Solarbird ([info]solarbird) wrote,
@ 2008-03-11 00:39:00
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Current mood: nervous
Entry tags:atypical events of scale, economics, zomg

Something I haven't been talking about but it's bubbled to the surface
Okay, so, there are these things called "black swan events." They're unpredictable (or at least, essentially unpredicted) disruptions of major scale. Near-turm peak oil with a substantial decline rate - over 2% - would probably qualify as one, despite some predictions of it, since that continues to be unplanned for and has a 20-year recovery timeframe. It causes massive systemic disruption along the way.

There is a huge - I mean massive - derivatives market out there in financials. I don't understand it. At all. As far as I can tell, nobody really does. I've been trying to get some vague hint of a grip on its scale since I first really started hearing about it in 2006. I've heard numbers like $150 trillion notational dollars (and up!) and haven't known what to do with that kind of number. Because what do you do with that kind of number, when your GDP is $15 trillion? Seriously - what?

It's my favourite, by which I mean most terrifying, candidate for a black swan economic event. And I still don't have a good grip on it. Either all this shit cancels itself out once things start to fall down - in that there's a big set of swaps that add up in the end to zero, or close to it - and it ends up not mattering, or the game is over. Completely, totally, fucking over, and it's time to unplug the machine, swap the power supply, and hope you can salvage the processor. It's one of those two things. I have been, and continue to be, betting on the former, despite what comes next here.

Marketwatch's Paul Ferrell reports that the actual number is more like $516 trillion notational, with an actual fall-out value of somewhere around $11 trillion. That's, again, against a GDP of $15 trillion. And as Financeguy on the Market Ticker Forums points out tonight, that market, like most of the other ones, is in trouble.

Now, you can't really plan for this. You can't really plan for a hard reboot of the entire financial system. I can't tell you what to do because I don't know. It's the kind of situation where since you cannot, definitionally, plan for the bad case, you plan for the one you can plan for, even if it's less likely, or unlikely. And in that case, it all falls in on itself and reduces to a much smaller number that, while nasty, can be handled as part of the rest of the credit implosion.

That's how you end up hoping the economy only takes a $1 trillion dollar hit over the next couple of years, instead of, well... who knows?

And that's why I haven't been talking about it. Because I'm hoping it just goes away.


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[info]oh6
2008-03-11 10:07 am UTC (link)
I am likewise expecting that the credit default swap workout will amount to a lot of destructive interference with a few $100-billion side lobes.

As for contingency plans, well hey, there's always gold! What's going to happen, the government nationalizes the gold supply and forces you to sell it to them at a fixed rate? That's never hap- oh wait.

So, yeah, like you said.

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[info]ellerisse
2008-03-11 04:09 pm UTC (link)
I have a bad feeling that what one does to plan is "invest" in non-cash alternatives (not real estate; I'm thinking more like 'canned food') and hide under the bed.

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[info]dogemperor
2008-03-11 07:22 pm UTC (link)
That, or one "invests" in skills (like learning to tan your own leather, learning how to hunt, learning how to make your own weapons and tools, and so on).

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[info]m_beebe
2008-03-11 06:57 pm UTC (link)
Solarbird,

A friend of mine pointed out your journal entry; if you don't mind, I'd like to comment:

More frightening than the massive dollar figure is the rotten base on which it rests. The leverage figure for some of these derivatives is in excess of 1:40, which is like you buying a $1.2 million home for $30,000 down -- if you were putting cash down. But if you're WaMu, Bear Stearns, BofA, well, you're not putting cash down.

Let's say I want you to loan me $1,000,000. "Ok," you say, "I want some collateral". "Fair 'nuff," I say, "I've got $125,020 in collateral -- far in excess of what's normally required."

"Safe as houses," you think.

Here's what I put up for collateral: Three one-ounce $20 gold coins and an "Inverted Jenny" stamp. I'm going to value this collection as such:

1. One coin is worth $20 -- the face value.

2. Two of the coins are worth $2,000 -- the value of two ounces of gold (fictitious value for the sake of this example)

3. The stamp I value at $123,000, which is what the last one sold for (fictitious value again).

That makes $125,020, right? You cough up $1,000,000 and my bank invests this in loans to people who shouldn't even be allowed to have checkbooks. Then things, as they're wont to do, go horribly bad. You hear a rumor that my bank is having some money problem, and you decide you want your money back ASAP. You call my loan and I shrug and tell you I ain't gotcho money, yo shit outta luck!

You realize you're going to take a bath, but you're at least going to get $125,020 out of the deal.

Right?

Nope.

The only real value in that collateral I gave you is the $20 gold coin -- the face and backed value of the coin. That's a "level one" asset. These are assets with set face values (read cash and/or AAA rated bonds [yes, separate discussion on the ratings fiasco]). This is the stuff the banks have the LEAST of. When you look at Level One holdings in banks, you'll find that number to be the lowest of the three number we're going to look at.

Now the two gold coins; they're supposed to be worth $2,000, but gold has tanked in our world and an ounce of gold is only worth $250. This is a Level 2 asset: it has an approximate value, usually assumed to be at least 85% of the quoted value on the asset sheet. These are things like Aaa- rated bonds and other loan products. When you look at a bank's balance sheet, Level 2 assets are usually 3:1 - 10:1 what their Level 1 assets are.

Finally, our Inverted Jenny, one of the most famous stamps every minted. Well, this particular stamp was not only canceled, but chewed up by my three-year-old nephew. As an item of abject curiosity, it's worth $12.30 -- if you can find anyone stupid enough to cough up for a chewed up stamp. This is a Level 3 asset. Level 3 assets are sometimes called "Marked to Fantasy" because NO ONE knows what these damn things are worth. If you look on some bank's books, these "assets" are 40:1 to the Level 1 assets.

