Another look at possible disaster scenarios for the world economy, this one perhaps the scariest of all. The starting point is a crisis in derivatives markets arising when ‘counterparties’ (those owing money on the transaction) for one of the big New York banks, such as J.P. Morgan Chase, refuse to pay up, either because they can’t or because they allege fraud. This has already happened in a small ($1 billion) way in the case of Mahonia, one of the shonky subsidiaries set up by Enron with the aid of JP Morgan. If it happened on a large scale it could cause a cascade of defaults. How big could it get? The short answer is “Huge”

“At the end of 2002’s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”

That’s trillion, not billion. For comparison, annual US GDP is around $10 trillion.

The ratios involved are staggering. JP Morgan alone is involved in assets with a gross value of 23.2 trillion, or around 500 times the firm’s capital base. This is comparable to the leverage exercised by Long Term Credit Management before its collapse. But before you panci too much, virtually all of this is hedged in some way.

(“Notional value” is the total value of the contract, and J.P. Morgan’s direct exposure to those derivatives was $51 billion as of Dec. 31, or less than 1% of the notional value, according to the firm. About 80% of the company’s exposure was with investment-grade counterparties.)

The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.

Who believes this stuff? As Aaron Task at The Street notes, the gold bugs do “For some time now, years literally, the hard-core bears have been talking about a “sum of all fears” scenario involving J.P. Morgan’s exposure to derivatives in general, and bearish bets on gold in particular”. The association with gold bugs tends to discredit the idea, but there are some more serious advocates, such as the guys at PrudentBear.com – The One-Stop Shop for the Bear Case
A couple of weeks ago, this kind of fear spread to the bearish side of the market in general, with a wave of rumours about problems about derivative problems at the big banks, particularly JP Morgan and Citibank. They were successfully hosed down and this contributed to the big rally last week.

How likely is it to happen? In view of the extent to which standards have been compromised in the financial world, some significant breakdown in derivative markets, leading to the failure of at least some players, seems more likely than not. On the other hand, the full-scale meltdown scenario, while far more plausible today than even a year ago, remains a low probability event.