John’s last post talks about how if $1 quadrillion worth of credit derivatives loses just 10% of their value, the world loses $100 trillion and there isn’t enough money in the world to fill that gap, so deflation is pretty much inevitable no matter how much money Bernanke prints.
But I don’t see how these credit derivatives are in any way a form of money that could have some effect on inflation or deflation. These things are just bets on something happening or not happening. If you and I bet $1 million on the outcome of a horse race, that doesn’t put $1 million more into the world’s currency. Even when one of us loses and has to come up with $1 million, that won’t create a new $1 million of currency. A bank would have to create a new loan to one of us before new money was created. If I lose the bet but refuse to pay you, that doesn’t create or destroy money either - it’s as if we had never made the bet then.
Perhaps someone could explain how these credit derivatives could have any effect on inflation or deflation.
SteveA
How can credit derivatives cause deflation?
Re: How can credit derivatives cause deflation?
As a novice in these matters, I am just trying to understand all this myself. But, thought I would express my thoughts.steveA wrote:John’s last post talks about how if $1 quadrillion worth of credit derivatives loses just 10% of their value, the world loses $100 trillion and there isn’t enough money in the world to fill that gap, so deflation is pretty much inevitable no matter how much money Bernanke prints.
But I don’t see how these credit derivatives are in any way a form of money that could have some effect on inflation or deflation. These things are just bets on something happening or not happening. If you and I bet $1 million on the outcome of a horse race, that doesn’t put $1 million more into the world’s currency. Even when one of us loses and has to come up with $1 million, that won’t create a new $1 million of currency. A bank would have to create a new loan to one of us before new money was created. If I lose the bet but refuse to pay you, that doesn’t create or destroy money either - it’s as if we had never made the bet then.
Perhaps someone could explain how these credit derivatives could have any effect on inflation or deflation.
SteveA
In the case of a bet as you describe it, there would be no deflation, as you point out, because money simply exchanged hands -- none was destroyed.
The problem with the trillions in derivatives is that the assets (mortgages, credit card loans, etc.) that they are based on are declining in value. That is where the deflation is.
The derivatives were often purchased with high leverage and so even small declines in the underlying assets could translate to large losses in the derivative product. The Banks, etc. are continuing to hold these products on the books at full value to avoid showing the losses. That is the problem.
If I could say what John said a little differently, I would say: there are trillions in derivatives out there being carried at face value and they are not worth that due to a decline in their underlying assets. When they are finally valued at their true worth it will be highly deflationary -- actually the deflation is already occurring, but they are trying to hide it. And these products are highly leveraged.
Concerning the Credit Default Swaps, again if they are naked--no asset behind them--I guess there is really only money changing hands. But the Banks, etc. often used them as insurance against default of bonds, CDO's, or who knows what. So, if it doesn't get paid, the bank has to write down what it has been carrying as an asset.
One of the problems that brought down AIG was its inability to pay off on CDS held by Goldman. But not to worry Geithner got the taxpayer to cough up the bucks.
Just my thoughts... Bill
Re: How can credit derivatives cause deflation?
Bill did a pretty good job of explaining it, but I'll go one step further.
The derivatives are recorded as assets on bank balance sheets, hedge funds, pension funds, insurance companies, etc. The consideration of these derivatives as "assets" on the balance sheet, provides the ability for said institutions to increase their "liabilities" on the other side of the balance sheet. Those liabilities are loans and other leveraged investments which in turn were used to purchase real assets (stocks, bonds, commodities, real estate, etc). This obviously inflated the prices of those assets.
Now that the counterparties to the derivatives are suspect, their value is dropping. This forces the institutions to compensate by raising capital or lowering the liabilities side of their balance sheet. To do this, they are forced to sell anything that is liquid to meet the capital ratios. This increased supply of assets pushes prices down and destroys the credit they were based upon - deflation.
But even this explanation is overly simplistic. Many of the institutions simultaneously recorded their liabilities as assets on the balance sheet (because they were expected to be paid back). This gave them even more capability to make loans. Typically, recording "future profits" as assets was considered to be accounting fraud. They called it "fractional reserve lending."
And then there's the trillions sitting off the balance sheet (Special Investment Vehicles.) Nobody knows what disasters are lurking in those piles of crap.
