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Are Interest Rate Derivatives a Ticking Time Bomb?

Submitted by George Washington on 04/22/2010 12:31 -0400

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Derivatives are the world’s largest market, dwarfing the size of the bond market and world’s real economy.

The derivatives market is currently at around $600 trillion or so (in gross notional value).

In contrast, the size of the worldwide bond market (total debt outstanding) as of 2009 was an estimated $82.2 trillion.

And the CIA Fact Book puts the world economy at $58.07 trillion in 2009 (at official exchange rates).

Interest rate derivatives, in turn, are by far the most popular type of derivative.

As Wikipedia notes:

The interest rate derivatives market is the largest
derivatives market in the world. The Bank for International Settlements
estimates that the notional amount outstanding in June 2009 were US$437 trillion
for OTC interest rate contracts, and US$342 trillion for OTC interest
rate swaps. According to the International Swaps and Derivatives
Association, 80% of the world’s top 500 companies as of April 2003 used
interest rate derivatives to control their cashflows.

So interest rate derivatives are the world’s largest market.

The largest interest rate derivatives sellers include Barclays, Deutsche Bank, Goldman and JP Morgan. While the CDS market is dominated by American banks, the interest rate derivatives market is more international.

In comparison to the almost $500 trillion in interest rate derivatives, BIS estimates that there were “only” $36 trillion in credit default swaps as of June 2009. Credit default swaps were largely responsible for bringing down Bear Stearns, AIG (and see this), WaMu and other mammoth corporations.

Where’s the Danger?

In 2003, John Hussman wrote:

What is not so obvious is the extent to which the U.S.
economy and financial markets are betting on the continuation of
unusually low short-term interest rates and a steep yield curve. This
doesn’t necessarily resolve into immediate risks, but it could
profoundly affect the path that the economy and financial markets take
during the next few years, by making the unwinding of debt much more
abrupt.
In response to very low short-term interest rates, many U.S.
corporations have swapped their long-term (fixed interest rate) debt
into short-term (floating interest rate) debt, to the extent that an
increase in short-term rates could substantially raise default risks.
Similarly, a growing proportion of homeowners have refinanced their
mortgages into adjustable rate structures that are also sensitive to
higher short-term yields. Finally, profitability in the banking system
is unusually dependent on a steep yield curve, with a widening net
interest margin (the difference between long-term rates banks charge
borrowers and the lower short-term rates they pay depositors) …

***

According Bank for International Settlements, the U.S. interest rate
swap market [has] nearly doubled in size in the past two years. The
reason this figure is so enormous is that there are usually several
links in the chain from borrower to investor. A risky borrower may
enter a swap with bank A, which then takes an offsetting swap position
with bank B (earning a bit of the credit spread as its compensation),
and so on, with a cheerful money market investor at the end of the
chain holding a safe, government backed security, oblivious to the
chain of counterparty risk in between.

Aside from the risk that any particular link in this chain might be
weak (know thy counterparty), the U.S. financial system has gone one
step further. In order to hedge against the risk of defaults, banks
frequently lay credit risk off by entering “credit default swaps” with
other banks or insurance companies. These swaps essentially act as
insurance policies for credit risk.

***

In short, the U.S. financial system is in a delicate balance. On the
issuer side, a great many borrowers have linked their debt obligations
to short-term interest rates. This is tolerated by the financial system
because the debt has been swapped out through financial intermediaries,
so investors get to hold relatively safe instruments like bank deposits
and Fannie Mae securities. This mountain of debt in the U.S. financial
system – tied to short-term interest rates – is ultimately and perhaps
somewhat inadvertently backed by the U.S. government.

On the investor side, Asian governments intent on holding their
currencies down relative to the U.S. dollar have purchased a great deal
of U.S. government and agency debt – effectively “buying dollars.” … A
reduction of demand for U.S. short-term debt, either by foreign
governments (particularly in the event that Asian governments decide to
revalue their currencies) or by U.S. investors, could have very
undesirable consequences.

