$1.2 Quadrillion Derivatives Market Dwarfs World GDP

AOL Finance

One of the biggest risks to the world’s financial health is the $1.2 quadrillion derivatives market. It’s complex, it’s unregulated, and it ought to be of concern to world leaders that its notional value is 20 times the size of the world economy. But traders rule the roost — and as much as risk managers and regulators might want to limit that risk, they lack the power or knowledge to do so.

A quadrillion is a big number: 1,000 times a trillion. Yet according to one of the world’s leading derivatives experts, Paul Wilmott, who holds a doctorate in applied mathematics from Oxford University (and whose speaking voice sounds eerily like John Lennon’s), $1.2 quadrillion is the so-called notional value of the worldwide derivatives market. To put that in perspective, the world’s annual gross domestic product is between $50 trillion and $60 trillion.

To understand the concept of “notional value,” it’s useful to have an example. Let’s say you borrow $1 million to buy an apartment and the interest rate on that loan gets reset every six months. Meanwhile, you turn around and rent that apartment out at a monthly fixed rate. If all your expenses including interest are less than the rent, you make money. But if the interest and expenses get bigger than the rent, you lose.

You might be able to hedge this risk of a spike in interest rates by swapping that variable rate of interest for a fixed one. To do that you’d need to find a counter party who has an asset with a fixed rate of return who believed that interest rates were going to fall and was willing to swap his fixed rate for your variable one.

The actual cash amount of the interest rates swaps might be 1% of the $1 million debt, while that $1 million is the “notional” amount. Applying that same 1% to the $1.2 quadrillion derivatives market would leave a cash amount of the derivatives market of $12 trillion — far smaller, but still 20% of the world economy.

Getting a Handle on Derivatives Risk

How big is the risk to the world economy from these derivatives? According to Wilmott, it’s impossible to know unless you understand the details of the derivatives contracts. But since they’re unregulated and likely to remain so, it is hard to gauge the risk.

But Wilmott gives an example of an over-the-counter “customized” derivative that could be very risky indeed, and could also put its practitioners in a position of what he called “moral hazard.” Suppose Bank 1 (B1) and Bank 2 (B2) decide to hedge against the risk that Bank 3 (B3) and Bank 4 (B4) might fail to repay their debt to B1 and B2. To guard against that, B1 and B2 might hedge the risk through derivatives.

In so doing, B1 and B2 might buy a credit default swap (CDS) on B3 and B4 debt. The CDS would pay B1 and B2 if B3 and B4 failed to repay their loan. B1 and B2 might also bet on the decline in shares of B3 and B4 through a short sale.

At that point, any action that B1 and B2 might take to boost the odds that B3 and B4 might default would increase the value of their derivatives. That possibility might tempt B1 and B2 to take actions that would boost the odds of failure for B3 and B4. As I wrote back in September 2008 on DailyFinance’s sister site, BloggingStocks, this kind of behavior — in which hedge funds pulled their money out of banks whose stock they were shorting — may have contributed to the failures of Bear Stearns and Lehman Brothers.

It’s also the sort of conduct that makes it extremely difficult to estimate the risk of the derivatives market.

How Positive Feedback Loops Crash Markets

Another kind of market conduct that makes markets volatile is what Wilmott calls positive and negative feedback loops. These relatively bland-sounding terms mask some really scary behavior for investors who are not clued into it. Wilmott argues that a positive feedback loop contributed to the 22.6% crash in the Dow back in October 1987.

In the 1980s, a firm run by some former academics came up with the idea of portfolio insurance.

Their idea was that if investors are worried about their assets losing value, they can buy puts — the option to sell their investments at pre-determined prices. They can sell everything — which would be embarrassing if the market then started to rise — or they could sell a fixed proportion of their portfolio depending on the percentage decline in a particular stock market index.

This latter idea is portfolio insurance. If the Dow, for example, fell 3%; it might suggest that investors should sell 20% of their portfolio. And if the Dow fell 20%, it would indicate that investors should sell 100% of their portfolio.

That positive feedback loop — in which a stock price decline leads to more selling — boosts market volatility. Portfolio insurance causes more investors to sell as the market declines by, say 3%, which causes an even deeper plunge in the value of investors’ holdings. And that deeper decline leads to more selling. Before you know it, many investors are selling everything.

The portfolio insurance firm started off with $5 billion, but as its reputation spread, it ended up managing $50 billion. In 1987, that was a lot of money. So when that positive feedback loop got going, it took the Dow down 22.6% in a day.

