While reviewing this post from 2002, foreshadowing a derivatives crisis like the current one, I found the following:
“At the end of 2002’s first quarter, the notional value of derivatives contracts involving U.S. commercial banks and trust companies was $45.9 trillion, according to the Office of the Comptroller of the Currency’s bank derivatives report. ”
The bulk of the exposure is in interest rate swaps, which are fairly well understood and seem to pose only modest risks in themselves. But there’s still around $1 trillion in more recent derivatives involving securitisation of various kinds of debts. This securitisation is sound only if the credit rating agencies have got their risk assessments right, which in turn requires that the accounts on which those assessments are based should be valid. A few years ago, when the market in debt derivatives was starting up, this assumption seemed safe enough, but now it looks a lot more dubious. The big danger is that defaults in the debt derivatives market could spread to the much larger interest rate derivatives markets.
As an update, the $1 trillion in credit derivatives has exploded to around $50 trillion. While less dramatic in proportional terms, the growth in interest rate swaps is actually more alarming, having reached around $300 trillion in notional values.
It now seems pretty well certain that, as the quote above suggests, the chaos in debt derivatives will shortly spread to interest rate swaps.
There are two reasons for this. First, swaps are essentially bets on interest rate spreads and these have gone wild in the last week, with interest rates on Treasury notes dropping to zero while commercial paper is just about unsaleable at any price. Imperfectly hedged players in the market must be sitting on losses of several percentage points. Depending on how much of this there is, the implied losses could be anywhere from tens of billions to trillions. Crowdsourcing plea: anyone who has a better estimate is welcome to offer it.
Second, hedging only works if you can collect from your counterparties. This Economist story indicates that Lehmans was a big player, but no-one really knows who is owed money by them. And it seems certain that there will be large-scale failures among hedge funds in coming months.
It’s hard to see this crisis being resolved by normal commercial or regulatory means. The hundreds of billions tipped into the market by central banks yesterday is just a drop in the bucket compared to the sums at risk here.
Unless that is, all normal calculations are rendered irrelevant by a US government asset purchase on a scale that will make all past nationalizations look puny. How that will play out I have no idea. For example, will US-based ratings agencies take the step (automatic if it were anyone else) of downgrading US government debt?
fn1. Under normal conditions, the exposure associated with a swap is of the order of 1 per cent of the notional value. But (a) 1 per cent of 300 trillion is 3 trillion (b) conditions are not exactly normal right now.