure Neil Barofsky, special inspector general for the Treasury’s Troubled Asset Relief Program, estimated in July 2009.
As Americans are being told that they need to tighten their belts and that Congress must do the same or the country will fall into economic ruin, these private bank bailouts, nearly double the size of the national debt, are handed out without any benefit to the public.
Indeed, it is of great detriment to the public who bear the brunt of the inflationary and tax burdens, as well as reduced public benefits forced by the failed Super Committee. Furthermore, it has been recently disclosed that the people’s FDIC will now backstop some $75 trillion in derivatives at Bank of America alone. And just today, they threw in a fresh new bailout of Europe that is just another temporary fix. When will the people tire of bailing out a clearly broken monetary system?
The blatant raping of the American people couldn’t be more obvious. The once-fringe Tea Party activists who were spawned from their anger over a meager $700 billion TARP bailout have now seemingly swelled into what appears to be a global “Occupy” movement. Regardless of their political differences, they both agree that the system of perpetual bailouts on the backs of Americans must end.
Perhaps the only two genuine public servants left in Congress are Ron Paul (R-TX) and Dennis Kucinich (D-OH); Paul being the early inspiration for the Tea Party, and Kucinich an early sympathizer with the Occupiers. Together they have clearly identified the Federal Reserve System as the disease, and have both proposed pragmatic solutions to cure the ills of the hijacked economy.
Before detailing their exact proposals, many people claim that the Federal Reserve System has a 100-year charter that will expire in 2013. However, the original Federal Reserve Act only allowed for a 20-year charter until the law was changed in 1927 (6 years before the Fed was up for renewal) to allow perpetual renewal of federal corporations where charters could only be “dissolved by Act of Congress or until forfeiture of franchise for violation of law.” (Source)
Regardless, given the increased rate of awareness of the Federal Reserve’s private, secretive, monopolistic, and destructive structure over the economy, their days are likely numbered. Perhaps that is the reason for the mass looting they, and their international member banks, are rapidly engaged in. In other words, they’re raiding the last crumbs of the cookie jar before Daddy comes to punish them.
Ron Paul, a leading proponent for “Ending the Fed” has put forward legislation to legalize competing currencies, which he believes is the first step toward breaking the monopolistic control over currency by the Fed. As with most of Paul’s legislation, it is undoing laws instead of writing them. The Free Competition in Currency Act (HR 1098) will essentially do three things: 1) repeal legal tender laws to remove the monopoly control of the Federal Reserve, 2) legalize private mints to issue coins to be controlled by anti-fraud and anti-counterfeit laws, and, 3) remove taxes from precious metal coins to ensure fair competition among new currencies.
Below Paul introduces the bill and explains its importance on the House floor in 2009:
Ron Paul is an advocate for returning to Constitutional money made of, or backed by, precious metals. Equally angry and aware of the heart of economic problems, Dennis Kucinich has introduced the NEED Act which will dissolve the Fed into the Treasury and return the power to issue currency back to Congress as outlined in the Constitution.
Kucinich explains why his bill is important in a recent video:
Although Kucinich’s legislation doesn’t call for currency to be backed by gold or other precious metals — and public trust for Geithner and the U.S. government’s handling of the economy are at all-time lows — seizing control from the Fed seems like a necessary early step to effectively transfer to something new.
As explained by author and documentary filmmaker, Bill Still, the Treasury still handles the coinage of U.S. currency and issues this money free of interest. This means that, technically, the entire U.S. debt could be erased by debt-free coins minted by the treasury. Crisis averted, prosperity for all.
Yet, these are just the early steps for getting the monetary system back on track. Perhaps the most acceptable longer term solution is what John F. Kennedy attempted to do with Executive Order 11110 which gave the Treasury the power to issue silver certificates to be backed by, and redeemable in, silver. This concept is the ideal blend of both Paul and Kucinich’s ideas, and the most Constitutional way to handle modern money.
Please comment and share this, and let’s get on with solutions instead of more bailouts and taxpayer servitude.
Derivatives Ownership Even More Concentrated Than Ever
As I noted in 2009, 5 banks held 80% of America’s derivatives risk.
Since then, the percent of derivatives held by the top 5 banks has only increased.
As Tyler Durden notes:
The latest quarterly report from the Office Of the Currency Comptroller is out [shows] that the top 4 banks in the US now account for a massively disproportionate amount of the derivative risk in the financial system. Specifically, of the $250 trillion in gross notional amount of derivative contracts outstanding (consisting of Interest Rate, FX, Equity Contracts, Commodity and CDS) among the Top 25 commercial banks (a number that swells to $333 trillion when looking at the Top 25 Bank Holding Companies), a mere 5 banks (and really 4) account for 95.9% of all derivative exposure …. the top 4 banks: JPM with $78.1 trillion in exposure, Citi with $56 trillion, Bank of America with $53 trillion and Goldman with $48 trillion, account for 94.4% of total exposure. As historically has been the case, the bulk of consolidated exposure is in Interest Rate swaps ($204.6 trillion), followed by FX ($26.5TR), CDS ($15.2 trillion), and Equity and Commodity with $1.6 and $1.4 trillion, respectively. And that’s your definition of Too Big To Fail right there: the biggest banks are not only getting bigger, but their risk exposure is now at a new all time high and up $5.3 trillion from Q1 as they have to risk ever more in the derivatives market to generate that incremental penny of return.
Amazingly, the top 5 banks have virtually 100% of all credit derivatives held by American banks (see the second to last line in the above table).
Dwarfing the World Economy
The amount of derivatives dwarfs the size of the world economy. As Bloomerg reported in May:
Mark Mobius, executive chairman of Templeton Asset Management’s emerging markets group, said another financial crisis is inevitable because the causes of the previous one haven’t been resolved.
