Face value of derivatives floating around the world is $1.14 quadrillion

One quadrillion. That’s 1,000,000,000,000,000 — one plus 15 zeroes, or one thousand trillion. It is incomprehensible. And that’s what’s terrifying. This summer, the Bank for International Settlements, the bank for the world’s central banks, estimated that the face value of derivatives floating around the world is $1.14 quadrillion. Derivatives are incredibly complex securities whose value is derived from some asset such as a bond, a stock, or a currency. They are used to bet on the weather and upcoming inflation, among many things. But derivatives aren’t really assets; they are crapshoots on the value of the underlying securities — a wager on another wager. They are based almost completely on borrowed money. And all too many are held by the nation’s largest banks and investment banks — yeah, one of those places where you may have parked your money.

Wall Street is now going through its greatest crisis in years. Over the weekend, Lehman Brothers went into bankruptcy, Merrill Lynch had to be bought by Bank of America, while insurance giant AIG tottered — all this following close on the heels of the government’s seizure of mortgage monsters Fannie Mae and Freddie Mac. At the center of these storms are derivatives.

Of that $1.14 quadrillion of derivatives, $548 trillion are listed derivatives, or ones that are traded on organized exchanges, and $596 trillion are over-the-counter derivatives that are basically unregulated and, essentially, unmonitored. They are traded in a chaotic marketplace in which record keeping is sloppy. Institutions that own these over-the-counter derivatives sometimes don’t know who is on the other end because these instruments have been bought and sold so many times.

Warren Buffett, America’s richest person, says derivatives are “financial weapons of mass destruction.” And that’s just what savvy economists and analysts fear: a financial nuclear reaction, with one institution after another failing after one party can’t meet its obligations. “The foot bone connected to the ankle bone, the ankle bone connected to the shin bone. Oh, mercy, how they scare!” Especially when the bones all start becoming disconnected. Early this month, the federal government seized mortgage behemoths Fannie Mae and Freddie Mac. They have $1.6 trillion of debt outstanding, and derivatives called “credit default swaps” guarantee payment of that debt. Those debt-guaranteeing derivatives motivated the government to seize the entities. There could have been a chain reaction.

On a weekend in March, the Federal Reserve rushed to keep Wall Street’s Bear Stearns from failing. It was committed to $13.4 trillion worth of derivatives. That’s chump change compared with a quadrillion. But our leaders justified pouring $29 billion into the rescue because, they said, the Dow Jones Industrial Average would plunge 2000 points if Bear went bankrupt. JPMorgan Chase took over Bear and now is a party to $90 trillion of derivatives. What would happen if Morgan came asunder?

We may find out. Last weekend, two brokerages disappeared because of excessive derivatives exposure. (Two years ago, thebanker.com named Lehman “Bank of the Year for Credit Derivatives.”) Here’s the bottom line: Derivatives with names such as credit default swaps, collateralized debt obligations, and mortgage-backed securities are the villains in the problems of Bear Stearns, Lehman, AIG, Merrill Lynch, Fannie Mae, Freddie Mac, and other financial institutions that may disappear.

The total annual output of the U.S. economy is around $14 trillion. The total output of world economies is around $67 trillion. Those who defend derivatives say that the notional (or face) value of derivatives — the $1.14 quadrillion — is misleading. The gambles between two parties net out against each other. Actually, only 1 or 2 percent of the notional value may be on the line, claim the optimists. So? Are you comforted that $10 trillion to $20 trillion could be at risk when total U.S. annual economic output is $14 trillion? Even if only a small portion of that $10 trillion to $20 trillion is actually at risk, as some claim, it is an almost inconceivable amount of money.

“The risk of a [chain] reaction is significant,” warns James Hamilton, economist at the University of California, San Diego. “The magnitude of these things is just staggering. I would have thought that the last year would have been a time of winding them down, battening down the hatches. We need to unwind these derivatives — we need to deleverage [cut down excessive debt].” But it’s not happening. “It’s more than a can of worms. It is a world full of tangled worms.”

Apologists argue that it’s not that institutions like Bear Stearns are too big to fail, it’s that they are too interconnected to fail. “But who is going to bail out the Federal Reserve? Who is going to bail out the federal government?” asks Hamilton. “Everybody wants to put their head in the sand. The derivatives are so complex. Sometimes the institutions don’t know what they’ve got.”

Indeed, the essence of white-collar fraud is contrived complexity. Derivatives are concocted by Harvard and MIT math Ph.D.s so that nobody can understand them.

Hamilton says they should be regulated. “If you are too big [or too interconnected] to fail, then you are too big not to be regulated,” he says. Following the Bear Stearns calamity, there have been moves to inject some orderliness in the over-the-counter derivatives market. There has been discussion of regulation.

“The possible compounding chain reaction to the failure of one or two major financial institutions is real and concerning,” says Arthur Lipper III, a Wall Street veteran who now lives in Del Mar. “The possible problems are vastly greater than any single or group of regulating bodies has an ability to manage.” Lipper suggests one route to reform: board members of institutions borrowing heavily to gamble on derivatives should not be indemnified against personal responsibility. Such a move “would have the immediate effect of financial institutions becoming more conservatively managed.”

Ross Starr, economist at the University of California, San Diego, says that if one party can’t make its obligation, “It causes the whole house of cards to come down. It’s not that the instruments themselves pose a systemic risk but rather that they redistribute financial losses in an unpredictable way. If it causes illiquidity to the rest of the economy, we have a problem. It’s something we haven’t quite figured out.” Amen. How can we figure out something we can’t comprehend?

The derivatives are so complicated that any regulators will have a hard time understanding them: “There’s not a lot of transparency there,” says Starr. “Regulators will not be able to focus on that. It’s a source of concern. We have not adequately come to terms with this.”

More than ten years ago, University of San Diego professor of law Frank Partnoy wrote the first exposé of derivatives abuses, F.I.A.S.C.O.: Blood in the Water on Wall Street. At that time, derivatives were not big potatoes. He admits to being surprised that the notional value has climbed to a quadrillion dollars. In a recent article for the Financial Times of London, Partnoy says that today’s derivatives crisis is similar to that of the 1990s, except it involves much more money. The crisis that forced Orange County into bankruptcy looks small by comparison with the mortgage write-downs of big financial institutions today.

He sees the end of this calamity on the horizon. “We will emerge from this crisis, and then another will hit in a few years,” he says, greatly because of moral hazard: if we keep bailing out the gamblers, they will continue to take egregious risks with borrowed money. For several reasons, including the fact that they are privy to information that others don’t have, Wall Street operators will prosper. “Finance industry employees will continue to outearn just about everybody,” says Partnoy.

Much of their great wealth is coming from you.