The big problem back then was the absence of a sufficient number of traders using a negative feedback loop strategy. With a negative feedback loop, a trader would sell stocks as they rose and buy them as they declined. With a negative feedback loop strategy, volatility would be far lower.

Unfortunately, data on how much money has been going into negative and positive feedback loop strategies is not available. Therefore, it’s hard to know how the positive feedback loops have gained such a hold on the market.

But it is not hard to imagine that if a particular investor made huge amounts of money following a positive feedback loop strategy, other investors would hear about it and copy it. Moreover, the way traders get compensated suggests that it’s better for them to take more and more risk to replicate what their peers are doing.

Traders Make More Money By Following the Pack

There is a clear economic incentive for traders to follow what their peers are doing. According to Wilmott, to understand why, it helps to imagine a simplified example of a trading floor. Picture yourself as a new college graduate joining a bank’s trading floor with 100 traders. Those 100 traders each trade $10 million: They “win” if a coin toss lands on heads and “lose” if it lands on tails. But now imagine you’ve come up with a magic coin that has a 75% chance of landing on heads — you can make a better bet than the other 100 traders with their 50-50 coin.

You might think that the best strategy for you would be to bet your $10 million on that magic coin. But you’d be wrong. According to Wilmott, if the magic coin lands on a head but the other 100 traders flip tails, the bank loses $1 billion while you get a relatively paltry $10 million.

The best possible outcome for you is a 37.5% chance that everyone makes money (the 75% chance of you tossing heads multiplied by the 50% chance of the other traders getting a head). If instead, you use the same coin as everyone else on the floor, the probability of everyone getting a bonus rises to 50%.

When Traders Say ‘Jump,’ Risk Managers Ask ‘How High?’

Traders are a huge source of profit on Wall Street these days and they have an incentive to bet together and to bet big. According to Wilmott, traders get a bonus based on the one-year profits of those on their trading floor. If the trading floor makes big money, all the traders get a big bonus. And if it loses money, they get no bonus — but at least they don’t have to repay their capital providers for the losses.

Given that bonus structure, a trader is always better off risking $1 billion than $1 million. So if the trader, who is the king of the hill at the bank, asks a lowly risk manager to analyze how much risk the trader is taking, that risk manager is on the spot. If the risk manager comes back with a risk level that limits how big a bet the trader can take, the trader will demand that the risk manager recalculate the risk level lower so the trader can take the bigger bet.

Traders also manipulate their bonuses by assuming the existence of trading profits before they are actually realized. This happens when traders get involved with derivatives that will not unwind for 20 years.

Although the profits or losses on that trade have not been realized at the end of the first year, the bank will make an assumption about whether that trade made or lost money each year. Given the power traders wield, they can make the number come out positive so they can receive a hefty bonus — even though it is too early to tell what the real outcome of the trade will be.

How Trader Incentives Caused the CDO Bubble

Wilmott imagines that this greater incentive to follow the pack is what happened when many traders were piling into collateralized debt obligations. In Wilmott’s view, CDO risk managers who had analyzed a future scenario in which housing prices fell and interest rates rose would have concluded that the CDOs would become worthless under that scenario. He imagines that when notified of that possible outcome, CDO traders would have demanded that the risk managers shred that nasty scenario so they could keep trading more CDOs.

Incidentally, the traders who profited by going against the CDO crowd were lone wolves whose compensation did not depend on following the trading floor pack. This reinforces the idea that big bank compensation policies drive dangerous behavior that boosts market volatility.

What You Don’t Understand, You Can’t Properly Regulate

Wilmott believes that derivatives represent a risk of unknown proportions. But unless there is a change to trader compensation policies — one which would force traders to put their compensation at risk for the life of the derivative — then this risk could remain difficult to manage.

Unfortunately, he thinks that regulators aren’t in a good position to assess the risks of derivatives because they don’t understand them. Wilmott offers training in risk management. While traders and risk managers at banks and hedge funds have taken his course, regulators so far have not.

And if regulators don’t understand the risks in derivatives, chances are great that Congress does not understand them either.

The Psychopathic Criminal Enterprise Called America

The Government uses the Law to Harm People and Shield the Establishment
By Prof. John Kozy
District of Criminals, for criminals and by criminals

District of Criminals, for criminals and by criminals.

