Guest Post: Notional IRS, CDS, and Printing Press Irrelevance

Tyler Durden's picture

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.
RhoRhoRhoBoat's picture

I used to see papers or articles like this with sophomore college students all the time.  Take some tools you don't understand, but know how to run (statistics), some concept you clearly don't understand which you can find random numbers for, and throw out some nice academic lingo to distract from the fact that you are saying nothing whatsoever of value.  Blah.

jm's picture

I'm just shocked (although pleased) that you could reach above your grade level to finish it.

Great job!


sgt_doom's picture

"..some concept you clearly don't understand which you can find random numbers for,.."

Yeah...I've got to agree with RhoRhoRhoBoat, put this in the category of drivel, please.

Tethys's picture

Of course your opinion would have more weight if you provided a single example from the article to back it up.  Otherwise, thanks for sharing.

Just sayin'


emsolý's picture

JM: John Meriwether?

Fritz's picture

Excellent post.

While the world is being distracted with a torrent of headline micro issues, I enjoy reading the high altitude macro thoughts, no matter how arcane.

Unintended consequences is the 800 pound gorilla.

sgt_doom's picture

I see, so arcane is a synonym now for "incomprehensible drivel"?

Arcane it is not, silly it be.

Anonymous's picture

Dude, if that's all you can do is snipe, then eff off, you accomplish nothing. You have no high ground to cede.

Anonymous's picture

Infinity is a large value. I see no evidence that the Fed's printing press is either ineffective or incapable of counting large numbers. The impossibility of debt repudiation is also questionable given the ongoing unwind of dearly departed Lehman, the disappearance of which has not caused time to stop.

jm's picture

I totally agree with you on QE.  As the data shows, notional has recovered to some degree.  It has stabilized things, and it may turn things around.  I wasn't trying to be apocalyptic. 

My point(s) are that traditional monetary policy may have been effective in the past, but it is ineffective given the large notional.  Even slight contraction in those markets generates volatility orders of magnitude greater in the underlying.

If conventional monetary policy is ineffective to counter this notional contraction, then QE or credit easing must become the monetary policy standard so long as notional has these effects.

QE and especially credit easing policy effects are not understood well enough to know the outcomes to which they lead.

This uncertainty is magnified even more by political manipulation of basic procedures realted to disposal exercise of collateral on the underlying.  Seems clear that the underlying can have massive effects on derived contracts.

Debt repudiation would be hard so long as a sufficient number of institutions have roughly equivalent gains and losses.  They will not be losing enough to say, "OK let's start all over now."  That there would be no repudiation indicates the system wouldn't implode.  Rather the system would continue operating as before in an imparied capacity. 

I stated these ideas in terms of conjectures and open questions, because there are open questions and insufficient data to "prove" my points.

Joe Sixpack's picture

I represented it as the white elephant in the room. See the header picture at

Double down's picture

I. love. ZH.  Keep these coming, please!

Anonymous's picture

This too shall pass! (I've always been a sucker for skipping to the punchline...too bad real life's not like fiction).

Anonymous's picture

A vote for Obama is a vote for deflation. The fed expands the base but the banks don't expand the supply. The dollar grows strong. Companies and countries can't service their debt. As countries falter so do those companies that depend on sales there. As the dollar grows strong the previous benefit is lost and earnings are revised lower.
Neighbor can't get a job to pay his mortgage while savers and short sellers come in sweep up his house on the cheap as well as his wife :-P. Does that sum this article up in Cliff Note Style?

Anonymous's picture

"As countries falter so do those companies that depend on sales there."

And what makes you think that the US would be immune from this process? At the end of the day US Treasuries would have to be liquidated in a true panic just the same as any other asset. The US Treasury bond market would be not be able to function. The Fed would have to become the buyer of last resort, which would in turn devalue the dollar. There is not enough capital in the world to even cover the gross market value of derivative contracts outstanding. This type of event would force the liquidation of foreign exchange holdings (which are mainly dollar denominated). There would not be enough dollars in the world to cover such an event, as a result all existing dollars held by foreigners would have to be liquidated in order to cover even a portion of the debts owed. Hence there would be inflation, if not hyperinflation due to the capital flight out of the dollar ultimately.

