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Really good article from Financial Sense
Sultans of Swap
Explaining $605 Trillion of Derivatives!
by Gordon T Long | February 24, 2010
Sultans of Swap
Explaining $605 Trillion of Derivatives!
by Gordon T Long | February 24, 2010
(The Bond Vigilantes are dead – RIP - Long Live the Sultans of Swap)
Every parent has had that moment when their child asks them the simplest sounding question but in that instance before you respond, you realize you have never really thought about it and actually don’t know the real truth. To not have an answer would be to lose all credibility as the ‘all knowing’ parent. Like generations of parents before you – you bluff!
When asked why there are $605 Trillion derivatives outstanding (1) how do you articulate an answer to this horrendous and almost unimaginable number? The US is the largest economy in the world but tallies only 2.3% in comparison. Global bank reserves amount to only 1.2% of this accumulation. The gargantuan size appears to defy all logic.
Before some of you experts out there accuse me of sensationalism let me quickly give you the response of the “all knowing” to knock this number down to something that is intended to allow you to once again sleep at night.
First $605 is the notional value. This number according to experts (2) is best used simply to get an indication of how rapidly the overall derivatives market is growing (wow) since it doesn’t represent the value of what is at stake to the parties engaged in the transaction. It double counts positions, doesn’t represent what changes hands and doesn’t discount hedges that offset each other. What we need to consider is settlement amounts if all the contracts had to be settled today for some unknown reason (i.e. a 1930’s bank holiday crisis?). Our number then drops to just over $25T. That sounds better but still is a staggering figure considering the assets of the US are estimated to be $56T and is 1/3 of global assets (3). Not to be deterred our ‘all knowing’ experts would then assuredly point out that actually the number is a mere $3.7T when all the contracts directly offsetting each other are netted. Appeased, our cocktail chatter would resume in a much more subdued tone. Or should it?
I have been thinking about the truth regarding this imponderable for a few years now. I have likewise successfully answered the question at numerous polite social gatherings but never felt comfortable with my response. My credibility intact I would scold myself to delve more thoroughly.
Eureka!
While authoring my recent article 8 Fault Lines in the Euro Experiment which was prompted by the debacle in Greece, I found myself like Archimedes the Greek before me, shouting Eureka – I have alas found it! But before I share the ‘all knowing truth’ with you I must caution those with weak hearts and small children: parental guidance is advised!
8 YEARS OF PAIN
In 2007 I authored another paper entitled ‘8 Years of Pain’. It called for a US housing collapse and a resulting derivatives implosion. We sort of got the score right but the lyrics were wrong. Similar to the Titanic, we knew Icebergs were out there but we didn’t have the required instruments needed to identify it clearly with sufficient precision. In hindsight we now realize it was because we still weren’t aware of exactly how banks were using SIV’s (Structured Investment Vehicles) to sell CDOs and protect themselves with CDSs. The mechanics of how Toxic instruments were actually being created wasn’t readily available in the public domain. These instruments had yet to have the media spotlight shown on them as they lurked quietly through dark waters. We knew of SPE’s (Special Purpose Entities) from the Enron debacle, so we suspected something similar but we could only speculate. The puzzle we had was that $437T of the $605T of the notional value of derivatives outstanding were Interest Rate Contracts and $342T of these were specifically Interest Rate Swaps with a Gross Market Value of $13.9T. Calculations indicated there was insufficient cross border corporate and financial sector needs for this level of exchange - by orders of magnitude.
EURO EXPERIMENT
The Enron debacle and the Financial Crisis taught me to dig deeper (and fast!) when I suspect the Wall Street Merlins have been insidiously concocting their magical brews. As the Greek crisis was unfolding, by happenstance I discovered SPC (Special Purpose Company) and PPI/PFI’s. I also discovered the SPC Titlos PLC which I outlined in 8 Fault Lines in the Euro Experiment. I realized;
1) A lender with the ability to lend,
2) A borrower with a need and
3) The same borrower with sufficient collateral to actually secure the loan.
ACCOUNTING STANDARDS – Corporate, Financial & Public
Almost all Sovereign Treasuries have the continuous lust for borrowing and historically almost unlimited public assets to pledge as collateral. The problem is neither the need nor collateral. The problem is public perception as viewed through the optic lenses of public sector accounting standards. Circumvent the restrictive public accounting standards and Eureka – we have a lender. Like Enron it was about circumventing private sector accounting standards through off balance sheet SPE’s. In the financial crisis we found it was the banks circumventing banking capital accounting standards by off balance sheet SIV’s. In both instances it is motivated by the advantage of removing obligations from the reported asset / liability ledger.
This is precisely the brew the great Merlins – like Goldman Sachs have delivered to Sovereign powers as the magic elixir for public accounting standards. Our political leaders like Enron executives and bank executives before them have become drunkards on the magic elixir. It gives politicians (the ultimate alcoholics) the power to take on more debt without impacting the traditional metrics which increase borrowing costs.
.
.
.
.
.
.
.
.
