Sometimes problems are bigger than we thought.  Sometimes we need a bigger boat.  

Here’s a reblog of an article by DKMatai which calculates the face values of “all derivatives”.   I think this article is sensational and incorrect to use this sort of math to estimate the size of the financial crisis.  

http://www.siliconvalleywatcher.com/mt/archives/2008/10/the_size_of_der.php

There are risks to many derivatives, leveraged ones and credit default swaps, certainly, but lets take for example interest rate swaps.  

Example: Interest Rate Swap

Putting on the Trade - Most swaps trades are put on at zero value (they exchange a fixed bond rate for a floating rate), either between a bank and a company or a bank and a bank.  In this case, we’ll say its between a large corporation, GN, and a large bank, called PIG.  The face value of our example swap is on GN’s bond issuance of $1 billion.  The market value of the swap on day 1 is simply the net present value differential of leg 1 of the swap vs leg 2, which is zero to start.

Change in Rates - Let’s say there’s a change in rates, so the value of our $1b GN-PIG swap might change by 12-15% if there were a 100 basis point shift in rates.  This has no impact on GN’s balance sheet other than the small changes in semiannual floating rates its making its swap payments on.  (The swap changed GN’s fixed rate bond to a floating rate bond).  There’s no change to PIG’s balance sheet or income because it has hedged both the fixed and the floating rate legs of the swap in the bond market.

Somebody Defaults - Let’s say PIG defaults on this swap, then GN would simply go back to paying its fixed rate on its bond.  If GN defaults on its bond and the swap, and if the swap is underwater (otherwise, GN would just unwind the swap and take its profit), then PIG will simply unwind it’s hedge and would lose the NPV of difference between its cash flow expectation on the swap vs. the hedge, which amounts to a spread of the interest rate changes that were hedged by PIG.  So in this case, there’s a derivative, the swap, but there’s really no leverage, nor is there the possibility for an enormous meltdown.  The $1billion value of the swap is simply a face value; no one can lose $1b here.  

Change in Credit Risk with No Default - But wait, there is another type of risk where PIG can lose money.  The mark-to-market value of the swap can also change if either counterparty has a change in their credit rating.  So, theoretically, PIG is holding an interest-only “note” in receiving the fixed rate payments from GN and next GN’s credit rating is downgraded, then the mark-to-market value of the whole swap goes down (by the NPV of GN’s new fixed theoretical borrowing rate).  While GN may be in no danger whatsoever of not making payments on the $1b bond or the swap, PIG  has to reflect the change in the price of this swap immediately on its balance sheet.  

Credit Risk and Capital - Any bank’s, including PIG’s, normal business practice would be to allocate very little of its risk capital to such a swap, as it is capable of hedging most of the risk, ideally 100% of its interest rate risk.   As for its credit risk, that was likely hedged with a credit derivative.   So low risk would indicate that PIG assign only a small amount of capital to hedge the different risks.  And so the picture of how this meltdown happened begins to emerge more clearly.  If hedge funds and banks are either at risk because of a paradigm shift in credit quality across every single security in the market, or default of a financial institution (Lehman, hedge fund)  with which the credit risk was hedged.

Summary - Under a shift in credit spread scenario, if there were the same shift in GN’s fixed borrowing spread when its rating is lowered, 100 basis points, PIG must take that whole hit immediately on  through its income statement (mark-to-market accounting), as if PIG was selling the security in the market.  So PIG takes the entire hit of the lower price, even though the bond and swap are still in place, and absolutely no one has defaulted on any portion of this transaction.  

Even if nobody defaults, everyone goes under

So it’s the combination of mark-to-market accounting rules and leverage that’s wiping out the theoretical values of  retained capital on balance sheets of banks, rendering them insolvent.  A shift to a just slightly more favorable economic environment (where credit ratings weren’t in free fall, but stabilized again, leaving many companies perfectly healthy) could make the whole financial crisis evaporate into thin air — as many assets that are underwater today could mark better with a fundamental shift in credit.  That said, bankruptcies, shrinking GDP, small business failures, defaults, tight/unavailable credit, falling prices, falling asset values — the domino effect that’s in place has a much bigger chance of falling the other way, depression, massive unemployment and slow growth.  

It’s not really the derivatives

So, blaming “derivatives” really misses the boat.  The meltdown’s roots are much more steeped in the sub-prime mortgage crisis, low interest rates, easy credit, the real estate bubble, and leverage previous allowed to home buyers.  By that kind of leverage I mean issuing a mortgage to a homeowner with no money down and accreting principal.  The sub-prime crisis created a domino effect with healthy banks becoming insolvent essentially overnight due to the mark-to-market values of any mortgage-related assets they were holding, and any defaults from insolvent institutions.   

It’s interesting to discuss capital here.  When there’s no capital down, corporations and people can walk away.   Our system has a built-in problem which kicks in during economic distress periods.    If someone’s home goes to 50% of its purchase value, the homeowner is probably going want to walk away, particularly if they have a small amount of capital in the property.   In this case, originally the bank was holding a mortgage, an asset, and when the owner walks away, they are now holding a house which at best is worth 50% of it’s value and needs to be maintained.  Much of America’s housing is at about 50% of it’s peak level.   Many intelligent homeowners would walk away on those economics alone, not to mention a layoff or a retirement fund wipeout.