Gordon_Gekko's picture

Very good stuff JM. Fascinating.

Frank Owen's picture

Nope, still feeling pretty damn nihilistic.

MsCreant's picture

The culture is laced with the problem of not letting folks fail. Failure is feedback. Failure is not grade inflation and unconditional acceptance and loans for everyone. We don't let failure happen and act like it is the end of the world when it does.

I am hopeful when I see someone talking about it head on like this (can't say I understood 100% of it, but I got the point).

Frank Owen's picture

Agreed. Thing is the longer failure is pushed back the worse it will be and even more people will be affected. All the shenanigans are basically a cover-up, short term benefits for everyone, long term benefits for few, and long term pain for most.

jm's picture

My main point is this:  The derivatives market is a sociological construction.

Its purpose is to manage risk/return profile AND I believe it also functions to absorb excess liquidity present in underlying assets. 

My main conjecture is this.  IF it is a liquidity absorption device that limits the physical delivery of liquidity (meaning inflation), then what happen in times of illiquidity?

Seems major problems happen, and ways to counteract the problems could lead to big problems themselves, because the proper application of these ways (QE and CE) is not well understood.

Make sense?    

Frank Owen's picture

The thing you were saying about the printing press being irrelevant because of all the other massive amounts of money in derivatives doesn't make sense to me (I'm a novice and really really hung over so take it easy), because those monies don't really exist... I mean they should all balance out because they are not really creating money (they're bets that usually don't pay out or if they do one side loses, the other gains) but when the fed/government pumps out money it is money that is spent, whereas total values for all the derivatives will never be spent into an economy.

However, what happens when counter-parties go bankrupt?

"IF it is a liquidity absorption device that limits the physical delivery of liquidity (meaning inflation), then what happens in times of illiquidity?"

SHTF, and possibly the dominoes start going down, or Johnny taxpayer gets the damn bill.

jm's picture

"Printing Press" is my shorthand for conventional monetary policy.  It doesn't work when the deflationary  impact is coming from huge dollar-value notional implosion.

What does appear to work is quantitiative/credit easing, a very non-conventional policy approach where US treasuries and agancy paper is purchased by the Federal Reserve.

You say the money pumped out by the Fed is spent.  It depend on what you mean by spent.  It could be spent on unwinding/rebuilding cratered hedge books or sidelined as excess reserves in anticipation of needed liquidity if, for example, underlying home values caused further notional contraction.

If this is the case, then the only impact the spending has is through collateral being traded around and leveraged among banks (rehypothecation).  It doesn't move to the underlying economy.  It stays tied up in the notional economy.

One other point.  Implosion or govt foreclosure screw-overs provide no debt jubilee, or reset that makes underwater homeowners magically owners. 

Worst case scenario:  if the whole thing implodes it will be deflationary, as huge notional dollar destruction wipes out current income (jobs) for just about eveybody because of mass default.  To arrest this the Fed would have to use monetary policy to pretty much nationalize the whole economy. 

Anonymous's picture

Yet how were those dollars created into existence? The Banks were already overcapitalized when lending out to consumers (inflation not counted by the Fed) via the use of derivatives. This of course led to consumers buying products from our trading partners which allowed them to accumulate massive foreign exchange reserves. Once the consumer mechanism is taken away our creditor nations will no longer be able to afford their foreign exchange holdings, they will be forced to liquidate their reserves in order to meet domestic demands. This would cause the eventual capital flight out of the dollar, hence inflation.

Gordon_Gekko's picture

Can't wait for this to start happening already. Let's rock 'n roll baby!


Dirtt's picture

"Oh Gordon. Remind me again why I love you."

And it's not twisted.  We didn't make this mess.

Hephasteus's picture

Most of us zero hedgers. We're a bunch of chiron in pisces pain bringers. Willing to shred these peoples cherished beliefs in sustainable lying and manipulation and false accounting.

We just seem immune to the silly song they sing to us.

Ruth's picture

Great exploration, although JM, Tyler, Marla and the team will tell you it comes at a price.  Keep thinking.  Kudos.