Hope that helps.
The derivatives are recorded as assets on bank balance sheets, hedge funds, pension funds, insurance companies, etc. The consideration of these derivatives as "assets" on the balance sheet, provides the ability for said institutions to increase their "liabilities" on the other side of the balance sheet. Those liabilities are loans and other leveraged investments which in turn were used to purchase real assets (stocks, bonds, commodities, real estate, etc). This obviously inflated the prices of those assets.
Now that the counterparties to the derivatives are suspect, their value is dropping. This forces the institutions to compensate by raising capital or lowering the liabilities side of their balance sheet. To do this, they are forced to sell anything that is liquid to meet the capital ratios. This increased supply of assets pushes prices down and destroys the credit they were based upon - deflation.
But even this explanation is overly simplistic. Many of the institutions simultaneously recorded their liabilities as assets on the balance sheet (because they were expected to be paid back). This gave them even more capability to make loans. Typically, recording "future profits" as assets was considered to be accounting fraud. They called it "fractional reserve lending."
And then there's the trillions sitting off the balance sheet (Special Investment Vehicles.) Nobody knows what disasters are lurking in those piles of crap.
Hope that helps.
Re: How can credit derivatives cause deflation?
Dear Steve,
Suppose you and I bet $1 million on the outcome of a horse race, and
we've written everything down in the form of a contract. Then I can
sell that contract to someone else for $10,000, and then that person
will win or lose the $1 million. But don't focus on the $1 million
-- that's irrelevant. Focus on the $10,000, because that's the
notional value of the bet (or contract).
These credit derivatives have intrinsic notional value, and they're
being carried on the books of financial institutions and investors at
that value.
Suppose you have a $500,000 home, and there's a 30-year fire
insurance policy on which you pay monthly premiums. Then you can
apply discounted cash flow computations to the flow of monthly
premiums, and discover that the value of the policy to the issuer is
$1 million, after accounting for the risk of an actual fire. The
insurance company could sell that policy to someone else for $1
million.
In other words, when you think of the value of an insurance policy,
don't focus on the value of the house; focus on the discounted cash
flow value of the premiums.
That's what's happened with the credit derivatives. Their $1+
quadrillion notional value is based on the value of the premium
payments and expected payouts, not on the value of the things being
insured.
It's true that you can't go to the grocery store and use a credit
derivative to purchase groceries with, but you CAN sell the credit
derivative just like a stock certificate, or you can use it as
security as collateral for a loan of money that you can then use to
buy groceries. So credit derivatives really are a form of money.
However, you can't take out a fire insurance policy on someone else's
house. But anyone can buy or sell a credit derivative on anything.
Thus, what's happened is that the $1+ quadrillion notional value of
these securities is based on probably about $10 trillion of
underlying value, with most credit derivatives insuring the same
things.
Thus, we have various different kinds of possible systemic
risk:
dollars of credit derivatives outstanding. But when you're talking
an astronomical number like $1 quadrillion ($1,000 trillion or $1,000
thousand billion) then an event with even a tiny probability can
result in tens of trillions of dollars of dislocation and
instability.
Sincerly,
John
I'll add to the comments of Bill and Matt (StilesBC).steveA wrote: > But I don’t see how these credit derivatives are in any way a form
> of money that could have some effect on inflation or deflation.
> These things are just bets on something happening or not
> happening. If you and I bet $1 million on the outcome of a horse
> race, that doesn’t put $1 million more into the world’s currency.
> Even when one of us loses and has to come up with $1 million, that
> won’t create a new $1 million of currency. A bank would have to
> create a new loan to one of us before new money was created. If I
> lose the bet but refuse to pay you, that doesn’t create or destroy
> money either - it’s as if we had never made the bet then.
> Perhaps someone could explain how these credit derivatives could
> have any effect on inflation or deflation.
Suppose you and I bet $1 million on the outcome of a horse race, and
we've written everything down in the form of a contract. Then I can
sell that contract to someone else for $10,000, and then that person
will win or lose the $1 million. But don't focus on the $1 million
-- that's irrelevant. Focus on the $10,000, because that's the
notional value of the bet (or contract).
