Sunday, 22 June 2008

financial weapons of mass destruction

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.


London estate agent said...

As you say, you "don't understand derivatives" Simmer down, girl, everything is under control.

VADO said...

This blog is a financial house of horrors. BTW, igore that prat - London Estate Agent.

David said...

Jim Sinclair has been writing about OTC derivatives for ages, albeit mainly from a US perspective. This mess runs into the trillions and could make sub-prime look like a tea party.

With regard to Buffet viewing "derivatives as time bombs", I guess he was right:

"May 03, 2008
OMAHA, Neb. (AP) -- Berkshire Hathaway Inc. said Friday its first-quarter profit fell 64 percent because it recorded an unrealized $1.6 billion pretax loss on its derivative contracts..."

Buffet says one thing and does another.

Edward Harrison said...

Everything is not under control. Derivatives are a problem. The basic problem, as I see it lies in the liquidity of the market. For example, if I bought shares in HBOS, there are hundreds of thousands of counter-parties who have an an interest in transacting with me should I wish to sell. Shares in HBOS are fungible because they are identical.

With derivatives, especially the type Buffett is concerned about, the contracts are not fungible. They are very specific to two individual counter-parties. Therefore, the liquidity of individual transactions is negligible. (I know because I worked on a trading floor transacting synthetic Russian bond trades before Russia defaulted. And this was a fairly liquid market.)

This means counterparty risk is very important. If a large player defaults, there is a tangled web of contracts that would seize up the market. This was the Bear Stearns Armageddon scenario.

The Estate Agent has no clue what he's talking about because it was this specific risk that caused the Fed to intervene in the Bear Stearns collapse to begin with.

Edward Harrison said...


As for the derivative contracts that Buffett owns, these are fairly safe. Puts and Calls on shares are common derivative instruments that are safe as an example. Currency futures are another.

He is not talking about of both sides of his mouth. He is referring to specific types of derivative instruments were counterparty risk is high and liquidity low.

old git said...

There great for bonuses and go well with the emperor's complexion.

Not long ago mortgage subprime derivatives were all the rage, but don't worry, it's all under control.

Edward Harrison said...

Anyone lookng for a primer o derivatives should visit Wikipedia:

Note the vast difference between OTC varieties and exchange traded. Not all derivatives are created equal.

Even within the OTC world, interest rate swaps are perfectly normal and reasonable transactions. They form the basis of the common credit market risk measure of LIBOR-OIS spread (one that even Greenspan used in the source articles for the blog entry below).

One really must know the difference to understand why some derivatives are more risky than others. Categorical statements about derivatives are always overly simplistic


Derivatives are one of the four Horsemen of the Apocalypse warned about by Michael Panzner in "Financial Armageddon". Looks like we're beginning to listen to Cassandra. I attempt a summary of his book here:

There's also Richard Bookstaber's warnings - and he was an insider on derivatives. I reviewed an interview with him on "Financial Sense" here:

RW said...

Alice....certainly agree that derivatives are dangerous. The Fed justified the Bear Stearns bailout arguing that Bear was a counterparty to some $400 billion of derivative contracts.

That said, I think the total nominal value of outstanding derivatives is a bit misleading since many contracts offset one another.

Incidentally, a very good writer in the U.S. has proposed CDS be regulated as insurance. He let me reprint his fascinating op-ed here.

Anonymous said...


The reason for the huge uptick in derivatives over the New Year, which happened everywhere, is the decline of the monolines IMHO. Lots of banks were sitting with crappy structured debt and knew they'd have to write it down cos the bond insurance wasn't worth a thing. So they took out a whole load of new insurance via CDS (probably written by credit hedge funds) and then has an excuse under FAS157 not to write them down no matter how low they traded in the market.

Just an opinion, but it's the only explanation that makes sense to me.


dearieme said...

Wild guess: could lots of people have reckoned that they were looking at losing bets and thought "I know, I'll double up!"?

traderboy said...

Alice, where to start....

Your second chart is definitely not right. Wherever you got it from, the data obviously hasn't been available until recently, there is no way credit derivative liability of UK banks was near zero before...Barclays, RBS and HSBC have all been large players in the credit markets for years, I see no reason why it has been zero until recently, unless it is conveying something else (losses?).