MsCreant's picture

Even though the wild corrections nature selects are the stuff of nightmares, this too shall pass.

There is no pilot to land the plane for us. Duck and cover. Let it fail.

Ruth's picture

I agree, I'll take my chances.  Let.It.Fail.

Crime of the Century's picture

I'm sympathetic, and obviously trying to protect my family beyond the damn "portfolio". But Jesse had an interesting contribution this morning. I don't endorse it, just found it worthwhile:

Tic tock's picture

If the unwinding does take place, overnight rates to cover, or the Discount window (QE) takes the slack. There is a clearing, and the books are drawn. One solution might be to simply state the day when central banks will lift rates to 6% and cut treasury issuance... the contracts have that long left to apply.. or have I got that completely wrong?

jm's picture

The issue is announcing in advance.  You could cause a run that makes things worse.

Anonymous's picture

Thank you for posting this analysis. I may be misunderstanding, but are you are saying that although QE is the only policy that can be effective against deflation, there is also a risk that QE will end up unintentionally causing deflation (due to derivatives that will blow up as a result of QE-triggered dollar devaluation)?

jm's picture

I think the best we can say is that QE and credit easing (CE) was successful in reinflating the notional market for now.  It was essential to do.  Conventional monetary policy wouldn't have made a snowball's difference in hell.

Case 1:  If the withdrawal of the current QE/CE policy causes more notional derivative contraction, then QE/CE will continue because the deflationary forces embedded in this contraction are huge.

Case 2:  If conditions are such that QE/CE is concurrent with notional contraction, then you have a world of problems.  QE must evolve to more radical CE that circumvents financial intermediation channels by directly purchasing CDOs, CLOs, and CBOs to keep people in jobs.  This involves the govt directly involving itself in the private economy and capital structure.

Case 3:  I'm not sure if this can happen.  Same as Case 2 above except that you have notional contraction and underlying expansion.  If QE continued in this context, it would probably mean severe inflation. 

How these working parts will interact is not understood well.   

Anonymous's picture

Of course inflation is not necessarily demand pull. Demand can go to zero and a nation can experience hyperinflation, which is not a demand driven event. A capital flight out of the US would cause hyperinflation. How would foreigners be able to meet liabilities in their own currencies? They would be forced to sell their dollar holdings.

Fix It Again Timmy's picture

We've been taken down the wrong path, crossed a bridge and have come to the edge of a cliff, anxiously looking back, we see that the bridge is collapsing - feel those beads of sweat yet?  Our rich guides, of course, know better than to cross the bridge.  How many times in human history does this have to reoccur before we wise up?  As Yogi Berra says, "This is like deja vu all over again."

Madcow's picture

here's a viable path forward - 

obama comes out and says that the RE financial markets got out of hand - and along with lots of other conflicts of interest, business fraud, regulatory abuse, wishful thinking and, fraud, crime, intellectual dishonesty and lots of basically delusional thinking - that that its time to settle up at the bar, share equitably in the pain, be done with it and move on.


you split the pain 1/3, 1/3, 1/3 - and provide a framework for solving the problem.  Some of this mess was caused by dumb-ass people (look in the mirror). Some of it was caused by idiot and in some cases conflicted and maybe even corrupt regulators and public officials (FNM, Moody's, FED/IRS), and some was caused by greedy rat bastard corporations and white collar criminals (the banks, big business). 

The only way forward will be one that shares the pain, blame, and burden of responsibility. Otherwise, business and commerce and civil society can't go on.

- banks forgive 33% of existing mortgage and other bank debt (say incurred between 1998-2008, during corporate-government-banker madness)

- people can write off 33% of their RE loss against ordinary income 

- the state shrinks by 33% and cleans house (crime, corruption, fraud, etc)

When a big deal goes horribly wrong, its not because of just one issue. The parties at fault here need to come together and acknowledge their roles in the crisis and responsibilities for the future.  Or they go to war with each money and give all the money to the lawyers. 




Anonymous's picture

We all shared equally on the upside too, right?



NOW that's egalitarian, and it's the only damn thing that's fair.