All of which is why the U.S. is now extremely dependent on short-term interest rates remaining low indefinitely.

In March 2009, Martin Weiss wrote:

Until the third quarter of last year, the banks’ losses
in derivatives were almost entirely confined to credit default swaps —
bets on failing companies and sinking investments.But credit default
swaps are actually a much smaller sector, representing only 7.8 percent of the total derivatives market.

***

Thus, considering their far larger volume, any threat to interest
rate derivatives could be far more serious than anything we’ve seen so
far.

And Monday, Jerome Corsi argued that cities, states and universities might be wiped out by changes in interest rates:

As interest rates begin to rise worldwide, losses in
derivatives may end up bankrupting a wide range of institutions,
including municipalities, state governments, major insurance companies, top investment houses, commercial banks and universities.

Defaults now beginning to occur in a number of European cities
prefigure what may end up being the largest financial bubble ever to
burst – a bubble that today amounts to more than $600 trillion.

***

A popular form of derivative contracts was developed to permit one
money manager to “swap” a stream of variable interest payments with
another money manager for a stream of fixed interest payments.

The idea was to use derivative bets on interest rates to “hedge” or
balance off the risks taken on interest-rate investments owned in the
underlying portfolio.

If an institutional investment manager held $100 million in
fixed-rate bonds, for example, to hedge the risk, should interest rates
rise or fall in a manner different than projections, a purchase of a
$100 million variable interest rate derivative could be constructed to
cover the risk.

Whichever way interest rates went, one side to the swap might win and the other might lose.

The money manager losing the bet could expect to get paid on the derivative to compensate for some or all of the losses.

In the strong stock and mortgage markets experienced beginning in
the historically low 1-percent interest rate environments of 2003
through 2004, the number of hedge funds soared, just as the volume of
derivative contracts soared from a mere $300 trillion in 2005 to the
more than $600 trillion today.

Unsophisticated Entities Getting Taken by Interest Rate Derivatives Salesmen

In 2008, Bloomberg pointed out that the SEC was investigating shady interest rate derivatives sales by JP Morgan and Morgan Stanley to school districts.

In 2009, New York Times writer Floyd Norris noted:

On the front page of The Times today, Don van Natta Jr. has a good article
about the woes of little towns and counties in Tennessee that bought
interest-rate derivatives sold by Morgan Keegan, an investment bank
based in Memphis.

It turns out that these municipalities did not understand the risks
they were taking. The derivatives have now blown up, and the officials
are blaming the bank.

Matt Taibbi also recently noted that JP Morgan used interest rate swaps to decimate a small Alabama town:

The initial estimate for this project was $250 million.
They ended up spending about $3 billion on this. And they ended up
owing about $5 billion in the end, after you look at all the
refinancing and the interest rate swaps and everything.

As the Bloomberg, Times and Taibbi stories hint, many
unsophisticated schools, cities, states and universities were played by
the big interest rate derivatives sellers, just as many people were
played by the CDS sellers. So the fallout will likely be substantial.

Indeed, Larry Summers lost virtually all of Harvard University's endowments using interest rate swap derivatives. Summers is the guy now running the U.S. economy.

But Aren’t Interest Rate Derivatives Straightforward and Useful?

You might assume that interest rate derivatives appear to have a
much more straightforward, legitimate business purpose than credit
default swaps.

Interest rate derivatives certainly help many individual businesses
control and hedge their costs. And they may be more straightforward
and transparent than CDS.

But people tend to overestimate their ability to understand complex
financial instruments. For example, the credit default swap salespeople
and their bosses didn't really didn't understand CDS.

And
- because the market for interest rate derivatives dwarfs the market
for CDS - the reduced risks of each transaction might be collectively
offset by the tremendous number of transactions and the gigantic size
of the market as a whole.

In addition, when a bunch of individuals all attempt to reduce their risks at the same time in the same way, it can increase the risk to the overall system.

