While reviewing this post from 2002, foreshadowing a derivatives crisis like the current one, I found the following:
“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. ”
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.
As an update, the $1 trillion in credit derivatives has exploded to around $50 trillion. While less dramatic in proportional terms, the growth in interest rate swaps is actually more alarming, having reached around $300 trillion in notional values.[1]
It now seems pretty well certain that, as the quote above suggests, the chaos in debt derivatives will shortly spread to interest rate swaps.
Update Unless that is, all normal calculations are rendered irrelevant by a US government asset purchase on a scale that will make all past nationalizations look puny. How that will play out I have no idea. For example, will US-based ratings agencies take the step (automatic if it were anyone else) of downgrading US government debt? End Update
There are two reasons for this. First, swaps are essentially bets on interest rate spreads and these have gone wild in the last week, with interest rates on Treasury notes dropping to zero while commercial paper is just about unsaleable at any price. Imperfectly hedged players in the market must be sitting on losses of several percentage points. Depending on how much of this there is, the implied losses could be anywhere from tens of billions to trillions. Crowdsourcing plea: anyone who has a better estimate is welcome to offer it.
Second, hedging only works if you can collect from your counterparties. This Economist story indicates that Lehmans was a big player, but no-one really knows who is owed money by them. And it seems certain that there will be large-scale failures among hedge funds in coming months.
It’s hard to see this crisis being resolved by normal commercial or regulatory means. The hundreds of billions tipped into the market by central banks yesterday is just a drop in the bucket compared to the sums at risk here.
fn1. Under normal conditions, the exposure associated with a swap is of the order of 1 per cent of the notional value. But (a) 1 per cent of 300 trillion is 3 trillion (b) conditions are not exactly normal right now.
John Quiggin 
It should be noted that the notional value of the swaps has no necessary connection to the size of the risk.
i wonder if there is some level of collapse that would inspire the mandarins of capital and their servitors in academia to surmise: ‘perhaps we must look at socialism again’, or is this belief in personal freedom to burgle the national finances genuinely religious in nature?
they say the weimar middle class came to national socialism when their money was wiped out, and there seems to be no shortage of ‘nazi’ personalities in the usa, and in oz. perhaps financial collapse will be even more exciting than the environmental one, and here sooner.
Perhaps Mr Obama will be the new FDR, expanding the role of government in a largely non-fascist fashion.
PrQ,
Surely you understand the risks inherent in an IRS better than that. The notional outstanding is just a parameter used in a calculation – the actual cash flows involved (the real exposure) are typically less than 1% of the notional value – and the value of the swap is likely to be even smaller. Lehman’s entry into Chapter 11 may mean that they are unable to meet their side of the deals under swap arrangements, but the actual cash flows involved will be miniscule compared to the notional you are bandying about there.
Anybody who feels the need to engage in excited speculation about the future of financial industry should remember two things:
1) Occasional turmoil is a normal and expected charachteristic of financial markets. The historical record has been equally unkind to people who predict the apocalypse during the bad times as those who predict eternal bliss during the good times.
2) If you have confidence in your predictions you should take those views to market. It is very easy to trade a prediction that things will get worse, better, or stay the same. If you are not doing this then you must not be very certain.
No use crying over past mistakes as the stakes are too high now as Thomas Palley points out-
The United States financial system is caught in a destructive liquidation trap that has falling asset prices cause financial distress, in turn compelling further asset sales and price declines. If unaddressed, it risks sending the economy into deep recession – or even depression.
Current conditions are the result of the bursting of the house price bubble and the end of two decades of financial exuberance. That exuberance was fostered by a cocktail of forces.
First, economic policy replaced wages and productive investment as the engines of growth with debt and asset inflation. Second, greed and free-market ideology combined to promote excessive risk-taking and restrain regulators. This was encouraged by audacious claims that mathematical economic models mapped reality and priced uncertainty, making old-fashioned precautions redundant.
Recognition of the scale of financial folly has created a rush for liquidity. This is causing huge losses, triggering margin calls and downgrades that cause more selling, damage confidence and further squeeze credit. That is the paradox of deleveraging. One firm can, but the system as a whole cannot.
Having failed to prevent the bubble, regulatory policy is now amplifying its deflation. One reason is mark-to-market accounting rules that force companies to take losses as prices fall. A second reason is rigid capital standards.
