Derivative financial instruments, it seems to me, are the underlying problem

[burythehatchet]

I've always found derivatives very interesting. I've also found them to be useful such as selling Delta Airlines the right to purchase fuel at a pre-determined price at a date in the future. This is a sound tool for budgeting and pricing.

But the potential for abuse is too great. Why? I think essentially because a derivative instrument is a first cousin to simple gambling. So while a futures contract like the one described in the Delta example above is a necessary part of doing business, a derivative such as a stock option is close to gambling.

The current crisis, just like the 1932 crisis, has occurred because of derivative financial products. Collateralized Debt Obligations (CDO) are a bundle of mortgages packaged together and sold to a third party, which can then sell the package to another party. Therefore, crappy loans can be wrapped up nicely and sold to investors who have no direct relationship to the debtor.

I think this is the basic issue: derivative products are bought and sold while shielded from regulatory oversight and essentially amount to self-dealing and gambling. The crisis occurs when we, the consumer, decide that the lack of transparency and convoluted nature of the transactions do not pass the smell test. When the trust is lost the market is unable to function.

[supernova]

1. You reminded me

I saw an article (on Sunday?) that said basically what you're talking about. That this debacle would be the end of the derivatives markets.

I can't remember where I saw it though. I'll look for it when I get home this evening.

[Kaleko]

4. Great article in the Guardian - might be what you're looking for...

http://www.guardian.co.uk/business/2008/sep/15/lehmanbrothers.wallstreet

Excerpt:

Wall Street crisis: Is this the death knell for derivatives?


by Nils Pratley

If this is the death of Wall Street as we know it, the tombstone will read: killed by complexity.

Derivatives in their baffling modern forms – collateralised debt obligations, credit default swaps and so on – lie at the heart of the failure of Lehman, Bear Stearns, Fannie and Freddie, and even our own Northern Rock.

The philosophy that underpins the growth of derivatives is the idea that risk can be transferred to institutions more able to take the strain. In theory, it's a terrific scheme – the weak can get rid of risks they can't handle, and the financial system should be stronger as a result.

The practice is very different, as Warren Buffett worked out years ago. His 2002 letter to his Berkshire Hathaway shareholders made headlines by condemning derivatives as "financial weapons of mass destruction". The passage comprised only a couple of pages of the lengthy letter but read it again today - it is the best guide to understanding how Wall Street has arrived at today's mess.

Rest is worth reading too.

[supernova]

8. That's it! Yes

I was reading The Guardian.

Thank you Kaleko. :thumbsup:

[burythehatchet]

11. Thanks.

[burythehatchet]

15. Money quote-

Buffett made a gloomy prediction half a decade ago. "The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear," he said. "Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts."

[RUMMYisFROSTED]

2. Government by the "elite" is the problem.

[Schema Thing]

3. I think "direct relationship" is THE key

both in the example you provide, and in the senseless speculation in the oil markets.

If you aren't buying oil to use or sell (hence "direct relationship"), then you shouldn't be allowed to just play around in the oil market. Vegas is still here if you want to gamble; we don't need you gambling with our resources, and we sure as hell don't need you MANIPULATING our resources.

[burythehatchet]

7. You nailed it. That's what I was driving at. The lack of a direct relationship

is what leads to the moral hazard.

[tbyg52]

5. Yep. They collect their fees and then palm off the risk. nt

[burythehatchet]

10. Yes, and because they deal back and forth with each other

the system becomes completely exposed through its' interdependency.

[indepat]

6. We can take some comfort that the current dollar volume of derivatives is not huge

in relation to the total volume of all financial transactions which have occurred in the entire history of man, but by any other measure, it is gigantic indeed. :P

[supernova]

9. Imagine if the Phoenecians

had been speculating in wheat futures?

[indepat]

12. Mind-boggling indeed

:P

[Karenina]

13. $500 Trillion, give or take a few...

[burythehatchet]

14. And that amount helped inflate the balance sheets of so many finance companies

It's all BS, pretend money. And now the laws of physics state that the vapor money must now evaporate.