As George Soros pointed out in 1994, the excessive use of hedging can and often does backfire:

I must state at the outset that I am in fundamental
disagreement with the prevailing wisdom. The generally accepted theory
is that financial markets tend toward equilibrium and, on the whole,
discount the future correctly. I operate using a different theory,
according to which financial markets cannot possibly discount the
future correctly because they do not merely discount the future; they
help to shape it. In certain circumstances, financial markets can
affect the so-called fundamentals which they are supposed to reflect.
When that happens, markets enter into a state of dynamic disequilibrium
and behave quite differently from what would be considered normal by
the theory of efficient markets. Such boom/bust sequences do not arise
very often, but when they do they can be very disruptive, exactly
because they affect the fundamentals of the economy…

The trouble with derivative instruments is that those who issue them
usually protect themselves against losses by engaging in so-called
delta, or dynamic, hedging. Dynamic hedging means, in effect, that if
the market moves against the issuer, the issuer is forced to move in
the same direction as the market, and thereby amplify the initial price
disturbance. As long as price changes are continuous, no great harm is
done, except perhaps to create higher volatility, which in turn
increases the demand for derivatives instruments. But if
there is an overwhelming amount of dynamic hedging done in the same
direction, price movements may become discontinuous. This raises the
specter of financial dislocation. Those who need to engage in dynamic
hedging, but cannot execute their orders, may suffer catastrophic losses.

This is what happened in the stock market crash of 1987. The main
culprit was the excessive use of portfolio insurance. Portfolio
insurance was nothing but a method of dynamic hedging. The authorities
have since introduced regulations, so-called ‘circuit breakers’, which
render portfolio insurance impractical, but other instruments which
rely on dynamic hedging have mushroomed. They play a much bigger role
in the interest rate market than in the stock market, and it is the role in the interest rate market which has been most turbulent in recent weeks.

Dynamic hedging has the effect of transferring risk from customers
to the market makers and when market makers all want to delta hedge in
the same direction at the same time, there are no takers on the other
side and the market breaks down.

The explosive growth in derivative instruments holds other dangers.
There are so many of them, and some of them are so esoteric, that the
risks involved may not be properly understood even by the most
sophisticated of investors. Some of these instruments appear to be
specifically designed to enable institutional investors to take gambles
which they would otherwise not be permitted to take ….

Doug Noland wrote an intriguing article in 2001 – based on the research of Bruce Jacobs
(doctorate in finance from Wharton, co-founder of Jacobs and Levy
Equity Management) on portfolio insurance – arguing that interest rate
derivatives were widely being used without understanding the risks they
create for the system (warning: this is long … go get some caffeine, sugar or exercise, and then come back and keep reading):

I would like to suggest moving Bruce Jacobs’ excellent
book, Capital Ideas and Market Realities to the top of reading lists.
From the forward by Nobel Laureate Harry M. Markowitz: “Many observers,
including Dr., Jacobs and me, believe that the severity of the 1987
crash was due, in large part, to the use before and during the crash of
an option replication strategy known as ‘portfolio insurance.’ In this
book, Dr. Jacobs describes the procedures and rationale of portfolio
insurance, its effect on the market, and whether it would have been
desirable for the investor even if it had worked. He also discusses
’sons of portfolio insurance,” and procedures with similar objectives
and possibly similar effects on markets, in existence today.”From Dr.
Jacobs’ introduction: “This book … examines how some investment
strategies, especially those based on theories that ignore the human
element, can self-destruct, taking markets down with them. Ironically, the greatest danger has often come from strategies that purport to reduce the risk of investing.

***

“In 1987, as in 1998, strategies supported by the best that finance
theory had to offer were overwhelmed by the oldest of human instincts –
survival. In 1929, in 1987, and in 1998, strategies that required
mechanistic, forced selling of securities, regardless of market
conditions, added to market turmoil and helped to turn market downturns
into crashes. Ironically, in 1987 and 1998, those strategies had held
out the promise of reducing the risk of investing. Instead, they ended
up increasing risk for all investors.”