Application of mark-to-market rules in an environment of asset price volatility can create a vicious cycle of accounting losses that drive further price declines and losses. Meanwhile, capital standards require firms to raise more capital when they suffer losses. That compels them to raise money in the midst of a liquidity squeeze, resulting in fresh equity sales that cause further asset price declines.
Bad debts will have to be written down, but it is better to write them down in an orderly fashion rather than through panicked deleveraging that pulls down good assets too.
This suggests regulators should explore ways to relax capital standards and mark-to-market rules. One possibility is permitting temporary discretionary relaxations akin to stock market circuit breakers.
Later, regulators must tackle the underlying problem of price bubbles. Currently, central banks are only able to control bubbles by torpedoing the economy with higher interest rates. New flexible measures of control are needed. One proposal is asset-based reserve requirements, which systematically applies adjustable margin requirements to the assets of financial firms.
The Federal Reserve must also lower interest rates, and not just for standard reasons of stimulating spending. Lower short-term rates are needed to make longer-term assets (including houses) relatively more attractive, thereby shifting demand to them and putting a bottom to asset price destruction.
Fears about a price-wage inflation spiral remain misplaced. Instead, the threat is deep recession triggered by the liquidation trap. If inflation is a wild card, now is the time to use the credibility the Fed has earned. Emergency rate reductions can be reversed when the situation stabilizes.
The great irony is central banks can produce liquidity costlessly. Usually the problem is restraining over-production: today, it is overcoming political concerns about “bail-outs”. Those concerns are legitimate, but they also risk inappropriately restricting liquidity provision and unintentionally imposing huge costs of deep recession.
At the moment the Fed is protecting banks and the treasury dealer network but leaving the rest of the system in the cold. That is perverse given how the Fed went along with expansion of the non-bank financial system. Instead, the Fed should consider an auction facility that makes longer-duration loans available to qualified insurance and finance companies too.
The facility’s guiding principle should be an expanded version of the Bagehot rule. Accordingly, the Fed would auction funds at punitive rates, with loans being fully collateralized. The goal should be to facilitate repair of distressed financial companies with minimum market disruption and at no taxpayer expense. By creating an up-front facility, the Fed can get ahead of the curve and reduce need for crisis interventions that are always more costly and disruptive.
Among financial conservatives there is a view that financial markets deserve punishment for their “sins” and only that will cleanse them. This view is often presented in terms of the need to restore market discipline and stay moral hazard.
The view from the left is strangely similar, arguing Wall Street “fat cats” need to be punished. Asset prices should fall, banks must eat their losses, and all but the most essential financial firms should be allowed to fail.
Both views have a moralistic dimension, and both risk unnecessary economic suffering. The mistakes of the past cannot be undone. All that can be done is to minimize their costs and then truly reform the system so that they are not repeated.
Thomas I Palley is the founder of the Economics for Democratic and Open Societies Project.
There is bipartisan support for that position now-
http://www.news.com.au/business/story/0,27753,24370562-31037,00.html
AR, please reread the post. I agree that the typical exposure is of the order of 1 per cent of the notional or less, which is why I talked about losses in the range “tens of billions to trillions”.
To give an idea of the arithmetic, 0.1 per cent of outstanding swaps is $300 billion, which sits neatly in the (log) middle of this range.
1. I’d agree that chaos is the right word. But what are the attractors in the system in question?
2. The quote contains numbers with $ signs. You call them notional values. To illustrate how one can generate these notional numbers I am going to ‘financialise’ my household economy’ for illustrative purposes.
My husband and I issue securities against all our real assets (from toothbrushes to …I won’t tell you), according to the ownership distribution between ‘him and her’ as determined at the time of acquisition. We are free to write any financial contract (with respect to time, borrowing and lending rates of real assets, conditions upon which a security is redeemed, etc) and we denominate the face value of the financial contract by putting an $ sign in front of the number and we agree that all trades have to be settled (redeemed) by means of issuing other securities or pay in ‘cash’ (ie government issued fiat money which also bears the $sign. All our activities in the household have to hence forth be consistent with the financial contracts. For example, the timing of usage of the bathroom has to be consistent with the financial contracts. Of course we are allowed to place bets on our respective financial commitments re usage of the bathroom by means of issuing put and call options, futures, as many as we like (including so many as to get back to where we started from). To be ‘objective’ and ‘transparent’ we agree to pay a fee (in ‘real’ $) on all financial securities issued to an ‘independent’ agent called a rating agency and we pay a fee for a financial accountant to ensure transparency. Suppose we started in or around 1982 and by 2002 we add up all the ‘values’ we have created by that time (of course net of all securities which have been redeemed during the process. Then we would arrive at a $ number which is ‘huge’.