Most Americans know that politicians make promises they never fulfill; few know that politicians make promises they lack the means to fulfill, as President Obama’s political posturing on the Deepwater Horizon disaster in the Gulf of Mexico makes perfectly clear.

Obama has made the following statements:

He told his “independent commission” investigating the Gulf oil spill to “thoroughly examine the disaster and its causes to ensure that the nation never faces such a catastrophe again.” Aside from the fact that presidential commissions have a history of providing dubious reports and ineffective recommendations, does anyone really believe that a way can be found to prevent industrial accidents from happening ever again? Even if the commissions findings and recommendations succeed in reducing the likelihood of such accidents, doesn’t this disaster prove that it only takes one? And unlikely events happen every day.

The president has said, “if laws are insufficient, they’ll be changed.” But no president has this ability, only Congress has, and the president must surely know how difficult getting the Congress to effectively change anything is. He also said that “if government oversight wasn’t tough enough, that will change, too.” Will it? Even if he replaces every person in an oversight position, he can’t guarantee it. The people who receive regulatory positions always have ties to the industries they oversee and can look forward to lucrative jobs in those industries when they leave governmental service. As long as corporate money is allowed to influence governmental action, neither the Congress nor regulators can be expected to change the laws or regulatory practices in ways that make them effective, and there is nothing any president can do about it. Even the Congress’ attempt to raise the corporate liability limit for oil spills from $75 million to $10 billion has already hit a snag.

The President has said that “if laws were broken, those responsible will be brought to justice” and that BP would be held accountable for the “horrific disaster.” He said BP will be paying the bill, and BP has said it takes responsibility for the clean-up and will pay compensation for “legitimate and objectively verifiable” claims for property damage, personal injury, and commercial losses. But “justice” is rendered in American courts, not by the executive branch. Any attempts to hold BP responsible will be adjudicated in the courts at the same snail’s pace that the responsibility for the Exxon-Mobile Alaska oil spill was adjudicated and likely will have the same results.

The Exxon Valdez oil spill occurred in Prince William Sound on March 24, 1989. In Baker v. Exxon, an Anchorage jury awarded $287 million for actual damages and $5 billion for punitive damages, but after nineteen years of appellate jurisprudence, the Supreme Court on June 25, 2008 issued a ruling reducing the punitive damages to $507.5 million, roughly a tenth of the original jury’s award. Furthermore, even that amount was reduced further by nineteen years of inflation. By that time, many of the people who would have been compensated by these funds had died.

The establishment calls this justice. Do you? Do those of you who reside in the coastal states that will ultimately be affected by the Deepwater Horizon disaster really believe that the President can make good on this promise of holding BP responsible? By the time all the lawsuits filed in response to this disaster wend their ways through the legal system, Mr. Obama will be grayed, wizened, and ensconced in a plush chair in an Obama Presidential Library, completely out of the picture and devoid of all responsibility.

Politicians who engage in this duplicitous posturing know that they can’t fulfill their promises. They know they are lying; yet they do it pathologically. Aesop writes, “A liar will not be believed, even when he speaks the truth.” Perhaps that’s why politicians never do.

Government in America consists of law. Legislators write it, executives apply it, and courts adjudicate it. But the law is a lie. We are told to respect the law and that it protects us. But it doesn’t. Think about it people! The law and law enforcement only come into play secundum vitium (after the crime). The police don’t show up before you’re assaulted, robbed, or murdered; they come after. So how does that protect you? Yes, if a relationship of trust is violated, you can sue if you can afford it, and even that’s not a sure thing. (Remember the victims of the Exxon-Valdez disaster!) Even if the person who violated the relationship gets sanctioned, will you be “made whole”? Most likely not! Relying on the law is a fool’s errand. It’s enacted, enforced, and adjudicated by liars.

The law is a great crime, far greater than the activities it outlaws, and there’s no way you can protect yourself from it. The establishment protects itself. The law does not protect people. It is merely an instrument of retribution. It can only be used, often ineffectively, to get back at the malefactor. It never un-dos the crime. Executing the murderer doesn’t bring back the dead. Putting Ponzi schemers in jail doesn’t get your money back. And holding BP responsible won’t restore the Louisiana marshes, won’t bring back the dead marine and other wildlife, and won’t compensate the victims for their losses. Carefully watch what happens over the next twenty years as the government uses the law to shield BP, Transocean, and Halliburton while the claims of those affected by the spill disappear into the quicksand of the American legal system.

