Sep 15, 2006 The bubble in derivatives Bill Bonner 321gold . . . 7

The bubble in derivatives

Bill Bonner
The Daily Reckoning
Sep 15, 2006

"... What a jolly time to be alive! Debt is stuffed into hedge fund portfolios as an investment. Debt is laid away at insurance companies and pension funds as an asset. Debt is traded, extended, extruded, pressed, bolted, wrung out and wadded up... debt for all seasons... "

Yesterday we posed a question from the classics: "What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?" asked Adam Smith. It was a rhetorical question in the eighteenth century.

Today, we have a real answer. Or rather, an unreal one.

A bubble!

Twenty years ago, the total notional sum of derivatives in the entire world was close to zero. At least that is the impression you get from looking at a chart showing the growth of derivatives in the years since. From nothing, the global supply of derivatives has risen faster than the Nasdaq... faster than oil... faster even than prices of Mayfair apartments. Other market bubbles were soap bubbles compared to the Hindenburg of derivatives, which the latest estimates judge to be worth some $236 trillion or about eight times the GDP of the entire planet.

In other words, derivatives make up a bubble larger than the old globe itself.

What a jolly time to be alive! There in front of us is the fattest, juiciest bubble that has ever existed. If only we had a long sharp pin in our hand!

But what are these derivatives, readers might want to know.

They are debt. Packages of debt. Bundles of debt. Piles of debt. Rocky Mountains of debt.

Debt that is stuffed into hedge fund portfolios as an investment. Debt that is laid away at insurance companies and pension funds... as an asset. Debt that is traded, extended, extruded, pressed, bolted, wrung out and wadded up. It is debt for all seasons... all people... all times and place... it is Urbi and Orbi Debt...

There. We have given you the technical description of it. What follows is an answer to the question: what do all these bubbled up derivatives really mean?

Derivative contracts are sometimes so difficult to understand that it takes teams of dusty mathematicians to keep an eye on them. That gives financial institutions comfort, but it shouldn't. Long Term Capital Management of Greenwich, Connecticut had two Nobel Prize winners among its quants when it managed to blow itself up after placing a few bad bets.

Why? Because behind the arcane complexity of derivative contracts are the simple-minded human beings who are at any moment in only one of two positions either long or short. Every contract is a bet. And every bet can go either way.

You might think that this means the whole shebang is a zero-sum proposition. Let them blow up, you might say; the longs and the shorts will offset each other. For every winner there will be a loser... and for every half dozen fools separated from his money there will be a new billionaire with peculiar art in a monstrous mansion in Greenwich.

Alas, that is not the whole story. Derivatives are not a zero-sum game... but a game in which the actual odds themselves follow long patterns of boom and bust. There are, for example, trillions of dollars worth of securities whose value is derived from the US housing market. Fast-talking lenders write adjustable-rate, payment optional mortgages (ARMs) for slow-witted homeowners. Then, they sell the contracts on... whence they are packaged with thousands of others into a mortgage-backed security (MBS). The mortgage backed security is backed by a mortgage. But who backs the mortgage? That would be those sad sacks you read about in the papers, who stretched too far to buy too much house with an ARM far too long and too complicated for them to grasp.

Most of the time, and especially during the long bull market in housing - roughly equal to the bull market in credit derivatives - the payers are ready and able to pay. Sometimes they are not. When they are not... the security of mortgage-backed securities disappears.

America's average homebuyer has not had a real wage increase in 34 years. Instead, he has become upwardly mobile by proxy... piggy-backing on the shiny surfaces of bubbles... in credit... in debt... in housing. But there must come a day when the bubbles take a bath... when the poor homeowner must find another money-tree or miss his mortgage payment.

And when he misses, what a hit he will take! And that will be the day all the bubbles blow up at once including the mother of them all... the bubble in derivatives.

Bill Bonner
email: DR@dailyreckoning.com
website: The Daily Reckoning

Bill Bonner is the founder and editor of The Daily Reckoning.

Bill's book, Mobs, Messiahs and Markets: Surviving the Public Spectacle in Finance and Politics, is a must-read.

He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).

In Bonner and Wiggin's follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is - an empire built on delusions.

321gold Inc