Friday, October 10, 2008

Derivatives and the economic crisis

With global stock markets continuing to plunge and speculation concerning the global economic future continuing to run rampant, it's somewhat amusing to sit at the sidelines and wonder what will go next.

Honestly, I think (and I've been telling friends for the past few weeks) the next big shockwave to the market is going to be related to derivatives. First of all - here's a nice link to a table that shows the derivative exposure of various US banks - take a look at JP Morgan. In case you're not familiar with derivatives - exposure isn't a good thing in the current market.

An interesting article from 1994 lays out the case for why derivatives are not as high-risk as they seem, but amidst the article's reassurances are some scary possibilities:
Although the "gross" derivatives exposure exceeds 100 percent of equity for all of these banks, only a default by all of a bank's counterparties would wipe out the bank's capital, and only then if there were no offsetting netting agreements and other risk-reducing mechanisms in force and the actual losses incurred were identical to the total exposure. Such conditions seem unlikely for derivatives as well as for loan defaults.
So in other words, derivatives are great UNLESS all hell breaks lose on the global financial market. Oh, that's really reassuring...

Among the financial instruments to keep an eye on - credit default swaps. Here's a good piece on why credit default swaps are so risky - basically, it's a bunch of unregulated, OTC gambling that has spiraled out of control.

Just to end with a less than reassuring quote, from Warren Buffett in 2002:
We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.


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