I will freely admit to having only a limited understanding of derivatives.
In the past I was be comfortable with my ignorance. Since I didn't buy them, I didn't worry about them. However, the market for these products appears to be expanding out of control. Moreover, I am beginning to think that I am not alone in my ignorance. I suspect that financial market regulators, as well as the banks who buy these products, are just as clueless. No one can fully articulate the multitude of financial chain reactions that these products could potentially produce. UK banks are building up risks that no one understands.
The numbers are jaw-dropping. As of March this year, UK resident bank total derivative liabilities stood at ₤3,561 billion. That number is 2.6 times larger than UK GDP in 2007. Since March 2001, which really isn't that long ago, total derivative liabilities increased by 372 percent.
It gets worse, in the three months between December 2007 and March 2008, banks wrote derivative liabilities amounting to ₤1,212 billion - which is 87 percent of GDP. Think about that for a moment - UK banks wrote derivative contracts worth almost the entire output of this economy in just three months.
Here is the picture; sit back, take a deep breath and be afraid, be very afraid.
If the total derivative liabilities chart is bad, the following is even worse. Take a look at total credit derivative liabilities:
Yes, those are billions not millions. By March 2008, UK banks had written ₤427 billion worth of credit derivatives. A year earlier, the market was writing around ₤6 billion. The market has grown from virtually nothing to one amounting to 31 percent of GDP in just one year. Bubble! There is no word in the English language that can accurately portray this kind of growth. Exponential growth doesn't even come close.
Credit derivatives are essentially insurance contracts. As wikipedia neatly puts it these transactions are "financial instrument or derivative whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded." These contracts insure against default.
This products are, which has appeared literally overnight, is trading on the "creditworthiness" of third party obligations. In other words, it is market built upon the risk of failure. In an economic downturn failure tends to be quite common.
I suspect that the total market size of the underlying assets could well be smaller than the size of the credit derivative market. Suppose an economic downtourn led to a significant increase in the default rate of the underlying assets. The credit derivatives would have to payout. If there are more credit derivatives contracts than underlying assets, the default will amplify the losses for the banks who wrote these contracts. Maybe I am wrong about this, but I suspect that these credit derivatives have the potential to exacerbate default losses.
This brings us to another question, who could possibly hold the other side of these transactions? Well, it is UK banks, who are writing derivative contracts with each other on a massive scale. How do we know this? Here is a final chart. It is the net asset position of derivative contracts for UK resident banks with counter parties.
The net asset position is still large, but here we are taking tens of billions, not thousands of billions. It looks erratic, risky and even dangerous, and probably should generate some serious concerns among regulators. It also suggests that banks are collectively writing contracts between themselves.
Perhaps, the famous US investor - Warren Buffett - summed up the situation best when in 2002 he said
"I view derivatives as time bombs, both for the parties that deal in them and the economic system. The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal"
Financial weapons of mass destruction offering mutually assured destruction to both counter parties. Perhaps, someone should wake up those jokers over at the FSA and tell them that there might be a problem brewing with credit derivatives.