.
.
ARCHIMEDES’ AXIOM
This allows the International Banks to effectively become mini Federal Reserves, lending money into creation by being ready whenever ANY global central bank is ready to expand their money supply. Like the US Mortgage bubble they can’t get enough product.
SULTANS OF SWAP
Why is everything hidden in the murky depths called “special” – like SPE, SPV or “Structured” – like SIV? The answer is to keep them off the balance sheet. Why would you not want something on the balance sheet where investors and interested parties could see what is happening? Obviously so you can camouflage them from what is happening.
The reason is fundamentally Credit Ratings. Keep your debts low and your credit ratings high and the cost of money is cheap. The cheaper money is, the more borrowing will occur. Everyone is happy except the unwitting lender.
It is here ladies and gentlemen that we discover the Sultans of Swap. The Bond Vigilantes are of a previous era. They are dead – RIP. Through the magic mix of Credit Default Swaps, Dynamic Hedging and Interest Rate Swaps the Sultans of Swaps effectively control interest rate spreads. Through Regulatory Arbitrage they extort tremendous political sway globally. They live in the world of risk free spreads. Low interest rates simply attract more volume for their concoctions. We have had an explosion in Money Supply globally as the charts (right) indicate. The parabolic rise matches the increase in these derivative products along with their ability to turn Interest Rate Swaps into high powered bank lending.
Like Achilles Heel in Greek mythology, there is an exposure. Everything is based on tax payers paying, GDP expanding and interest rates staying low. Titlos PLC shows severe structured collateral calls when these assumptions change even modestly (5).
CASCADING COLLATERAL CALLS
With $3.7T in Gross Derivative Credit Exposure outstanding, how many Greek Sovereign downgrades would it take to begin cascading collateral calls? Don’t forget that we have witnessed dramatic shortening of government “duration” over the last few years. There are massive ‘rollovers’ looming that will further compound rates and their associated collateral requirements.
One final point, I need to be really clear here. Nothing is actually hidden in all this. It is typically there in the small type footnotes that are extremely difficult to interpret or referenced to a document that is difficult to get your hands on. With enough time and efforts you can get the facts. Also it is incorrect to consider that the actions undertaken are to ‘evade’ laws or regulatory guidelines. They are done to avoid regulatory hurdles. I need to differentiate this because it is what the lawyers always point out. I will leave it to others why people might want to worry about the wording of what are clearly material facts in such a manner.
As an investor it says to me simply - Caveat Emptor in bold letters.
Like Archimedes the Greek before me, I discovered the answer in Greece – Eureka!
Every parent has had that moment when their child asks them the simplest sounding question but in that instance before you respond, you realize you have never really thought about it and actually don’t know the real truth. To not have an answer would be to lose all credibility as the ‘all knowing’ parent. Like generations of parents before you – you bluff!
When asked why there are $605 Trillion derivatives outstanding (1) how do you articulate an answer to this horrendous and almost unimaginable number? The US is the largest economy in the world but tallies only 2.3% in comparison. Global bank reserves amount to only 1.2% of this accumulation. The gargantuan size appears to defy all logic.
Before some of you experts out there accuse me of sensationalism let me quickly give you the response of the “all knowing” to knock this number down to something that is intended to allow you to once again sleep at night.
First $605 is the notional value. This number according to experts (2) is best used simply to get an indication of how rapidly the overall derivatives market is growing (wow) since it doesn’t represent the value of what is at stake to the parties engaged in the transaction. It double counts positions, doesn’t represent what changes hands and doesn’t discount hedges that offset each other. What we need to consider is settlement amounts if all the contracts had to be settled today for some unknown reason (i.e. a 1930’s bank holiday crisis?). Our number then drops to just over $25T. That sounds better but still is a staggering figure considering the assets of the US are estimated to be $56T and is 1/3 of global assets (3). Not to be deterred our ‘all knowing’ experts would then assuredly point out that actually the number is a mere $3.7T when all the contracts directly offsetting each other are netted. Appeased, our cocktail chatter would resume in a much more subdued tone. Or should it?
I have been thinking about the truth regarding this imponderable for a few years now. I have likewise successfully answered the question at numerous polite social gatherings but never felt comfortable with my response. My credibility intact I would scold myself to delve more thoroughly.
Eureka!
While authoring my recent article 8 Fault Lines in the Euro Experiment which was prompted by the debacle in Greece, I found myself like Archimedes the Greek before me, shouting Eureka – I have alas found it! But before I share the ‘all knowing truth’ with you I must caution those with weak hearts and small children: parental guidance is advised!
