"It is hard for us, without being flippant, to even see a scenario within any kind of realm of reason that would see us losing one dollar in any of these [credit default swap] transactions."
-- AIG financial products head Joseph Cassano, August 2007

Lesson learned: Wall Street disastrously overestimated its intelligence when it comes to the obscurity of derivatives. George Soros's warning that "we don't really understand how [derivatives] work" wasn't meant jokingly.

And don't fool yourself: Just because AIG (NYSE:AIG) gets to backstop its derivative losses with a blank check from Uncle Sam doesn't mean this nightmare is over. Plenty of Wall Street banks -- all of them "too big to fail" -- are ticking time bombs when it comes to bloated derivative books. Have a look:

Bank

Total Assets

Notional Value of Derivative Contracts

JPMorgan Chase (NYSE:JPM)

$2.2 trillion

$87.4 trillion

Bank of America (NYSE:BAC)

$1.8 trillion

$38.3 trillion

Citigroup (NYSE:C)

$1.9 trillion

$31.9 trillion

Goldman Sachs (NYSE:GS)

$884 billion

$30.2 trillion

Wells Fargo (NYSE:WFC)

$1.3 trillion

$1.5 trillion

Bank of New York Mellon (NYSE:BK)

$237 billion

$1.1 trillion

Sources: Yahoo! Finance and Office of the Comptroller of the Currency.

To put this in perspective, AIG nearly blew up the universe with derivatives notionally worth about $2.7 trillion -- a fraction of some of our largest banks. With that in mind, ask yourself what happens when:

  • Debt markets go completely haywire again, dislocating credit markets.
  • Losses and writedowns push a major bank with trillions of dollars of derivative exposure to insolvency.

Now maybe we can grasp why the Treasury has been adamant on keeping failing giants alive at any cost. The failure of any of our largest banks could conceivably set off an explosion magnitudes larger than the AIG mess. And since many of these are commercial banks with deposits guaranteed by the FDIC, the Treasury and Federal Reserve have a tremendous incentive to make sure failures don't occur -- this is where the celebrated chant of "too big to fail" comes in. 

Too big to fail, too ignorant to think
Accordingly, you'd think we'd be taking steps to dramatically reduce commercial banks' derivative exposure, right?

Wrong. Here's how the Office of the Comptroller of the Currency opened its latest quarterly derivatives report:

The notional value of derivatives held by U.S. commercial banks increased $24.5 trillion in the fourth quarter, or 14%, to $200.4 trillion, due to the migration of investment bank derivatives business into the commercial banking system.

Ah, yes -- that's right. Bank of America bought Merrill Lynch -- a deal tantamount to buying Chernobyl -- for $50 billion. Before that, JPMorgan Chase bought Bear Stearns and Washington Mutual. Wells Fargo bought Wachovia, too. At a time when investors and politicians are cautioning over the peril of "too big to fail," banks are getting bigger and more complicated than ever before, all as one-fifth of a quadrillion (with a q!) worth of notional derivatives saturate their books.

Now, every bank boss will tell you they've got a handle on their derivatives, of course. Risk is contained. They've got this stuff down pat. They understand risk better than anyone else. As JPMorgan Chase CEO Jamie Dimon recently wrote, "[JPMorgan] manages [derivative] exposures name by name -- like a hawk."

That's reassuring, but one has to wonder how anyone can manage something that's notionally worth more than $87 trillion like a blind ostrich, let alone a hawk.

Rene Stulz in The Wall Street Journal recently took it a layer deeper and touted the glorious benefits of derivatives, writing:

That derivatives benefit our financial system and our national economy is well established. Twenty-nine of the 30 companies that make up the Dow Jones Industrial Average use derivatives.

Also, five of the 30 Dow stocks have been bailed out by the federal government due to exploding balance sheets. Almost anything can be abused and exploited to a fatal level. Just sayin'.

In all likelihood -- and as has been proven over the past year -- banks' chief risk-management tool on decatrillion-dollar derivatives is a combination of hope, optimism, and an unyielding faith in Uncle Sam's pledge to backstop anyone who's too big to fail. That should scare you.

Is there a solution?
I'm a strong supporter of saving systemically significant financial institutions from collapse, but it's insanity to continue to allow -- and even entice -- banks to become larger and even more systemically significant than they've ever been. Protecting the financial system in a manner that truly protects the economy won't take place until:

  • Banks that are too big to fail are unwound into smaller pieces.
  • Mammoth acquisitions of one systemically significant institution to another are prevented. 

Until then, we're putting Band-Aids over cancer, and it won't do a thing to help the economy.

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Fool contributor Morgan Housel doesn't own share of any of the companies mentioned in this article. The Fool has a disclosure policy.