***

I would like to explore the concepts behind the current dangerous
fad of derivatives as a mechanism to insure against rising interest
rates, as well as the momentous ramifications to both financial market
and economic stability from these instruments that rely on dynamic
hedging strategies. From Jacobs: “Option replication requires
trend-following behavior – selling as the market falls and buying as it
rises. Thus, when substantial numbers of investors are replicating
options, their trading alone can exaggerate market trends. Furthermore,
the trading activity of option replicators can have insidious effects
on other investors.”

Dr. Jacobs adeptly makes the important point that the availability
of portfolio insurance during the mid-1980s played a significant role
in fostering speculation that led to the stock market bubble and the
crash that followed in October 1987. “Rather than retrenching and
reducing their stock allocations, these investors had retained or even
increased their equity exposures, placing even more upward pressure on
stock prices. And, of course, as equity prices rose more, ‘insured’
portfolios bought more stock, causing prices to rise even higher…Ironically,
the dynamic trading required by option replication had created the very
conditions portfolio insurance had been designed to protect against –
volatility and instability in underlying equity markets.And,
tragically, portfolio insurance failed under these conditions
(because…it was not true insurance). The volatility created by the
strategy’s dynamic hedging spelled its end.”

***

“In the months following the (1987) crash, a number of investigative
reports examined the trading data for the crash period. The Securities
and Exchange Commission and the Brady Commission (the Presidential Task
Force), for two, found that the evidence implicated portfolio insurance
as a prime culprit.” …

Dr. Jacobs’ wonderful effort explains … the potential dangers of a
complex financial theory taken up with little appreciation of its
suitability for real-world conditions and applied mechanistically with
little regard for its potential effects. It is a story about how a
relatively small group of operators, in today’s complicated and
interconnected marketplaces, can wreak havoc out of all proportion to
their numbers…it is a story of unintended consequences. For synthetic
portfolio insurance, although born from the tenets of market
efficiency, affected markets in very inefficient, destabilizing ways.
And option replication, although envisioned as a means for investors to
transfer and thereby reduce unwanted risk, came to be a source of risk
for all market participants.”

Unfortunately, this language seems at least as applicable to today’s interest rate derivative market as it was for equity portfolio insurance.
It is certainly our view that the contemporary U.S. and global
financial system characterized by unfettered money, credit and
speculative excess creates unprecedented risk for all market
participants, as well as citizens both at home and abroad. Not only
have flawed theories prevailed and past crises been readily ignored,
derivatives (interest rate in particular)
have come to play a much greater role throughout the U.S. and global
financial system. The proliferation of derivative trading is a key
element fostering credit excess and a critical aspect of the monetary
processes that fuel recurring boom and bust dynamics, as well as the
general instability wrought by enormous financial sector leveraging and
sophisticated speculative strategies. This certainly makes the
proliferation of interest rate derivatives significantly more dangerous
than stock market derivatives. Under these circumstances, it does seem
rather curious that more don’t seriously question the soundness of this
unrelenting derivative expansion. Unfortunately, ignoring the
dysfunctional nature of the current system does not assist in its
rectification – anything but. Indeed, it is my view that these previous
market dislocations will prove but harbingers of a potentially much
more problematic crisis that is quietly fermenting in the U.S. (global)
credit system.

