I asked my brother, a genius on all things legal, techical, and financial, to comment on this post. In 3 e-mails, I got this:
One of the really big question marks is the largely unregulated derivatives market, which has massive nominal amounts outstanding. From all accounts Fannie Mae is a huge player in the $123 TRILLION notional amount interest rate swap market, and if it collapses and defaults on its obligations, it could cause massive cross-defaults – which of course the gov’t would have to bail out to avoid the collapse of the banking system (and yes, that is actually possible that b/c of the failure of one large derivatives player, say JP Morgan, the entire banking system would become insolvent). See e.g. Gold-Eagle.com:
“Indeed J.P. Morgan Chase dwarfs everyone in this business. The business is derivatives. In the USA J. P. Morgan Chase is over 50% of the derivatives market. According to figures from the Office of the Comptroller of the Currency (OCC) as at December 31, 2001 JPM had notional amounts of derivative contracts outstanding of US$ 23,520 billion or US$ 23.5 trillion. That was out of total derivatives of reporting banks of US$ 45.4 trillion. The aforementioned Royal Bank of Canada had at the end of their second quarter a notional amount outstanding of approximately US$ 1.2 trillion.”
By comparison the US GDP totals roughly US$ 10 trillion and total outstanding debt of all sectors totals just over US$ 19 trillion.
Derivatives are contracts based on the value of some other asset or financial measure. A typical interest swap would say, “I pay you 5% interest on $10 million” (where $10 million would be the “notional amount”), “and you pay me the prime rate on $10 million, payable in net amounts quarterly over the next 5 years”. In this example, if the prime rate is below 5%, I make money; if it is over 5%, you make money.
Of course they get much more complex – you have currency swaps, caps, collars, commodity (based on price of gold vs. price of oil or currency value). They can be used to hedge risk (e.g., Fannie Mae may need to finance itself at a variable rate of interest, but may make long-term loans at a fixed rate, so it may enter into a swap agreement to convert the variable rate it has to pay to the fixed rate it receives) or for speculation.
There are established derivatives dealers. As you saw, JP Morgan is the biggest, but almost all commercial banks enter into them. They are also regulated to some extent (banks need offsetting transactions to keep things in balance, but of course if one side fails, like Fannie Mae, and the bank is not able to cover its position, the balance can get quickly lost and the bank goes insolvent since it may owe billions on the hedge and not get any money under the contract – imagine e.g. a Fannie Mae 10% swap on $5 trillion notional amount, that is $500 billion per year or $40 billion per month).
I am moving my money into two types of funds: Euro / Pacific companies (with investments held in foreign currencies, rather than dollars) and precious metals and other natural resources funds (e.g., uranium, timber, copper). I am keeping 35% in a money market fund as a hedge, everything else I am moving into real assets (the natural resources) or into other currencies (you just know the Yuan will become more valuable a/g the dollar).
