$707,568,901,000,000: How (And Why) Banks Increased Total Outstanding Derivatives By A Record $107 Trillion In 6 Months
- AIG
- American International Group
- Counterparties
- Gross Domestic Product
- Mean Reversion
- MF Global
- notional value
- OTC
- OTC Derivatives
- Volatility
While everyone was focused on the impending European collapse, the latest soon to be refuted rumors of a quick fix from the Welt am Sonntag notwithstanding, the Bank of International Settlements reported a number that quietly slipped through the cracks of the broader media. Which is paradoxical because it is the biggest everreported in the financial world: the number in question is $707,568,901,000,000 and represents the latest total amount of all notional Over The Counter (read unregulated) outstanding derivatives reported by the world's financial institutions to the BIS for its semi-annual OTC derivatives report titled "OTC derivatives market activity in the first half of 2011." Indicatively, global GDP is about $63 trillion if one can trust any numbers released by modern governments. Said otherwise, for the six month period ended June 30, 2011, the total number of outstanding derivatives surged past the previous all time high of $673 trillion from June 2008, and is now firmly in 7-handle territory: the synthetic credit bubble has now been blown to a new all time high. Another way of looking at the data is that one of the key contributors to global growth and prosperity in the past 10 years was an increase in total derivatives from just under $100 trillion to $708 trillion in exactly one decade. And soon we have to pay the mean reversion price.
What is probably just as disturbing is that in the first 6 months of 2011, the total outstanding notional of all derivatives rose from $601 trillion at December 31, 2010 to $708 trillion at June 30, 2011. A $107 trillion increase in notional in half a year.Needless to say this is the biggest increase in history. So why did the notional increase by such an incomprehensible amount? Simple: based on some widely accepted (and very much wrong) definitions of gross market value (not to be confused with gross notional), the value of outstanding derivatives actually declined in the first half of the year from $21.3 trillion to $19.5 trillion (a number still 33% greater than US GDP). Which means that in order to satisfy what likely threatened to become a self-feeding margin call as the (previously) $600 trillion derivatives market collapsed on itself, banks had to sell more, more, more derivatives in order to collect recurring and/or upfront premia and to pad their books with GAAP-endorsed delusions of future derivative based cash flows. Because derivatives in addition to a core source of trading desk P&L courtesy of wide bid/ask spreads (there is a reason banks want to keep them OTC and thus off standardization and margin-destroying exchanges) are also terrific annuities for the status quo. Just ask Buffett why he sold a multi-billion index put on the US stock market. The answer is simple - if he ever has to make good on it, it is too late.
Which brings us to the the chart showing total outstanding notional derivatives by 6 month period below. The shaded area is what that the BIS, the bank regulators, and the OCC urgently hope that the general public promptly forgets about and brushes under the carpet.
Try not to laugh. Or cry. Or gloss over, because when it comes to visualizing $708 trillion most really are incapable of doing so.
Total outstanding gross market value by 6 month period:
There is much more than can be said on this topic, and has to be said, because an increase of that magnitude is simply impossible to perceive without alarm bells going off everywhere, especially when one considers the pervasive deleveraging occurring at every sector but the government. All else equal, this move may well explain the massive surge in bank profitability in the first half of the year. It also means that with banks suffering massive losses, and rumors of bank runs and collateral calls, not to mention the aftermath of the MF Global insolvency, the world financial syndicate will have no choice but to increase gross notional even more, even as the market value continues to get ever lower, thus sparking the risk of the mother of all margin calls: a veritable credit fission reaction.
But no matter what: the important thing to remember is that "they are all hedged" - or so they say, a claim we made a completely mockery of a few weeks back. So ex-sarcasm, the now parabolic increase in derivatives means that when the bilateral netting chain is once again broken, and it will be (because AIG was not a one off event), there will simply be trillions more in derivatives that no longer generate a booked cash flow stream for the remaining counterparty, until at the very end, the whole inverted credit0money pyramid collapses in on itself.
And for those wondering what the distinction is between notional and
Notional amounts outstanding: Nominal or notional amounts outstanding are defined as the gross nominal or notional value of all deals concluded and not yet settled on the reporting date. For contracts with variable nominal or notional principal amounts, the basis for reporting is the nominal or notional principal amounts at the time of reporting.Nominal or notional amounts outstanding provide a measure of market size and a reference from which contractual payments are determined in derivatives markets. However, such amounts are generally not those truly at risk. The amounts at risk in derivatives contracts are a function of the price level and/or volatility of the financial reference index used in the determination of contract payments, the duration and liquidity of contracts, and the creditworthiness of counterparties. They are also a function of whether an exchange of notional principal takes place between counterparties. Gross market values provide a more accurate measure of the scale of financial risk transfer taking place in derivatives markets.
