UpInTheCut
Member
I have learned so much from John in the past 7 years that I have known him...
He truly worries about the good, decent, ordinary folks... A truly humble man...
He can explain things better than I ever could
Here's a little Q and A about the derivatives market.
He truly worries about the good, decent, ordinary folks... A truly humble man...
He can explain things better than I ever could
Here's a little Q and A about the derivatives market.
John’s last post talks about how if $1 quadrillion worth of credit derivatives loses just 10% of their value, the world loses $100 trillion and there isn’t enough money in the world to fill that gap, so deflation is pretty much inevitable no matter how much money Bernanke prints.
But I don’t see how these credit derivatives are in any way a form of money that could have some effect on inflation or deflation. These things are just bets on something happening or not happening. If you and I bet $1 million on the outcome of a horse race, that doesn’t put $1 million more into the world’s currency. Even when one of us loses and has to come up with $1 million, that won’t create a new $1 million of currency. A bank would have to create a new loan to one of us before new money was created. If I lose the bet but refuse to pay you, that doesn’t create or destroy money either - it’s as if we had never made the bet then.
Perhaps someone could explain how these credit derivatives could have any effect on inflation or deflation.
Suppose you and I bet $1 million on the outcome of a horse race, and
we've written everything down in the form of a contract. Then I can
sell that contract to someone else for $10,000, and then that person
will win or lose the $1 million. But don't focus on the $1 million
-- that's irrelevant. Focus on the $10,000, because that's the
notional value of the bet (or contract).
These credit derivatives have intrinsic notional value, and they're
being carried on the books of financial institutions and investors at
that value.
Suppose you have a $500,000 home, and there's a 30-year fire
insurance policy on which you pay monthly premiums. Then you can
apply discounted cash flow computations to the flow of monthly
premiums, and discover that the value of the policy to the issuer is
$1 million, after accounting for the risk of an actual fire. The
insurance company could sell that policy to someone else for $1
million.
In other words, when you think of the value of an insurance policy,
don't focus on the value of the house; focus on the discounted cash
flow value of the premiums.
That's what's happened with the credit derivatives. Their $1+
quadrillion notional value is based on the value of the premium
payments and expected payouts, not on the value of the things being
insured.
It's true that you can't go to the grocery store and use a credit
derivative to purchase groceries with, but you CAN sell the credit
derivative just like a stock certificate, or you can use it as
security as collateral for a loan of money that you can then use to
buy groceries. So credit derivatives really are a form of money.
However, you can't take out a fire insurance policy on someone else's
house. But anyone can buy or sell a credit derivative on anything.
Thus, what's happened is that the $1+ quadrillion notional value of
these securities is based on probably about $10 trillion of
underlying value, with most credit derivatives insuring the same
things.
Thus, we have various different kinds of possible systemic
risk:
Concurrent risk. It's possible that, say, $100 trillion in
credit derivatives are making an insurance bet on the same $1
trillion event. That means that if the event occurs, it's not a $1
trillion event, but a $100 trillion event.
Counterparty risk. The credit derivatives are highly
interlocked, with one company assuming perhaps $100 trillion in
possible insurance payouts, but protecting itself with credit
derivatives that will pay them $100 trillion if an event occurs.
That creates a chain of counterparties, and if one company fails,
then the entire chain might fail.
Loss of market value. If someone hold $100 trillion in credit
derivatives, and the company's rating is lowered (as is happening
very frequently these days), then the values of those credit
derivatives are automatically devalued, since it's possible that the
company won't be able to pay off its insurance bets in the event of a
default. In a "mark to market" world, this might require other
companies to reduce the claimed market value of the credit
derivatives in their own portfolios.
None of this would matter much if there were only a few trillion
dollars of credit derivatives outstanding. But when you're talking
an astronomical number like $1 quadrillion ($1,000 trillion or $1,000
thousand billion) then an event with even a tiny probability can
result in tens of trillions of dollars of dislocation and
instability.