Derivatives debacle

The wipeout of a major U.S. bank could easily be one consequence of the explosion in derivatives — now totaling $370 trillion, nearly seven times the world's economic output — according to Strategic Investment 's Dan Amoss:

Most of the incomprehensibly large notional value of derivatives are traded "over the counter," meaning one guy calls another and writes a contract saying "let's swap fixed liabilities for floating liabilities." Then, the one that wants to shoulder interest rate risk (basically speculation on the future direction of rates) agrees to make the payments on the floating-rate instrument in return for getting the other guy to make the payments on the fixed-rate instrument.

Normally, one party is hedging and the other is speculating. The problem is, there's no good disclosure in the public domain on who the speculators are and how exposed they are to risk.

My conclusion after studying them pretty intently: this market will experience growing pains. But this was my conclusion in 2002-2003. Now, considering the exponential growth of the derivative market (and its subtle connections with housing market speculation), I think we may see LTCM on a nationwide scale, with the U.S. dollar playing the role of LTCM's capital base. In other words: waking up one morning to the announcement that a bank heavily exposed to derivatives is insolvent and working with the Fed and Treasury on an orderly liquidation and bankruptcy.

The most likely catalyst for this announcement? Interest rate spikes due to massive movements out of the dollar (Chinese/Japanese/Saudis/Hedge funds). Those who contracted to pay skyrocketing floating rates are immediately insolvent and unable to pay the myriad other obligations they have. This sets off more bank failures, and all of a sudden Ben Bernanke has too few fingers to plug into an increasingly leaky dike.