Well, no. It is logical that the BIS will advise everyone to ignore the bigger number and focus on the small one: just like everyone was told to ignore gross exposure and focus on net... until Jefferies had to dump all of its gross PIIGS exposure or stare bankruptcy in the face; so no - the correct thing to say is "gross market values provide a more accurate measure of the scale of financial risk transfer" if one assumes there is no counterparty risk. Because once the whole bilateral netting chain is broken, net becomes gross. And gross market value becomes total notional outstanding. And, to quote Hudson, it's game over.
As for the largely irrelevant gross market value, which is only relevant in as much as it will be the catalyst which will precipitate margin calls on the underlying notionals, all $700+ trillion of them:
Gross positive and negative market values: Gross market values are defined as the sums of the absolute values of all open contracts with either positive or negative replacement values evaluated at market prices prevailing on the reporting date. Thus, the gross positive market value of a dealer’s outstanding contracts is the sum of the replacement values of all contracts that are in a current gain position to the reporter at current market prices (and therefore, if they were settled immediately, would represent claims on counterparties). The gross negative market value is the sum of the values of all contracts that have a negative value on the reporting date (ie those that are in a current loss position and therefore, if they were settled immediately, would represent liabilities of the dealer to its counterparties).The term “gross” indicates that contracts with positive and negative replacement values with the same counterparty are not netted. Nor are the sums of positive and negative contract values within a market risk category such as foreign exchange contracts, interest rate contracts, equities and commodities set off against one another.As stated above, gross market values supply information about the potential scale of market risk in derivatives transactions. Furthermore, gross market value at current market prices provides a measure of economic significance that is readily comparable across markets and products.
And here again, what they ignore to add is that the measure of economic significance is only relevant in as much as the world's banks don't begin a Lehman-MF Global tango of mutual margin call annihilation. In that case, no. They are not measures of anything except for what some banks plug into some models to spit out a favorable EPS treatment at the end of the quarter.
Expect to see gross market value declines persisting even as the now parabolic increase in total notional persists. At this rate we would not be surprised to see one quadrillion in OTC derivatives by the middle of next year.
And, once again for those confused, the fact that notional had to increase so epically as market value tumbled most likely means that the global derivative pyramid scheme (no pun intended) is almost over.
Source: OTC derivatives market activity in the first half of 2011 and Semiannual OTC derivatives statistics at end-June 2011
The Fiat Money End Game
Jim Sinclair has a slogan "QE to infinity." That's "Quantitative Easing to infinity." That's inflation to infinity. That's the case for gold and silver in a nutshell. I think he's right. I'd like to explain why I think he's right, but in a roundabout way that gives me a chance to express some of my thoughts on the financial crisis we are observing.
The last time we had a really serious depression, the public didn't start massively flying into quality for quite some time. Currency held by the public was stable all the way to October 1930. At that point, there was an increase in Midwestern bank failures. And the Bank of United States failed. The New York banking department tried mightily to save it and merge it, but the Clearing House banks doomed the deal. They didn't trust the bank's real estate holdings. These events triggered bank runs, which meant currency withdrawals. That created deflation in money supply, with its depressing economic effects. This is because currency is part of the money base and enters the money multiplier and multiple deposit expansion. Starting in October of 1930, the curve of currency held by the public suddenly started to rise. That accelerated the drop in money supply that was already occurring. In the pre-Fed days, the banks would have suspended payments en masse and stopped the resulting chain of bank failures. Since the Fed was around, they were more complacent. The Fed, however, didn't stop the chain reaction. The banking system fell apart, which means bank closures became endemic into 1933.
Compare September 2008. The authorities could not save Lehman or maybe did not. The Fed says they tried (see here), which makes the Lehman event very much like the Bank of United States event. This triggered a stock market panic and a flight to currency and safety much like October of 1930 and in other panics. We had an old-fashioned panic. People even shifted out of money market funds. Even with insured deposits, people still flew to safety all across the board. Picking and choosing who will fail and who won't fail is a mish-mash policy. The captains of the fiat money-big debt-big government-fractional-reserve system, who want to keep their jobs and see the system survive, either have to save it in the usual ways, inflation and taxpayer-funded bailouts, or else end the system altogether, which, of course, ain't goin' to happen if they can help it. The logic of the system has only one direction: rescues, more inflation, more bailouts, and the invention of new kinds of credits and currencies. The call for worldwide currency baskets is a step toward the ultimate bubble-making machine, a world fiat currency.
