SDR: The notional trading value of derivatives world-wide is absolutely staggering. Somewhere in excess of $600 trillion (yep, trillion).

I have to believe that Bernanke, Paulson and that whole Wall Street cabal are terrified of having to come completely clean on actual “mark to market” (what those derivatives would bring in real dollars) value versus letting them remain on a “mark to model” valuation (what the investment houses and banks can claim they’re worth).

If recent activity is any indicator (like E-trade’s sale), there are huge discrepancies in the two valuations. Coming clean with a real-world valuation would probably put several banks out of business, as they lack the capital base to cover the losses. Think Citi, Bear Stearns, Merrill, etc. Even banks like Wells Fargo that had fairly strong underwriting protocols in place and avoided much of the sub-prime debacle would get hit due to investing in these (CDO, CDS) type products.

SDR: The notional trading value of derivatives world-wide is absolutely staggering. Somewhere in excess of $600 trillion (yep, trillion).

I have to believe that Bernanke, Paulson and that whole Wall Street cabal are terrified of having to come completely clean on actual “mark to market” (what those derivatives would bring in real dollars) value versus letting them remain on a “mark to model” valuation (what the investment houses and banks can claim they’re worth).

If recent activity is any indicator (like E-trade’s sale), there are huge discrepancies in the two valuations. Coming clean with a real-world valuation would probably put several banks out of business, as they lack the capital base to cover the losses. Think Citi, Bear Stearns, Merrill, etc. Even banks like Wells Fargo that had fairly strong underwriting protocols in place and avoided much of the sub-prime debacle would get hit due to investing in these (CDO, CDS) type products.

SDR,

The total amount of derivatives outstanding is indeed staggering, but you have to keep in mind that most of these contracts cancel each other out. The net exposure is probably a tiny, tiny fraction of it. Imagine I sell you some contract, then you sell it further to someone else, and so on, maybe 1000 times. There would be 1000 open positions, although only I and the guy at the other end of the chain would have net open positions (I would be a net seller, the guy at the other end a net buyer). You and everyone else in between would be “hedged”.

So, does that mean the problem is small? Not really, as there is “counterparty risk”. If links in the chain go broke, then all of the sudden many more market participants would have net open positions, although they weren’t really planning on it. The ends of the chain at least knowingly took the positions they took, so, if things go wrong, have only themselves to blame. The folks in the middle, though, may get burned quite unexpectedly (like BSC).

SDR,

The total amount of derivatives outstanding is indeed staggering, but you have to keep in mind that most of these contracts cancel each other out. The net exposure is probably a tiny, tiny fraction of it. Imagine I sell you some contract, then you sell it further to someone else, and so on, maybe 1000 times. There would be 1000 open positions, although only I and the guy at the other end of the chain would have net open positions (I would be a net seller, the guy at the other end a net buyer). You and everyone else in between would be “hedged”.

So, does that mean the problem is small? Not really, as there is “counterparty risk”. If links in the chain go broke, then all of the sudden many more market participants would have net open positions, although they weren’t really planning on it. The ends of the chain at least knowingly took the positions they took, so, if things go wrong, have only themselves to blame. The folks in the middle, though, may get burned quite unexpectedly (like BSC).

SDR,

The total amount of derivatives outstanding is indeed staggering, but you have to keep in mind that most of these contracts cancel each other out. The net exposure is probably a tiny, tiny fraction of it. Imagine I sell you some contract, then you sell it further to someone else, and so on, maybe 1000 times. There would be 1000 open positions, although only I and the guy at the other end of the chain would have net open positions (I would be a net seller, the guy at the other end a net buyer). You and everyone else in between would be “hedged”.

So, does that mean the problem is small? Not really, as there is “counterparty risk”. If links in the chain go broke, then all of the sudden many more market participants would have net open positions, although they weren’t really planning on it. The ends of the chain at least knowingly took the positions they took, so, if things go wrong, have only themselves to blame. The folks in the middle, though, may get burned quite unexpectedly (like BSC).

Daniel: That’s correct, but with a caveat. It presupposes that in case of a correction, the various positions will not unwind in a disorderly fashion. This would be akin to what happened with LTCM in ’98. These various hedged positions are built using computer models that have not been tested in a full-blown crisis.

Moreover, many of the supposed “controls” (like insurance) are at grave risk due to both a lack of understanding and a lack of transparency.

Bernanke himself had to undergo a refresher course recently in this area. This is a very arcane area of finance, and many of the hedge fund players have been very lucky up to this point. The markets are under increasingly severe strain and, due to a lack of real-world testing for these computer models, there is a great deal of concern over what might happen.

I don’t think it is any surprise that Buffett has jumped into the monoline insurance/reinsurance market. There is a great amount of fear out there, which means there is a great deal of money to be made.

Daniel: That’s correct, but with a caveat. It presupposes that in case of a correction, the various positions will not unwind in a disorderly fashion. This would be akin to what happened with LTCM in ’98. These various hedged positions are built using computer models that have not been tested in a full-blown crisis.

Moreover, many of the supposed “controls” (like insurance) are at grave risk due to both a lack of understanding and a lack of transparency.

Bernanke himself had to undergo a refresher course recently in this area. This is a very arcane area of finance, and many of the hedge fund players have been very lucky up to this point. The markets are under increasingly severe strain and, due to a lack of real-world testing for these computer models, there is a great deal of concern over what might happen.

I don’t think it is any surprise that Buffett has jumped into the monoline insurance/reinsurance market. There is a great amount of fear out there, which means there is a great deal of money to be made.