How Big is the Derivatives Crisis?

My last post discussed the general concept of Derivatives. Now, let me give you some wild conjecture about the scope of the derivatives crisis.

The Bureau of International Settlements (BIS) estimates the derivatives market at about $600 Trillion. But that's the notional value - the face value. That's like saying that the face value of insurance policies is $600 Trillion - the actual amount paid out by insurance companies is a fraction of the total of all the face values of all the policies in the world combined.

So what's the real risk level?

Well, derivatives can be mere side bets - and, like the Super Bowl, the bets for and against any particular outcome should roughly even out. The BIS tries to estimate

But how much money is really going to be lost? Here's some guesses.

The derivatives market "insures" the value of assets, typically financial assets like stocks, bonds, and real estate. Financial assets are under pressure right now. The majority of real estate loans issued in the last few years borrowed against property in Florida, California, and Nevada. The once-hottest markets are now the icy-est, with property-value declines of 40% in the Sacramento market, and, conservatively, 20% in the majority of really-hot (and widely invested-in) markets. The stock market is down from a Dow of 14,000 to less than 9,000 (about a 35% decline). Oil is down from a high around $140 to today's value around $70 - a 50% decline.

So the assets that underlie the derivatives contracts have declined by about 30% (a very, very rough average of the declines in major asset categories). A homeowners' insurance contract doesn't pay out unless the house is damaged - an awful lot of our financial houses are on fire right now. This is an economic Hurricane Katrina, 1906 Earthquake, and Midwestern flood all in one.

If an insured car is totalled, the insurance company will try to sell the car for scrap and parts, while paying the car's owner to replace the car. The insurance company is out the difference between the market value of the car and the scrap value of the car. Well, with an options contract, you don't actually lose the full notional value of the contract, you merely lose (or win) the difference between today's market value and the notional value. If I buy a put contract on Corning stock at $20, the counter party doesn't lose $20 - they lose the difference between today's stock price (~$11) and the $20 contract price. So instead of losing $20, they lose $9.

So BIS says the total derivatives market is about $600 Trillion in notional value. That's like saying the Corning derivatives market is $20 - it doesn't mean anyone is losing $20 (or $600 Trillion). What they'll lose is the difference between today's value and the contract value.

Let's try a wild guess. If the major assets (real estate, stocks, oil) are down, that's the economic equivalent of a house fire. The "insurance companies" (derivatives counter parties) will have to pay out. The house isn't a total loss. Suppose that 10% of the derivatives market has to pay out - 10% of a $600 Trillion market is $60 Trillion. Now, stocks, bonds, real estate, and oil aren't total losses - they're just down.

So suppose the payout on the insurance policies (derivatives market) is the difference between face value and current value - that's about a 20% decline, on average, conservatively. That's $60 Trillion of derivatives (10% of the total derivatives market) paying out a 20% loss. That's $12 Trillion. That is, roughly, the equivalent of a full year's income for the United States as a whole. That is about 1/6th of the entire world's annual income.

Let's put this in perspective. Would you be okay with a salary reduction of 1/6th of your income? Would you be okay with your taxes increasing by 1/6th of your income? Would you lose weight if you ate 1/6th less than you eat today? 1/6th of the entire world's GDP is a lot.

I really think that assuming only 10% of the derivatives market will have to pay out, and that their losses will only be 20% of the total notional value at risk, is incredibly conservative. But, at least, having a reasonable floor gives us a basis for guesstimating the ceiling.