“There is definitely going to be another financial crisis around the corner because we haven’t solved any of the things that caused the previous crisis,” Mobius said …“Are the derivatives regulated? No. Are you still getting growth in derivatives? Yes.”
The total value of derivatives in the world exceeds total global gross domestic product by a factor of 10, said Mobius, who oversees more than $50 billion. With that volume of bets in different directions, volatility and equity market crises will occur, he said.
The global financial crisis three years ago was caused in part by the proliferation of derivative products tied to U.S. home loans that ceased performing, triggering hundreds of billions of dollars in writedowns and leading to the collapse of Lehman Brothers Holdings Inc. in September 2008.
Huge Amount of Derivatives Are Dangerous
And unexpected changes in interest rates could cause a major bloodbath in interest rate derivatives.
And, no, there have not been any reforms or attempts to rein in derivatives, and the Dodd-Frank financial legislation was really just a p.r. stunt which didn’t really change anything.
But the big banks and their minions claim that the huge amounts of derivatives themselves is unimportant because these are only “notional” values, and – after netting – the notional values are deflated to much more modest numbers.
But as Durden – who has a solid background in derivatives – notes:
At this point the economist PhD readers will scream: “this is total BS – after all you have bilateral netting which eliminates net bank exposure almost entirely.” True: that is precisely what the OCC will say too. As the chart below shows, according to the chief regulator of the derivative space in Q2 netting benefits amounted to an almost record 90.8% of gross exposure, so while seemingly massive, those XXX trillion numbers are really quite, quite small… Right?
…Wrong. The problem with bilateral netting is that it is based on one massively flawed assumption, namely that in an orderly collapse all derivative contracts will be honored by the issuing bank (in this case the company that has sold the protection, and which the buyer of protection hopes will offset the protection it in turn has sold). The best example of how the flaw behind bilateral netting almost destroyed the system is AIG: the insurance company was hours away from making trillions of derivative contracts worthless if it were to implode, leaving all those who had bought protection from the firm worthless, a contingency only Goldman hedged by buying protection on AIG. And while the argument can further be extended that in bankruptcy a perfectly netted bankrupt entity would make someone else whole on claims they have written, this is not true, as the bankrupt estate will pursue 100 cent recovery on its claims even under Chapter 11, while claims the estate had written end up as General Unsecured Claims which as Lehman has demonstrated will collect 20 cents on the dollar if they are lucky.
The point of this detour being that if any of these four banks fails, the repercussions would be disastrous. And no, Frank Dodd’s bank “resolution” provision would do absolutely nothing to prevent an epic systemic collapse.
Prior to Fukushima, nuclear industry engineers said nuclear was safe.
Reuters and wanttoknow.info provide prima facie evidence that the US 1% runs Wall Street as rigged-casino gambling to transfer wealth from the 99% to themselves. The amount of money fraudulently gambled is not millions of dollars, not billions, not even tens of trillions, but over five hundred trillion ($532,000,000,000,000).
Look at Demonocracy’s images to get an idea of this magnitude of money.
Let this sink in: $532 trillion means that the 1% US banksters gamble over $5 million dollars for every US household and $1.7 million for every American.
It also means that the 1% has cooperation from “leadership” in Congress, law enforcement, and almost all corporate media to have this gambling as the core of the 99%’s mortgages and pension funds, with the criminal fraud of representing this as “investments,” “regulated,” and “fair.”
Ending global poverty would be accomplished with an annual investment of $100 billion a year for ten years. This would save the lives of a million children who die from preventable poverty each month, is less than 0.7% of the developed countries’ GNI, has reduced population growth rates in every historical case, and is the best way the CIA concludes to reduce terrorism. The annual amount to end poverty is 0.02% of what the top five US banks gamble every year.
Excerpts from Reuters:
(Reuters) – U.S. Attorney General Eric Holder and Lanny Breuer, head of the Justice Department’s criminal division, were partners for years at a Washington law firm that represented a Who’s Who of big banks and other companies at the center of alleged foreclosure fraud, a Reuters inquiry shows…. Reuters reported in December that under Holder and Breuer, the Justice Department hasn’t brought any criminal cases against big banks or other companies involved in mortgage servicing, even though copious evidence has surfaced of apparent criminal violations in foreclosure cases.
Excerpt from http://www.wanttoknow.info:
OCC’s Quarterly Report on Bank Trading and Derivatives Activities: Third Quarter 2011
December 2011, OCC (U.S. Office of the Comptroller of the Currency, Administrator of National Banks)
The OCC’s quarterly report on trading revenues and bank derivatives activities is based on Call Report information provided by all insured U.S. commercial banks and trust companies, reports filed by U.S. financial holding companies, and other published data. The notional amount of derivatives held by insured U.S. commercial banks decreased $1.4 trillion, or 0.6%, from the second quarter of 2011 to $248 trillion. Notional derivatives are 5.7% higher than at the same time last year. Derivatives activity in the U.S. banking system continues to be dominated by a small group of large financial institutions. Five large commercial banks represent 96% of the total banking industry notional amounts. Insured commercial banks have more limited legal authorities than do their holding companies.
Note: Graphs in this report show that the holding companies for the top five banks also control massive amounts of derivates totaling $326 trillion! The holding companies JPMorgan Chase, BofA, Morgan Stanley, Citigroup, and Goldman Sachs have over $311 trillion in derivates, 95% of the total U.S. market. So these banks and their holding companies combined own $532 trillion in derivates, equivalent to roughly $75,000 for every person on the planet. What are the bankers doing? If the above link fails, click here.
After 15 years of my own research after US political leadership reneged on all promises (public and private) to end poverty after we led to create the Microcredit Summit in 1997, here’s my best explanation of what’s driving economics: