A Warning About the Exploding Derivatives Markets
August 21, 2014 • 9:38AM

"We've reformed nothing. We have more leverage and more derivatives risk than we've ever had," reports an analyst for a structured finance broker-dealer, speaking of the latest bubbles in the global, unregulated, over-the-counter derivatives markets, to the Aug. 20 Financial Times.

On Tuesday it was 15 members of Congress confronting the Federal Reserve on the fact that it was still making rules allowing it to bail out big, bankrupt banks with trillions in liquidity injections, to keep them going as zombies. Today the Financial Times is warning that exotic credit derivatives are again exploding in volume, which can turn completely toxic to financial institutions in case of market volatility, a disease that could be called "AIG syndrome." The Financial Times begins by citing a warning on this from Kyle Bass, founder of the Dallas hedge fund Hayman Capital Management, who published the first detailed warning, back in early 2007, that credit derivatives would bring down the banking system.

The FT's story is that Wall Street banks are piling into the issuance of extremely complex credit derivatives which are bets on entire global securities and credit markets — total return swaps — or bets on indices of credit default swaps, known as swaptions. JPMorgan Chase's London Whale team lost $6 billion on these, so they're not for sophisticated investors any more than for unsophisticated ones, but the fees make them very profitable for banks issuing them. The leaders, though not named in the FT article, are Goldman Sachs, Morgan Stanley, and ... JPMorgan Chase.

Taking the swaptions, for example, $60 billion of them are now being traded every week. The proliferation is due to a trans-Atlantic credit market situation of very low interest rates — forced by the central banks — and virtually no market volatility, because of the huge amounts of liquidity being pumped in by the central banks, most of it seeking exactly the same high-yield, high-risk securities.

"The markets don't really need a Lehman or even a Lehman-lite event for a credit dislocation," a hedge fund manager is quoted. "You just need spreads to widen or rates to go up."