The derivative effect
Derivatives are defined as an investment that derives its value from another asset, many times it’s mortgage debt or the value of commodities, but it can be something as ridiculous as a simple bet. Every major corporation and bank is vested in the daily ongoings in the derivative market, where they hedge their own investments with high leverage bets against other corporations and bankers. Consider derivatives to be the casino of billionaires and institutions, it’s a zero sum game of high stakes gambling.
Worse is that derivative investments are huge, and often highly leveraged. Depending on the credit ranking of the two parties, the buyer may put up just a few percentage points of the overall payoff before the time comes around. Consider this example: Investment bank Goldman Sachs has $10 Billion of Yahoo stock at the current price of $21 per share. They choose to make a bet with another bank on the future price of Yahoo stock, Goldman bets $2 Billion that the price of Yahoo will be below $20 per share in 3 years. Another investment bank takes them up on their offer and puts up $200 Million in collateral. Goldman firmly believes that Yahoo stock will be worth $30 per share in three years. If Goldman is right, they stand to make $5 Billion minus the $2 billion bet. If it’s worth $15 in three years, they stand to lose only $500 Million combining the proceeds of their bet and the capital loss of $6 per share.
This really is how the derivatives market works, many players work out complicated bets to spread their risk among a larger group. By hedging the risk, they seek the perfect arbitrage. In three years, it seems as though it would be almost impossible for Goldman to lose heavily. The problem is that their ability to hedge their bets comes only from the ability of both parties to pay up if they lose. Thus begins the problem with the derivative market, if only a few players are unable to payup on their bets, the derivative market can be thrown horribly out of sync.
Today the derivative market is worth $550 Trillion dollars, though some estimates go as high as $800 Trillion. This market is so large that it outpaces the wealth of the world, the GWP (Gross world product) is worth less than $66 Trillion per year. The derivative market outpaces that by a figure of eight. The total worth of the worlds stock and bond markets is just above $100 Trillion.
The fact is, derivatives are high stakes gambles that outpace the world’s wealth. Because of this, the derivatives market is horribly illiquid. Due to the complex bets made in the derivative market, only about $11 Trillion is at risk during the day to day. If some players are unable to make good on their bets, the full notional value of $550 Trillion will come into risk. The derivatives market is fully vested in the fact that every player has enough to cover their bets, obviously they don’t, so its only a matter of time until derivatives crash when a major player like JP Morgan (which controls $26 Trillion of bets on the derivatives market) cannot make good on payments.
Most people have never even heard of this market largely because its kept off the books at every major corporation. The derivatives market for most is a way to hedge bets and profit off arbitraging the system, if one player can’t pay then this is where the problems come full circle. No matter how hedged you are, you simply win if the loser can’t pay up.
Quite frankly, the derivatives market is bound to blow up when a few major players do. During the 1990s LTCM, a derivative investing business lost just $5 Billion and was no longer able to cover itself. It was feared that their exit would crash the then $100 Trillion derivative market but the Federal Reserve stepped in and made payments to avoid a full on crash.
Never in the history of the world has a market worth as much as this one is today crashed. We have no idea what a crash could do, how it could affect the markets or when it might occur. If banking interests like JP Morgan and others lose their shirt on the subprime market, their chance of defaulting on bets becomes greater. If $26 Trillion is wiped out of the system through JP Morgan’s default, the risk algorithms of many of the hedgers is thrown out of sync. A sell off in a market this illiquid could only bring catastrophic collapse.
