Injecting liquidity to inflate the derivative bubble.

It is well known mathematically that liquidity injections cause
volatility to decline. How does it do the job? By inflating the derivative bubble.
This has been our “solution” for every financial mess since 1987 crash.
It has been our “solution” in the Fall of 2008, when TED spread
(spread between 3-month libor and t-bill rates) soared to unimaginable
highs. Why did it soar? Simple, really, as a few large firms went under,
counterparty risk skyrocketed, for which Ted spread is a direct indicator.
While CDS were blamed for the crisis, naturally, these beasts are only a tiny part
of the whole universe. The real values for interest rates contracts skyrocketed
much further. Unlike CDS, however, interest rate swaps are “slow bleeders” –
they don’t bankrupt a firm right away when the bet goes bad, rather, they
cause insolvency and large payments over time.

A little problem here – the derivative Ponzi scheme inflated 10-fold during
the last decade due to these policies and now stands at 10 times the GDP
of the World. Thus, bailing it out in 2008 required enormous liquidity injections.
About 23 Trillion in government guarantees, loans, and direct printing for the US,
or 1.5 times US GDP, by some estimates.

Instead of being the lender of last resort for this Casino, don’t we need to just let
the gamblers go broke and go home, then deal with the economic mess that results?
Yep, we do. But that requires political courage because of incredible mess
the blowup will cause, and that’s not what we did.

BIS derivative report for June 2009 is out.

Highlights? It “worked” yet again

1. Volatility declined.

2. Markets soared as a result.

3. Notional values increased, except for CDS market, where they dropped

4. Real values declined (expected with decline of volatility)

Resume: Derivative bubble, the biggest bubble of them all, inflated again to 605
Trillion dollars notional. Note that this is only a part of the derivative universe.
The other, much smaller part, trades on the exchanges.

Next time the mess will be even bigger.

Key developments:

•notional amounts of all types of OTC contracts rebounded somewhat to stand at $605 trillion at the end of June 2009, 10% above the level six months before,
•gross market values decreased by 21% to $25 trillion,
•gross credit exposures fell by 18% from an end-2008 peak of $4.5 trillion to $3.7 trillion,
•notional amounts of CDS contracts continued to decline, albeit at a slower pace than in the second half of 2008 and
•CDS gross market values shrank by 42%, following an increase of 60% during the previous six-month period.

BIS OTC Derivative market statistics, 2009, first half

Thursday, November 26th, 2009 The global financial and economic crisis

1 Comment to Injecting liquidity to inflate the derivative bubble.

  1. Agree, but note that notional values on the whole have gone up while replacement cost have gone down. This IMO is not a good sign because we are going to have some monetary tremors. On the other hand, notional values are so incredibly large that perhaps change in any direction is irrelevant….would you rther get crushed by a falling Steinway or flattened by an onrushing locomotive?

    Notional values on interest rate derivatives were up 13% from the six months prior to June ’09. The increase was on stuff maturing in more than five years. This is crazy, IMO. The taking on of crazy risk continues unabated.

  2. carranza2 on November 27th, 2009

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