STAFF NEWS & ANALYSIS
The Destructive World of Toxic Derivates
By - December 08, 2008

The most urgent matter for the Treasury to address is the toxic derivatives market. The notional amount of outstanding derivatives, as noted by the Bank of International Settlements, comes close to $512 trillion. This represents a figure that is impossible to settle and is the real Armageddon which Banks are preparing for by hoarding the cash that they have received through the T.A.R.P. Unless this time bomb is defused by bringing the undeclared positions on the table, the duration and gravity of this crisis can only increase. As the underlying assets of these instruments crumble the Banks' exposure to counterparty risk increases and will lead to the inevitable collapse of even more banks and reduce the availability of investment credit even more. The underlying assets include interest rates, mortgages, foreign exchange rates, credit ratings on companies and even creditworthiness of entire countries. This is the level of insanity that has passed for "Leveraged Investment". – Global Researcher

Dominant Social Theme: None: A timely reminder.

Free-Market Analysis: This article functions as a timely reminder for something that is no longer currently at the top of the public consciousness, or search engines either. A search on Google – "derivatives mess" – (an increasingly suspicious search engine in our opinion) reveals little that is immediately dire about US$500 trillion in potentially unraveling obligations. In fact, according to Google, there is not much to worry about, at least at the present. The articles called to the front of the line are soothing, even calming. Derivatives are mentioned but not for the most part in an alarmist fashion. Are we comforted? We remember there wasn't all that much talk about a housing crunch either, right up until it happened.

We don't pretend to be expert on these instruments, or even to understand them thoroughly, though we have written about them before and are aware that they break down into several major categories. We do understand a few things, however. First, if one is laying off risk, then at least to some degree, a counterparty is assuming it. Second, these instruments will not prove as complex as they have been made out to be; Wall Street tends to be a creature of habit and the breadth and popularity of these instruments would seem to mitigate their complexity, at least to some extent. Finally, it does not seem possible, given the major dislocation of markets worldwide, that at least some of these transactions are not already under water. In fact, we have a suspicion that some of the secretiveness of the Federal Reserve when it comes to the current "bailout" has to do with assumption of risk involving these instruments.

It stands to reason. If indeed some derivatives deals are already headed south, then a US$500 trillion market is in jeopardy. Where one transaction can go, others can follow. As the article above points out, and it is not the only by far, the central banking mechanisms around the world that stand ready to support institutions in crisis would face a crisis themselves if asked to underwrite the credit obligations of a $500 trillion market.

Indeed, this must be the nightmare scenario that keeps up at night the central bankers and financial regulators now charged with salvaging what is left of the capital markets. Of course, the derivatives debacle, if and when it all comes crashing down, will also be blamed on capitalism and free markets. Just for the record, once more, these sorts of inflated financial sectors are almost purely the result of a central banking economy which has distorted a number of hitherto well functioning economic arenas in the 2000s. The availability of cheap money, the certainty that central banks would underwrite moral hazard and the funneling of inflationary speculation to a relatively few vehicles controlled by massive public and private fund managers is a central banking phenomenon (and a regulatory phenomenon as well) and not a natural evolution of a normal marketplace.

We are well aware that if and when the derivatives market falters, as it already may be doing, that capitalism will take the brunt of the blame. It will be, however, an entirely false analysis – and also an agonizing one for those who understand what is actually going on. Every day, those who are responsible for the mess, the central banking crowd itself, will be paraded on TV and in financial and political capitals around the world – as in fact they already are. They will be photographed seated in comfortable chairs around big tables with grave expressions. They will dine expensively and talk expansively about the crisis of capitalism that they themselves have helped to underwrite. And finally they will propose solutions, if any are to be had, that involve yet further monetary expansion.

After Thoughts

The detonation of a US$500 trillion market is well beyond the salvaging of even the largest central bank. It will be left to God-knows-who to pick up the pieces. Hyperinflation, Depression and the eventual collapse of fiat money would be the rotten result of such an event. Of course, while the outcome would be catastrophic, a more rational system might eventually emerge from the ruin. It would be one that would feature honest money, gold and silver, and would impose some considerable discipline on those who seek unlimited fractional banking without any asset anchor.

Are there alternatives, even to this? The Masters of the Universe, faced with the immanence of a derivatives meltdown could create yet a further centralization of the current system, seeking to salvage it via enlargement. This might put off the final catastrophe until next time – when it will be even more savage.

"After me, the deluge," a certain French King used to say. He got his wish.

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