"This [sic] products are, which has appeared literally overnight"
CDS have been around for well over a decade now...

If there are more credit derivatives contracts than underlying assets, the default will amplify the losses for the banks who wrote these contracts.
No. You can only trigger contracts if you can deliver a defaulted underlying asset, so to be pedantic losses would likely be SMALLER for the ones writing the contracts if the size of the underlying assets is smaller than the derivatives contracts outstanding...

I think Edward Harrison above summed it up well when he stated "Categorical statements about derivatives are always overly simplistic". In general, derivates help transfer risk around the system (which is a good thing). And also, notional value is a very misleading term, I'd urge you to ignore it, be that in credit derivates or interest rate derivatives.

I think any big bank failures we see are likely to come not from bad derivatives exposure, but from a good old fashioned liquidity crisis combined with owning bad assets, as we've already seen at Northern Rock, Bear Stearns, Countrywide (it would have gone bust anyway if they hadn't been bought..)...and I'm sure plenty more banks in the next year or two.

aSteve said...

This is a Herculean attempt to tackle the world of financial derivatives... and I would love to read more from the source of your statistics. ;)

I've been an interested amateur concerning derivatives since January 2007 when I devoured a popular masters-level text book on the subject (John Hull:Options, Futures & other derivatives). It was really interesting, though few people believe me! Over the past year I've found myself in many discussions/arguments with posters (mainly with professional exposure) at – and my understanding has progressed a little from its dull academic roots.

The first thing to note is that there are lots of types of financial derivatives. There are interest-rate swaps (the opposite side of fixed-rate borrowing); currency-swaps (to hedge the risk of borrowing abroad) - as well as Credit Default Swaps (CDS) which are the most interesting in the context of your blog post. It is important, however, to realise that non-financial derivatives are affected too by credit... because equity/commodity derivative demand is hedged using credit wherever suitable counter-parties can't be found.

Derivative trading, and CDS trading has been expanding at an exponential rate... and this has concerned some. This, however, is not, in itself, evidence of impending financial implosion... The important question is not of the number of contracts (which, for all we know, might be between financial organisations and subsidiaries) or their total value – but rather a combination of:

1.Bilateral net sums (i.e. the risk taken on by a market participant assuming all contracts are honoured)
2.Systemic risk that takes into account the potential failure of substantial counter parties.

I discovered recently that there are Basel regulations, but (I think) they only apply to the net positions – not the gross. If true, this goes some way to explain the explosive growth in nominal value of CDS contracts. While the nominal sums do not let us quantify anything, the massive activity in this sector clearly indicates that market participants are extremely concerned about risk. Since accepting sensible risks imply profit... participants will only hedge if they feel the risk too great relative to the premiums. The premiums (or CDS spreads) have been increasing recently – but this has not calmed demand... which, to me, suggests an ongoing systemic credit crisis.

In addition to all this, CDS come in two distinct flavours... first standard traded contracts... such as the Itrax for Europe and the ABX for the USA... though even these two examples work in entirely different ways. Second, there are (Over The Counter) OTCs – which are far less amenable to regulation – and, some report, are processed manually by some market participants... essentially precluding any sensible risk analysis.

In addition to this, I've been suggesting for quite a while that credit derivatives are substantially responsible for the “compression of risk premiums” that Mervyn King attributes with having caused the credit crisis. I consider that derivatives have an asymmetric effect on markets – in extreme brief – because a price can only fall to zero, but can increase to infinity. Put another way, the existence of insurance undermined the ability of lenders to charge the larger risk premiums they (may have) considered appropriate by virtue of the fact that borrowers would simply switch to another lender. The trick, I think, has been in getting investors to accept risks for reward... and I think the “Synthetic CDO” (which started to gain popularity in 1997 - and, maybe, similar instruments) were important in this regard. The idea is that an investor in a synthetic bond does not need collateral to invest for the face value...but can be purchased using a thin margin – with the holder collecting the difference between the risk-inclusive and risk-free rates of interest... very lucrative until there's a crash. By expanding the marketplace to take on risk of default – by not requiring 100% collateral – and bypassing Basel rules for fractional reserve banking... the cost of credit was marginalised... until lending was no-longer profitable. What we're seeing now is a steady return to normality – as appetite to underwrite loans has evaporated. I see numerous similarities with the debacle with insurance at Lloyds of London in the late 1980s... the barrier of entry to profit from accepting risk was lowered to such an extent as to flood the market with “investors” - many of whom had no idea what risk was really involved. After a few years of very cheap insurance, disaster struck and newcomers lost their shirts... This time, I suspect, the newcomers are pension funds.