***

Clearly, the gigantic interest rate derivative market should be
recognized as a very unusual beast. Instead of providing true interest
rate hedging protection, this is clearly the financial sector having
created a sophisticated mechanism that, despite its appearance, is
limited to little more than “self insurance” – “The Son of Portfolio
Insurance.” I have written repeatedly that markets cannot hedge
themselves, and that derivative “insurance” is different in several
critical respects from traditional insurance. From Dr. Jacobs:
“Synthetic portfolio insurance differs from traditional insurance where
numerous insured parties each pay an explicit, predetermined premium to
an insurance company, which accepts the independent risks of such
unforeseeable events as theft or fire. The traditional insurer pools
the risks of many participants and is obligated, and in general able,
to draw on these premiums and accumulated reserves, as necessary, to
reimburse losses. Synthetic portfolio insurance also differs critically
from real options, where the option seller, for a premium, takes on the
risk of market moves.” Such exposure to unrelated events is far
different from exposure to a market dislocation. Quoting leading
proponents of portfolio insurance from 1985, “it doesn’t matter that
formal insurance policies are not available. The mathematics of finance
provide the answer…The bottom line is that financial catastrophes can
be avoided at a relatively insignificant cost.”Amazingly, such thinking
persists to this day. The above language, of course, is all too similar
to the flawed analysis/erroneous propaganda that is the foundation for
the proliferation of hedging strategies and the explosion of derivative
positions. Dynamic hedging makes two quite bold assumptions that become
even more audacious as derivative positions balloon: continuous markets
and liquidity. As writers of technology puts …experienced, individual
stocks often gap down significantly on earnings or other disappointing
news, not affording the opportunity to short the underlying stock at
levels necessary to successfully hedge exposure. And when the entire
technology sector was in freefall, market illiquidity made it
impossible for players to dynamically hedge the enormous amount of
technology derivatives (put options) that had been written over the
boom (especially during the final stage of gross speculation). The
buying power necessary to absorb the massive shorting necessary for
derivative players to offload exposure (through shorting stocks or
futures) was nowhere to be found – so much for assumptions.

Granted, derivatives can be a very
effective mechanism for individual participants to shift risk to
others, but a proliferation of these strategies significantly
influences their effectiveness and general impact. The availability of
inexpensive “insurance” heightens the appetite for risk and exacerbates
the boom. This characteristic has significant ramifications for both
the financial system and real economy. It also creates completely
unrealistic expectations for the amount of market risk that can be
absorbed/shifted come the inevitable market downturn. Many
adopt strategies to purchase insurance at the first signs of market
stress. Once again, the market cannot hedge itself, and the tendency is
for derivative markets operating in a speculative environment to
transfer risk specifically to financial players with little capacity to
provide protection in the event of severe financial market crisis.

***

There is another key factor that greatly accentuates today’s risk of
a serous market dislocation, that was actually noted by the BIS: “Net
repayments of US government debt have affected the liquidity of the US
government bond market and the effectiveness of traditional hedging
vehicles, such as cash market securities or government bond futures,
encouraging market participants to switch to more effective hedging
instruments, such as interest rate swaps.”

This is actually a very interesting statement from the BIS. First,
it is an acknowledgement that “liquidity” and the “effectiveness of
traditional hedging vehicles” have been impaired, concurrently with the
exponential growth of outstanding derivative positions. This is not a
healthy divergence. We have posited that the explosion in private
sector debt, having been the leading factor fueling U.S. government
surpluses, has produced The Great Distortion. As such, the viability of
hedging strategies such as those that entailed massive Treasury
securities sales in 1994 is today suspect. There are fewer Treasuries
and a much less liquid Treasury market, in the face of unimaginable
increases in risky private-sector securities and hedging vehicles. And
while this momentous development has not yet created significant market
disruption, the true test will come
in an environment of generally increasing interest rates. Rising market
rates will dictate hedging-related securities sales, and will test the
liquidity assumptions that lie at the heart of derivative strategies.
It is certainly my view that models that rely on historical
relationships between public and private debt are increasingly
inappropriate in today’s bubble environment, as are the associated
assumptions of marketplace liquidity. Importantly, dynamically shorting
securities in the liquid Treasuries market is no longer a viable method
for the financial sector to hedge the enormous interest rate risk that
they have created. The “answer” to this dilemma, apparently, has been
an explosion of “more effective hedging instruments, such as interest
rate swaps (from the BIS).” We very much question the use of the
adjective “effective.” …

