How Many Lifetimes Does It Take to Count One Quadrillion Dollars of Derivatives?

Five-hundred-ninety-five and one-quarter. Not kidding. I typically do this sort of math when trying to comprehend very large piles of money. Think about that for a second. Assuming an average life span of 80 years and that you counted (1-2-3, etc.) every waking moment from birth, it would take 595.23 lifetimes to count one quadrillion dollars, which is roughly the total notional value of financial derivatives in existence on the planet today. Unbelievable! And this notional value is just that ...notional...existing merely as marks on paper or more likely electrons on computer screens somewhere. As Dr. Evil would say, "Frickin' weird!".

Financial derivatives have existed for a long time and were originally created by highly educated mathematicians intent on providing hedges or insurance to dampen the risk associated with their clients underlying tangible investments. But since the late 1980s the industry has grown exponentially --- largely unchecked, regulated or accounted for --- and now dwarfs the value of the underlying assets they were originally meant to protect. Indeed, this value is more than 15X annual world GDP, roughly 10X the values of all tangible illiquid goods (land buildings etc.) and more than 5X the value of semi-liquid property (stocks, bonds, mortgages, etc.). I hadn't realized just how big the monster had grown until....well, yesterday when Hernando De Soto wrote in the Wall Street Journal,

everything of value we own travels on property paper. At the beginning of the decade there was about $100 trillion worth of property paper representing tangible goods such as land, buildings, and patents world-wide, and some $170 trillion representing ownership over such semiliquid assets as mortgages, stocks and bonds. Since then, however, aggressive financiers have manufactured what the Bank for International Settlements estimates to be $1 quadrillion worth of new derivatives (mortgage-backed securities, collateralized debt obligations, and credit default swaps) that have flooded the market.

I had been focusing on the $60-$70 trillion number being batted around the press the last few months, which represented the size of the Credit Default Swaps (CDS) market which rose to prominence in the back half of 2008 as financial firms were fighting for their lives and more recently as the reason why AIG keeps getting a "big gulp" refill from Uncle Sam. I thought that number was huge relative to the original size ($1 trillion) of the subprime problem (given the havoc it had wreaked)and been very concerned how we would survive unwinding the CDS mess and so was stupefied to realize the CDS market was still largely tip of the iceberg. I thought $1 quadrillion may have been a typo but then had it confirmed later in the day after listening to an interview on NPR's Fresh Air with current law professor, former derivatives salesman and author Frank Partnoy.

Until what seems like only a short while ago, I held no more than a passing interest in this strange and opaque world filled with exotic instruments that were generally so difficult to understand my brain hurt trying. I am not a stupid person but was generally made to feel like one by practitioners when trying to understand what real purpose many of these instruments served beyond as simple speculative currency. And as the complexity multiplied so did the acronyms by which they were named until at some point I lost nearly all interest. Apparently so did a lot of people until the acronyms --- MBSs, ABSs, CDLs, CDOs, CDSs --- exploded on to center stage at the heart of the sub prime crises in the summer of 2007.

So what precisely is the problem with unregulated derivatives? Their purpose being largely undefined in reality, they have grown vastly bigger than the tangible property they were meant to hedge or insure in the first place. As such, they have become the tail wagging the dog--at best--more likely a vaccine that has turned into a life threatening virus. Mr. De Soto makes the point that global commerce and trade, which has done so much to positively transform our collective standards of living can only operate in a system based on trust that property, as evidenced largely by pieces of paper---or now electrons---is reliable. And that it is that system of trust in paper and promises etc. that has been compromised by the shadow system of opaque claims that are the basis of the vast OTC derivatives market. Once again from his op-ed,

Today's global crisis -- a loss on paper of more than $50 trillion in stocks, real estate, commodities and operational earnings within 15 months -- cannot be explained only by the default on a meager 7% of subprime mortgages (worth probably no more than $1 trillion) that triggered it. The real villain is the lack of trust in the paper on which they -- and all other assets -- are printed. If we don't restore trust in paper, the next default -- on credit cards or student loans -- will trigger another collapse in paper and bring the world economy to its knees.

These derivatives are the root of the credit crunch. Why? Unlike all other property paper, derivatives are not required by law to be recorded, continually tracked and tied to the assets they represent. Nobody knows precisely how many there are, where they are, and who is finally accountable for them. Thus, there is widespread fear that potential borrowers and recipients of capital with too many nonperforming derivatives will be unable to repay their loans. As trust in property paper breaks down it sets off a chain reaction, paralyzing credit and investment, which shrinks transactions and leads to a catastrophic drop in employment and in the value of every one's property.

How did we get here? Many ways to be sure, but its important to understand some of the key players who politely opened the door, several generations after the disaster of unregulated risk from the 1920s/30s had largely faded from memory, for the geeks bearing formulas onto the unsupervised and hidden playground that global financial institutions had been only too eager to construct and exploit. And according to Mr. Partnoy, we hear at about the 10 minute mark of the interview how Wendy and Phil Gramm, from the late 1980s until about 2000, were probably most responsible for enabling the massive deregulation of derivatives that has directly led to our problems today. According to Partnoy, conservative economist Wendy Gramm, when head of the Commodity Futures Trading Commission, in 1993 signed an order exempting derivatives from regulation, making them vastly easier to market and grow and shortly thereafter left government to join Enron's board. Others bearing significant responsibility are former Treasury Secretary Robert Rubin, Fed Chairman Alan Greenspan and former Treasury Undersecretary and current Director of White House Council of Economic Advisors Lawrence Summers, who opposed CFTC Chair Brooksley Born in 1998, who sought comments on the need to regulate derivatives, specifically swaps that are traded at no central exchange (known as the dark market), and thus have no transparency except to the two counter-parties. With such strong opposition, it went no further, no actual regulatory scheme was proposed and Born resigned her post. Shortly after, the Commodity Futures Modernization Act of 2000 cemented the deregulated status of derivatives and it was Gramm's husband, Senator Phil Gramm who added the provision virtually unnoticed to an 11,000 page omnibus bill voted on and passed just before Christmas recess. The rest is history! Listen to the interview--it's 30 minutes long---but fascinating.