This time around, unlike October of 1930, the Fed counteracted the panic with massive inflation, so now we have a new scenario that differs from 1931-1933. Bernanke studied his Friedman & Schwartz. He knew how to stop a chain of failures. But, funny thing, the broader money aggregates are still moribund and bank failures are still occurring. Stopping the bank runs doesn't solve the insolvency problems of banks with illiquid assets whose values are so much lower than their liabilities (by 30-50% it appears.) Inflation is not a cure all.
The Emergency Banking Act of 1933 included a host of inflation measures. They included purchase of preferred stock of banks by the Reconstruction Finance Agency. This reminds one of the TARP program in 2008. Inflation is built into the fractional-reserve system as a rescue device, and so is the taxpayer-funded bailout. Everything to save a flawed system rather than fix it properly, for it cannot be fixed without getting rid of the accompanying big government.
If the EU lets Greece fail, it's like letting Lehman fail in 2008 or the Bank of United States fail in 1930. It sends out a signal. The dithering of the EU may already have sent out such a signal. They may already have altered expectations and behavior. The rescue package may lack believability for the moment. It may not have sunk in quite yet.
The rescue team, which consists of the stronger countries and the IMF, are damned if they do and damned if they don't. Instead of banks being insolvent with runs occurring on them as in the 1930s and 2008, we have whole countries being bankrupt, but their paper is held by banks in France and elsewhere, so there is a contagion thing to worry about. If the EU lets default happen, there is a run against all the bonds of all the weaker countries. Their yields rise, and they have to default too, and then that weakens a host of banks and others who hold the paper, and then they demand to be bailed out. If instead they rescue Greece and others, then the rescuing governments have to issue more debt, or else the IMF does too, or else the ECB gets into the act too, and this weakens the stronger countries and drives down the euro. So, either way, there are problems. It appears that the rescue option has been invoked, although tardily and reluctantly. This means that the governments are rescuing the bondholding banks and whoever else holds the Greek paper. That's the bailout here. This is preferable to the rescuers as compared with an outright default which then starts a contagion via the bond yields rising sharply which induces country bankruptcies and defaults.
The deflation at work here has already happened. It's that the values of loans held by banks have declined a great deal, and are below the values of their liabilities. The fractional-reserve banking system doesn't work today and it didn't work in the 1930s and at other times when depositors demanded cash or gold and the banks couldn't liquidate assets or gain access to cash flows to pay them. Even with the Fed turning bank loans into cash, the FDIC has to keep closing banks every week because they are way below any regulatory standards of operation.
Central bank inflation is necessary in this kind of a fiat money-fractional-reserve banking system to prevent the whole system from collapsing due to flight to safety. More money is like a blood transfusion to a patient who is losing blood. But this doesn't resolve the insolvency in the system. The regulators have what is called "forbearance." They ignore the insolvency and do not enforce mark to market. They then close the worst banks and hope that the rest make enough money to rebuild their liquidity. Gradually, as the banks use reserves that cost them 0% to invest in U.S. Treasuries at 3.5%, they make some money. The Treasury market stays firm for this reason. The Fed keeps rates low for this reason. The banks build up potential liquidity by holding treasuries. In a few years, they sell these and start making more loans, and price inflation starts appearing. Meanwhile, the economy limps along. This is the muddle-through scenario.
The boom-bust cycle had to end with a deflationary bust. The central bankers eventually prick bubbles to stop inflation, because if inflation takes hold and interest rates rise, the government finances are doomed. And so, the latest boom-bust cycle did come to an end. Greenspan, toward the end of his reign, and Bernanke caused this bust by restricting money growth. Most people don't know this. One has only to look at money growth to see this. Look at the very low rates of growth of money between 2005 and 2008. There was a deceleration.
The Fed was fighting inflation from 2005 into 2008. However, a money and banking system and an economic system built on fiat money inflation cannot handle that. It's geared to inflation. Deflation sends the economy into a tailspin. It shocks the banking system. In this case, the shock was severe. Bernanke didn't expect that. He thought it was just another mild post-World War II style recession.
