The Bank of International Settlements, which seems to be the only institution that tracks the derivatives market, has recently reported that global outstanding derivatives have reached 1.14 quadrillion dollars: $548 Trillion in listed credit derivatives plus $596 trillion in notional/OTC derivatives.

Yes, that is Quadrillion. One and 15 zeroes!

A Gold-Eagle article sheds some light on the mess:

Derivatives, as you may know, are essentially unregulated, high-risk credit bets. Unlike the earnest farmer who might employ a futures contract to hedge the price of the beans he’s worked so hard to grow, many of today’s institutions use futures, forwards, options, swaps, swaptions, caps, collars and floors—any kind of leverage device they can cook up—to bet the hell out of virtually anything.

What drives derivatives, at their very roots (if you can somehow get back that far), are base assets that get leveraged to a demented degree. Martin Mayer writing for the Brookings Institute, said, “the receiver of the payments on these loans or securities has bought the securities for the duration of the swap on 95% margin, even though the law says nobody can buy securities without putting up half the price.”

It takes one thousand Trillion to make a Quadrillion. And despite calls for more regulation from such mandarins of the finance world as George Soros, it seems that the value (and consequently the risk) of this ‘derivatives time-bomb’ is exponentially increasing. As Bershire Hathaway’s 2002 Annual Report stated:

“Charlie and I are of one mind in how we feel about derivatives and the trading activities that go with them: We view them as time bombs, both for the parties that deal in them and the economic system,”

That time bomb almost went off in March 2008 with the Bear Stearns debacle. The title of an article by noted analyst Ambrose Evans-Prichard—“Fed’s rescue halted a derivatives Chernobyl”—says virtually everything you need to know.

According to the article, Bear Stearns held a jaw-dropping $13.4 trillion in derivatives, which is “greater than the U.S. national income.” So where did it all go? Well, this time anyway, JP Morgan was encouraged to step in to add Bear’s derivatives to its own $77 trillion portfolio, giving the financial giant a grand total of $90 trillion in spooky derivatives.

Which begs the question, why didn’t we just let Bear Stearns—$13 trillion in derivatives and all—go belly up? Wouldn’t that have taught the nation a lesson and given Wall Street a long-deserved wake-up call? “Twenty years ago the Fed would have let Bear Stearns go bust,” said credit specialist Willian Sels. “Now it is too interlinked to fail.”

Ed Murphy
The Gold Blog