So where do we go from here? Mr. De Soto offers six principals that he claims have rooted global trade for centuries and are necessary conditions for returning balance to the system. Waiting to let "the markets" figure it out will never work. Governments must take coordinated action to restore the trust and sense of order necessary to allow trade to once again flourish without reservation. Mr. De Soto offers six requisites

Property is much more than a body of norms. It is also a huge information system that processes raw data until it is transformed into facts that can be tested for truth, and thereby destroys the main catalysts of recessions and panics -- ambiguity and opacity. To bring derivatives under the rule of law, governments should ensure that they conform to six longstanding procedures that guarantee the value and legitimacy of any kind of paper purporting to represent an asset:

- All documents and the assets and transactions they represent or are derived from must be recorded in publicly accessible registries. It is only by recording and continually updating such factual knowledge that we can detect the kind of overly creative financial and contractual instruments that plunged us into this recession.

- The law has to take into account the "externalities" or side effects of all financial transactions according to the legal principle of erga omnes ("toward all"), which was originally developed to protect third parties from the negative consequences of secret deals carried out by aristocracies accountable to no one but themselves.

- Every financial deal must be firmly tethered to the real performance of the asset from which it originated. By aligning debts to assets, we can create simple and understandable benchmarks for quickly detecting whether a financial transaction has been created to help production or to bet on the performance of distant "underlying assets."

- Governments should never forget that production always takes priority over finance. As Adam Smith and Karl Marx both recognized, finance supports wealth creation, but in itself creates no value.

- Governments can encourage assets to be leveraged, transformed, combined, recombined and repackaged into any number of tranches, provided the process intends to improve the value of the original asset. This has been the rule for awarding property since the beginning of time.

- Governments can no longer tolerate the use of opaque and confusing language in drafting financial instruments. Clarity and precision are indispensable for the creation of credit and capital through paper. Western politicians must not forget what their greatest thinkers have been saying for centuries: All obligations and commitments that stick are derived from words recorded on paper with great precision.

Which brings us to what the government is doing? Well under George Bush, largely turn a blind eye. To be fair to Hank Paulson, he saw the need for a vast overhaul of regulation of the financial services industry to eliminate the possibility of regulatory gaps and he had an awareness that certain institutions had become much too big to be left unattended as they had the ability to bring down the entire system through their own stupidity. But actions speak louder than words and unfortunately none were really taken. Now, its the Obama administration's turn and I'm heartened to hear Treasury Secretary Geithner, testifying before the House Financial Services Committee today citing the need for "comprehensive reform -- not modest repairs at the margin, but new rules of the road", including the creation of a new entity to oversee risks to the financial system, systemically important firms and systemically important payment and settlement systems. He said that federal authority over credit-default swaps and other over-the-counter derivatives was too fragmented (or non-existent). Under Treasury's plan, the government would regulate the markets for credit-default swaps and over-the-counter derivatives for the first time. The devil is in the details and there will be enormous push back from the very powerful derivatives and financial services lobbies. But I'm delighted to see that they are willing to pick the fight and the current and potential future crises are too enormous not to have the stomach for this. Governments around the world must safely put the genie back in the bottle and restore these products to their original intent and purpose for the safety of all involved.

And what can we do? At a minimum, here's what I've committed to do. When hearing about derivatives on the radio or TV, turn up, not down, the volume. When seeing a headline in a newspaper or magazine about derivative, read it instead of looking for something more interesting on the next page. When somebody wants to discuss the derivatives mess with me, I won't give them the bleary-eyed look of someone cornered who thinks they're about to be bored to tears and tune out-- I will fully engage. Knowledge is power and we have been denied the knowledge (and therefore the power) for too long. Yes, we have been tricked but we also allowed ourselves to stay in the dark longer than we should have, hoping somebody else was on point when they obviously weren't. Now, we must all take responsibility to look out for ourselves. Contrary to former Fed Chairman Alan Greenspan's positive characterization at the beginning of the decade as shock absorbers to offset systemic catastrophe, Warren Buffet several years ago more accurately depicted financial derivatives as weapons of mass destruction. More recently and bluntly, the Oracle of Omaha offered this sage advice, "Beware of geeks bearing formulas". There are derivatives underlying, or more accurately on top of, almost any and all loans, mortgages, bonds, stocks, insurance contracts, leases, currency holdings, agriculture, commodities, and the list goes on. Adding to Mr. Buffet's warning, if someone offers to sell you a financial instrument that relies on a series of hoops to be jumped through in order to get paid, that is labeled with an acronym, and is based on an asset in which you have no financial interest to begin with, I would advice you to quietly step back, hold fast to your wallet and ....run away. Trust no one, particularly not your broker if he's the seller. Buying a derivative through a central clearing exchange with full transparency as a hedge to an underlying asset (ie buying a put option on an underlying stock position) is logical and prudent. Buying an OTC derivative from a broker on an underlying asset in which you have no economic interest is speculative and dumb. This is something we can all do better at.