All the same, the interest rate swaps market remains Wall Street’s
favorite “Son of Portfolio Insurance.” A similar pre-’87 Crash
perception of a “free lunch” conveniently opens the door to playing
aggressively in a speculative market. But an interest rate swap is only
a contact to exchange a stream of cash flows, generally with one party
agreeing to pay a fixed rate and the other party a floating rate
(settling the difference with periodic cash payments). With
characteristics of writing an option, the risk of loss is open ended
for those taking the floating side of the swap trade. There’s no magic
here, with one party a loser in this contract in the event of a
significant jump in market rates. In such an event, this “loser” will
certainly plan to dynamically hedge escalating exposure. If you are on
the “winning” side, you had better accept the fact that the greater
your “win,” the higher the probability of a counterparty default.
Somewhere along the line, these hedging strategies must be capable of
generating the necessary cash flow to pay on derivative “insurance” in
the event of higher interest rates. Obviously, the highly leveraged and
exposed financial institutions that comprise the swaps market have
little capacity to provide true insurance. In a rising rate
environment, these players will have enough problems of their own
making as they are forced to deal with their own bloated balance
sheets, mark-to-market losses [what a quaint notion], and other
interest rate mismatches, let alone enormous off-balance sheet
exposure. As I have written previously, purchasing large amounts of
protection against sharply higher interest rates from the U.S.
financial sector makes about as much sense as the failed strategy of
contracting with Russian banks for protection against a collapse in the
ruble. Sure, one can play this game, but we are all left to hope that
the circumstances never develop where there is a need to collect on
these policies.

***

At some point, higher interest rates will force the financial sector to
short securities to dynamically hedge the massive interest rate
exposure that has been created. What securities will be sold and from
where will buyers be found with the necessary $100s ($ trillion plus?)
of billions of liquidity? Will agency securities be aggressively
shorted? What are the ramifications of such a development to a market
that is almost certainly highly leveraged with enormous speculative
trading? I can assure you that these are questions that the derivative
players would rather not contemplate, let alone discuss. …The problem
is that the strong perception that has developed that holds that the
Fed will ensure that interest rates and liquidity conditions remain
market friendly is actually the key assumption fostering the explosion
in interest rate derivatives and reckless risk-taking. It should be
clear that the assumptions of liquidity make no sense whatsoever
without the unspoken assurances from the Federal Reserve. The resulting
proliferation of derivatives, then, has played a momentous role in the
intermediation process whereby endless risky loans are transformed into
“safe” securities and “money.” The credit system’s newfound and
virtually unlimited capability of fabricating “safe” securities and
instruments is the mechanism providing unbounded availability of credit
– the hallmark of “New Age Finance.” It is the unbounded availability
of credit that, at this very late stage of the cycle, that creates
extreme risk of dangerous financial and economic distortions, including
the distinct possibility of heightened inflationary pressures. Ironically,
the proliferation of interest rate derivatives has created the very
conditions that they had been designed to protect against – volatility
and instability in the underlying credit market, as well as acute
vulnerability to the real economy.

***

The bad news is that there sure is a lot riding on what appears to
be one massive and increasingly vulnerable speculation and derivative
bubble that fuel the perpetuation of the historic U.S. Credit Bubble. I
have said before that I see the current bets placed in the U.S.
interest rate market as probably “history’s most crowded trade.”

Conclusion

Most economists and financial institutions assume that interest rate derivatives help to stabilize the economy.

But cumulatively, they can actually increase risky behavior, just as
portfolio insurance previously did. As Nassim Taleb has shown, behavior
which appears to decrease risk can actually mask long-term risks and lead to huge blow ups.

Moreover, there is a real danger of too many people using the same strategy at once. As economist Blake LeBaron discovered last year, when everyone is on the same side of a trade, it will likely lead to a crash:

During the run-up to a crash, population diversity
falls. Agents begin using very similar trading strategies as their
common good performance is reinforced. This makes the population very
brittle…

Given that the market for interest rate derivatives is orders of
magnitude larger than credit default swap market – let alone portfolio
insurance – the risks of a “black swan” event based on interest rate
derivatives should be taken seriously.

Anything that is orders of magnitude larger than the global economy
could be risky – one unforeseen event and things could destabilize very
quickly. Too much of anything can be dangerous. Water is essential for life … but too much and you drown.

