The $700 Trillion Elephant

The $700 Trillion Elephant
Gargantuan Derivatives Market Weighs On All Other Issues

By Thomas Kostigen, Marketwatch | 11 March 2009

SANTA MONICA, Calif. (MarketWatch)— There's a $700 trillion elephant in the room and it's time we found out how much it really weighs on the economy. Derivative contracts total about three-quarters of a quadrillion dollars in "notional" amounts, according to the Bank for International Settlements. These contracts are tallied in notional values because no one really can say how much they are worth.

But valuing them 'correctly' is exactly what we should be doing because these comprise the viral disease that has infected the financial markets and the economies of the world. Try as we might to salvage the residential real estate market, it's at best worth $23 trillion in the U.S. We're struggling to save the stock market, but that's valued at less than $15 trillion. And we hope to keep the entire U.S. economy from collapsing, yet gross domestic product stands at $14.2 trillion.

Compare any of these to the derivatives market and you can easily see that we are just closing the windows as a tsunami crashes to shore. The total value of all the stock markets in the world amounts to less than $50 trillion, according to the World Federation of Exchanges. To be sure, the derivatives market is international [[and probably over two-thirds of derivatives 'cancel' out, ie, represent opposite contracts for the same potential event : normxxx]]. But much of the trouble we're in began with contracts "derived" from the values associated with U.S. residential real estate market. These contracts were engineered based on the various assumptions tied to those values.

Few know what derivatives are worth. I spoke with one derivatives trader who manages billions of dollars and she said she couldn't even value her portfolio because "no one knows anymore who is on the other side of the trade." [[Thanks to a completely unregulated market gone wild!: normxxx]]Derivatives pricing, simply put, is determined by what someone else is willing to pay for the contract. The value is based on an artificial scenario that "X" will be worth "Y" if "Z" happens. Strip away the fantasy, however, and the reality of the situation is akin to a game of musical chairs— with just a few, rapidly diminishing number of chairs.

So now the music has finally stopped.

That's why stabilizing the housing market will do little to take the sting out of the snapback we are going through on Wall Street. Once people's mortgages were sold off to secondary buyers, and then all sorts of crazy types of derivative securities were devised based on those, and those securities were in turn traded on down the line, there is now little if any relevance to the real estate values on which they were pegged.

We need to identify and determine the real value of derivatives before we give banks and institutions a pass-go with more tax dollars. Otherwise, homeowners (and those in need of credit) will continue to suffer as banks simply patch up the holes left in their balance sheets by the derivatives gone poof; new credit won't be extended until the raff[sic] of the old credit is put behind us.

It isn't the housing market devaluation, or the sub-prime mortgage market defaults that have us in real trouble. Those are nice fakes to keep attention away from the place where greed truly flourished— trading phony instruments to the tune of $700 trillion.

Let's figure how to get out from under that. Then maybe capital will flow again through the markets. Right now, this elephant isn't just in the room, it's sitting on us. [[Actually, most of it has already just "disappeared." What is left are many huge banks and governments trying desperately to fill the hole left behind ($100 trillion, $200 trillion, $300 trillion, who knows!?!): normxxx]]