Mon Mar 24th, 2008 at 06:06:20 PM EST
Jerome a Paris:
The Truth and Consequences
Of $172 Trillion in Derivatives
Derivatives are essentially bets ... and ... debts.
But what was once a small sideshow in the traditional world of stocks, bonds and loans has become the towering center ring in the big-top: The derivatives market has now ballooned into a monster of unimaginable dimensions.
At U.S. commercial banks alone, the total notional value of the derivatives is $172.2 trillion, according to the latest report by the U.S. Comptroller of the Currency (OCC).
How can there be $172 worth of derivatives? That's between two and three times the world's GDP and about 17 times the US' GDP. How did it come to this and what can happen if they are found to be worthless?
I don't pretend to have an answer to those questions, especially the one about what comes next, but below the fold I take a stab at illuminating the issues so we can have a discussion.
Take Micro$oft, a large and liquid stock. The following is from Yahoo! Finance:
As of today, Micro$oft's shares are worth about $29 per share. The market capitalization
of $271bn corresponds to 9.3bn shares outstanding
. Each day, 93M shares change hands (this is a 3-month average). That's 1% of the shares outstanding. It means that the average holding period of a share is 100 trading days, or nearly 5 months.
Now, suppose I have 90 shares of Micro$oft. For how much can I sell them? For $2600 and change, you say, ignoring commissions. Okay, that's good for two Illinois-shaped corn flakes. I'm happy.
Suppose now I have 9 thousand shares of Micro$oft. For how much can I sell them? For $260k, more or less. Maybe I can buy a house with that. Or maybe that's what I did with the equity I withdrew from my home (more about this later).
Say, what if I have 900 thousand shares? How much are those worth? Well, $26M. Maybe I'm a pension fund manager and that's how much of my portfolio is in Microsoft. You get the idea.
Let's multiply the holding by 100 again... Say I am a Micro$soft executive and I have 90 million shares of Micro$oft, how much are they worth? Do we have to go through that again? It's $2.6bn! Well, no. because 90 million shares is about one full trading day's worth of volume and if you try to move that amount of shares through the market you're going to move the market. Just by yourself, you'd double the market volume so maybe you'd make the stock drop by its typical daily range of about 35 cents per share. That's a loss of 32 million dollars right there! As soon as you start trading those shares people will pick up the trend and start selling into it to cut their losses, or hoping to buy again when it bottoms out. Your 100% extra daily volume will trigger a sell-off. The stock migh drop by, say, $2 - that's a $180M loss for you!
So, no, 90 million shares are definitely not worth 90 million times the share price, unless you can enter into a deal over the counter (off the exchange) with someone else who would like to own 1% of M$. And, most definitely, the entirety of the shares of Micro$oft are not immediately worth $271bn even though 1000-share lots (see the "bid" and "ask" in the Yahoo! Finance screen capture) can be quickly bought and sold at the share price.
If you want to quietly sell your 90 million shares you might want to set yourself a threshold of, say, 5% of average volume, and trade in randomly-sized lots through various brokers in order to pass unnoticed. This means it will take you 20 days (4 weeks!) to sell the stock and a lot can happen to the stock price in 4 weeks. So, not only you're exposed to the price risk over 4 weeks, but you also don't have all the money available now, not nearly.
However, one thing you can do is use the 90 million shares as collateral for a loan of $2.6 billion, use the money now and sell the stock over the next month in order to pay the loan back.
Maybe a bank will balk at your request for a $2.6 billion loan, so let's scale the example back a couple of notches, to 9000 shares for $260k. Say you want to use the shares as collateral to help you get a mortgage. The bank says "yup, 9000 shares owned outright, Micro$oft is solid and liquid, you don't have any other debt..., sure, we'll give you a mortgage for $260k." Now imagine across the US and the World, millions of people, fund managers and companies have been using their M$ shares as collateral for loans, or writing them as assets on their balance sheets. The $271bn of M$'s market capitalization, which are not liquid and would take 5 months to convert to cash, in which time the shares could well go from $30 to worthless, are being used as liquid assets as good as cash in countless financial transactions. All in one lump they couldn't be used in this way - they would have to be discounted at least by the 5-month interest rate. But in small pieces the entire amount can be used as if it were cash. What happens when everyone decides they need their cash now? Or, to make it a little more realistic, suppose that a bank has accepted M$ stock as collateral for 10000 adjustable-rate mortgages. What happens when raising interest rates force the holders of those mortgages to try and liquidate their stock? Can those 90 million shares be converted to $2.6 billion now? The bank can suddenly find itself with $2.6 billion of loans backed by crap collateral. What happened was that what looked to the bank as 10000 separately sensible transactions were in fact correlated and collectively were a bad idea. Globally, $271bn of perfectly good, sensible collateral for credit can be wiped out in this way.
And so, by the magic of margin buying and leverage we have ended up with $171 trillion of derivatives, which are, in small lumps, more or less liquid and more or less good substitutes for cash, more or less good collateral, and definitely written on the assets side of companies' balance sheets. What happens to the credit backed by these assets when everyone rushes for the exits? What happens to the companies whose balance sheets are kept technically solvent just by the value of the derivatives they hold? How much are these $171 trillion actually worth? As I said at the beginning, $171 trillion is 15 to 20 times the US' GDP. Does this mean it has to be discounted at the 15- or 20-year interest rate? That would make it worth a lot less, maybe only $60 trillion. But, in any case, this illustrates that when people talk about how much money there is in this or that asset class it is patent nonsense. Except, of course, that it can all be used as collateral for credit in a peacemeal fashion, and so multiplied by leverage even beyond $171 trillion. Remember Archimedes' dictum on the lever: "give me a fulcrum and I'll move the Earth".
How did we get ourselves into this, how do we get out, and how can we teach ourselves to stop thinking that there isn't liquidity risk involved in the actions of everyone else because our own transactions are minute? I don't know a whole lot about economics, but I know enough mathematics to know that mathematical economics is a load of crock. It it axiomatic in mathematical finance and mathematical economics that prices are linear, otherwise economists wouldn't be able to use linear algebra to prove nice theorems about finance.