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The Derivatives bubble

 

 


 

Derivatives have grew into a massive bubble, some USD
1,144 Trillion
by 2007. The new derivatives bubble was fuelled by five key economic and political trends:

  1. Sarbanes-Oxley increased corporate disclosures and government oversight
  2. Federal Reserve’s cheap money policies created the subprime-housing boom
  3. War budgets burdened the U.S. Treasury and future entitlements programs
  4. Trade deficits with China and others destroyed the value of the U.S. dollar
  5. Oil and commodity rich nations demanding equity payments rather than debt

In short, despite Buffett’s clear warnings,”
in my view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

That warning was in Buffett’s 2002 letter to Berkshire shareholders. He saw a future that many others chose to ignore. On Buffett’s mind also was His acquisition of General Re four years earlier, about the time the Long-Term Capital Management hedge fund almost killed the global monetary system. How? This is crucial: LTCM nearly killed the system with a relatively small $5 billion trading loss. Peanuts compared with the hundreds of billions of dollars of subprime-credit write-offs now making Wall Street’s big shots look like amateurs. Buffett tried to sell off Gen Re’s derivatives group. No buyers. Unwinding it was costly, but led to his warning that derivatives are a “financial weapon of mass destruction.”


A massive new derivatives bubble is driving the domestic and global economies, a bubble that continues growing today parallel with the subprime-credit meltdown triggering a bear-recession. In five years comes from the most recent survey by the Bank of International Settlements, the world’s clearinghouse for central banks in Basel, Switzerland. The BIS is like the cashier’s window at a racetrack or casino, where you’d place a bet or cash in chips, except on a massive scale: BIS is where the U.S. settles trade imbalances with Saudi Arabia for all that oil we guzzle and gives China IOUs for the tainted drugs and lead-based toys we buy.

To grasp how significant this bubble is let’s look at these numbers

U.S. annual gross domestic product is about $15 trillion

  • U.S. money supply is also about $15 trillion
  • Current proposed U.S. federal budget is $3 trillion
    • U.S. government’s maximum legal debt is $9 trillion
    • U.S. mutual fund companies manage about $12 trillion
    • World’s GDPs for all nations is approximately $50 trillion
    • Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
    • Total value of the world’s real estate is estimated at about $75 trillion
    • Total value of world’s stock and bond markets is more than $100 trillion
    • BIS valuation of world’s derivatives back in 2002 was about $100 trillion
    • BIS 2007 valuation of the world’s derivatives is now a whopping $516 trillion

Moreover, the folks at http://www.bis.org/statistics/derstats.htm
BIS tell me their estimate of $516 trillion only includes “transactions in which a major private dealer (bank) is involved on at least one side of the transaction,” but doesn’t include private deals between two “non-reporting entities.” They did, however, add that their reporting central banks estimate that the coverage of the survey is around 95% on average.

Also, keep in mind that while the $516Trillion “notional” value (maximum in case of a meltdown) of the deals is a good measure of the market’s size, the 2007 BIS study notes that the $11 trillion “gross market values provides a more accurate measure of the scale of financial risk transfer taking place in derivatives markets.”


The fact is, derivatives have become the world’s biggest “black market,” exceeding the illicit traffic in stuff like arms, drugs, alcohol, gambling, cigarettes, stolen art and pirated movies. Why? Because like all black markets, derivatives are a perfect way of getting rich while avoiding taxes and government regulations. And in today’s slowdown, plus a volatile global market, Wall Street knows derivatives remain a lucrative business.

Recently Pimco’s bond fund king Bill Gross said “What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid-August.” In short, not only Warren Buffett, but Bond King Bill Gross, our Fed Chairman Ben Bernanke, the Treasury Secretary Henry Paulson and the rest of America’s leaders can’t “figure out” the world’s USD .1,144 Trillion $ derivatives.(see below)

BIS is primarily a records-keeper, a toothless tiger that merely collects data giving a legitimacy and false sense of security to this chaotic “shadow banking system” that has become the world’s biggest “black market?”

Here are some of the types of derivatives that are out there.

Have you ever heard of them?

Chances are your local bank manager hasn’t either!

But I bet his Head office has a few slick traders that are trading these on a Daly bases and I’m

Pretty sure that they must be in it up to their necks!

  • Foreign exchange contracts
  • Listed credit derivatives
  • OTC ( over the counter)
  • Forwards and forex swaps
  •  Currency swaps
  • Options on Interest rate contracts
  • Forward rate agreements
  • Interest rate swaps
  • Options on
    Equity-linked contracts
  • Forwards and swaps
  • Options on Gold & Other commodities
  • Credit default swaps
  • Single-name instruments
  • Multi-name instruments
  • Unallocated instruments
  • CDS (credit default swaps)
    CDSs are derivatives whose cost is determined using financial models and by arbitrage relationships with other credit market instruments such as loans and bonds from the same ‘Reference Entity’ to which the CDS contract refers

     

  • ABS (asset-backed securities)
  • MBS (mortgage-backed securities)
  • OTC derivatives
  • Futures

    To name but a few!

  •  According to various distinguished sources including the Bank for International Settlements (BIS) in Basel, Switzerland — the central bankers’ bank — the amount of outstanding derivatives worldwide as of December 2007 crossed USD 1.144 Quadrillion, ie, USD 1,144 Trillion. The main categories of the USD 1.144 Quadrillion derivatives market were the following:

  • 1. Listed credit derivatives stood at USD 548 trillion;

    2. The Over-The-Counter (OTC) derivatives stood in notional or face value at USD 596 trillion and included:

    a. Interest Rate Derivatives at about USD 393+ trillion;

    b. Credit Default Swaps at about USD 58+ trillion;

    c. Foreign Exchange Derivatives at about USD 56+ trillion;

    d. Commodity Derivatives at about USD 9 trillion;

    e. Equity Linked Derivatives at about USD 8.5 trillion; and

    f. Unallocated Derivatives at about USD 71+ trillion.

 

For a more indebt information on the latest actual derivative figures please follow this link

It makes very interesting reading

Link  http://www.bis.org/statistics/derstats.htm

Source http://www.elliottwavetechnology.com

Tom Foremski at http://www.siliconvalleywatcher.com/mt/archives/2008/10/the_size_of_der.php

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