Posted by
Mike Dixon on Saturday, October 04, 2008 6:40:56 AM
I was recently chatting with a brilliant ex-banker friend who remarked how insignificant the risk of default on troubled mortgages is compared to the potential impact of the tsunami of complex financial instruments known as derivative securities. Here are some eye opening facts about this hidden market, a market that is poorly understood, even by its practitioners. Further, it is rather difficult to regulate a complex industry that not only dwarfs our national economy, but that has grown at a faster rate than even the most spectacularly successful companies we have ever seen.
| United States GDP (purchasing power parity): |
$13.78 trillion (2007 est.) |
| Notional Amount of Outstanding Credit Derivatives, ISDA Mid-Year Survey 2008, International Swap Dealers Association |
$54.6 trillion |
| Notional Amount of Outstanding Interest Rate Derivatives, Mid-Year 2008, ibid |
$464.7 trillion |
| Notional Amount of Outstanding Equity Derivatives, ibid |
$11.9 trillion |
| Total Notional Amounts, ibid |
$531.2 trillion |
| Gross Mark to Market Value of all Notional Amounts (* This is the gross credit exposure) |
2.4% of notional amounts = $12.7 trillion, estimated value |
| Net Credit Exposure, net of collateral |
0.3% if notional amounts = $2.7 trillion, estimated value |
Here's the challenge. There are complex and poorly understood valuation models used to estimate these risks. If the Nobel laureates that ran Long Term Capital Management and the various failed Wall Street CEOs who inadequately assessed the risks of their mortgage derivative portfolios could not properly price or estimate these derivative risks, how do we expect government regulators to do any better? Simply put, if the pros can not, how can the schmoes do any better?
I am not a practitioner, but allow me to explain what a derivative is and the significance to our economy. The term literally defines a financial instrument deriving its value from the intrinsic value of some other underlying securities or set of conditions affecting these underlying securities. For example, derivatives may be created through a contractual obligation to issue debt in the future or an interest rate contract to synthetically convert your interest rate from fixed to variable. And yes, the lowly mortgage backed security and collateralized mortgage obligation, themselves securities arising from the securitization of underlying pools of mortgages, are also financial derivatives. However, what is poorly understood by the general market is the volume and rapid growth of the derivative market.
From 1987 to 2007, total interest rate and currency derivatives had a notional value that grew from $866 billion to $383 trillion, at a compounded annual growth rate over 20 years of 36%. I defy you to find a market that has grown that fast and for that prolonged a period of time. To put in contrast, the market size of the semiconductor industry is $270 billion. The global electronics industry is
$1.7 trillion. Microsoft, arguably the single most successful company in recent times, grew from sales of $140 million in 1985 to $60 billion in 2007, for a 23 year compounded annual growth rate of 30%. Yes, the notional amount of outstanding derivatives is 8,900 times the size of Microsoft and growing at a faster rate than Microsoft ever has!
But are these esoteric securities with minimal impact for Wall Street? Let's examine the not-so distant history of the demise of a firm called Long-Term Capital Management. Started by the distinguished theoreticians and Nobel laureates who created the stock option pricing model, an innovation that ushered the era of financial engineering, Long-Term Capital Management was a Connecticut hedge fund employing sophisticated pricing models to manage its highly leveraged investments and complex bets on the market place. Turmoil in the financial markets in 1997 placed unusual and unaccounted for stress on these financial models, leading to massive losses. Further, the positions were so highly leveraged that Long-Term Capital Management received a Federal bail out. According to Wikipaedia, "At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off balance sheet derivative positions with a notional value of approximately $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps." Poor market bets led to losses in their equity position, triggering a decoupling of certain other key investment strategies and ultimately the prospect of significant losses. Further, their significant off-balance sheet derivative positions threatened to impact the broader markets as it was feared that other creditors would similarly be pressured and fail to meet their obligations. Ultimately, the Federal Reserve Bank of New York orchestrated a $4 billion bailout which successfully averted a panic in the financial markets and enabled the private sector providers of the bailout funds a small profit over time as the fund assets were liquidated.
Joe Biden is wrong in stating that "past is prologue." The past is in no way an indicator of the future. The world is rapidly unfolding. No two times are exactly alike - there are myriad factors all impacting each other in myriad ways at any one given time. So, pardon me Senator Biden, but the past is a false hope and illusion. As Nassim Taleb has explained so well in his books on statistics and the trouble with extrapolating based on the past, 500 successful tries does not indicate a successful model. It may in fact mask that a massive failure will occur on the 501st trial. I don't know about you, but I would surely like to understand how these $531.2 trillion in notional debt really only amount to a net debt of $2.67 trillion. Under what conditions does that model fail and if it does fail, what will the impact be? And what about the mark to market gross debt that approximates the entire US GDP? I agree with my friend - the derivative market is the more pressing problem. Populist sentiment aside, the mortgage market is the tip of the iceberg. Wall Street is not necessarily crooked, but definitely too clever by half.