What is a derivative? it is a time bomb and an accident waiting to happen, a nuclear financial bomb which will destroy the financial system.
A financial instrument whose value is derived from an underlying asset. For example, the US paper dollar is a derivative. Its value was once derived from the gold, or silver (then lawful money) held at the US Treasury and/or gold and silver coins the US government had minted and placed in circulation. Decades ago, one could take a paper dollar to any bank and demand a coin of precious metal in exchange.
|Most Paper Currencies used to be derivatives from Treasury bonds.|
The notional value of the derivative market is roughly $1.4 QUADRILLION and 144 trillion Dollars. Derivatives are "derived" from underlying assets (homes, debt, etc). A lot of smart people have tried to explain what these things are, but miss the forest for the trees. A derivative is NOT an asset. It's, in reality, nothing, just an imaginary security of no value that banks trade as a kind of "gentleman's bet" on the value of future risk or securities.
Let's say you and I want to bet on whether our neighbor Joe will default on his mortgage. Is the bet an asset? Does it have any real value? Both counts register a definite "no." That's the equivalent of a derivative.
It is total and complete lunacy to claim these items are anything more than fiction (perpetuated by another fiction: that Wall Street is able to value these things or price them accurately). But thanks to Wall Street's lobbying power, they've become the centerpiece of the financial markets.
I realize that number sounds like something out of Loony tunes, so I'll try to put it into perspective.
$1.4 Quadrillion is roughly:
40 TIMES THE WORLD'S STOCK MARKET.
10 TIMES the value of EVERY STOCK AND EVERY BOND ON THE PLANET.
23 TIMES WORLD GDP.
Keep in mind the notional value of the total amount of OTC derivatives outstanding reported by the BIS was reduced by 50% about two years ago when the BIS changed their computer basis for valuation by considering all derivatives as going to closure as value to maturity. The actual total value of all outstanding OTC derivatives that was then carried for two reporting periods on the books of the BIS is one quadrillion, one hundred and forty four trillion US dollars notional value. This is fact. The $700 trillion US dollars that is quoted now has not changed since it was manufactured by a change in the method of accounting for notional value by reducing the number by approximately 50%.
“After an increase of only 3% in the second half of 2010, total notional amounts outstanding of over-the-counter (OTC) derivatives rose by 18% in the first half of 2011, reaching $708 trillion by the end of June 2011. Notional amounts outstanding of credit default swaps (CDS) grew by 8%, while outstanding equity-linked contracts went up by 21%.”-The Bank for International Settlements, Nov. 2011
As early as 1998, soon to be chairperson of the Commodity Futures Trading Commission (CFTC), Brooksley Born, approached Alan Greenspan, Bob Rubin, and Larry Summers (the three heads of economic policy) about derivatives. She said she thought derivatives should be reined in and regulated because they were getting too out of control. The response from Greenspan and company was that if she pushed for regulation that the market would implode.
The most liberal estimate of the bailout costs ($24 trillion) is equal to less than 2% of the derivatives market and very dangerous is that the vast bulk of them (84%) are based on interest rates: this is why 'they' will sell their mother and father to keep the interest rates LOW and why by doing this 'they' will create a hyperinflation which in turn will push up the interest rates and destroy the financial system.
In 2008 the Credit Default Swap (CDS) market (which is only 1/10th the size of the interest rate-based derivative market) nearly destroyed the entire financial system. One can only imagine what would happen if the interest rate-based derivative market (which is ten times as large) suffered a similar Crisis.
The vast majority of derivative exposure involves only a small handful of institutions: JP Morgan, Goldman Sachs, Bank of America, Citibank, and HSBC. JP Morgan is holding double the amount Goldman and Bank of America are holding. [An intelligent saver will for obvious reasons stay away from these financial institutions.]. If 4% of derivatives are "at risk" and 10% of those bets go bad, you've wiped out ALL OF THESE BANKS' EQUITY and they go to ZERO.
We have unfortunately not seen the end of the cumulative credit losses.
OTC derivative problems are not going away. Rather than being under control, the problems have just started!
The biggest danger yet to come are $ 62 trillion Credit Swaps....!
$ 444 trillion interest rate derivatives....
The BIS (Bank of International Settlements) announced the biggest gain in derivatives ever since 1930. The total is approximately $ 1,144 Quadrillion. Notional value becomes real value when either counter party to the OTC derivative goes bankrupt. The OTC derivative house cannot be allowed to go broke. This means that whatever funds are required to rescue failing international investment banks, banks and financial entities will be provided. Bearing in mind that monetary inflation precedes price inflation, there is little doubt we are about to see Hyperinflation...click here for more
After the crash of 1920, the legislators issued laws (Glass Steagall-act) forbidding banks to speculate on the Stock and Money markets. Ever since they have found a way around this. As a result, what we see today has become a lot WORSE.
Compared to the Credit Swaps, the Sub-prime looks like a walk in the park!