Did I get a $10 Million bonus for living and honest and thrifty life? (Or did I get one for committing mortgage and securities fraud.)

Let be honest here, sharing the PAIN, places a disproportionate burden on THOSE THAT DIDN'T benefit from this shit, and is a slap on the wrist to those that did.

I think you can do what the LAW SAYS, and resolve all this shit in recievership. What a NOVEL IDEA, FOLLOW THE FUCKING LAWs.

jm's picture

I sympathize with your point.  But the collective pain for you and I and everybody is so great that it just isn't feasible to let everything just go bankrupt.

Even if you own your home and have sufficient income to support yourself without work, if the world held too many homeless, jobless, hungry families bankruptcy laws and property rights would vaporize.  The rules would change for the worse for everyone.

No one appreciates just how close the US came to disintegration in the 30s depression.  The hunkering down and huddling came first. But FDR took a socialist agenda to ease unrest more than to solve the economic porblems.   Just letting trillions of derivatives net exposure burn off could make unemployment and unrest even worse.  

It would be prison rules at best, the law of the jackal at worst.  That you are money good would be a terrible position.  You would be a prime mark.  

It will be good for no one to let this thing go.  We need decisive ways to manage the problem and nobody--I mean nobody-- knows how to manage it.

SWRichmond's picture

We need decisive ways to manage the problem and nobody--I mean nobody-- knows how to manage it.

Which is precisely why we just let it settle; no one is smart enough to manage an economy made of 300 million souls, let alone one made of 6 Billion souls.  I've read Jesse's piece as well.  What he doesn't say is who he'd like to put in charge, who is smart enough to manage this, who is trustworthy.  He doesn't say, and you don't say, because there is no one.  The people who are in charge are doing what people in charge do: they're taking advantage, lining their own pockets by directly and overtly stealing from me at gunpoint, lying their asses off, and bragging about how fucking good they are at their jobs and how they deserve bonuses for performace.

Let's try something different.

jm's picture

What you recommend requires political coordination beyond democracy's demonstrated ability to accomplish. The free rider problem is too great.

You must also keep in mind that this is a global phenomenon.  The United States and mortgages in particular is only the tip of the iceberg.

There really is no solution other than muddling through as best we can, QEasing as the situation allows to avert extreme monetary contraction or to stimulate real econ growth.

Anonymous's picture

You are forgetting the distressed property values from such a write-off, yes?

That alone would completely wipe out the banks(not just the big 4 either).

Hephasteus's picture

I'm not slding into nihilism. I'm being shoved there by EVERY LYING STUPID GOVERNMENT on the planet. The author has discovered the fractional reserve scam. The M3 scam now with new stupid derivatives, and credit default stops added to expand it to M4 scam. There's a reason why M3 stastics stopped being given and a reason why ISDA works alone wihout any help from grownups.

SWRichmond's picture

Swaps aided the ongoing expansion by enabling leverage.  How?  By making it easy to lie about credit quality, swaps let the big shops "hedge" almost anything, and so they can lever up on damned near anything.  IRS are what keeps the fiat game going.  Risk?  Hedge it, and go for it, baby!

Hephasteus's picture

Yup. Fake M4 to go along with fake M3. Those losses should come from M3 but they are too big now. So they have to congress and get a bailout and then fractinally reserve it and 10x lever the bailout. The first thing they did with the bailout was take 100 billion and lever it 10x to a trillion.

Anonymous's picture

Wasn't it China who told its banks that they could go ahead and default on derivatives contracts and they would not be dragged to court for it? That would be the start of some sanity brought back into the system if it were to actually happen. Derivatives are the biggest con-game ever devised by Goldman and friends, and the sooner they are made illegal, the sooner policies can actually have some sort of predictable outcome, IMHO.

Greenhead's picture

JM, if I understand your last comment, you are saying we should continue to inflate, keep the current system in place and hope for a good outcome.  Sorry, without changing the system, we will continue down the same path with increasing volatility and drama.  I too have read history and understand that there was a strong socialisti movement in the 30's but there was a strong bent towards capitalism too.  People will always take the "free" stuff from the productive.

