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I'm not enough of a mathematician to fully comprehend this, but it seems to be a bit like the reverse of Newtonian mechanics.  Newtonian mechanics works well at the macro level but breaks down at the level of sub atomic particles where quantum mechanics is required to explain observed behaviour.  

The linear mathematics Migeru refers to works well at the micro level, in a liquid market, but breaks down at the macro level when everybody, or a significant proportion (= <1% of the total population) are trying to do the same thing.  Its a bit like trying to approach the speed of light - prices inflate/deflate exponentially/astronomically as the total volume of transactions approaches total market size.

This isn't rocket science, and it should be possible to predict the behaviour of prices as the proportionate of the market seeking to liquidate/invest rises significantly.  It should also be possible to draft regulations which prevent the linear algebraic assumptions of "non-herd like" buyer/seller behaviour leading to inflated asset valuations and the "multiplier effect" that that can have on the total value of derivatives outstanding.

It should have been obvious to everyone - bankers, regulators etc. that there is no way that Derivatives valued at 2 to 3 times Global GNP can be outstanding at any one time.  So was everybody playing chicken?  Blinded by pure greed? Convinced they could defy gravity?  Or just playing with other people's money and banking fat bonuses all along the way?

It would be criminal for an individual business to inflate the value of their business for the purpose of persuading investors to pay unrealistic prices for their shares.  Somehow the rules of accountancy and book keeping are going to have to change to take account of the cyclical and non-linear nature of pricing behaviour in the real world.  At least Microsoft has a solid business model and fairly predictable costs and revenues, but these people knew they were trading in junk.

"It's a mystery to me - the game commences, For the usual fee - plus expenses, Confidential information - it's in my diary..."

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Mon Mar 24th, 2008 at 08:06:59 PM EST
Thanks, Frank, that's a very good comment. And this is one of my hobby horses: linear algebra is used in many disparate fields of applied mathematics because it is convenient, not because it is the best model.

Frank Schnittger:

The linear mathematics Migeru refers to works well at the micro level, in a liquid market, but breaks down at the macro level when everybody, or a significant proportion (= <1% of the total population) are trying to do the same thing.
It is patent nonsense to value the whole by the price at the margin. What that implies for marginalist macroeconomics is left as an exercise for the readr.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris
by Migeru (migeru at eurotrib dot com) on Mon Mar 24th, 2008 at 08:17:16 PM EST
[ Parent ]
Migeru:
It is patent nonsense to value the whole by the price at the margin. What that implies for marginalist macroeconomics is left as an exercise for the readr.

Given that the price at the margin is determined by "scarcity value", pricing the whole lot as if 99%+ were not for sale isn't even pretend economics.

"When you have a hammer, every problem looks like a nail" seems like an apt aphorism for those whose maths extends only to linear algebra.

However the value of its simplicity lies in its utility as an ideology.  Every fool can explain to you how the "the market" works and how that is better than state bureaucratic allocation of resources.

It is the foundation stone for the neo-con political project where the freedom of the few to buy and sell at the margin is expressed as a feature of the entire system - when the reality is that most have very little they can sell or buy - and are forced sellers into a labour market regardless of the price available.

"It's a mystery to me - the game commences, For the usual fee - plus expenses, Confidential information - it's in my diary..."

by Frank Schnittger (mail Frankschnittger at hot male dotty communists) on Mon Mar 24th, 2008 at 09:28:38 PM EST
[ Parent ]
Frank Schnittger:
It should have been obvious to everyone - bankers, regulators etc. that there is no way that Derivatives valued at 2 to 3 times Global GNP can be outstanding at any one time.  

Not at all.

Let's take a nice little example in the Brent Crude Oil "15 Day" market in Forward Contracts for cargoes of  500,000 barrels.

A has rights to production and in January he sells a July cargo to B at $100/ bbl; in due course trader B sells a cargo at $105 to C; then a month or two later C at $95 to D, who sells to E and so on until K sells at $102 to A and A sells to X at $104.

Eventually the time comes when the July forward contract reaches the point when it goes into its delivery cycle, and what happens then is that "chains" of "nominations" form, and that "nomination" process is always great fun, as people who have sold "short" try not to be left still holding a nomination at 5 o'clock which they cannot pass on in time.

In which case a "distressed" seller who has been "clocked" needs a cargo to fulfil his contract and is fair game for being stuffed by a seller who has one.

So maybe 250 outstanding "open" forward July contracts are settled as nominations pass one way down chains, and the money flows the other way up them, with traders collecting profits, or suffering losses, along the way.

It wasn't unknown for chains to be over 100 links long and for "book-outs" to take place wherever nominations  went full circle, as in the example, from A back to A again.

Only the net (say) ten cargoes actually pumped out that month go to delivery and become "wet" so that tankers are chartered to arrive at the nominated "delivery window" at Sullom Voe. All the rest of the forward sales/ derivatives are cashed out.

Great fun.

Note that like the credit derivatives markets, the Brent 15 day market is a bilateral "Over the Counter" market with no central clearer standing in the middle to guarantee and settle trades.

The point is that although there may well be $172 trillion of derivatives out there, they will in fact - if they are all performed - for the most part net down to zero (unlike derivatives in real things like oil where physical delivery takes place in "money's worth" rather than money).

The problem is that no one has the foggiest idea as to which of these derivatives are going to be performed, and which are not, let alone who is actually holding the shit, who can stand the losses and who cannot.

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Mon Mar 24th, 2008 at 09:27:16 PM EST
[ Parent ]
ChrisCook:

The point is that although there may well be $172 trillion of derivatives out there, they will in fact - if they are all performed - for the most part net down to zero (unlike derivatives in real things like oil where physical delivery takes place in "money's worth" rather than money).

The problem is that no one has the foggiest idea as to which of these derivatives are going to be performed, and which are not, let alone who is actually holding the shit, who can stand the losses and who cannot.

So we have a large collection of assets which individually look like they have value (and sit on the assets column of balance sheets) but in the aggregate have no value at all? That's even worse than with stock shares. Or maybe not, maybe a share is an "option on liquidity" and has nothing to do with a proportional share of discounted future dividends, or with a proportional share of a company's net equity.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris
by Migeru (migeru at eurotrib dot com) on Tue Mar 25th, 2008 at 04:25:36 AM EST
[ Parent ]
I once asked the guy sitting next to me how many June Brent cargos there were (about 1995 ish).  He said roughly 50.  "and I own 80 of them".  He had a fun month with that squeeze play.  15 day Brent was such a stupid contract.

Not a market for widows and orphans.  But it's not like people just get to walk up and start punting.  The credit groups were paid very well to try to keep a handle on who  we had too much risk exposure with and to demand margin from the poorer credit risks.

by HiD on Wed Mar 26th, 2008 at 07:32:26 AM EST
[ Parent ]
HiD:
The credit groups were paid very well to try to keep a handle on who  we had too much risk exposure with and to demand margin from the poorer credit risks.

Well I came into regulation in 1986, (and the IPE in 1990) people were still coming to terms with Brent credit risk after a few embarrassments which came about from trading with "tiddlers".

Btw this

Metallgesellschaft Case study

 is interesting in the oil market context....  

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Wed Mar 26th, 2008 at 09:00:55 AM EST
[ Parent ]
that's the real problem.  People in the credit world assume Exxon or MG are too big to actually fail and give them open credit.  And then they really really F/up.

I got lightly singed a time or two by small players but no worse than a bad demurrage snafu.  part of doing business.  

Trading is not for the faint of heart or the risk adverse.

by HiD on Tue Apr 1st, 2008 at 01:45:59 AM EST
[ Parent ]

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