8 YEARS OF PAIN
In 2007 I authored another paper entitled ‘8 Years of Pain’. It called for a US housing collapse and a resulting derivatives implosion. We sort of got the score right but the lyrics were wrong. Similar to the Titanic, we knew Icebergs were out there but we didn’t have the required instruments needed to identify it clearly with sufficient precision. In hindsight we now realize it was because we still weren’t aware of exactly how banks were using SIV’s (Structured Investment Vehicles) to sell CDOs and protect themselves with CDSs. The mechanics of how Toxic instruments were actually being created wasn’t readily available in the public domain. These instruments had yet to have the media spotlight shown on them as they lurked quietly through dark waters. We knew of SPE’s (Special Purpose Entities) from the Enron debacle, so we suspected something similar but we could only speculate. The puzzle we had was that $437T of the $605T of the notional value of derivatives outstanding were Interest Rate Contracts and $342T of these were specifically Interest Rate Swaps with a Gross Market Value of $13.9T. Calculations indicated there was insufficient cross border corporate and financial sector needs for this level of exchange - by orders of magnitude.
EURO EXPERIMENT
The Enron debacle and the Financial Crisis taught me to dig deeper (and fast!) when I suspect the Wall Street Merlins have been insidiously concocting their magical brews. As the Greek crisis was unfolding, by happenstance I discovered SPC (Special Purpose Company) and PPI/PFI’s. I also discovered the SPC Titlos PLC which I outlined in 8 Fault Lines in the Euro Experiment. I realized;
Massive Monetary Money is being created through Interest/Currency Rate Swap Derivatives
In our modern monetary fractional banking system money can only be borrowed into existence. It can only be created through the act of lending. By facilitating the ability to lend, money can and is created. It takes three elements for this to occur: 1) A lender with the ability to lend,
2) A borrower with a need and
3) The same borrower with sufficient collateral to actually secure the loan.
ACCOUNTING STANDARDS – Corporate, Financial & Public
Almost all Sovereign Treasuries have the continuous lust for borrowing and historically almost unlimited public assets to pledge as collateral. The problem is neither the need nor collateral. The problem is public perception as viewed through the optic lenses of public sector accounting standards. Circumvent the restrictive public accounting standards and Eureka – we have a lender. Like Enron it was about circumventing private sector accounting standards through off balance sheet SPE’s. In the financial crisis we found it was the banks circumventing banking capital accounting standards by off balance sheet SIV’s. In both instances it is motivated by the advantage of removing obligations from the reported asset / liability ledger.
This is precisely the brew the great Merlins – like Goldman Sachs have delivered to Sovereign powers as the magic elixir for public accounting standards. Our political leaders like Enron executives and bank executives before them have become drunkards on the magic elixir. It gives politicians (the ultimate alcoholics) the power to take on more debt without impacting the traditional metrics which increase borrowing costs.
.
.
.
.
.
.
.
.
.
.
ARCHIMEDES’ AXIOM
This allows the International Banks to effectively become mini Federal Reserves, lending money into creation by being ready whenever ANY global central bank is ready to expand their money supply. Like the US Mortgage bubble they can’t get enough product.
SULTANS OF SWAP
Why is everything hidden in the murky depths called “special” – like SPE, SPV or “Structured” – like SIV? The answer is to keep them off the balance sheet. Why would you not want something on the balance sheet where investors and interested parties could see what is happening? Obviously so you can camouflage them from what is happening.
The reason is fundamentally Credit Ratings. Keep your debts low and your credit ratings high and the cost of money is cheap. The cheaper money is, the more borrowing will occur. Everyone is happy except the unwitting lender.
It is here ladies and gentlemen that we discover the Sultans of Swap. The Bond Vigilantes are of a previous era. They are dead – RIP. Through the magic mix of Credit Default Swaps, Dynamic Hedging and Interest Rate Swaps the Sultans of Swaps effectively control interest rate spreads. Through Regulatory Arbitrage they extort tremendous political sway globally. They live in the world of risk free spreads. Low interest rates simply attract more volume for their concoctions. We have had an explosion in Money Supply globally as the charts (right) indicate. The parabolic rise matches the increase in these derivative products along with their ability to turn Interest Rate Swaps into high powered bank lending.
Like Achilles Heel in Greek mythology, there is an exposure. Everything is based on tax payers paying, GDP expanding and interest rates staying low. Titlos PLC shows severe structured collateral calls when these assumptions change even modestly (5).
CASCADING COLLATERAL CALLS
With $3.7T in Gross Derivative Credit Exposure outstanding, how many Greek Sovereign downgrades would it take to begin cascading collateral calls? Don’t forget that we have witnessed dramatic shortening of government “duration” over the last few years. There are massive ‘rollovers’ looming that will further compound rates and their associated collateral requirements.
One final point, I need to be really clear here. Nothing is actually hidden in all this. It is typically there in the small type footnotes that are extremely difficult to interpret or referenced to a document that is difficult to get your hands on. With enough time and efforts you can get the facts. Also it is incorrect to consider that the actions undertaken are to ‘evade’ laws or regulatory guidelines. They are done to avoid regulatory hurdles. I need to differentiate this because it is what the lawyers always point out. I will leave it to others why people might want to worry about the wording of what are clearly material facts in such a manner.
As an investor it says to me simply - Caveat Emptor in bold letters.
Like Archimedes the Greek before me, I discovered the answer in Greece – Eureka!
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