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A Derivatives Market Meltdown: "We Apologize for the Inconvenience"

The collapse of the Collateralized Debt Obligation (CDO) market underscored the enormous overhang of the larger over-the-counter derivatives contracts market. This is far from over, folks! For example, we have not yet to seen a full-blown Credit Default Swap (CDS) market implosion. I have been warning blog readers about CDS instruments since 2005. And even though our politics are diametrically opposed, I was not surprised to see George Soros recently chime in on the subject. Derivative instruments are essentially unregulated and they measure in the hundreds of trillions of dollars. The counterparty risk is enormous, yet the derivatives market is quite opaque and little understood, even by most of the people that work in the financial sector.

To illustrate both the potential magnitude of a derivatives disaster, and the incredibly blissful ignorance of most investors, I offer the following analogy:

You are a business traveler. It is 9 a.m. on a Monday morning and you are seated at a crowded gate at the Newark, New Jersey airport, waiting for boarding of the 9:25 Delta Airlines flight to Atlanta. You are feeling nervous, because the 20-something man that is sitting next to you is suffering from a bad hangover. You've correctly surmised that over the weekend he got fleeced at the gaming tables in Atlantic City after the casino offered him too many "comp" cocktails. He looks only semi-conscious and you are afraid that he is going to puke on your nice suit. A ticket agent announces on the loudspeaker: "Ladies and gentlemen, I have some bad news." She pauses and you think to yourself: "Oh great, two or three of us are going to get bumped." The agent goes on: " It was just announced by the chairman of Delta Airlines that the company has declared bankruptcy. All Delta flights have been cancelled for the foreseeable future. Because Delta is now insolvent, no replacement tickets, vouchers, or refunds will be issued. We apologize for the inconvenience. Have a nice day, and thanks for flying Delta Airlines." There are shouts and anguished cries from the other passengers. You sit for a minute in stunned silence. Your mind is racing. You remember reading that Delta has over 1,630 scheduled flights a day, moving roughly 277,000 passengers per day from city to city. The drunken gambler shouts "Hey!" and he leans close to your face. With his breath smelling like a dog kennel and his eyes glassy, he asks: "I don't get it, man. What do they mean, "insolvent"? You take a few minutes to explain the situation in simple terms to him. But the gambler just gives you a blank stare. "What do you mean,?" he repeats. Now you are angry, and you shout at him: "Aren't I getting through to you? I'm talking about two hundred and seventy seven thousand bumped passengers!" Finally, the dazed drunk has a flash of realization across his face. "Oh. I get it. This is bad news. It'll be hours before they'll call for seating on my row!"

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