But I am confident that no one
– even the people that design, sell or write about the various interest
rate derivatives – really know how much of a danger they do or don’t
pose to the overall economy. In addition to all of the other
complexities of the instruments, the very size of the market is
unprecedented. Independent risk analysts would do a great service if
they quantified and modeled the risk.

Finally, even if the widespread use of interest rate derivatives
does not harm the economy as a whole, it will certainly harm the
cities, states and other governmental and quasi-governmental entities
which are on the wrong side of the trade. My hunch is that – just as
the fraud in the CDO and CDS markets was exposed when the “water level”
of the economy fell, exposing the rocks underneath – rising interest
rates will reveal massive fraud in the interest rate derivative market.

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Fri, 04/23/2010 - 00:26 | 314067 PalladiumTrading

Nice post, George Washington!

Thu, 04/22/2010 - 18:04 | 313640 Rainman

Thanks, GW.

The very magnitude, complexity and opaqueness of these derivatives schemes boggle the mind. Now I can understand why bond yields must be crammed down by every means available to the Fed. I thought it was about political pride, but it is actually about financial survival at many levels.

Despite the effort, it all seems to have BIG FAIL written large over it in sovereign debt red lettering.

Thu, 04/22/2010 - 17:35 | 313605 spinone

If everyone is dependant on interest rates staying low, then the FED will keep rates low through QE.

No problem.

Thu, 04/22/2010 - 17:14 | 313571 SWRichmond

DUPE

Thu, 04/22/2010 - 16:39 | 313488 fsudirectory

So wait, everyone went into Interest Rate Derivatives to obtain short term low interest rates, which, could adjust upwards later on?

Man, that reminds me of something from a couple years ago with RMBS, must be Deja Vu or something.

Oh... wait, isnt that what made everyone lose their house?.. damn I knew ive seen this before.

Thu, 04/22/2010 - 15:49 | 313398 Captain Willard

A derivative is a zero-sum situation. Somebody wins, somebody loses.

Usually, this means the dumb client, a state/local/ municipal/national government, loses and a hedge fund or prop desk wins. Or put differently, Wall Street wins and taxpayers lose.

Magical!

Thu, 04/22/2010 - 15:12 | 313324 The Alarmist

To paraphrase the line about lawyers from "Other Peoples' Money,"

Derivatives are like nuclear weapons ... everybody has to have them, but once you use them everything is f****d up.

But seriously, the real danger in the derivatives world is the fact that when the proverbial sh*t will hit the fan, rather than let the chips fall where they may (including a lot of these contracts simply falling by the wayside because the counterparties prove to be totally unreliable), some serious politico type is going to step in and give someone like AIG or Goldman Sachs a few hundred billion the "prevent the system from collapsing," which is some kind of secret code that tells the TBTF types that we still have money in our pockets for the picking.

I would wager that the only people who would suffer from an interest rate derivative meltdown are the suckers like pension funds that actually put real cash behind these things and then watched it sucked away by the daily collateral calls.

Thu, 04/22/2010 - 14:48 | 313273 FranSix

You know, interest rate bets are nothing new. Prior to the collapse in 1875, and 1929 - each crash which led to a prolonged depression, the bulk of the money was in interest rate bets.

Prior to 1875, you had what were called participating bonds used in developing railway networks and mines which increasingly became bonds with no underlying assets, except the interest rate bets which they contained.

Leading up to 1929 and the stock market crash were the trusts, which contained nothing so much as bets on interest rates, where at one time, they were aglomerated companies.

Now we have what you call derivatives, which are no more than a networked junk bond pyramid containing virtually no assets but are primarily a bet on interest rates.

I would speculate the gold as an asset is a bet on a decline in the discount rate, which peaked in year 2000, and continues to decline. Of course, there are other factors working here as well. To a very small extent, trusts are still in use since the depression.

To find an example of how participating bonds worked in 1902, which were secured by assets, there is a brief description here: