OTC derivatives

edmundfitzgerald

Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is largely unregulated with respect to disclosure of information between the parties, since the OTC market is made up of banks and other highly sophisticated parties, such as hedge funds. Reporting of OTC amounts are difficult because trades can occur in private, without activity being visible on any exchange. According to the Bank for International Settlements, the total outstanding notional amount is US$684 trillion (as of June 2008).[6] Of this total notional amount, 67% are interest rate contracts, 8% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. Because OTC derivatives are not traded on an exchange, there is no central counter-party. Therefore, they are subject to counter-party risk, like an ordinary contract, since each counter-party relies on the other to perform.


Can anyone explain why these derivatives have hurt our economy ? Isn't this just something between two parties, where one party is the winner and one party is the loser ? Thanks.

derryb

Robert Schiller says derivatives are good for the economy

This guy says they are bad for the economy

See if This Guy answers your question



<< <i>Isn't this just something between two parties, where one party is the winner and one party is the loser ? Thanks. >>


Unfortunately the selling party is able to sell many times what they can physically back up with cash. The problem for the economy is that the losses are so great, especially when mortgages are involved, that taxpayer money is needed for the bailouts (AIG for example). Also, the losses are always passed on to the consumer one way or the other.

roadrunner

The big problem is when the losing party defaults or is allowed to go under. In that case there may not be adequate assets or any will by a bankruptcy court to pay off the winning side of those derivatives. This is what happened to Lehman. By defaulting, all their derivative losses had to be paid off to the winning parties. The govt stepped in and between all the big boys, paid off all the winning bets with special Treasury and FED programs. That meant paying off all the overseas creditors as well. It probably cost trillions in the end with much of the payola hidden under Treasury/FED alphabet soup programs. Had someone just taken over Lehman (as was done with BSC and Merrill Lynch) those contracts could have been kicked down the road further just like most otc derivatives have been. But the big boys wanted Lehman dead and that's what they got. And the beauty of JPMorgan taking over BSC allowed the two entities to cancel out related long and short derivative contracts as necessary. So by allowing a weak sister to survive under another company allows the derivative's day of reckoning to be extended, ideally indefinitely since the contracts will never perform.

So how does this hurt the economy? It really hurts when firms are allowed to completely fail and all the assets/bets paid out. And a bankrupt entity like Lehman didn't have the cash to go and pay off leveraged derivative losses of 50-1 to 100-1. So to keep the financial system from imploding, all that got paid off via the govt, or in simpler terms, we taxpayers are ultimately responsible for the TRILLIONs in increased debt that was assumed. Those trillions that were paid out went to further speculate in already over-speculated areas around the world (ie bigger and new bubbles). Lehman's derivative's portfolio once sold off netted about 9 cents on the dollar. We paid the other 91 cents behind the scenes. This is why letting another TBTF bank go down won't be allowed to happen again. They will just get taken over and all liabilities assumed by a new entity rather than risk having to pay out on all contracts. It's estimated that round 1 of the derivative's failure (2008-2011) will ultimately cost taxpayers $15-$20 TRILL. The real risk of these derivatives if that if asked to perform tomorrow, our top 5 banks would immediately go down in a heap, setting off a world-wide financial chaos that would make the BSC and Lehman defaults seem trivial.

Also note that the $684 TRILLION number reported by the BIS in late 2008 following the financial crisis was an effective restatement of the higher number they published only 6 months earlier (ie $1.14 QUAD). The restatment was done by shifting their valuation model to one that was marked to maturity rather than current value. I would imagine the bankers didn't want to have to explain why >$1 QUAD of anything was needed in finanical bets in a world where $50-$100 TRILL was approximately "all the money" available. The $1.14 QUAD in contracts are only those required to be reported to the BLS. There are no doubt many dozens or hundreds of trillions more that don't have to be reported. If 67% of all the contracts are interest rate related, that's $1.14 Quad x .67 = $938 TRILLION reasons why interest rates can't be raised significantly without putting entities into a bankrupt mode where they can't cover their bets. So interest rates stay low until someone comes up with a scheme to rid the world of these bets w/o upsetting the apple cart. I know that all the big banks that are sitting on winning tickets won't be too happy not getting their payola. These "winners" have already booked their wins on their balance/off-balance sheets. If they are not ultimately paid off, it's an unexpected loss that hurts shareholders and can take them down just as surely as the loser was taken down. No one wins unless govts ensure the payouts of bankrupt firms. And J6P when govts socialize the losses as they have done so far. When derivative losses were first socialized in 1998 during the LTCM failure (and later Enron) it gave the bankers the green light to increase the leverage and raise the stakes. One could go so far as to say that the bailout of the Savings and Loans in the 1980's was the first signal that the path was clear to unbridled bankster gambling because the govt would bail you out.

roadrunner

edmundfitzgerald

Very well explained RR, as usual.

But these big boys are playing with money that just doesn't exist. So now the taxpayer has to come up with money to pay back money that
never existed in the first place ? Did the government allow the banks to play with money that didn't exist, knowing that it
could implode a company or a nation due to its vast power ? Or is that going a little too far.