15 X GDP = 0

What is a logical reaction to the following statement?

“In the last quarter of 2012 US bank and savings institutions held $223 trillion of derivatives – fifteen times our GDP.” (Emphasis is in the original.)

A: Become anxious and feel scared.

B:  Sigh…and wonder how it is possible that stuff like this still gets printed.

C: Look to see who wrote it. Discover that it was by a former US Senator who helped shape the financial reform legislation, and that it appeared in the American magazine Forbes. Become anxious. Wonder how stuff like this gets printed. Channel energy and write a media.comment blog post about it.

So here goes:

A recent column in Forbes, part of a larger series on “the failed promises of the Dodd-Frank financial reform package,” looks at the state of derivatives regulation.

It warns readers early on exactly what to expect, stating: “we can discuss derivatives without knowing exactly how they work.” Really?

And then it goes on to try and prove that point.

The column, which is supposedly about OTC derivatives regulation, states: “Had hundreds of billions of dollars worth of AAA-rated CDOs not lost most of their value in a matter of days, there would have been no crisis.”

Well, that’s almost right. As the statement infers, real estate was at the heart of the financial crisis. But real estate values (and the mortgage-based securities and CDOs based upon them) had been declining for some time, and did not lose their value “in a matter of days.”

The larger issue, though, is that CDOs are not OTC derivatives. They are securities. They are not included in the “scary” number cited above. And they are certainly not covered by OTC derivatives regulations. They are also not what the Forbes column is supposed to be about.

Maybe we do need to know how something works before we talk about it…

But moving on: the column rails against the requirements imposed regarding the number of quotes a firm must get before it can execute an OTC derivatives contract. It states: “The requirement had been reduced to require dealers to obtain votes from only five banks before executing a contract. Even that was watered down after more pressure from Wall Street; the final vote required only two bids.”

Two points here, one small, one large. First: “obtain votes?” Obviously an editing mistake.

Second, while the value of setting any minimum level of quotes is debatable, it’s important to remember that market participants are always free to get as many quotes as they like. How many quotes would you get before buying a car? Two? Five? You – the customer – can and should decide. Seems like a great concept to us.

Finally, to end where we began: What is there to say about the “fifteen times our GDP” comment? How about exactly what we have been saying for almost three decades?

Notional amounts outstanding indicate activity and not risk. Credit risk is better gauged by gross market value, which is 3.9% of notional (or $24.7 trillion), and even better yet by net market value, which is 0.6% of notional (or $3.6 trillion). Collateralization further reduces credit exposure, to about 0.2% of notional (or about $1.1 trillion).

These are still big numbers, but should be looked at in context. According to data from McKinsey and the BIS, the global stock of debt and equity outstanding includes $62 trillion of non-secured lending; $50 trillion of equity; $47 trillion of government bonds and $42 trillion of financial bonds.

Notional is admittedly a big number and it’s easy to use it to create scary headlines and stories. But we imagine most informed commentators know what it really represents. Which may mean that those who do conflate its meaning may have their own purposes in mind?

TIME for an April Fool joke? If only….

It’s Easter Monday. Europe is closed. The US wishes it were.  Along comes this scary headline…which is even scarier because it’s from a column in TIME written by a contributor: Why Derivatives May Be the Biggest Risk for the Global Economy.

We furiously click through the link to get to the entire article. We read through it, drawing nary a breath. We see claims (with absolutely no attribution or substantiation) that the OTC derivatives market is bigger than the BIS says it is. Which means the risks are even greater than many had supposed.

We are puzzled.

And then we come to the piece de resistance, the giveaway:

“…in theory, at least, the total losses could add up to more money than there is in the entire world.”

A moment of clarity descends upon us. We “get” it.

It’s April 1. The column is an April Fool’s Day prank.

It has to be…because the story simply makes no sense. The venerable TIME would never run a column that confuses its facts so badly. It mixes up notional amounts outstanding with the level of OTC derivatives risk outstanding (which is properly measured by market value). If you do a $100 million interest rate swap, you agree to exchange payments based on the $100 million notional amount. You don’t actually exchange the $100 million.

We know people sometimes find OTC derivatives confusing, but we had imagined that by now just about everyone gets this point (or at least everyone with the yank to write a column in TIME). Notional does not measure risk. In fact, the amount at risk in OTC derivatives typically averages about 4% of the notional outstanding. And it’s less after you factor in collateralization and netting (about 0.2% of notional).

Unfortunately, the misguided notions on notional are not all that’s wrong with the column. It also fails to recognize the significant growth in central clearing, the progress made in increasing regulatory transparency, the continuing efforts in collateral management – all of which help to reduce risk.

We’re glad April Fool’s Day only comes once a year.