(This is Part 1 of a 2-part article.)
Don't get me started! Okay, just a little bit. I'm going to talk about just one aspect of the increasingly Alice-in-Wonderland financial world.
I'm going to talk about derivatives. Yes, derivatives. How boring! Who cares what the total amount of derivatives is?
Well just for laughs, try this number on for size: The total amount of derivatives is now estimated, by the Internation Swaps and Derivatives Association, to be $283.2 trillion.
And what are these derivatives they're talking about? No, they're not talking about exchange derivatives, like stock options, futures contracts and such, which are piddling by comparison. They're talking about
unregulated, unseen derivatives contracts between banks, insurance companies, pension funds, hedge funds, etc.
These are complex, non-market financial transactions—based upon underlying instruments like bonds, stocks and real estate—between gargantuan financial pools of money. And like an iceberg, most of it is unseen and unremarked. When was the last time you heard about this in the financial media? But believe me, this iceberg, like the one that sank the Titanic, could sooner or later could bring about a similar result.
Now let's back up a moment. You may have thought that the number quoted for the total amount of derivatives was $283.2 billion, and I made a little typo. Oh, no. The number is $283.2 trillion, with a "t".
To show you just how unfathomable that number is, consider this:
That number is about 7 times the economic output of the entire world, at about $40 trillion. It's about 9 times the value of all real estate in the entire United States, at about $30 trillion. It's about 7 times the value of all stock markets in the entire world, at about $41 trillion.
These derivative contracts are of two main types: In general, they're either bets, say about the direction of interest rates or the direction of some market; or they're insurance, that is, they take on a hedging function against a market position. Often the same contract is both things at once, just opposite sides of the same transaction.
As far as bets go, we've recently seen in the $6 billion loss in natural gas by the Amaranth hedge fund that even bets by experienced traders can suddenly, unexpectedly and spectacularly go south in a big way.
And as far as insurance or hedging goes, tell me this: If the financial world suddenly experiences a big crunch, where is a couple hundred
trillion dollars of insurance to be found, given that it exceeds the wealth of the entire world?
In fact, the world has been awash in liquidity the past few years (actually for decades, but that's another story). Central banks and other entities have been creating money and credit, especially the past few years, like there's no tomorrow. In my opinion, that's the only thing that's been keeping this Everest of debt and derivatives going.
Yes, the sun's been shining. But what happens when the sun goes behind a cloud and the financial system suddenly experiences a major shock of some kind?
Call me a Cassandra, but history teaches that a system of any kind, whether it's an empire or a financial system, will experience a major shock sooner or later. It's just in the nature of things. And if that system is fragile, it's far less likely to be able to withstand the shock.
Better get some gold, my friends. It's the only thing that's really money, it's been that way for 5000 years, and it may be the only thing that has a chance of preserving some value intact if that cold-looking object up ahead is what I think it is.
(This is the end of Part 1. Go to Part 2.)
—jim sloman, 9.28.06
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