Wednesday, September 27, 2006

Putting some numbers on it

Derivative danger
The derivatives market has soared, reaching nearly $300 trillion in value. Considering the total value of the stock and bond markets combined amounts to only $65 trillion, it's worth wondering how so much extra value can be squeezed out of instruments that are essentially fake.

The capital market is hedged now more than ever. The notional value of derivatives has almost tripled overt the last five years, growing from $98 trillion in 2000 to $270 trillion in 2005, according to Wall Street research firm TowerGroup. This year derivatives are on path to grow even more.

And I wouldn't expect that growth to stop anytime soon because what is driving it is Wall Street profits. "Wall Street has made record profits from derivatives and structured products in the first three quarters of 2006," according to a TowerGroup report. "U.S. brokerage firms will generate $33.2 billion from derivatives-related revenue in 2006 as the rapidly growing market catches up with the cash market."

According to the Structured Products Association, about $50 billion worth of structured products annually flows into the U.S., with between 20% to 25% growth projections this year even though "many U.S. retail investors aren't aware of what a 'structured product' is."

With the global numbers and values already enormous, adding U.S. pension funds, more institutions and a retail investment audience to the hundreds of trillions of capital the derivatives market attracts could further shift the scale in favor of them more than any other financial instrument or asset class.
Yet, it wouldn't take all that much to create a domino effect of market mishap. And there is no net.

The Securities Investor Protection Corporation, which insures brokerage accounts in the event of a brokerage-firm failure, recently announced its reserves. It has about $1.38 billion. That may sound like a lot. Compared with half a quadrillion, it's a pittance.

Scary but true.

"They" say that a 1987 type crash can't happen again because what "caused" that one was so-called portfolio insurance which just exaggerated the plunge.

So, what's a hedge fund???

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