$1.14 Quadrillion In Derivatives— What Goes Up…

June 16, 2008

Quadrillion? That’s a number only astronomers use, right? You know…as in the North Star is “just” a couple of quadrillion miles away.

But, ominously enough, Earth’s economists are actually starting to use it, too. No, not to discuss the amount of dollars out there (though it might feel like the Fed just pumped a quadrillion greenbacks into the economy). The Bank of International Settlements recently reported that the amount of outstanding derivatives has now reached the $1.14 quadrillion mark ($548 Trillion in listed credit derivatives plus $596 trillion in notional [or face value] OTC derivatives).

Whether you’re an astronomer or an economist, that’s an awfully big number. In case you need a mega-number refresher course, million is followed by billion which is followed by trillion which is followed by quadrillion (and, okay, quintillion and sextillion follow that). Yes, it takes a thousand trillion to make up one quadrillion, and, sadly, that’s where we now find ourselves with the derivative situation.

Leverage Madness

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.”

Extrapolated, $1.14 quadrillion in assets “owned” on something like 95% margin has to be one of the scariest phenomena in economic history.

Mathematicians and academics are supposedly the air traffic controllers of the derivative complex, keeping everything neatly hedged, up-to-date and safe. But a quadrillion-plus of these highly leveraged investments is like multiplying America’s fleet of planes a million-fold…while not bothering to boost the number of air traffic controllers. The potential for financial disaster is simply overwhelming.

“Financial Weapons of Mass Destruction”

So warned Warren Buffet of derivatives six years ago.

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,” is how the Oracle of Omaha put it.

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.”

Meaning that a Bear Stearns collapse today could be the first falling domino in a collapsing domino configuration tomorrow. Derivatives really are all interlinked. So expect the Fed to move with Panzer-like velocity to rescue any bank struggling with its derivative load.

But what happens when that’s not enough?

Surviving the Coming Derivatives Collapse

Eventually, shockingly, something will happen. Some bank will slip up, some mathematician will miscalculate or the Fed just won’t react fast enough, and the whole $1.4 quadrillion derivative complex will come tumbling down around our feet. Only it might not be $1.4 quadrillion by then. It might be a whole lot more.

What could happen next?

Whatever it was, it wouldn’t be pretty. Referring to Bear Stearns, “There was a risk of a total meltdown at the beginning of last week. I don’t think most people have any idea how bad this chain could have been,” said James Melcher, a well-known hedge fund manager.

The New York Times was even more pointed: “If the Fed hadn’t acted this morning and Bear (Stearns) did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system.”

Yes…the New York Times actually said that.

But there’s too much leverage, too much money, too much greed and too many shenanigans involved here to believe this story will have a happy ending. So, soon as you can, you need to buy some derivative-collapse insurance.

You need to buy gold.

Think of gold—this beautiful, glittery precious metal—as its own currency, an honorable investment divorced from the old boy paper money network that has bred derivative beasts. Should the worst happen, gold would be the only financial sanity around; investors not mangled by a derivative collapse would flock to the precious metal if only to wait things out.

If you just rolled your eyes, Google Bear Stearns to see just how close we all came. Then go ahead and Google diversification then gold.

China has only 2% of its Total Foreign Reserves in gold.