The Astonishing $600 Trillion Interest-Rate Derivatives Market

A post from April 21, 2010 on Washington’s Blog calls derivatives “the world’s largest market, dwarfing the size of the bond market and world’s real economy” and says that the derivatives market “is currently at around $600 trillion or so (in gross nominal value).” — See “Are Interest Rate Derivatives a Ticking Time Bomb?

In contrast, Washington says that the worldwide bond market in 2009 was $82.2 trillion and the world economy was $58.07 trillion.

The most popular derivative, he says, are interest rate derivatives, in which “the underlying asset is the right to pay or receive a notional amount of money at a given interest rate,” according to the Wikipedia definition of interest rate derivative.

Washington quotes various economists to demonstrate why such derivatives have the potential to seriously destabilize the world economy (which we all know is so solid right now). He includes a long quote from portfolio manager Doug Noland, who compares interest rate derivatives with the so-called “portfolio insurance” that played a role in the stock-market crash of 1987.

One proponent of portfolio insurance is cited as making this breathtaking statement in 1985:

[I]t doesn’t matter that formal insurance policies are not available. The mathematics of finance provide the answer…The bottom line is that financial catastrophes can be avoided at a relatively insignificant cost.

About interest rate derivatives,Washington believes:

[N]o one – even the people that design, sell or write about the various interest rate derivatives – really knows how much of a danger they do or don’t pose to the overall economy. In addition to all of the other complexities of the instruments, the very size of the market is unprecedented.

AB — 22 April 2010

Defining Asset Bubbles

Here is an interesting interview with Jeremy Grantham of investment firm GMO, discussing asset bubbles, what they are, and how they should affect investment decisions.

Economist Edward Harrison at Naked Capitalism adds some analysis and explanation in his post “Jeremy Grantham on Bubbles.” Harrison’s “informal working definition of a bubble is “a price rise that is at least two standard deviations above trend.” He says that

Above two-standard deviations the psychology of prior price movements starts to dominate price activity and a bubble forms in which power law characteristics come into play.

In “power law” relationships, a quantity varies more than you should expect. It kind of refers to the “tall head” part of a distribution graph, the opposite of the “long tail.”

AB — 21 April 2010

The annoying thing about The Big Oligarchy

The annoying thing about The Big Oligarchy …

the banks

the insurance companies

the government

the giant firms

and their privileged controllers

… is that you pay into It all your life through premiums, taxes, and the money It makes from the float on your cash …

but then when you ask for the promised (or implied) benefits, It begrudges paying you and does Its best to stonewall.

AB — 26 March 2010

How the Wall Street Boom Went Kablooey

Reading Barbara Ehrenreich’s new book Bright-Sided recently, I became aware of Michael Lewis’s November 2008 article for Portfolio, “The End of Wall Street’s Boom,” which offers a fascinating inside look at how bubbles develop, sustain themselves, and then collapse.

Lewis makes an interesting connection with the delusional “positive thinking” mode that seems to be an important component of economic bubbles. This is the source of Ehrenreich’s interest in what Lewis has to say.

The main character of Lewis’s story is Steve Eisman, who built a busines toward the end of the bubble short-selling mortgage originators and homebuilders riding the subprime boom, as well as Wall Street firms and even rating agencies that were complicit.

Lewis relates that Eisman said something both interesting and funny to Brad Hintz, a prominent financial analyst at a conference in spring of 2007. Eisman told Hintz that his group had just shorted Merrill Lynch. Hintz wanted to know why.

“We have a simple thesis,” Eisman explained. “There is going to be a calamity, and whenever there is a calamity, Merrill is there.” When it came time to bankrupt Orange County with bad advice, Merrill was there. When the internet went bust, Merrill was there. Way back in the 1980s, when the first bond trader was let off his leash and lost hundreds of millions of dollars, Merrill was there to take the hit. That was Eisman’s logic—the logic of Wall Street’s pecking order. Goldman Sachs was the big kid who ran the games in this neighborhood. Merrill Lynch was the little fat kid assigned the least pleasant roles, just happy to be a part of things. The game, as Eisman saw it, was Crack the Whip. He assumed Merrill Lynch had taken its assigned place at the end of the chain.

Lewis is a former Wall Street hack who wrote the 1989 expose Liar’s Poker about his experiences in the industry in the 1980s.

His 2008 article ends on a curiously touching note as he recounts his recent lunch meeting with John Gutfreund, the ex-CEO of Salomon Brothers who took the company public and then led it during its period of prominence in the 1980s.

In relating his meeting with Gutfreund, Lewis offers an interesting analysis of the shift that took place in the 1980s, led by figures such as Gutfreund:

You can’t really tell someone that you asked him to lunch to let him know that you don’t think of him as evil.

Nor can you tell him that you asked him to lunch because you thought that you could trace the biggest financial crisis in the history of the world back to a decision he had made. John Gutfreund did violence to the Wall Street social order—and got himself dubbed the King of Wall Street—when he turned Salomon Brothers from a private partnership into Wall Street’s first public corporation.

… From that moment … the Wall Street firm became a black box. The shareholders who financed the risks had no real understanding of what the risk takers were doing, and as the risk-taking grew ever more complex, their understanding diminished.

The moment Salomon Brothers demonstrated the potential gains to be had by the investment bank as public corporation, the psychological foundations of Wall Street shifted from trust to blind faith.

AB — 15 January 2010

Simon Johnson: ‘What kind of catastrophe would you like?’

Economist Simon JohnsonOn CNBC’s “Squawk on the Street” on 7 January, MIT economist Simon Johnson delivered a perky, upbeat prediction of economic catastrophe in the next year due to the megalomania of banks that have drunk the too-big-to-fail Koolaid — see “Crisis Just Beginning: Economist“.

You’ll get a kick out of Johnson’s collegial banter with CNBC’s Erin Burnett and Mark Haines — for example:

Johnson: “The next 12 months could really be exciting. People could be very positive. But we are setting ourselves up for an enormous catastrophe.”

Haines: “Aw, man! Here we go again! Isn’t there anybody who comes on this show and doesn’t see storm clouds on the horizon? What kind of catastrophe?”

Johnson: “Ah, well, what kind of catastrophe would you like?”

Enjoy the full five minutes of comradely back-and-forth in this video linked from YouTube:

AB — 8 January 2010

‘The whole economy is a pyramid scheme’

That was a quote I picked up from the recently-posted trailer for a documentary called Collapse, which features the ideas of Michael Ruppert, an independent journalist who predicted the current financial crisis in his newsletter From the Wilderness. The movie opens in theaters Nov. 6, 2009.

From the trailer I picked up an interesting quote from Ruppert in the movie:

It’s not that Bernie Maddof was a pyramid scheme. The whole economy is a pyramid scheme.

The mortal blow to human industrialized civilization will happen when oil prices spike and nobody can afford to buy that oil, and everything will just shut down.

Watch the trailer here:

AB — 28 Oct. 2009

‘Life Inc.’ author Douglas Rushkoff on Colbert Report

Douglas Rushkoff, who writes about media and popular culture, appeared July 15, 2009, on The Colbert Report. Rushkoff is currently promoting his new book, Life Inc.: How the World Became a Corporation and How to Take it Back.

Rushkoff does a great job explaining the premise of his book, which is that corporations are only happy when individuals are contributing to the GDP, which is why they are always bugging us to do something productive rather than something useless like, for example, going out and watching birds.

As always, Colbert does a great job of helping Rushkoff explain his book by pretending not to like it. Here’s a link to the video — it’s a great six minutes.

AB — 17 July 2009