Explaining the massive derivatives market and why the Bear Stearns bailout was necessary
With the markets looking a little more rosier these days, we can only remind ourselves of the ghost of Bear Stearns' bail out only 48 days ago. It's still being interpreted. On Saturday, Warren Buffett talked about the bailout, the problems with the derivatives market, and the declining risk of a financial meltdown, and mentioned an incredible statistic that I thought was a typo:
To put this in perspective, the 2008Q1 US Gross Domestic Product is about the same as the value of Bear's derivative contracts - $14.2 trillion. And I agree, a panicked run on $14.5 trillion could have taken out a few banks along the way.If Bear had failed, one or two other investment banks would probably have collapsed within a few days, he said, adding that Bear had roughly $14.5 trillion of derivative contracts outstanding the day after it was bailed out.
"The parties that had those contracts would have had to establish the damages that they could claim against that estate very quickly," he said. "Imagine the damage of everyone trying to unwind those contracts," Buffett said. "That would have been a spectacle of unprecedented proportions. It would have resulted in another one or two investment banks going down in a few days."
*US commercial banks own about $170 trillion of the total ~$516 trillion derivatives market
I didn't exactly realize how big the derivatives market was vis-a-vis the underlying assets they hedge:
Derivatives let holders bet on or guard against gains or declines in an underlying asset without having to own the asset. They can be tied to things ranging from gold to cocoa, with most based on interest rates and currencies. Swaps, agreements to exchange types of interest payments, make up the largest portion of the market.Derivatives generally give institutional investors greater flexibility and liquidity for portfolio risk management in exchange for higher leverage that makes them riskier. However, credit tightening has made these markets more illiquid. The Armageddonists have been claiming logically that the derivatives can accelerate a meltdown sparked by a death spiral that could have been initiated with the bankruptcy of several US banks like Bear Stearns.
The market for derivatives, contracts based on underlying assets, is more than five times as big as global gross domestic product for 2002 as measured by the World Bank. Of the world's largest 500 companies, 92 percent use derivatives to insure against moves in borrowing costs, currencies or commodities, according to the International Swaps and Derivatives Association.
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