Please don’t tell me this is stupid – I know that. But why do people do something very much akin to what I have described only because there are more ‘players’ involved?
The story isn’t finished. Suppose him and her get it so wrong that at least one has to borrow in ‘real’ dollars (fiat money), or, worse still, all energy has been spent on writing contracts, properly certified and risk assessed on the basis of reports provided by the accountant that all real assets have deteriorated including no more veggies in the garden. Then both have to borrow in ‘real dollars’ to buy consumables. And this is the stage we are at. (… I forgot the fees for the corporate lawyers).
3. I agree one can’t solve the problem by the same methods by which they were created.
4. Question: Would it be sensible to look for the critical numbers in this system to reduce spill over effects into the ‘real economy’ – a plan B, so to speak, just in case the mess is even bigger than imagined. By ‘critical numbers’ I mean financial contracts that are seen as useful for the real economy (housing loans, commercial loans to non-financial institutions, deposits, plans for business expansion, superannuation funds invested in equity valued in some to be determined sensible way) – the sort of stuff that can easily be related to the real economy, defined as {people, resources, technological know-how}. Sort all securities into ‘useful’ and ‘foam’. It seems to me this might reduce the complexity of the problem significantly.
To illustrate, the critical numbers to get out of the mess of the hypothetically financialised household economy are: $ amount of net borrowings in real $ (as defined) and job opportunities to pay off the debt and live. (Burn the box labelled ‘foam’ – sorry, environmental concerns require recycling and the hope the next potential revisionist guru on a mission won’t discover the pieces and learn from it such that in another 70 years or so the next generation has to go through it again)
“It is very easy to trade a prediction that things will get worse, better, or stay the same.”
Umm, not really. I’m out of stocks and the US and UK authorities have banned shorting of financial stocks. There’s no point going in to the CDS market (assuming a retail investor could do so) when your counterparty might go broke and default.
So, how should I trade a prediction that things will get worse for the US financial sector?
Kenneth Rogoff, professor of economics at Harvard University and former chief economist of the International Monetary Fund, thinks the financial crisis will cost American taxpayers between one and two trillion dollars.
He writes in the Financial Times:
“Were the financial crisis to end today, the costs would be painful but manageable, roughly equivalent to the cost of another year in Iraq. Unfortunately, however, the financial crisis is far from over, and it is hard to imagine how the US government is going to succeed in creating a firewall against further contagion without spending five to 10 times more than it has already, that is, an amount closer to $1,000bn to $2,000bn.”
That’s a massive increase, and it’s going to effect everyone somehow.
“A large expansion in debt will impose enormous fiscal costs on the US, ultimately hitting growth through a combination of higher taxes and lower spending. It will certainly make it harder for the US to maintain its military dominance, which has been one of the linchpins of the dollar.
The shrinking financial system will also undermine another central foundation of the strength of the US economy. And it is hard to see how the central bank will be able to resist a period of allowing elevated levels of inflation, as this offers a convenient way for the US to deflate the mounting cost of its private and public debts.”
JQ,
“So, how should I trade a prediction that things will get worse for the US financial sector?”
It doesn’t need be shorts. You can still sell futures or buy puts very easily. If you think there will be a big move I suggest buying puts because you don’t have to worry about margins. You can trade on whole sector or individual stocks. If you’re serious get in touch and i’ll give more specifics. There are some very large potential returns if the state of the world you are forecasting eventuates.
Re 11: JC, Why should “A” buy and pay for a put on a security at t which “A” expects to be delisted at time t+1?
I have to agree with #11. It would be both easy and comparatively cheap, even for a retail investor, to get exposure to a trade that would most probably offer spectacular returns should the state of the world JQ is forecasting eventuate.
Btw, John why is your website so slow?
Re #13, tin tin, may I have your answer to my question in #12, too?
The other big risk for someone wanting to bet against financial corporations is that of a massive all-purpose government bailout, which now appears to be on the cards. I think I will stay on the sidelines.