Now you're holding $550 in cash and a wad of pulp that used to be a stamp. Thanks for your million bucks! Now you have to make another call on another bank to make up the shortfall from my bank. That bank has a bridge to sell you -- oops, SOLD you -- and so the cycle go. This is the "systemic margin call" that was mentioned last week. It's still ongoing.

When everyone was making scads of money on bizarre loan products based on housing going up forever, this collection of assets was pretty much all in theory, since no one was EVER going to call a loan. When reality roused its self like a bear angry from being awakened following a heavy meal and began mauling the hell out of housing prices, suddenly these three asset classes became critical. The reason the Fed is pumping money like mad is to give the banks at least SOME chance of meeting margin calls and hopefully calm the credit markets. If this works, Bernanke's "money drop" theory is vindicated and he goes down in history as a financial genius par excel. If this flood of cash doesn't stop the calls . . . well, you know that number you quoted above? The one that's also in theory? It stops being theory and starts being real money -- real money that doesn't exist.

(in before tl;dr)

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[info]solarbird
2008-03-13 06:24 am UTC (link)
I understand the levels of collateral; really, I have a pretty good understanding of the components, I think. The market as a whole, on the other hand - its shape, its liabilities, its actual dollar fallout value - I got nada. That's the part I haven't gotten my head around. At all.

That said, thanks for the clear explanation, it's useful. ^_^

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[info]honormac
2008-03-11 11:54 pm UTC (link)
The list of people in the first article who don't understand it makes me, at least, feel a little better about not understanding it.

What I do understand is that a transition to "money market" based economy, where most of what we "produce" is just moving imaginary money around, has always preceded some pretty major societal crashes.

That's a terrifying number, though... Seriously. Maybe all that crazy survivalist bitch stuff from the cold war will come in handy after all.

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Book recommendation
(Anonymous)
2008-03-12 12:57 pm UTC (link)
If you haven't already read it, I think you would really appreciate "The Misbehavior of Markets" by Benoit Mandelbrot (as in, the fractals and chaos guy).

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[info]investingartist
2008-03-13 06:19 am UTC (link)
Currently, several livejournal search phrases having to do with derivatives and currencies are banned and non-searchable on livejournal. At least for me. http://investingartist.livejournal.com/530.html

Are these terms banned and non-searchable for you, too?

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[info]solarbird
2008-03-13 06:28 am UTC (link)
AFAIK underlined just means "we've re-indexed down this far." You can search for non-underlined interests and find relevant hits in the Search box of the upper right hand corner. I was able to search for several of your non-underlined interests and found both of (your? the?) accounts.

Edited at 2008-03-13 06:29 am UTC

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[info]investingartist
2008-03-13 12:28 pm UTC (link)
Ah, okay, it just works slower than I thought then. Thanks! =)

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[info]wrog
2008-03-13 11:21 am UTC (link)
I've heard numbers like $150 trillion notational dollars (and up!) and haven't known what to do with that kind of number.
Back when I was more regularly reading Gold Eagle, I was constantly seeing this shit. So when I see mentions of "notional value of derivatives", that's been generally my cue to tune out, since in the (admittedly few) cases where I know something about it, it's a case of somebody basically quoting the largest numbers on the page and adding them together, whether it there's any point to that or not.

Just to take an example in another arena, I've always been amused by the argument that short-selling is far more dangerous than buying stock because when you're just buying stock, the absolute worst that happens is the stock goes to zero and you're merely out your entire investment, but if you short-sell, then oh my god the stock could go just keep going up to INFINITY and you could lose INFINITE DOLLARS, many many times your original investment....
... which ignores the small matter that once you get to the point where there aren't funds in your account to cover the position, your broker says, "um, margin call" and then your position is closed and that's that, and while you might lose somewhat more than you expected if the market had been moving quickly and you/they couldn't close out the position fast enough, it's not like this stuff doesn't happen on the long side (where stocks can and really do occasionally go to zero and you get stuck riding it all the way down because the bad news about the company is out and there are NO buyers...)
... which is not to say that making money off of short-selling isn't more difficult than the usual long stuff for various reasons (e.g., the information you tend to need is generally well hidden, the trend is usually against you, etc...) but it has nothing to do with the potentially infinite notional value of the shorted stock.

Or take futures. For maybe five thousand dollars in margin, I can buy a a gold contract which is 100 oz, and with the current market at around $900+/oz, you get people say oh my god that's a notional value of $90,000. But do I really have $90,000 at stake? Well, no. If gold dips enough to wipe me down to margin call level then I'm done. Maybe it's a really fast drop and I lose a bit more than the original $5K and the broker has to sic a collection agency on me.

But is there a chance that I'd really be on the hook for $90K? Is gold really going to drop to zero? Not bloody likely. So reporting this situation as me holding a position "with a notional value of $90,000" is grossly misleading at best. It's the easy number to report, and it may be the largest and most impressive number on the page -- and if one is trying to scare people, that's the number to use -- but it doesn't have much to do with what's actually at risk in that position.

Now it is true that in a lot of these cases, the usual sorts of margin rules that are supposed to keep things from getting too insane are, well, kind of nonexistent seeing as hedge funds and banks don't always have to play by the same rules as us ordinary folks, and nobody's actually checked to see that things are going to balance out. So that is a slightly different situation than what happens in my futures account.

Still I tend to think that $500 trillion notional probably translates to a few hundred billion in actual losses once the dust settles, which is nothing to sneeze at and may well take down one or more of the larger players, but I really don't see something that's going to be able to suck away the entire economy


Edited at 2008-03-13 11:28 am UTC

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