The Fed is the root cause of the inflation and money pyramid which is teetering/tottering along.  If we continue and just inflate our way beyond the current problem we set the stage for the next blow up, only greater.  How about we boldly look to dismantling the inflation pyramid and substitute what worked in the past: a gold standard?

jm's picture

Above all, I'm saying that in today's extreme situation OTC derivatives markets have so much more information content to them about the state of affairs that Fed reporting on monetary aggregates is irrelevant.

I see relative scarcity of some things, so there can be relative price inflation in some goods, and I see artificial support for prices in some other markets.  But I see no general increase in prices.  Rather I observe on average lower prices.  So inflation is not the word I would use.  I said "reflation" in the sense that QE has effectively counteracted severe deflation since March 2009.  The issue isn't inflation.  It is the other unclear aspects of what QE and CE could do that is problematic.

The thing that must change is either:

1) the impact of the derivative market on underlying assets.  This is absurd, as derivatives are designed to impat the underlying.


2) The size of notional derivatives relative to the underlying markets must be reduced to a non-catastrophe inducing size.  No one knows how to do this without causing the same type of volatility and damage that policymakers are trying to avoid in the first place.

I'm going to avoid the socialism/capitalism labels because the issue has a far more pragmatic logic.  At best, it is how to get or stay elected.  At its worst, it is how to keep society from unravelling.

This is bigger than the Fed.  What is needed probably won't happen.  We need honesty about the magnitude of the issues starting with a clear understanding of the risks inherent in shareholder equity.

How would a gold standard, either in the US or worldwide, solve things?

SWRichmond's picture

Perhaps thousands of trillions of dollars in notional exposures in the age of stored electronic money has made debt repudiation in underlying
liabilities impossible without setting off a chain reaction in the derivatives market.

Granted.  So does this mean you believe we have no choice but to keep the current system, that Hank was right?

Dollars can’t be so easily discarded when nearly every player in the financial system holds staggeringly interlocked debits and credits. Interlocked debits and credits means that nearly every institution that matters holds at least some vested interest in keeping the system alive. They win some and they lose some, but importantly the majority remains vested in the casino’s blackjack table.

So, again, keep the current "Blackjack Table" system or back to subsistence farming?  I agree completely, all the big money is completely vested in maintaining the current system, the very same system that will grind what's left of the middle class into mince meat over the next few decades.  So, basically, it's class warfare.

Interlocking denotes net (gains added and losses subtracted) as opposed to notional (all of it aggregated) exposures. These gains and losses from derivatives exposures are not concentrated in a handful of institutions.

Yes, they are.  The OCC quarterly derivative report says so.

There is just too much to lose by walking away.

When you say this, what you are saying is that the Western middle class has to willingly accept its coming destruction, but the monied interests will stay at the top of the heap, wealth concentration at the top will accellerate, and we have to accept that as the new reality, because the alternative is...the Western middle class gets destroyed.  Did I get that right?


jm's picture

The problem is global.  You and I do not matter.  Political vantage point is irrelevant.  This is not an issue of a fresh start.

The issue is you accept the injustices of keeping the system going for the collective good, or you accept system failure, which in the end will be worse for you and everyone else.

In the former case, the middle class loses ground at the expense of people with connections.  This is politics.  Nothing new here.  In the latter case, the middle class loses much more.  The current poeple in charge choose the former.  Accept it, trade it, profit from it.  Protect the ones you love.

Blame whoever you wish, but accept the situation as it is.  And understand that the worst case is so bad that it makes unjust redistribution policies look good in comparison anyway.

Either the system is maintained at a functioning level so that change to it can be made in a manageable incremental fashion, or you choose no system.  This is anarchy.  Everybody loses. 


In some of this your facts are unclear.  No offense meant.

Nearly 100% of corporations, goverments, and banks worldwide use derivatives to manage their risk/reward profile.  This is not an issue of a few institutions holding even the majority of positions.  Everyone has skin in the game.  These exposures net out to only a fraction of notional exposure.   

Re: OCC I'm not sure to what you refer specifically. 

I do know that OCC CDS report is national in scope and should not be construed as illustrative of the entire OTC market.