Derivatives: $516 Trillion Ticking Time Bomb

[barbaro]

This article is lengthy and has lots of info. I don't know what derivatives are, honestly. Can anybody clue me in, in layman's terms. When Warren Buffets writes and speaks, I do listen.

PAUL B. FARRELL
Derivatives the new 'ticking bomb'
Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen


By Paul B. Farrell, MarketWatch
March 10, 2008

ARROYO GRANDE, Calif. (MarketWatch) -- "Charlie and I believe Berkshire should be a fortress of financial strength" wrote Warren Buffett. That was five years before the subprime-credit meltdown.

"We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

That warning was in Buffett's 2002 letter to Berkshire shareholders.

Derivatives bubble explodes five times bigger in five years
Wall Street didn't listen to Buffett. Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. The new derivatives bubble was fueled by five key economic and political trends:

1. Sarbanes-Oxley increased corporate disclosures and government oversight
2. Federal Reserve's cheap money policies created the subprime-housing boom
3. War budgets burdened the U.S. Treasury and future entitlements programs
4. Trade deficits with China and others destroyed the value of the U.S. dollar
5. Oil and commodity rich nations demanding equity payments rather than debt

In short, despite Buffett's clear warnings, a massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession.

Entire: Derivatives are the new ticking time bomb - MarketWatch

[bkkandrew]

Old news really.

In laymans terms, massive debt has been repackaged and sold on to others, whilst bets on performance of debt has been repackaged and sold on likewise. These are derivatives.

The net result is that, whereas historically for every $1 saved in a bank, $8 would be loaned out, the leveraging achievable with debt repackaging (CDO's, or Collatorised Debt Obligations - or worse - CDO squared - where a CDO is repackaged with other CDO's and then sold...) and derivatives mean that the $1 deposit can result in $80-$400 of loans. This has resulted in very easy credit availablility up intil the summer of last year, worldwide.

Now we are seeing the reverse. As the CDO's and derivative contracts are reversed, the leveraging of debt as described above is likewise reversed. This means that we are back to age-old $1 deposit to $8 loans. Apart from the fact that now banks are hoarding their cash in fear of the amount of their future losses in CDO, CDo squared and derivative contracts, so are now not looking to lend any money at all.

In any event, the deleveraging means that a contraction of money from the commercial market to the order of 90%-98% is upon us, namely a credit crunch. The FED, BoE, Euro Central Bank etc. have sought to remediate this by flooding the market with replacement funds. Doomed to failure, this will inevitably lead to a prolonged period of depression in the world economy, possibly greater than that experienced in 1929-1936, as the debt leveraging now is exponentially greater that 80 years ago...

[Jet Gorgon]

^ Where did you copy that from, BkkA?
Partly true. The key derivatives market is made up of futures, options and warrants, where the investor spends only a small portion of the underlying asset (based on the stock price) and bets that the stock will either go up or down in value for the term of the contract (usually short term, like 1-3 months). It's high risk coz you can lose WAY more than you invested as your loss is NOT limited to what you invested. And you don't even have the underlying asset (ie, the stock) to recoup some of your money. Example: Stroller Carey Inc is trading at $25. You think it will go to $50. But it nosedives to $2. You have to pay the spread. Margin call. The only way to redeem your cash is to find a market newbie to buy your derivative. Prob is, these contacts expire really quickly. And all you got is a piece of paper and a big debt.

[bkkandrew]

^ Where did you copy that from, BkkA?

I wrote it last night (UK time, albeit after a bottle and a half of a decent red wine - being back in UK this week has some benefits...)

Partly true. The key derivatives market is made up of futures, options and warrants

Yes, well I was focussing on debt derivatives, which are the most (IMO) exposed to massive loss at this time. Due to their ability to super-lever underlying debts owned as an asset, their unwinding, in turn super-delevers money supply.

I have, for the purposes of illustration, invented the terms super-lever and super-delever and have not copied them from anywhere.

I also have only inbibed orange juice since waking up today...

[Butterfly]

I think the article is also refering to re-insurance, a little known industry which has become massive and important in the last 10 years,

[bkkandrew]

I think the article is also refering to re-insurance, a little known industry which has become massive and important in the last 10 years,

I posted extensively on the so-called monoline insurance crisis a while back:

https://teakdoor.com/us-domestic-issu...tml#post530913

Right now, many of the country's largest investment banks are holding $500 billion in mortgage-backed securities and other structured investments that are steadily depreciating in value. As these assets wear-away the banks' capital, the likelihood of default becomes greater. This week, Fitch Ratings announced that it will (probably) cut ratings on the 5 main bond insurers (Ambac, MBIA, FGIC, CIFG,SCA)

And the real cruncher:

https://teakdoor.com/us-domestic-issu...tml#post532615

Feb. 11 (Bloomberg) -- Bond insurance sold by MBIA Inc., Ambac Financial Group Inc. and Security Capital Assurance Ltd. is backfiring on counties, universities and hospitals across the U.S., more than doubling some borrowing costs.

Park Nicollet Health Services in Minneapolis may pay an extra $5 million to $6 million this year, about a quarter of its operating profit, because interest on $375 million in floating- rate debt doubled in the last six weeks, said Chief Financial Officer David Cooke. The rate on $98 million insured by Ambac climbed to 6 percent on Jan. 30 from 3.06 percent on Jan. 2.

``We'll have to reduce our capital expenditure program, which means less equipment, less modernization of facilities,'' Cooke said in an interview. The hospital paid Ambac to ``count on that AAA insurance for 30 years. Now it's going away on us.''

Investors are shunning insured bonds after three of the biggest guarantors, owned by Ambac, Security Capital and FGIC Corp., were stripped of at least one AAA credit rating amid losses on debt tied to subprime mortgages. Interest costs on floating-rate bonds sold by more than 100 governments, hospitals and colleges rose as much as 7 percentage points since the beginning of January even as the Federal Reserve lowered its benchmark rate for U.S. borrowing by 1.25 percentage points.

Essentially this means any company that has PAID for insurance for the bonds they issue (such as Arsenal FC, for the Emirates Stadium), now faces massive increases in their interest payments, as the insurance policies are worthless!

As a Spurs fan, I find the latter effect quite funny actually...

[Jet Gorgon]

True on all counts. Thanks for extra info. De-lever -- cool. Or deleverage?
Ya, BFly, the reinsurance mkt is where alot of the big boys got sucked into the subprimes, right? Good thing to re-check, thanks.

[Butterfly]

re-insurance is basically the "reselling" and "stripping" of insurance policies to other insurance companies, exactly like a mortgage, so insurance companies would get rid of the liabilities, but still keep part of the income from the premium. In theory it spreads the risk to multiple insurance companies through "diversification" of the policies.

What we don't know is that usually those contracts end up in "offshore" companies, called captives, which like Enron, are built to sucked in all the risks and possible losses an insurance company might face with "dodgy" contracts.

If they crack, hell will break loose,