Derivatives: the mother of all bubbles
By
Bill Bonner Sep 05, 2007
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“What can be added to the happiness of a man who is in health, out of debt, and has a clear conscience?” asked Adam Smith.
A bubble!
Here at MoneyWeek headquarters we are occasionally beset with bouts of irrational happiness. We count on our naturally gloomy bent to get us through. And when that fails, we think of derivatives.
Twenty years ago, the total notional sum of derivatives in the entire world was close to zero. At least that is the impression you get from looking at a chart showing the growth of derivatives in the years since. From nothing, the global supply of derivatives rose faster than the Nasdaq, faster than oil, faster even than prices of Mayfair flats. Other market bubbles were like soap bubbles compared to the Hindenburg of derivatives. The latest estimates judge it to be worth some $236 trillion – or about eight times the GDP of the entire planet. In other words, it is a bubble larger than the world itself.
What a nice time to be alive. There in front of us is the biggest bubble that ever existed. We feel like a boy with a pin in his hand! What are these derivatives? Our own Cris Sholto Heaton answers the question in The dangers of derivatives and raises many more, ‘don’t bubbles always blow up?’ being the headliner.
We have no ready answers. But consider this: behind the complexity of derivative contracts are simple-minded human beings who are either long or short. Every contract is a bet. And every bet can go either way.
You might think this means the whole shebang is a zero-sum game. Let them blow up, you might say, the longs and the shorts will offset each other. For every winner there will be a loser; for every half-dozen fools separated from their money there will be a new billionaire with a home in Kensington.
Alas, that is not the whole story. Derivatives are not a zero-sum game, but a game in which the actual odds themselves follow long patterns of boom and bust. There are, for example, trillions of dollars of securities whose value derives from the housing market. Fast-talking lenders write an adjustable-rate, payment-optional mortgage contract for a slow-witted buyer. Then, they sell the contract on – whence it is packaged with thousands of others into a mortgage-backed security. This security is backed by a mortgage that is backed by a mortgage payer. Most of the time, especially during the long bull market in housing – roughly equating to the bull market in credit derivatives – payers are ready and able to pay. Sometimes they are not. When they are not, the security in mortgage-backed securities disappears.
The typical American mortgage payer has not had a real wage rise in 34 years. He can only afford his bigger house and bigger car by working longer hours, putting his wife to work, and taking on more debt. This he can do easily – as long as the credit bubble, the housing bubble, and the bubble in credit derivatives are still expanding. When they stop growing, then the poor homeowner seeks another source of cash. Finding none, he can no longer pay his mortgage. And then all the bubbles blow up – including the mother of them all, the bubble in derivatives.
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