## internett off

Right now and for the upcoming weeks I am without internet access at home, so basically without internet. Here thus fast a blog post related to the financial crisis.

About 2 weeks ago the Group of 20 finance ministers and central bankers of the biggest developped economies had met in southern England in order to prepare for the upcoming G20 summit. A “sustained effort” was pledged to end the global recession and to cleanse banks of toxic assets. In particular according to Bloomberg

“Our key priority now is to address the value of assets held on banks’ balance sheets, which are constraining banks’ lending” and damaging economies, the G-20 statement said.
Banks are still hoarding cash after being stung by more than \$1.2 trillion of writedowns and losses.”

Meanwhile governments -in particular the US government- are pumping money into the market. For example in Europe the total amount of money has almost doubled within the last 6 years (money supply wikipedia, the Berliner zeitung march 28, 2009 Tagesthema diagram is including 2008 but unfortunately not visible)

And still inflation is low – as if the money would disappear!

And even more mysterious: the pumped-in money meanwhile exceeded the amount of one or two trillion dollars, which were acclaimed as possible losses. And still the money is been hoarded.

Why?

remark: I currently have absolutely not the time for writing these kinds of blog posts (I am amidst moving and basically without internet…) so I can’t put the care into this post here, which I usually prefer to put in. However given the urgency of the upcoming G20 summit I decided to pin down briefly what I sofar understood. In particular if I am wrong (which is not unlikely, given the hasty circumstances) I strongly urge you to correct me in the comments!!!

So here comes my suspicion about why the banks are hoarding money:
Because maybe its not that whats on the balance sheets which gives bankers sleepless nights.

So what’s not on the balance sheets?

These are the socalled financial derivatives or “derivative instruments”, which seem generally to be carried off-balance sheet.

Why is that so? What is a financial derivative?

A “derivative instrument” or shortly derivative (not to confuse with the mathematical derivative) can be usually seen as some kind of insurance. Lets look at an example.

A socalled “call option” is a certain type of derivative, with which you can lower the risk of share prices (to make it simple: a bond or a share is very very roughly a certificate that companys/governments are handing out for getting cash for their investments, a bundle of bonds/shares is very roughly called a stock.

Assume you buy a “1 month call option” on some XXX-stock at a socalled “strike price” of 30 Euros. This “call option” gives you the right but not the obligation to purchase 100 XXX-shares at 30 Euros in one months time. So you have now a great price secrurity. Lets assume you pay 400 Euros for that option, i.e. that price security.

Assume in one month the price of the share had risen to 60 Euros, that is the shares value is then 100*60 Euros= 6000 Euros, you however have the right to buy the shares at an value of 100*30 Euros= 3000 Euros, so you could either sell your option on the market for at most 6000-3000-400 Euros = 2600 Euros or you could buy the shares for 3000 Euros (although their value is now 6000 Euros). If the price of the shares had however gone down to e.g. 15 Euros, that is their total value would be now 100*15 Euros= 1500 Euros, you could buy them at that cheaper value which is less then the original strike price of 3000 Euros. You would have lost your 400 Euros for the option, though. So the 400 Euros are something like an insurance premium, which is lost in any case.

The financial institution which is handing out the derivative can thus be understood as some kind of “insurance company” which compensates for the risk.

There are derivatives on all kinds of financial products, not only for shares but also for interest rates, food prices etc.

In the above example the loss for the “insurance company” is the difference between the actual value which was in the above worst case scenario 6000 Euros and the options “notional value” (here 3000 Euros) minus the price of the option. So in the above example the company could have had a loss of 2600 euros – if the shares would have gone up to 60 Euros.

The possible losses of these derivatives (and thus the prices for the premium) are mostly calculated based on the socalled volatility of the underlying financial asset. That is if the company XXX has highly fluctuating share prices (a “high volatility”) then the risk of a highly different price for the underlying asset (the shares in our example) than that which is written on the option is high, and so the price of the option would be high. On the other hand if the XXX-share prices are usually stable (“low volatility”) then there would be no great risk and the “insurance premium” (the option price) could be rather small. However since the true value or risk of an option or derivative is not really determinable before it is used the derivatives are usually kept off-balance. Moreover:

The risk assessment of the derivative relies in particular on the predictablitiy of a market.

Or in other words: since we are now in a situation where the market is quite unpredictable previous predictions (like about volatilities) of most of these companies were quite probably wrong and thus there could still be many losses ahead.

How many more losses are there possibly ahead?

This is hard to determine however the notional value of a derivative is in some way an indicator. The risk of loosing cash in the amount of the notional value of a derivative (which was in our case 3000 Euros and thus such a loss approximately happened in our worst case scenario of a share price of 60 Euros) should be usually very small. However the more the market is fluctuating and unpredictable the more this rather worst case scenarios could be true.

The financial ministers say there should be more clarity in the derivatives market. Shall they opt for making the notional value of all derivatives public?

This is not necessary. The notional value of derivatives can be found right here on the website of the Bank for international settlements.

It is easy to see that the notional value (=notional amount*strike price of the option) sometimes shortly called just “notional amount” has approximately doubled since 2006.

Alone OTC derivatives have an outstanding notional amount of 683,725 billion dollars = 6.8*10^5*10^9 dollars= 6.8*10^14 dollars (as of Jun 2008).(10^14 (speak “ten to the 14″) this is a 1 with 14 zeros). source from this website.

Thus the outstanding notional amounts of e.g. Credit Default Swaps (that’s what is used in a CDO) with 57,325 billion dollars are “considerably small” against that number.

However the worlds gross domestic product (thats roughly what the world produces in market value) with 54,589 billion dollars (IMF 2007) is even smaller…

And there are derivative financial instruments traded on organised exchanges which add to the outstanding amounts (link).

All of the above could give you some glimpse into how much cash could be needed to raise the banks confidence among themselves.

The more I learn and read about these issues the more I start to get angry.

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