Derivatives – The $600 Trillion Time Bomb Set to Explode

by Keith Fitz-Gerald | October 14, 2011 11:05 am

pocket watch in hand 185 Derivatives   The $600 Trillion Time Bomb Set to Explode[1]Do you want to know the real reason banks aren’t lending and the PIIGS have control of the barnyard in Europe?

It’s because risk in the $600 trillion derivatives market isn’t evening out. To the contrary, it’s growing increasingly concentrated among a select few banks, especially here in the United States.

In 2009, five banks held 80% of derivatives in America. Now, just four banks hold a staggering 95.9% of U.S. derivatives, according to a recent report from the Office of the Currency Comptroller[2].

The four banks in question are JPMorgan Chase (NYSE:JPM[3]), Citigroup (NYSE:C[4]), Bank of America (NYSE:BAC[5]) and Goldman Sachs (NYSE:GS[6]).

Derivatives played a crucial role in bringing down the global economy, so you would think that the world’s top policymakers would have reined these things in by now — but they haven’t.

Instead of attacking the problem, regulators have let it spiral out of control, and the result is a $600 trillion time bomb called the derivatives market.

Think I’m exaggerating?

The notional value of the world’s derivatives is actually estimated at over $600 trillion. Notional value, of course, is the total value of a leveraged position’s assets. This distinction is necessary because, when you’re talking about leveraged assets like options and derivatives, a little bit of money can control a disproportionately large position that may be as much as 5, 10, 30 or, in extreme cases, 100 times greater than investments that could only be funded in cash instruments.

The world’s gross domestic product (GDP) is only about $65 trillion, or roughly 10.83% of the worldwide value of the global derivatives market, according to The Economist. So there is literally not enough money on the planet to backstop the banks trading these things if they run into trouble.

Compounding the problem is the fact that nobody even knows if the $600 trillion figure is accurate, because specialized derivatives vehicles like the credit default swaps that are now roiling Europe remain largely unregulated and unaccounted for.

Tick…Tick…Tick

To be fair, the Bank for International Settlements[7] (BIS) estimated the net notional value of uncollateralized derivatives risks is between $2 trillion and $8 trillion, which is still a staggering amount of money and well beyond the billions being talked about in Europe.

Imagine the fallout from a $600 trillion explosion if several banks went down at once. It would eclipse the collapse of Lehman Brothers[8] in no uncertain terms.

A governmental default would panic already-anxious investors, causing a run on several major European banks in an effort to recover their deposits. That would, in turn, cause several banks to literally run out of money and declare bankruptcy.

Short-term borrowing costs would skyrocket and liquidity would evaporate. That would cause a ricochet across the Atlantic as the institutions themselves then panic and try to recover their own capital by withdrawing liquidity by any means possible.

And that’s why banks are hoarding cash instead of lending it.

The major banks know there is no way they can collateralize the potential daisy chain failure that Greece represents, so they’re doing everything they can to stockpile cash and keep their trading under wraps and away from public scrutiny.

What really scares me though, is that the banks think this is an acceptable risk because the odds of a default are allegedly smaller than 1 in 10,000.

But haven’t we heard that before?

Although American banks have limited their exposure to Greece, they have loaned hundreds of billions of dollars to European banks and European governments that may not be capable of paying them back.

According to the Bank of International Settlements, U.S. banks have loaned only $60.5 billion to banks in Greece, Ireland, Portugal, Spain and Italy — the countries most at risk of default. But they’ve lent $275.8 billion to French and German banks, and undoubtedly bet trillions on the same debt.

Key Takeaways

There are three key takeaways here:

It seems to me the world’s central bankers and politicians should be less concerned with stimulating “demand” and more concerned with fixing derivatives before this $600 trillion time bomb goes off.

Endnotes:
  1. [Image]: http://investorplace.com/wp-content/uploads/2011/10/pocket_watch_in_hand_185.jpg
  2. a recent report from the Office of the Currency Comptroller: http://www.occ.gov/topics/capital-markets/financial-markets/trading/derivatives/dq211.pdf
  3. JPM: http://studio-5.financialcontent.com/investplace/quote?Symbol=JPM
  4. C: http://studio-5.financialcontent.com/investplace/quote?Symbol=C
  5. BAC: http://studio-5.financialcontent.com/investplace/quote?Symbol=BAC
  6. GS: http://studio-5.financialcontent.com/investplace/quote?Symbol=GS
  7. Bank for International Settlements: http://www.bis.org/
  8. Lehman Brothers: http://moneymorning.com/tag/lehman-brothers/
  9. BNPQY: http://studio-5.financialcontent.com/investplace/quote?Symbol=BNPQY
  10. NBG: http://studio-5.financialcontent.com/investplace/quote?Symbol=NBG

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