$1.5 Quadrillion Derivatives Time Bomb

[eridani]

Appropriate government action might be able to spike this.

http://www.marketoracle.co.uk/Article51600.html

Ellen Brown calls the “derivatives casino...a last-ditch attempt to prop up a private pyramid scheme” - slowly crumbling under its own weight.

For years, Warren Buffett called derivatives “financial time bombs” - for economies and ordinary people.

Unless collateralized or guaranteed, their worth depends on the creditworthiness of counter-parties. Earnings on derivatives are “wildly overstated,” Buffett explains - because they’re “based on estimates whose inaccuracy may not be exposed for many years.”

When corporate bosses ask financial executives how profits look in any quarter, they, in turn, ask how much do you want, then manipulate things to oblige when told.

Since 2008, too-big-to-fail banks consolidated to much greater size than ever. They’re financial and political powerhouses controlling world economies to their own advantage.

Civilization’s only hope is smashing them - dismantling them into small, impotent pieces, or ideally putting money back in public hands where it belongs.

[TreasonousBastard]

1. When you get right down to it...

you have to wonder just how derivatives can effect real life. Some genius invents a way to make a buck off the spread separating interest from principle but what happens if someone goes bust from that? Since the money involved was largely fictional to begin with, does it matter?

We've already seen huge Wall Street firms and major banks go bust, but houses are still being built and cars still being sold. Wage and wealth differentials are at abominably high levels, but the causes aren't so much the bankers demanding it as social situations, employers, etc. just being able to get away with it.

Rather than attempting to break up banks and traders, adding a transaction tax and treating inherited wealth and most capital gains as ordinary income would go a long way toward fixing things.

[6chars]

2. if only it were so simple

if gov't is going to bail out losers in these derivative deals, or if people lose life savings, it definitely has an effect. houses stopped being built for a few years after 2008 and a lot of people lost their homes and fortunes and jobs - that was real life, and it will still have more long term effects including the effects of high govt debt. sure, if one billionaire wants to play blackjack with another, it doesn't affect us. but empirically from the last time around we know it can be huge. while your points about taxes are worthwhile, we also don't want to be on the hook for the next derivatives mess.

[TreasonousBastard]

3. Well, you've got a point that it's not so simple, but...

the key problem then was trading all those subprime mortgages. When it became clear that people couldn't pay the inflated values of their houses, all hell broke loose.

Not that the problem couldn't be repeated from another trigger, of course. From the Dutch Tulip Bulb mania to the Depression, we've had never-ending waves of greed and stupidity threatening the works.

The important point, however, is that people have to eat, so even in the worst of times things will eventually get back to something close to normal. The greed that caused the problem will come back with something to sell and a way for it to be bought. Economics abhors a vacuum as much as nature does. Maybe more.

A good argument against this is the Depression, where even the New Deal seemed like it was just bandaging the problems at first, until WWII started and we started making stuff again. And the draft cut the labor pool way down.

But, there is no way to tell just what would have happened without the war had Hoover's path continued. Or Roosevelt's.

[Fortinbras Armstrong]

4. Let me tell you a story that will illustrate the problem.

There is a financial model, the Black-Scholes model (sometimes called the Black-Scholes-Merton model), which attempts to determine the proper price for certain financial derivatives. It actually does a pretty good job of doing that, provided one makes a fundamental assumption: That the traders in these derivatives are acting "rationally" -- that is, they are driven solely by reason.

In the 1990s, there was a hedge fund, Long Term Capital Management, which would determine option prices using the Black-Scholes model (both Scholes and Merton were partners in LTCM). If an option price differed significantly from the calculated price, LTCM would trade on that option on the generally justified belief that the price would "correct" to match the model. For several years, this worked very well and LTCM made a ton of money, entering 1997 with assets of $3.6 billion.

However, the twin whammies of the 1997 Asian financial crisis and 1998 Russian financial crisis hit LTCM. All of a sudden, traders were acting irrationally and wanting liquidity (i.e., cash) and were willing to pay premium prices to get it. Under these circumstances, the Black-Scholes model wasn't working (there were other problems as well, such as LTCM getting involved in trades that didn't meet the Black-Scholes criteria). Added to this was that while banks are restricted in how much of their capital they can lend and stock traders are limited in how far they can go on margin trades, hedge funds were not limited in how far they can leverage (that is, borrow against) their assets. LTCM's $3.6 billion was leveraged at about 30 to one, making their total exposure about $100 billion. So, when LTCM crashed, it had the potential to wipe out companies such as Chase, Credit Suisse First Boston, Deutsche Bank, Goldman Sachs, Merrill Lynch, JP Morgan, Morgan Stanley, and others -- all of which had been eager to lend money to LTCM.

The head of the Federal Reserve Bank in New York arranged a bailout with LTCM's creditors, and LTCM went out of business fairly quietly.

The problem with LTCM is that the men running it relied too heavily on the theory of Black-Scholes, and ignored the fact that arbitrage is done by human beings, not by computers. Human beings sometimes are motivated by things other than just logic. Clausewitz's dictum, "War is waged by human beings" comes to mind.

There's a fascinating book on LTCM, When Genius Failed: The Rise and Fall of Long-Term Capital Management, by Roger Lowenstein. Lowenstein says, in as many words, that there should be limits on leverage. That there is not is largely due to opposition by Alan Greenspan, then the libertarian chairman of the Federal Reserve.