John could easily sell futures and then bleed to death on margin calls before his prediction comes to fruition, even if he is ultimately right.
has anyone got a tip on the value of the yuan, 5 years from now?
re: #14. The exchanges I am familiar with have rules to deal with the scenario you mention. Here is one example from the Montreal Exchange: http://www.m-x.ca/promo/options/new_options15_en.php.
John,
Don’t be discouraged! You can buy calls on the other side as well so you make money in the event of large bailout or a large crash.
sdfc,
If you’re worried about that you buy options instead. Set and forget!
EG,
I’m not sure what you mean. The option still pays if the company goes bankrupt.
Joseph, a combined put and call is effectively a bet on volatility, and the market has already priced in an awful lot of that.
And to both you and tintin, tu quoque (translating – if you’re so confident, why aren’t you going into debt to buy the stocks of the remaining Wall Street investment banks so you can profit when the market comes to its senses).
JC. assuming the writer of the put is a financial institution that is still still liquid. So you have in mind a case where the put is on an operating company (non-financial). However, a major part of the current problem is with the financil institutions.
Exactly, you can buy calls and puts to cover, assuming the writers remain liquid. For the rest see my hypothetical financialisation of a household economy.
John, re your update on the bail-out. Rest assured Ben Bernanke (BB) will do absolutely everything he can to rescue the US economy and in doing so the US banking system – even if it comes at great expense to the US taxpayer. He is known in the markets as “Helicopter Ben” for a good reason.
John,
My portfolio reflects my views. I’m not requiring that other people do the same as me, I just think it’s strange that people with strong views are not prepared to trade on them.
Quote: “I just think it’s strange that people with strong views are not prepared to trade on [their strong views]”
I’m as subject as anyone else to a false consensus bias, but I’m still rashly tempted to think that (a) that most people around the world would find this an unintelligible sentiment, and (b) the fact that some people do feel this way could well have a great deal to do with some of the various messes we’re in.
The greater risk to any remaining form of controlled crash, redemptions and panic, was brought home in one those quite moments as I was tugging the forelock to the customer service officer in my local bank yesterday afternoon. I could not help but overhear some of our more elderly and it would seem surprisingly wealthy octagenarians seeking advice and wanting to transfer very large sums out of Goldman Sachs into the their safe Aussie bank. Hmmmm!
i think its strange in the reverse sense joseph,
that somehow you are precluded from giving an opinion or that your opinion is somehow worth less if you dont gamble on the share market
i think its the worse time in a hundred years to own shares, if i had any i’d sell them,
somehow betting on this opinion seems to against the logic of the opinion
Joseph, as Ernestine pointed out, you’re ignoring counterparty risk.
You’ve also tried to introduce options as a way of avoiding the margin call risk that sdfc pointed out, but now you’re ignoring the theta (time decay) of the options, and still ignoring the counterparty risk.
Good luck with your portfolio, dude.
tin tin, thanks for the reference to the Canadian exchange. Interesting, my question was also in the ‘question of the month’.
Off-topic but is Rudd setting himself up for ridicule? Next week he will address the UN General Assembly to announce Australia will lead research efforts into large scale clean coal, regarded as a technological fantasy by serious observers.
John, you may also be able to trade on a prediction that things will be worse for the financial sector by making a bet on prediction markets.
Hermit, carbon dioxide sequestration is looking a lot more credible than it was a year or two back.
There are several groups claiming to have significantly improved the efficiency of the carbon capture process and there’s also been progress on locking the stuff up chemically rather than simply pumping it underground.
The Melbourne Institute is making the pretty heroic call that the Australian economy will avoid recession.
http://www.abc.net.au/news/stories/2008/09/19/2369658.htm?section=justin
SJ,
If you want to eliminate counterparty risk and still make a downwards bet you can short sell. Borrow the stock (there are many that do it) for a period of days or months, sell them up front and then make money when you buy them back later to repay the initial borrow. Same as buying a put, but the whole market then becomes your counterparty. If the stock is worthless then you do not even have to replace the borrow.
The U.S. government is now getting paid to borrow money. And it should borrow lots of it, Treasury bills at 0% should fund the bailout of the computer modeling pseudo-capitalists
If I might comment on Hermit’s off-topic #29. Yes, Rudd is illustrating his scientific and economic ignorance by pushing “clean coal” technology. Either that or he is pandering to the coal interests whilst knowing the path is wrong.
