Do You Spell Contagion? D-E-R-I-V-A-T-I-V-E-S
I can't tell you how many times I've heard analysts and credit market cheerleaders, including our own illustrious Fed, repeat this comforting phrase over the last few months:
"Oh, don't worry, the sub-prime problem is isolated to the United States. And even here, sub-prime represents only a minor piece of the total credit market."
Talk about talking your book!
If only things were so easy in the real world! But the truth is: In real markets, there is real leverage, with real people motivated by fear and greed. Plus, with US$415 trillion or so in derivatives value, AND 3,000 hedge fund "masters of the universe" running rampant with real money, you can NEVER afford to be complacent.
Let's go to the numbers for a moment. Total world stock market capitalization was about US$37 trillion in 1990. It grew to about US$51.225 trillion in March 2007. According to Morgan Stanley, the total world nominal value of derivatives stood at around US$5.7 trillion in 1990. It grew to US$415 trillion by the end of 2006.
In Just 16 Years, Derivatives Have Exploded to a Dangerous Level
Doing the math, it means the U.S. dollar value of derivatives is about 8 times larger than stocks now. In 1990, the reverse was true: Stocks were 6.5 times larger than derivatives. Hmmm!
So what does this mean? I have some thoughts...
* There are too many derivatives in the world* Parceling out those derivatives into smaller bundles so anyone can jump on the "derivatives train" doesn't seem to be reducing risks as the "experts" had expected* Derivatives have never faced a serious test in this cycle* Derivatives have become increasingly connected to price * Ratings agencies (S&P and Moody's) prefer fees to due diligence when doling out their coveted "AAA" ratings * Private equity is more interlinked to derivatives than most investors realize* Stress testing a derivatives portfolio can be tricky if you don't know whether or not the counterparty (maybe one of the 3,000 hedge funds) will be in business next week or next month * Tied to my last point: It sets the stage for a massive global deflation, though everyone seems to think inflation is the problem. (If we accept that inflation is too much money chasing too few goods, then why isn't it higher with so much money generated since 1990? Maybe the massive deflationary pump of billions of new labor market entrants and overcapacity is stronger than experts realize.) A debt default is deflationary and it leads to forced savings, which adds deflationary pressures in a world driven by "drunken sailor spending." * I personally wonder why stock prices aren't a lot higher given the massive amount of leverage (or "liquidity") manufactured across the globe* There could be much, much further to go "on the downside" as funds rush for the rapidly narrowing exits
I can't tell you how many times I've heard analysts and credit market cheerleaders, including our own illustrious Fed, repeat this comforting phrase over the last few months:
"Oh, don't worry, the sub-prime problem is isolated to the United States. And even here, sub-prime represents only a minor piece of the total credit market."
Talk about talking your book!
If only things were so easy in the real world! But the truth is: In real markets, there is real leverage, with real people motivated by fear and greed. Plus, with US$415 trillion or so in derivatives value, AND 3,000 hedge fund "masters of the universe" running rampant with real money, you can NEVER afford to be complacent.
Let's go to the numbers for a moment. Total world stock market capitalization was about US$37 trillion in 1990. It grew to about US$51.225 trillion in March 2007. According to Morgan Stanley, the total world nominal value of derivatives stood at around US$5.7 trillion in 1990. It grew to US$415 trillion by the end of 2006.
In Just 16 Years, Derivatives Have Exploded to a Dangerous Level
Doing the math, it means the U.S. dollar value of derivatives is about 8 times larger than stocks now. In 1990, the reverse was true: Stocks were 6.5 times larger than derivatives. Hmmm!
So what does this mean? I have some thoughts...
* There are too many derivatives in the world* Parceling out those derivatives into smaller bundles so anyone can jump on the "derivatives train" doesn't seem to be reducing risks as the "experts" had expected* Derivatives have never faced a serious test in this cycle* Derivatives have become increasingly connected to price * Ratings agencies (S&P and Moody's) prefer fees to due diligence when doling out their coveted "AAA" ratings * Private equity is more interlinked to derivatives than most investors realize* Stress testing a derivatives portfolio can be tricky if you don't know whether or not the counterparty (maybe one of the 3,000 hedge funds) will be in business next week or next month * Tied to my last point: It sets the stage for a massive global deflation, though everyone seems to think inflation is the problem. (If we accept that inflation is too much money chasing too few goods, then why isn't it higher with so much money generated since 1990? Maybe the massive deflationary pump of billions of new labor market entrants and overcapacity is stronger than experts realize.) A debt default is deflationary and it leads to forced savings, which adds deflationary pressures in a world driven by "drunken sailor spending." * I personally wonder why stock prices aren't a lot higher given the massive amount of leverage (or "liquidity") manufactured across the globe* There could be much, much further to go "on the downside" as funds rush for the rapidly narrowing exits
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