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Wednesday, 18 April 2012

US taxpayers cover unquantifiably large derivatives risk

Avery Goodman has written an excellent explanation of the US derivatives situation, in which he argues that the astronomical value of US issued derivatives has created a frightening concentration of risk.  That is why large scale quantitative easing (money printing) will continue indefinitely, causing high inflation.

The estimated value of derivatives issued from the US and the UK exceeds US$700 trillion.  The estimation of value is highly unreliable, because the valuations are not based upon real market prices, but upon disparate mathematical models whose assumptions and valuations differ widely from issuer to issuer.  The fact that the valuations are so large and also so unreliable creates great risk:  the inability to uniformly quantify risk increases the risk of large financially devastating "surprises".

The performance of derivative instruments is only as good as the creditworthiness of the issuer.  Information from the Federal Deposit Insurance Corporation (FDIC) reveals "a frightening concentration of risk" in the five largest US banks, deemed "too big to fail" (TBTF), who hold 96% of the $291 trillion worth of derivatives issued in the United States.

Most of the positions cancel one another out.  However, if any issuer is unable to meet their obligations, counter parties lose, and some positions will no longer cancel one another out.  Failure of the "insurer" exposes the "insured" to failure.  Because the positions are so large, failure of the insurer-issuer almost guarantees failure of the insured.  And because the positions are so large, the US government has implicitly guaranteed those institutions.  And because those institutions now perceive themselves to be unconditionally guaranteed, they continue to grow their financial risk astronomically.

The huge derivative positions will keep interest rates low for a very long time.  Goodman argues that a sudden very large increase in interest rates could trigger trillions of dollars worth of liabilities.  That is why US interest rates cannot be raised for many years.  Low interest rates and quantitative easing foster eventual inflation, which now appears to be inevitable.  And because quantitative easing (money printing) cannot be suspended, for that would destroy already damaged sentiment, it is possible that future inflation could be severe.

The American taxpayer, through the FDIC, is coming to be guarantor for a very large and an increasing amount derivatives positions.  The system encourages banks to insure their riskier derivative assets with the FDIC.

Goodman provides a detailed breakdown of the trillions involved for each of the five banks.

See Avery Goodman's Seeking Alpha article "Details of the $291 trillion in derivatives to which the American taxpayers are exposed", which I acknowledge with thanks.

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