JQ,
I have trouble believing that there could be such a large amount ready to fall over. 300 trillion is the full value of 800 million 500 thousand dollar homes. So that would imply that there was a home and matching commercial property mortgaged to the hilt for every single american times 2. Have these people been trading in the finance of Europe as well?
Pr Q perhaps Rudd’s clean coal initiative is a big topic for next week if it becomes an international embarrassment. The linked article is thorough so I doubt Rudd has anything new up his sleeve.
“being engineered by Treasury Secretary Hank Paulson, Federal Reserve chairman Ben Bernanke and Congressional leaders “would represent perhaps the biggest intervention in financial markets since the 1930s.” The NYT, ahem, believes it could even “become the biggest bailout in United States history.” Period. The NYT writes, “while details remain to be worked out, the plan is.. ”
while you guys argue about just how many financial angels can dance on a pinhead, the american ship of state is exhibiting stability failures that would preclude even liberian registration. i realize your focus is a mixture of academic preening and searching for the car keys under the street light, but don’t any of you mighty intellects think about the design and operation of financial systems that need not function as a mixture of ok corral, gang-rape, and lottery?
why is there no public discussion of the merits of socialism? or democracy? not even from ‘democratic socialists’…
Sorry, 600 million.
“why is there no public discussion of the merits of socialism? or democracy?”
Because its a theory that has been falsified.
Democracy is the reason we will recover over time, what democracy does is enforce a contract and deliver property rights, this is what our free markets combined with capitalism needs.
What has happened here is not capitalism, capitalism is about taking risks, these buffoons believed they were operating in a risk free/reduced environment, which they were not.
That environment was created for them by very clever people who thought they could know the unknowns (as mr Rumsfeld said) ..and created computer models that pretended to support this stupid idea.
All the experimental evidence says, when humans think they are in a safe environment they take more risks, and this is what happened on a gigantic scale.
at the heart of all this, is not greed, but Pseudo-science.
Falsified? Just like public beaches, libraries, roads, and parks?
What is pseudo – science is capitalist based usury systems.
Further to John’s update, the US government is effectively extending government deposit insurance to money market funds by pumping $230 billion into merchant banks to be used to buy illiquid assets from the funds so they can meet investor redemptions.
http://www.abc.net.au/news/stories/2008/09/19/2369267.htm
Having set the precedent, like Fannie Mae, money market accounts now have an “implicit government guarantee”
“Falsified? Just like public beaches, libraries, roads, and parks?”
Actually, the theory that public beaches, libraries, roads and parks do in fact exist is supported by quite a bit of empirical evidence. It would be difficult to falsify the ‘beaches exist’ hypothesis. Sorry, what was your point? That socialism = public ownership of public goods?
BBB
As I noted a while back, the term “socialist” has become meaningless and should be retired.
off-topic #29
The coal industry is now in a bit of a bind, do they come out and say clean coal is nonsense and argue against carbon trading, or do they suck it up.
I think it’s just like the GST, to get the thing up a few things that don’t made sense will be done to outflank the knockers. I think it’s called politics.
Ian, a whole lot of words have become meaningless. But I think we should try to reclaim some of them from meaninglessness. Neoliberal is one that ought to be wrested from the control of Naomi Klein fan club. Fascist and socialist are probably too far gone to ever make them useful in intelligent conversation.
BBB
The gold standard is long gone, now it’s only paper, as long as the fed (or whoever) can pull the money back when the private sector gets over itself they can add liquidity as desired. The way they get the stuff back is to lend not give it away. What they get as collateral really only effects pull back leakage.
That seems to be the rub; all the chit chat in the world dont mean diddley squat unless you are prepared to back it up with cash.
Andrew
The short sale suffers from the same problem as the futures trade, i.e. you might eventually be right, but you can still get wiped out in the meantime. Like, you sell mac bank at $26 and the next day it’s at $36.
I don’t think there’s a serious problem in understanding either “neoliberal” or “social democratic”, and since these terms span the effective spectrum of debate here, that’s all to the good.
Not to say that each of these terms doesn’t cover a wide range of political positions, but I know what to expect when I see them. But “conservative”, “liberal” and “socialist” are not nearly so satisfactory.