Bernanke was forced into inflating again. Apart from the Lehman event/misstep or maybe because of it, he did.
His only somewhat strange behavior was to bail out Fannie Mae with $1.25 trillion of MBS purchases. Why did he do that? My guess is he thought that would stimulate the housing sector and revive the economy. Probably that's the reason. I say that because in the past, the Fed always created housing (and auto) revivals whenever it inflated out of recessions. That was like clockwork. So the Fed probably figured that since the Fed Funds rate was already 0%, they had to buy these mortgage securities directly in order to revive the economy.
Greece is merely one instance of the basic malady of the whole fiat money system: DEBT. From the moment that money can be created without the constraint of gold, from 1971 onwards, that's when the DEBT curve lifts off and just goes parabolic. The fractional-reserve banking system just multiplies the DEBT incredibly. Here is an example, showing the federal government's debt.
Why do the borrowers borrow so much? The banks are like dope pushers, but why are there so many addicts? Why do people and governments go into debt so deeply?
Why do people borrow so much? They pretty much do what they're told to do. They are taught to borrow and encouraged to borrow. It's made easy. They get credit cards in the mail. They want to consume more now.
Inflation changes the prevailing attitudes. People become more consumerist at the margin. Keep up with the Joneses. Buy something that you imagine is crucial to your life and happiness, which, as it turns out, isn't. In the housing case, there were all sorts of teaser rates and inducements, plus the speculative hope of making a profit. The banks were mailing out dozens of credit cards. These offers are still hitting selected mail boxes. So people fell for it. This continued a trend of installment buying that started in the 1920s.
The government's behavior is understandable. Voters don't really control legislators, and they get all sorts of political benefits by borrowing and spending. That's their life. Ordinary folks hardly ever worry about government debt. It's never paid off. Everyone thinks that it's someone else's debts. Who worries apart from some kooks? So getting rid of the gold constraint has unleashed a huge government debt bubble. Now, remember, when this debt gets too large, the governments either (a) default outright, or (b) the stronger ones rescue the weaker -- for awhile. But here's the catch. Eventually, they all have to default, every last government with excessive debt, which means that the yields will have to go up, as they have in Greece. That's going to trigger a REVOLUTION.
Faced with handling mountainous debt levels, the governments either walk away from all bondholders everywhere, this is feasible, or else they inflate and pay them off in nominal terms, or some combination of these two paths. It's these two options that we need to think through as to their effects, in order to decide which one they are likely to choose. So far, the big guys, the U.S. and Britain and Japan and probably China, have gone for inflating. They're trying not to default outright. Why? The outright default basically ends the government's ability to pay pensioners, poor people, and keep government spending up. So it revolutionizes the government itself. It ends government as we know it for awhile, and as far as politicians are concerned who have only one life to live, that's too long. The only reason that the smaller countries who default (there are many, many such defaults) have survived their defaults and kept going is that the bigger countries refinance them, through their banks and through the IMF and World Bank. But there's no one who can finance the U.S. if it defaults!!! So it won't default, because of the revolutionary results of shrinking the government drastically. Therefore, of the two options, it will choose inflation. But how can it inflate without causing the government's interest costs to soar, which will bring down the government and terminate the system? It can't. And so we are back to default of some kind. The default or default-cum-inflation will have to be suppressed and/or controlled and/or moved to a higher level through a new lender of last resort. Someone will dream up some tricks that will wreck the wealth of the bag holders. It's only a question of who they are going to be. Example: What the government can do is issue a new dollar that's worth two of the old dollars, by fiat. If it owes $1,000, it pays off with $500 of the new dollars. But, again by fiat, it makes everyone else accept the new dollars on par with the old dollars. In this way, the government defaults on its loans to all its creditors, who get half what they expected. The government debt is thereby cut in half. Of course, lenders will now want twice the interest rate. So the government, by fiat, makes banks or savers or both, take its bonds at the old interest rate. It's simple. Power can attempt anything in order to preserve itself.
Quantitative easing to infinity is the slogan of James Sinclair, and he is right. The fiat money-big debt-big government system cannot go on without QE to infinity. That's what the system is all about. It has to run its course on this racetrack. It's not about to jump the fence and run on some other course. But before it reaches the finish line, we are liable to see some changes in the way the race is run.
Posts
No comments:
Post a Comment