These credit derivatives have intrinsic notional value, and they're
being carried on the books of financial institutions and investors at
that value.
Suppose you have a $500,000 home, and there's a 30-year fire
insurance policy on which you pay monthly premiums. Then you can
apply discounted cash flow computations to the flow of monthly
premiums, and discover that the value of the policy to the issuer is
$1 million, after accounting for the risk of an actual fire. The
insurance company could sell that policy to someone else for $1
million.
In other words, when you think of the value of an insurance policy,
don't focus on the value of the house; focus on the discounted cash
flow value of the premiums.
That's what's happened with the credit derivatives. Their $1+
quadrillion notional value is based on the value of the premium
payments and expected payouts, not on the value of the things being
insured.
It's true that you can't go to the grocery store and use a credit
derivative to purchase groceries with, but you CAN sell the credit
derivative just like a stock certificate, or you can use it as
security as collateral for a loan of money that you can then use to
buy groceries. So credit derivatives really are a form of money.
However, you can't take out a fire insurance policy on someone else's
house. But anyone can buy or sell a credit derivative on anything.
Thus, what's happened is that the $1+ quadrillion notional value of
these securities is based on probably about $10 trillion of
underlying value, with most credit derivatives insuring the same
things.
Thus, we have various different kinds of possible systemic
risk:
- Concurrent risk. It's possible that, say, $100 trillion in
credit derivatives are making an insurance bet on the same $1
trillion event. That means that if the event occurs, it's not a $1
trillion event, but a $100 trillion event. - Counterparty risk. The credit derivatives are highly
interlocked, with one company assuming perhaps $100 trillion in
possible insurance payouts, but protecting itself with credit
derivatives that will pay them $100 trillion if an event occurs.
That creates a chain of counterparties, and if one company fails,
then the entire chain might fail. - Loss of market value. If someone hold $100 trillion in credit
derivatives, and the company's rating is lowered (as is happening
very frequently these days), then the values of those credit
derivatives are automatically devalued, since it's possible that the
company won't be able to pay off its insurance bets in the event of a
default. In a "mark to market" world, this might require other
companies to reduce the claimed market value of the credit
derivatives in their own portfolios.
dollars of credit derivatives outstanding. But when you're talking
an astronomical number like $1 quadrillion ($1,000 trillion or $1,000
thousand billion) then an event with even a tiny probability can
result in tens of trillions of dollars of dislocation and
instability.
Sincerly,
John
Re: How can credit derivatives cause deflation?
Thanks, StilesBC, for the additional information/explanation.
Bill
Bill
Re: How can credit derivatives cause deflation?
steveA wrote:John’s last post talks about how if $1 quadrillion worth of credit derivatives loses just 10% of their value, the world loses $100 trillion and there isn’t enough money in the world to fill that gap, so deflation is pretty much inevitable no matter how much money Bernanke prints.
But I don’t see how these credit derivatives are in any way a form of money that could have some effect on inflation or deflation. These things are just bets on something happening or not happening. If you and I bet $1 million on the outcome of a horse race, that doesn’t put $1 million more into the world’s currency. Even when one of us loses and has to come up with $1 million, that won’t create a new $1 million of currency. A bank would have to create a new loan to one of us before new money was created. If I lose the bet but refuse to pay you, that doesn’t create or destroy money either - it’s as if we had never made the bet then.
Perhaps someone could explain how these credit derivatives could have any effect on inflation or deflation.
SteveA
I've read some of the other responses, which all seemed to be very informative but I have developed a very simplistic way of thinking about this that may work for other simple-minded people like me:
As these derivatives were created (out of thin air) they created wealth that simply didn't exist. This wealth spread throughout the economy as it showed up in corporate earnings by way of leverage. Banks loaned money based on this false wealth and people bid up the price of houses, stocks and everything else, knowing that they could always sell for more in the future. People FELT richer but they weren't. People felt free to pay more for a house because their 401k was larger than it would have been. Eventually the house of cards starts tumbling as home prices begin to drop. The rest is history, or will soon be.
These derivatives are an almost perfect deflationary creation because their value can deflate just as easily as it was created; by a stroke of a pen or the flow of the bits and bytes in a computer. But as we see, there are very real effects on the economy because now the TRUST is gone. We no longer know what is real wealth and what is false wealth.