Jim Kouri, citing FBI studies, writes that “some of the character traits exhibited by serial killers or criminals may be observed in many within the political arena.;” they share the traits of psychopaths who are not sensitive to altruistic appeals, such as sympathy for their victims or remorse or guilt over their crimes. They possess the personality traits of lying, narcissism, selfishness, and vanity. These are the people to whom we have entrusted our fate. Is it any wonder that America is failing at home and world-wide?

Some may say that this is an extreme, audacious claim. I, too, was surprised when I read Kouri’s piece. But anecdotal evidence to support it is easily cited. John McCain said “bomb, bomb, bomb” during the last presidential campaign in response to a question about Iran. No one in government has expressed the slightest qualms about the killing of tens of thousands of people in both Iraq and Afghanistan who had absolutely nothing to do with what happened on nine/eleven or the deliberate targeting of women and children by unmanned drones in Pakistan. What if anything distinguishes serial killers from these governmental officials? Only that they don’t do the killing themselves but have others do it for them. But that’s exactly what most of the godfathers of the cosa nostra did.

So, there are questions that need to be posed: Has the government of the United States of America become a criminal enterprise? Is the nation ruled by psychopaths? Well, how can the impoverishment of the people, the promotion of the military-industrial complex and endless wars and their genocidal killing, the degradation of the environment, the neglect of the collapsing infrastructure, and the support of corrupt and authoritarian governments (often called democracies) abroad be explained? Worse, why are corporations allowed to profiteer during wars while the people are called upon to sacrifice? Why hasn’t the government ever tried to prohibit such profiteering? It’s not that it can’t be done.

In the vernacular, harming people is considered a crime. It is just as much a crime when done by governments, legal systems, or corporations. The government uses the law to harm people or shield the establishment from the consequences of harming people all the time. Watch as no one from the Massey Energy Co. is ever prosecuted for the disaster at the Upper Big Branch coal mine. When corporations are accused of wrongdoing, they often reply that what they did was legal, but legal is not a synonym for right. When criminals gain control, they legalize criminality.

Unless the government of the United States changes its behavior, this nation is doomed. No one in government seems to realize that dissimulation breeds distrust, distrust breeds suspicion, and suspicion eventually arouses censure. Isn’t that failure of recognition by the establishment a sign of criminal psychopathology?
John Kozy is a retired professor of philosophy and logic who blogs on social, political, and economic issues. After serving in the U.S. Army during the Korean War, he spent 20 years as a university professor and another 20 years working as a writer. He has published a textbook in formal logic commercially, in academic journals and a small number of commercial magazines, and has written a number of guest editorials for newspapers. His on-line pieces can be found on http://www.jkozy.com/ and he can be emailed from that site’s homepage.

White House, British Petroleum Oil Spill Cover-Up

Wayne Madsen Report

WMR has been informed by sources in the US Army Corps of Engineers, Federal Emergency Management Agency (FEMA),BPand Florida Department of Environmental Protection that the Obama White House and British Petroleum (BP), which pumped $71,000 into Barack Obama’s 2008 presidential campaign — more than John McCain or Hillary Clinton–, are covering up the magnitude of the volcanic-level oil disaster in the Gulf of Mexico and working together to limit BP’s liability for damage caused by what can be called a “mega-disaster.”

Obama and his senior White House staff, as well as Interior Secretary Ken Salazar, are working with BP’s chief executive officer Tony Hayward on legislation that would raise the cap on liability for damage claims from those affected by the oil disaster from $75 million to $10 billion. However, WMR’s federal and Gulf state sources are reporting the disaster has the real potential cost of at least $1 trillion. Critics of the deal being worked out between Obama and Hayward point out that $10 billion is a mere drop in the bucket for a trillion dollar disaster but also note that BP, if its assets were nationalized, could fetch almost a trillion dollars for compensation purposes. There is talk in some government circles, including FEMA, of the need to nationalize BP in order to compensate those who will ultimately be affected by the worst oil disaster in the history of the world.

Plans by BP to sink a 4-story containment dome over the oil gushing from a gaping chasm one kilometer below the surface of the Gulf, where the oil rigDeepwater Horizon exploded and killed 11 workers on April 20, and reports that one of the leaks has been contained is pure public relations disinformation designed to avoid panic and demands for greater action by the Obama administration, according to FEMA and Corps of Engineers sources. Sources within these agencies say the White House has been resisting releasing any “damaging information” about the oil disaster. They add that if the ocean oil geyser is not stopped within 90 days, there will be irreversible damage to the marine eco-systems of the Gulf of Mexico, north Atlantic Ocean, and beyond. At best, some Corps of Engineers experts say it could take two years to cement the chasm on the floor of the Gulf.