[Karenina]

16. POOF!!!

[indepat]

18. Only about 500 times the stated Federal debt when the Gipper took office not even 28 years ago

or more that seven times all the Federal government's current unfunded liabilities: I wonder what that $500 trillion is made up of and portends and also wonder if there is anyone in this universe who has a good handle on it and what it portends. :shrug: :P

[burythehatchet]

17. Relevant excerpt of MoJo article

http://www.motherjones.com/news/feature/2008/07/foreclosure-phil.html

It didn't quite work out that way. For starters, the legislation contained a provision—lobbied for by Enron, a generous contributor to Gramm—that exempted energy trading from regulatory oversight, allowing Enron to run rampant, wreck the California electricity market, and cost consumers billions before it collapsed. (For Gramm, Enron was a family affair. Eight years earlier, his wife, Wendy Gramm, as cftc chairwoman, had pushed through a rule excluding Enron's energy futures contracts from government oversight. Wendy later joined the Houston-based company's board, and in the following years her Enron salary and stock income brought between $915,000 and $1.8 million into the Gramm household.)

But the Enron loophole was small potatoes compared to the devastation that unregulated swaps would unleash. Credit default swaps are essentially insurance policies covering the losses on securities in the event of a default. Financial institutions buy them to protect themselves if an investment they hold goes south. It's like bookies trading bets, with banks and hedge funds gambling on whether an investment (say, a pile of subprime mortgages bundled into a security) will succeed or fail. Because of the swap-related provisions of Gramm's bill—which were supported by Fed chairman Alan Greenspan and Treasury secretary Larry Summers—a $62 trillion market (nearly four times the size of the entire US stock market) remained utterly unregulated, meaning no one made sure the banks and hedge funds had the assets to cover the losses they guaranteed.

[slipslidingaway]

19. Kick, hope this gets two more R's. n/t

[slipslidingaway]

20. Fed Readies A.I.G. Loan of $85 Billion for an 80% Stake

http://www.nytimes.com/2008/09/17/business/17insure.html?_r=1&hp&oref=slogin

"...Without the help, A.I.G. was expected to be forced to file for bankruptcy protection.

The need for the loans became necessary after the major credit ratings agencies downgraded A.I.G. late Monday, a move that likely to have forced the company to turn over billions of dollars in collateral to its derivatives trading partners worsening its financial health.

Until this week, it would have been unthinkable for the Federal Reserve to bail out an insurance company, and A.I.G.’s request for help from the Fed of just a few days ago was rebuffed.

But with the prospect of a giant bankruptcy looming — one with unpredictable consequences for the world financial system — the Fed abandoned precedent and agreed to let the money flow."

[burythehatchet]

21. this is to delay the inevitable. President O will be dealing with it.

[slipslidingaway]

22. Agree, but I have to wonder why our elected officials have not

been making more noise about the growth in derivatives.

:(

http://www.contraryinvestor.com/moarchive2000/mo091200.htm

This is from September 2000...

"Thirty Nine and Holding...Thirty nine trillion that is. That's right, as we told you last Thursday, the 2Q '00 Bank Derivatives report has hit the street. Well, in this case, the backstreet as we just never find mention of it in the popular financial press or the Wall Street analytical community. We keep you updated with the highlights of this report quarterly as the derivatives complex is inextricably linked with the credit markets. They are self reinforcing. Although the report shows the total notional value of derivatives held by the US banking system at $ 39.3 trillion as of 2Q quarter end, there is simply no question in our mind that by now, banks have rolled over the big Four-O. Is it really all downhill from here? (Unless money and credit creation in the financial system slows, not a chance.)

Somebody Stop Me...This is a new economy. Unfortunately one that has become dangerously dependent on credit. It may appear like a brand new world, but it's really an age old trap. Instead of depending on savings and rising incomes for capital formation and economic growth (the old fashioned method), the US economy and financial markets are now dependent on a steady supply of new credit to achieve acceptable nominal levels of growth...


Chillin Wit Shady G...We've caught our fearless Fed leader in too many a rap proclaiming that derivatives have helped "raise the standard of living" in the US and globally. Possibly Greenspan means that mankind is supplying credit where no credit has ever been supplied before. If derivatives usage is so wonderful, according to Greenspan, then why has the Fed fought tooth and nail to keep the facts a secret? The Fed has ignored/turned down requests by the FASB for both disclosure and mark to market mandates. The Fed has actively lobbied to keep the derivatives market unregulated. This in spite of the fact that widespread and broad usage of derivatives barely has ten years of history in our and the global financial system. Completely untested in any scenario that could even remotely be characterized as discontinuous..."