--Fred
Re: How can credit derivatives cause deflation?
Thanks for the illuminating comments guys. So summing up and extrapolating a bit, this is how it looks to me:
1. The quadrillion in derivative contracts is the payoff amount, and has nothing to do with the value of what’s begin bet on.
2. Some of these contracts are not just one time bets but agreements where someone pays so much a month for insurance against something happening.
3. The payment for the insurance, whether it’s a onetime amount or a stream of premiums, becomes an asset on the books of the insurer that can be used as security for a loan, or in the case of an investment bank, as reserves against which to loan out ten times that amount, or more.
4. The insurance itself – the promise to pay me if event X occurs - is an asset that I can use as collateral for a loan. Steps 3 and 4 are the money creation part of the process. We don’t know how much money is created by this process since the lenders will allow different amounts for various securities, but the notional value of the contracts – the payoff amounts - could be a first approximation. Actually, if both the insurer and the insured receive documents they can use as collateral, perhaps twice the notional value of the contracts is closer to the amount of money created here.
5. The problems start when the ability of the insurer to pay the bet comes into question or the ability of the insured to continue making the premiums comes into question Then the lenders who made loans based on these streams or promises insist on more collateral, as is their right according to the loan agreements. When the extra collateral cannot be raised the loans are called and debt begins contract in a vicious cycle.
It’s interesting that the value of the derivative contracts would actually increase as the companies that are being insured get into trouble, since the likelihood of a payout increases - except that the whole system of creating and paying these derivative contracts is also in trouble. The likelihood of the contract “going in the money” is irrelevant when the payer is going into bankruptcy.
SteveA
1. The quadrillion in derivative contracts is the payoff amount, and has nothing to do with the value of what’s begin bet on.
2. Some of these contracts are not just one time bets but agreements where someone pays so much a month for insurance against something happening.
3. The payment for the insurance, whether it’s a onetime amount or a stream of premiums, becomes an asset on the books of the insurer that can be used as security for a loan, or in the case of an investment bank, as reserves against which to loan out ten times that amount, or more.
4. The insurance itself – the promise to pay me if event X occurs - is an asset that I can use as collateral for a loan. Steps 3 and 4 are the money creation part of the process. We don’t know how much money is created by this process since the lenders will allow different amounts for various securities, but the notional value of the contracts – the payoff amounts - could be a first approximation. Actually, if both the insurer and the insured receive documents they can use as collateral, perhaps twice the notional value of the contracts is closer to the amount of money created here.
5. The problems start when the ability of the insurer to pay the bet comes into question or the ability of the insured to continue making the premiums comes into question Then the lenders who made loans based on these streams or promises insist on more collateral, as is their right according to the loan agreements. When the extra collateral cannot be raised the loans are called and debt begins contract in a vicious cycle.
It’s interesting that the value of the derivative contracts would actually increase as the companies that are being insured get into trouble, since the likelihood of a payout increases - except that the whole system of creating and paying these derivative contracts is also in trouble. The likelihood of the contract “going in the money” is irrelevant when the payer is going into bankruptcy.
SteveA
Re: How can credit derivatives cause deflation?
Hmmm... This seems ridiculous, but I don't really know. I can't imagine that this is the "asset value" of the derivatives because they would end up on the books somewhere and the total asset value of all public companies in the world has never been larger than $100T. Mortgage trades are valued in pips, that's millionths of underlying value. Mortgage trade derivatives are even less, but the instruments that are bundled together carry liability on the entire value of the loan, which is about 2xAsset on a residential mortgage. It seems to me that although the values may have been significantly inflated, nobody ever thought that they had $1Q sitting in their pockets. Because these contracts are written both ways, the real total value is somewhere around zero, so unraveling is nothing to fear. The problem is that the markets are 'frozen', so the banks can't trade out of their positions and therefore must horde reserves because they don't know how their liability may change in the future. This is what causes deflation - reserve hording. This is why the treasury is trying to add liquidity to the paper markets, but politicians at every level are confusing the process by adding uncertainty.John wrote:That's what's happened with the credit derivatives. Their $1+ quadrillion notional value is based on the value of the premium payments and expected payouts, not on the value of the things being insured.... based on probably about $10 trillion of underlying value
And more fundamentally, I don't recall the source (please provide if you remember) of the $1Q number, but I remember that it included all ETFs and mutual funds and options and whatnot, all of which can be held by other funds and counted multiple times, but leverage cannot be applied in these instruments like they were in the 1920s holding companies, so the loss is 1:1 for the asset holders even though the total loss across all instruments may be 20:1 or more.
I don't know, I could be wrong, but I think this $1Q number can be misleading. Please disabuse me if I am way off-base.
Re: How can credit derivatives cause deflation?
Dear John,
companies because there are two counterparties to each contract. For
one party it's an asset, and for the other party it's an equal
obligation. So the total asset value is zero.
Theoretical, any company can protect itself by holding derivatives on
both sides, so that they cancel out. The problem is that a major
credit event may cause a chain of bankruptcies that spirals out of
control. For example, how many credit default swaps are being held
against a default by General Motors? I don't know, but if GM goes
bankrupt, then it could trigger a major chain reaction and crisis.
google "bis quadrillion" (without the quotes).
The figures were reported by the Bank of International Settlements.
I tried to verify the figure, but I ran into difficulties.
It's supposed to be the sum of the notional values of
Over-The-Counter (OTC) derivatives (about $600 trillion) plus the
values of exchange traded credit derivatives (about $500 trillion).
You can look up the latest BIS quarterly review:
http://www.bis.org/publ/qtrpdf/r_qt0903.htm
and download the Statistical Annex.
The OTC derivatives figure can be found in Table 19 on page A-103:
$683,725 billion, or $684 trillion.
The exchange-traded credit derivatives are supposed to be in Table
23A on page A-108, but I can't find the correct number there.
Perhaps you can check for yourself and let us know.
Sincerely,
John
Credit derivatives don't add to the total asset value of all publicJLak wrote: > Hmmm... This seems ridiculous, but I don't really know. I can't
> imagine that this is the "asset value" of the derivatives because
> they would end up on the books somewhere and the total asset value
> of all public companies in the world has never been larger than
> $100T.
companies because there are two counterparties to each contract. For
one party it's an asset, and for the other party it's an equal
obligation. So the total asset value is zero.
Theoretical, any company can protect itself by holding derivatives on
both sides, so that they cancel out. The problem is that a major
credit event may cause a chain of bankruptcies that spirals out of
control. For example, how many credit default swaps are being held
against a default by General Motors? I don't know, but if GM goes
bankrupt, then it could trigger a major chain reaction and crisis.
I didn't make the number up. It's been widely reported -- justJLak wrote: > And more fundamentally, I don't recall the source (please provide
> if you remember) of the $1Q number, but I remember that it
> included all ETFs and mutual funds and options and whatnot, all of
> which can be held by other funds and counted multiple times, but
> leverage cannot be applied in these instruments like they were in
> the 1920s holding companies, so the loss is 1:1 for the asset
> holders even though the total loss across all instruments may be
> 20:1 or more.
google "bis quadrillion" (without the quotes).
The figures were reported by the Bank of International Settlements.
I tried to verify the figure, but I ran into difficulties.
It's supposed to be the sum of the notional values of
Over-The-Counter (OTC) derivatives (about $600 trillion) plus the
values of exchange traded credit derivatives (about $500 trillion).
You can look up the latest BIS quarterly review:
http://www.bis.org/publ/qtrpdf/r_qt0903.htm
and download the Statistical Annex.
The OTC derivatives figure can be found in Table 19 on page A-103:
$683,725 billion, or $684 trillion.
The exchange-traded credit derivatives are supposed to be in Table
23A on page A-108, but I can't find the correct number there.
Perhaps you can check for yourself and let us know.
Sincerely,
John
Re: How can credit derivatives cause deflation?
I think inflation and deflation are simply the tools of the fiscal policy which are employed by the central bank of any country to control the interest rates on loan and the prices of commodities in the market. The rest of the techniques are only the tools to complicate the financial matters in order to make the common public under control and keep them busy in moneys matters rather to object on the rich people policies.
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