A Ticking Time Bomb

"Now, you're perfectly safe, Willard, there's nothing to worry about as long as it's ticking...
Er, when it stops ticking, that's something else again, Willard.
Now, listen Willard, get control of yourself...
You and I are going to disarm that thing...
I've got the instruction manual...
Well, no! I'm not coming down there, Willard...
Well, I mean I can't just leave the office anytime I want to!...
NO!!!...
DON'T BRING IT IN HERE, WILLARD, NO!!!" - An exert from Bob Newhart's skit on Diffusing a Bomb

Nassim Taleb, the world famous crisis trader, looks for Black Swans.  His theory is that there is only one thing we can be certain of and that is there will be another collapse.  He has no idea where or when or how but he knows that the markets will at some point in time take a nose dive.  As such, rather than try to time the market he bets all the time on the market dying.  Normally he losses but the days when he wins he wins so big that it takes care of the losses and makes him a lot of money.

Now a Black Swan event is an event that is completely unknown and therefore takes the markets by complete surprise however some times there are things that build to a point where it is relatively obvious that this is a problem but for some reason the markets choose to ignore them (think greed or fear).  Take as an example the NASDAQ bubble or the housing bubble, these were pretty obvious to see.  These bubbles do not derail the markets while they are held together, but when they burst the Black Swan is discovered and this has catastrophic consequences on most portfolios.

To me there are two very obvious problems that unless resolved soon will rear their ugly heads at some point in the future and will make the housing problems look tame.  The first is derivatives held off the balance sheets of the major banks of the world and the second is the underfunding of US Pension Funds.  I will deal with the first in this blog and will return to the second next week.

Derivatives are contracts written against an underlying asset.  For example you can write an option to buy a house at a specified price and at a specified time.  The seller of this option pockets the premium that is paid to the buyer giving the buyer the right to buy the house.  This option has value all the way up to the exercise date when if the value of the house is less than the price agreed to in the option the contract is worthless.  In this example this option really creates no problem or concern.

Now what if we magnify this derivative, create ever more complex derivatives and start to sell them in truck loads?  In fact forget about truck loads as that is too small, what if we sold them in trillions?  Well that is precisely what has happened.  The notional value of the over the counter derivatives market is roughly $650 trillion.  Yes that is not a misprint.  The vast majority are derivatives related to interest rate swaps but there are derivatives written on essentially everything.  I will not go into detail about this market but suffice it to say this is an enormous market which is largely unregulated.

Now I have been watching a show on TV about the planets and the big bang theory and one thing rings true about that as with this market.  Big bang theory states that everything came from nothing for the simple reason that for every positive energy there has to be a countering negative energy.  The one offsets the other and sums to nothing.  Well the same is basically true in the derivatives market.  While the notional value is $650 trillion one side offsets the other so the actual value is relatively small.  For this reason there is not a lot of press on this subject and banks are able to push the risk off their balance sheets.  This is fine while everything is working well, but what happens when the market has its next Black Swan event?

Years ago I worked on the Enron bankruptcy, not at Enron but at Aquila energy.  When Enron went down the derivative contracts that were written were taken under the control of the bankruptcy court and the rules in bankruptcy court are very different from those on the exchanges.  The bankruptcy code said that any contract where Enron was making a profit they could keep the money and any contract where Enron was losing they could get the money back from the counter party.  The chain was broken and it took Aquila down.  This is a small example but you can see that should any one of the major banks have a problem it will have the effect of dragging the others down.

This is why when Lehman and AIG went down the Federal Reserve was required to come to their rescue as without their guarantee to protect these contracts the notional value, not the netted value, is what comes into play.  Remember that during the housing bubble $30 trillion of global wealth was created and vanished and we are still dealing with the mess.  Taking this number to $650 trillion is a number that is far too large even for a unified global effort to repair.

The problem is that unless this market is more strictly regulated banks will continue to add to their portfolio of derivatives creating a larger and larger problem.  If history is anything to go on then it will only be after the fact when the regulation will be enacted.  By the way the regulatory environment was put in place after Long Term Capital Management went down but the Glass-Steagall Act was repealed in 1999 and since then it has been another Black Swan in the making.