$1.14 Quadrillion in Derivatives - What it Means For Gold

Quadrillion? That’s a number only astronomers use, right? You know…as in the North Star is “just” a couple of quadrillion miles away?

But, ominously enough, Earth’s economists are actually starting to use the number, too. No, not to discuss the amount of dollars out there (though it might feel like the Fed just pumped a quadrillion greenbacks into the economy). The Bank of International Settlements recently reported that the amount of outstanding derivatives has now reached the $1.14 quadrillion mark ($548 Trillion in listed credit derivatives plus $596 trillion in notional [or face value] OTC derivatives).

Whether you’re an astronomer or an economist, that’s an awfully big number. In case you need a mega-number refresher course, million is followed by billion which is followed by trillion which is followed by quadrillion (and, okay, quintillion and sextillion follow that). Yes, it takes a thousand trillion to make up one quadrillion, and, sadly, that’s where we now find ourselves with this whole derivative mess.

Leverage Madness

Derivatives, as you may know, are essentially unregulated, high-risk credit bets. Unlike the earnest farmer who might employ a futures contract to hedge the price of the beans he’s worked so hard to grow, many banking institutions now use futures, forwards, options, swaps, swaptions, caps, collars and floors-the whole wacky inventory of leverage devices-to bet the hell out of virtually anything.

What drives derivatives, at their very roots (if you can somehow get back that far), are base assets that get leveraged to a demented degree. Martin Mayer writing for the Brookings Institute, said, “the receiver of the payments on these loans or securities has bought the securities for the duration of the swap on 95% margin, even though the law says nobody can buy securities without putting up half the price.”

Extrapolated, $1.14 quadrillion in assets “owned” on something like 95% margin has to be one of the scariest phenomena in economic history.

Mathematicians and academics are supposedly the air traffic controllers of the derivative complex, keeping everything neatly hedged, up-to-date and safe. But a quadrillion-plus of these highly leveraged investments is like multiplying America’s fleet of airplanes a million-fold…while not bothering to boost the number of air traffic controllers. The potential for financial disaster here is simply overwhelming.

“Financial Weapons of Mass Destruction”

So warned Warren Buffet of derivatives six years ago.

“We view them as time bombs, both for the parties that deal in them and the economic system,” is how the Oracle of Omaha put it.

That time bomb almost went off in March 2008 with the Bear Stearns debacle. The title of an article by noted analyst Ambrose Evans-Prichard-“Fed’s rescue halted a derivatives Chernobyl”-says virtually everything you need to know.

According to the article, Bear Stearns held a jaw-dropping $13.4 trillion in derivatives, which is “greater than the U.S. national income.” So where did all those derivatives go? Well, this time anyway, JP Morgan was encouraged to step in to add Bear’s derivatives to its own $77 trillion portfolio, giving the financial giant a grand total of $90 trillion in these wobbly investments.

Which begs the question, why didn’t we just let Bear Stearns-$13 trillion in derivatives and all-go belly up? Wouldn’t that have taught the nation a valuable lesson and given Wall Street a long-deserved wake-up call? “Twenty years ago the Fed would have let Bear Stearns go bust,” said credit specialist William Sels. “Now it is too interlinked to fail.”

Which means that a Bear Stearns collapse today could be the first falling domino in a collapsing domino configuration tomorrow. Derivatives really are all interlinked. So expect the Fed to move with SWAT-like velocity to rescue any bank struggling with its derivative load.

But what happens when even that’s not enough?

Surviving the Coming Derivatives Collapse

Eventually, shockingly, something will go wrong. Some bank will slip up, some mathematician will miscalculate or the Fed just won’t react fast enough next time, and the whole $1.4 quadrillion derivative complex will simply “go Chernobyl.” Only it might not be $1.4 quadrillion by then. It might be a whole lot more.

What would be the aftermath?

Whatever happened, it wouldn’t be pretty. Referring to the Bear Stearns emergency, James Melcher, a well-known hedge fund manager, said, “There was a risk of a total meltdown at the beginning of last week. I don’t think most people have any idea how bad this chain could have been.”

The New York Times was even more pointed: “If the Fed hadn’t acted this morning and Bear (Stearns) did default on its obligations, then that could have triggered a widespread panic and potentially a collapse of the financial system.”

Yes…the Times said that.

But there’s too much leverage, too much money, too much greed and too many shenanigans involved here to believe this story will have a happy ending. So, as soon as you can, you really need to buy some “derivative-collapse insurance.”

You need to buy gold.

Think of gold-this beautiful, glittery precious metal-as its own monetary system, an honorable investment divorced from the old-boy paper money network that has bred so many nasty derivative beasts. Should the worst happen, gold would represent the only financial sanity around; investors not mangled by a derivative collapse would flock to the precious metal if only to wait things out.

If you just rolled your eyes, Google Bear Stearns to see just how close we all came. Then go ahead and look into gold…before we start wondering just how much $1 quintillion in derivatives is.

Source by Kevin A. Demeritt

$1.14 Quadrillion in Derivatives - What it Means For Gold