February 14th, 2009

I know alot of people have trouble understanding the derivatives market, and that's no big surprise since the bankers themselves are mostly clueless as well - in fact they usually don't even know what it is they're holding. How many times haven't we heard the same thing lately - some bank that has been untouched by "credit losses", declares itself completely free of these silly papers that all the other stupid banks are holding, and then a few months later they turn up millions (or billions) of so-called credit losses. Well, let's look at the big picture to try to get some clarity:

First there was the repeal of the Glass-Steagall Act of 1933 in the US, along with plenty of deregulation in the the rest of the world in the late 90's. Basically the repeal of the above mentioned act and deregulation in the world at large, was nothing more than to allow credit institutions to also be directly involved in investments. The problem here is that an institution that is able to create credit and also act as an investment company has the ability to create any kind of leverage it wants through derivatives or re-packaging of interest-rate yielding papers. These companies can use credit with investment vehicles in any way they want, and that's the reason that this regulation was created in the first place.
The derivatives market has completely exploded since this deregulation. In 1999 the derivatives market stood at about 50 trillion USD, today it stands at almost 700 trillion! The world economy is only worth something like 50 trillion today, soon to be less of course. This is simply telling you that the deregulation has created a completely out of control leverage in the system... the losses have only just begun, they keep coming in and there doesn't seem to be any end in sight.
The main problem here is that most derivatives that have been created rely on stability in the system, or a kind of financial status quo. We all know that basically there are no status quos in the financial industry, and so these financial instruments (if you will) are tuned into a narrow economic scenario ... and now that yields and values are jumping up and down - these derivatives become frozen or worthless.

Ok, that's the big picture, but how can we know how much of the derivatives market that is actually bad? Well, sadly I don't think that's possible but the size of the derivatives market is telling us that this must be alot of false value. You can't create 650 trillion of value in 10 years by manipulating financial papers and credit, something is definitely wrong here. This is mostly leverage... that is, fake prosperity, just like the "prosperity" you get by loaning money to buy crap you don't really need.

I don't know if that clarified anything to you? Then there's the problem of getting all the details right, maybe I'll try to delve into the different specimens of the derivatives waste-land some day when I have too much free time on my hands... oh, and here's a complimentary music video: