bostonbubble.com

[CC]

The following article shows JPMorgan Chase holds a staggering $88 trillion in derivatives and other 4 banks also hold a lot of derivatives. How could this possible? $88 trillion? That's probably more than the US public debts. I guess it could be $88 "billions".....?

Any idea?

http://www.rense.com/general85/econn.htm

[balor123]

I've read that as well. Just because there's a lot of derivatives doesn't mean there's a lot of risk. Much of it is likely hedges which cancel each other out. It is unfortunate that we've built a financial system where the systemtic risk can't be determined though, especially when we allow large transactions of OTC products. Politicians should consider a solution to this problem, like requiring that all transactions over a certain amount be registered in some central database that they can monitor.

[GenXer]

While derivatives vary in their levels of risk, the only way the banks can make any money is to take risk. Derivatives is a way for them to get paid for taking risk, and as with any investments, these securities are structured in such a way that an unpredictable event can trigger a massive wave of losses, just like we already saw happened. The lesson is clear: banks are sitting on a powder keg, and it simply a matter of time until somebody lights the fuse. By the way, money markets are largely derivatives, and almost everybody, including your mutual funds hold derivatives. Unfortunately, there is no guarantee that you will not lose money (just like many money market holders found out not too long ago).

[ConcernedCitizen1]

Derivatives are as old as farming (the first futures contracts took place in Mesopotamia and Egypt) but some are more dangerous than others. So they are not inherently bad. They provide quite a good service in many cases. Just as the farmer wants to sell his wheat now the baker wants to buy his wheat now so it's a win win. Similarly interest rate swaps provide a very positive service. I am reading more about swaps that pension funds are trying to use to hedge out unwanted risks (e.g. longevity the risk that people live longer than modelled).
Coming to credit default swaps, the trillions quoted are overstated - recently I've been reading that something like 1/3 (maybe more) of the whole CDS market disappeared over a few months as the banks cleaned up their back office and closed out all the netting trades. Once CDS are on an exchange I think things will be much better and they'll function just like other useful tools like commodity futures.
But people took the good parts of derivatives and used the arguments to try to sell cr*p ones like CDOs of CDOs. Because interest rates were artificially low in my view during the bubble period, the chase for yield began and naive institutions bought these terrible products.
Robert Shiller talks about the idea of GDP swaps or unemployment swaps where you could try to hedge out the biggest risks you will face as an individual. This is probably fantasy at this point because who would take the other side of the trade but I think he's right to point out the risk of loading up your eggs in one basket, which is often what putting a huge amount of your wealth in 1 house in 1 location does (as discussed on other posts).

[CC]

Thanks for the messages! But my question is mainly regarding the amount. For example, it says JPMorgan Chase holds a staggering $88 trillion in derivatives. I think it should be $88 "BILLIONS", since $88 trillion is probably more than US public debts or more than the whole stock market.

[GenXer]

I think 'trillion' is a typo. It should read billion.

[GenXer]

Though it is possible to have trillions in derivatives, maybe they are right...though it doesn't mean much - its like saying that Federal Reserve has ability to print trillions of $. Just says that they are able to exercise immense leverage.

[ConcernedCitizen1]

It's true, see page 22 of the report from the Officer of the Comptroller of the Currency

http://www.occ.treas.gov/ftp/release/2009-34a.pdf

However this number is not synonymous with risk. See that JPM has 56 trillion in the swaps column. These I think would mostly be interest rate swaps (therefore less risky in my view than CDOs of CDOs of CDOs etc which are quite hard to value).

Here, the notional just tells you the amount off which payments will be made (so I agree to pay Libor to a counterparty and the notional is 20,000,000, I will only be paying Libor multiplied by 20mn. Currently Libor is 1.5%.

There are also netting and collateral posting factors to consider. It's not easy to take those numbers and extrapolate risk. VaR, stress testing, counter party exposures, all have to be taken into account. I have to run now but will try to post other helpful things if they come my way.

And sorry one last analogy: on how you have to look hard at what a bank is holding and not generalise: take 2 hypothetical banks: one is holding derivatives, but they are the highest quality tranche of a mortgage back securitisation, and they bought them at 50 cents on the dollar. The other bank has simple, plain vanilla loans but they are all to commercial real estate developers clustered in one region. The latter will go bust first.