Anonymous said...


Like most people here I think derivatives are hideously complex and very difficult to make sense of. It's not an accident. The problematic ones (CDSs) are deliberately opaque because they are OTC and tailored to a specific need between writer and buyer.

Big problems, which I can't quantify, are:
1) The growth of OTCs mean it's not a simple "net" issue. Gross exposure matters due to counterparty risk
2) Gross matters because contracts don't perfectly match in terms, maturity and other specifics
3) Reinsurance increases counterparty risk because it provides so many extra opportunities for weak links in the chain, and so many more court cases
4) Lack of standardisation basically guarantees tortuous court cases as people try to shift the losses
5) There's a serious back office confirmation and settlement backlog. Apparently lots of OTC trades are verbal or handwritten
6) Concentration risk. JPM, BoA and Citi control the whole market (look at the OCC website for numbers). Only JPM isn't obviously a risky counterparty.
7) There was a precedent last year of a company going bust and there being more CDSs than bonds. I forget the name. The result was the bond prices soared as CDS holders scrambled to buy them in order to present for payment. Weird.

The main learning point of OTC CDSs is that something is going to blow up spectacularly.

There's only two ways it can go:
- Defaults occur, insurance pays out, CDS writer takes loss
- Defaults occur, insurance doesn't pay out, CDS buyer takes loss.
The loss won't be magicked away.

Anonymous said...


I'd like to see you tackle predictions on the job losses coming in the financial sector in the UK. Fancy taking it on?

For analytical purposes it's probably worth making some kind of separation between:
- Deal making / front office and middle-back office which are less transaction dependent
- Core functions that can't be cut much even in a recession
- Likely growth areas, e.g. compliance and legal
- Professional vs non-professional
- City finance and local mortgage broker finance
- New entrants and experienced
- Particular sectors (e.g. strucured debt houses, asset managers)


aSteve said...

Anonymous (10:15),

According to the OCC, as I interpret the figures on page 13, HSBC is the bank with the largest exposure to credit derivatives... with $483bn exposure - compared with JPM in second place with $419bn.

I'm also a little worried that this concentrates almost exclusively on banks active in the USA. For example, I'd have expected to see UBS among the big hitters... I imagine that most of their contracts are Euro denominated - maybe that explains things?

I would be very interested to establish which company you refer to in point (7) - since it is my understanding that you do not need to be a bond-holder to cash in on bond insurance. This was certainly the case when the three traders at Goldman Sachs earned the largest sum ever recorded because they bet against US subprime - I understand - using surplus CDS contracts.

Anonymous said...


That anonynous was me. Forgot to sign it. I really should get myself an ID.

Delphi was the company. See near the bottom of this article by Mish

For numbers, I'm going from the tables from page 22 onwards. Agreed HSBC have the highest exposure by % but are not a top four player in any other respect.


aSteve said...

It looked like you, Nick, but I didn't want to accuse you of something you'd not written. :)

I think that Delphi is an interesting and distinct case... though one with which I was not previously familiar. It seems to me that CDS contracts for Delphi had likely been so cheap that no-one cared too much about over-insuring their position... then, as Delphi collapsed, they looked set to make a killing. Incredulous at their luck, I guess, they looked to hedge their bets... take a smaller amount now - rather than risk it all on an administrator managing to repay all the debts without a default.

On the OCC pdf, we're singing from the same hymn sheet. HSBC are the 5th biggest player, according to the tables... and, in any case, isn't it sensible to look at the least well capitalised bank as being the one most likely to be unable to make margin calls? This, of course, flies in the face of conventional wisdom - i.e. that HSBC is the world's most stable bank.

Anonymous said...


I seriously doubt if there's a single person in the world who is fully abreast of the CDS issue. That won't stop me from venturing my own opinion, though.