Only after the magnitude of the disaster became evident did Obama order Homeland Security Secretary Janet Napolitano to declare the oil disaster a “national security issue.” Although the Coast Guard and FEMA are part of her department, Napolitano’s actual reasoning for invoking national security was to block media coverage of the immensity of the disaster that is unfolding for the Gulf of Mexico and Atlantic Ocean and their coastlines.

From the Corps of Engineers, FEMA, the Environmental Protection Agency, Coast Guard, and Gulf state environmental protection agencies, the message is the same: “we’ve never dealt with anything like this before.”

The Obama administration also conspired with BP to fudge the extent of the oil leak, according to our federal and state sources. After the oil rig exploded and sank, the government stated that 42,000 gallons per day was gushing from the seabed chasm.  Five days later, the federal government upped the leakage to 210,000 gallons a day.

However, WMR has been informed that submersibles that are  monitoring the escaping oil from the Gulf seabed are viewing television pictures of what is a “volcanic-like” eruption of oil. Moreover, when the Army Corps of Engineers first attempted to obtain NASA imagery of the Gulf oil slick — which is larger than that being reported by the media — it was turned down. However, National Geographic managed to obtain the satellite imagery shots of the extent of the disaster and posted them on their web site.

There is other satellite imagery being withheld by the Obama administration that shows what lies under the gaping chasm spewing oil at an ever-alarming rate is a cavern estimated to be around the size of Mount Everest. This information has been given an almost national security-level classification to keep it from the public, according to our sources.

The Corps and Engineers and FEMA are quietly critical of the lack of support for quick action after the oil disaster by the Obama White House and the US Coast Guard. Only recently, has the Coast Guard understood the magnitude of the disaster, dispatching nearly 70 vessels to the affected area. WMR has also learned that inspections of off-shore rigs’ shut-off valves by the Minerals Management Service during the Bush administration were merely rubber-stamp operations, resulting from criminal collusion between Halliburton and the Interior Department’s service, and that the potential for similar disasters exists with the other 30,000 off-shore rigs that use the same shut-off valves.

The impact of the disaster became known to the Corps of Engineers and FEMA even before the White House began to take the magnitude of the impending catastrophe seriously. The first casualty of the disaster is the seafood industy, with not just fishermen, oystermen, crabbers, and shrimpers losing their jobs, but all those involved in the restaurant industry, from truckers to waitresses, facing lay-offs.

The invasion of crude oil into estuaries like the oyster-rich Apalachicola Bay in Florida spell disaster for the seafood industry. However, the biggest threat is to Florida’s Everglades, which federal and state experts fear will be turned into a “dead zone” if the oil continues to gush forth from the Gulf chasm. There are also expectations that the oil slick will be caught up in the Gulf stream off the eastern seaboard of the United States, fouling beaches and estuaries like theChesapeake Bay, and ultimately target the rich fishing grounds of the Grand Banks off Newfoundland.

WMR has also learned that 36 urban areas on the Gulf of Mexico are expecting to be confronted with a major disaster from the oil volcano in the next few days. Although protective water surface boons are being laid to protect such sensitive areas as Alabama’s Dauphin Island, the mouth of the Mississippi River, and Florida’s Apalachicola Bay, Florida, there is only 16 miles of boons available for the protection of 2,276 miles of tidal shoreline in the state of Florida.

Emergency preparations in dealing with the expanding oil menace are now being made for cities and towns from Corpus Christi, Texas, to Houston, New Orleans, Gulfport, Mobile, Pensacola, Tampa-St.Petersburg-Clearwater, Sarasota-Bradenton, Naples, and Key West. Some 36 FEMA-funded contracts between cities, towns, and counties and emergency workers are due to be invoked within days, if not hours, according to WMR’s FEMA sources.

There are plans to evacuate people with respiratory problems, especially those among the retired senior population along the west coast of Florida, before officials begin burning surface oil as it begins to near the coastline.

There is another major threat looming for inland towns and cities. With hurricane season in effect, there is a potential for ocean oil to be picked up by hurricane-driven rains and dropped into fresh water lakes and rivers, far from the ocean, thus adding to the pollution of water supplies and eco-systems.