I'm reminded of Nassim Nicolas Taleb's phrase (I paraphrase) that "every contract you write has JPMorgan as the ultimate counterparty".

I think page 22 of that report tells you the following:
- Bear wasn't bailed out. JPM was
- Citi is totally screwed
- JPM's share price defies gravity
- JPM, Citi and BoA are all in a LTCM position: the exposure is so large that it isn't possible to hedge it or reduce it
- If this is just what the OCC knows about, before the recent explosion in Q1 2008 contract writing, then god forbid what the current overall position it.

But yes, I take your point about HSBC. They dodged most of the share price falls so far but if anything goes wrong in CDSs they are in big trouble.

Interesting comment on Delphi. My reading is based on basic incentives: If you must present a bond for a CDS to pay out, and there's way more CDS than bonds, then the bond price will naturally rise to almost the value of the CDS strike because all CDS holders will bid up the bonds preferring some payout to nothing.

It's one of the bizarre properties of CDSs. The other one is that it encourages holders of bonds to force through a credit event rather than help the company get through its difficulties.


aSteve said...

Taleb gets around, doesn't he... I've got both of his books on my bedside table and I'm up-to chapter 4 on "Fooled by Randomness" - reading in chronological order. It's pretty easy going - but I've not come across anything as political as that JPM quote from him... yet.

My impression, too, reading between the lines was that the Fed bale-out of Bear Stearns was actually a bale-out for JPM. Of course, proving this is somewhere between hard and impossible. JPM certainly seems to have close ties to congress and the Fed.

I disagree in comparing LTCM to Bear Stearns... in the former case, the Fed (allegedly) held the banks who had loaned to LTCM responsible - and told them to bale-out LTCM at their own expense. That seemed remarkably honest - if more political brinkmanship than I'd have hoped would have been necessary.

I'm not sure I want to make the comment I seemed to about HSBC... I'm definitely confused. It certainly looks (from the OCC doc) that it is extremely exposed to CDS contracts... and if that is the case, it suggests that investors in HSBC either have confidence that the CDS will pay out, or they're simply clueless. While I can imagine most investors being hopeless, I imagine that enough would get cold feet to move the share price downwards.

I am more than 99.9999% certain that you don't need the corresponding bond to cash a CDS... and have read that explicitly in many places. I think the bond price rose - essentially - because people couldn't believe that they'd make such a massive gain at near-zero cost... and wanted to lock in their profits fearing that they'd otherwise evaporate. This squares with bonds trading only at 70% of face value... I imagine the rising bond price itself was a vicious/virtuous cycle as holders of CDS assumed that the market knew something they didn't.

If I was a CFO sitting on a £1m CDS that I didn't really need... that I paid £1,000 to buy - say - and my choice was between buying a Delphi bond and trousering a guaranteed £300K - or sitting on a likely-to-win £1m lottery ticket (the CDS) I know which I'd choose. A pound in the pocket, as they say. If I'd thought Delphi likely to go bankrupt, I'd likely not have been doing business with them in the first place – and wouldn't have the CDS anyway.

I think there are a lot of interesting anomalies that arise through derivative contracts. The one that makes me most worried are out-of-the-money options that can change hands for half-sucked Worthers' Originals... yet can yield millions in the event of the collapse of a major corporation. It strikes me that this investment strategy is the most likely to make obscene amounts of cash - even though it is least ethical... especially if the next step is to conspire to bankrupt otherwise sound businesses.

The thing that strikes me about the OCC report is that if that's the best they can do then they are utterly clueless about the risks inherent. Nominal value sums are almost irrelevant - except as a gauge of fear/sentiment... and similar disparaging remarks can be levelled at the other statistics too. They need to be concerned with the potential for systemic failure... and none of the information in the report gives any hope of quantifying that risk.

Anonymous said...


Taleb made his fortune in 1987 on out of the money options. His very investment strategy was as you describe - invest most money prudently and then divert a little to out of the money options to maximise exposure to positive black swans.

By comparing JPM to LTCM I didn't mean the Bear bail out. I meant that LTCM spent so many years building up such huge positions that they simply couldn't get out of them as the market changed without speeding the collapse even faster. I think JPM is in such a position with CDSs.

Nice analysis of Delphi. I'm gonna think about that.


David said...

How right you were.