By: elvis-is-here
25 Mar 2008, 11:53 AM EDT
Msg. 691723 of 691750
Jump to msg. #
Derivative Dangers Threaten Global Markets
By Paul Strand
CBN News Sr. Washington Correspondent
March 25, 2008
CBNNews.com - Add up the gross domestic product for all the world and it comes to about $50 trillion.
But now there's a wild trade going on between investors in something called derivatives that adds up to more than $700 trillion.
Derivatives So Large, It Threatens Markets
RELATED STORIES:
Desperate Times for the Economy
Food Prices Scary? You're Not Alone
Home Sales on the Rise
Gas Prices to Fall?
Some people are worried this massive trade in derivatives is so big, so widespread and in some cases possibly so dangerous, it could seriously threaten the world's markets. And your pocketbook.
Phil Kerpen, a policy analyst at Americans for Prosperity, a group promoting free markets, said if you go back a few centuries, you'll find the origin of derivatives was innocent enough: farmers wanting to protect the price for their crops.
"A farmer in the field didn't want to risk it that when his crop came in, he wouldn't be able to get the price that he wants. He might go to a grocer and say 'let's agree that on this future date I'll sell to you for this price.' And that's what's called a forward contract," he said.
And the grocer would agree because he knew he would get as many crops as he needed that year at a guaranteed price. So both the farmer and the grocer came out ahead: they already agreed on a certain price for a given amount of grain. So both were protected financially, even in case of a bad year for crops. Thanks to the contract, the grocer had his crops, and the farmer had his money.
The contract itself was the "derivative" because it was derived from something else: the crops and the agreed-upon price for them.
Not Assets, But Deals Made about Assets
So derivatives aren't actually assets, but deals made about assets.
And in many cases, they're just bets. Kerpen said, "Let's say you're in the oil business and you're going to sell a lot more heating oil if it's a cold winter. You might want to bet against a cold winter so that if there isn't one, you'll make more money that way and it'll smooth out your risk."
This hedging of risk is an insurance policy for both sides. Kerpen explained, "Maybe you wouldn't go into a business if you had to assume all the risk, but if you can spread it through some of these hedging mechanisms, suddenly some economic activities that wouldn't happen do happen, so there's a gain to the overall economy."
Over time, the derivatives market exploded, from simple futures contracts for farmers to -- well, almost anything.
From Farms To Stocks, Bonds, Commodities
There are all kinds of financial assets in the world - including stocks, bonds, or commodities like gold, oil, grains and so on. Today you can bet on all sorts of derivatives for almost any of them: whether their value will go up or down, how the weather might affect them, and so on.
And now -- with basically every financial firm as well as regular businesses -- involved in all sorts of derivatives on a daily basis -- they number hundreds of billions of dollars.
Michael Mackenzie of the Financial Times points out there are frightening aspects to all this.
"The derivative market: it does scare people, because people say, 'okay, these are huge amounts,'" Mackenzie said.
Some of the biggest derivatives traders are not nearly as regulated as ordinary banks and brokerages. And they make much riskier bets. Mackenzie pointed out, "A hedge fund has much, much greater credit risk if you're trading with them."
They also borrow unbelievably large amounts of money in the hopes of making more and more profits using high leverage.
Derivatives Growing More Complicated
And over the decades, derivatives have grown more and more complicated.
Some of the deals are now so complex, firms hire NASA physicists or top-flight economists just to manage them, or to figure out new derivatives.
But the trade has grown so big and is carrying so much risky debt, that one of the world's savviest investors of all -- Warren Buffett -- labeled derivatives "financial weapons of mass destruction, carrying dangers that. are potentially lethal."
One of the biggest dangers is tied up in what's called counterparty risk, where several firms may be involved in one derivatives deal.
And that leads to a serious risk because, as Mackenzie explained, "if they fail, it's like a chain of dominoes. Once one person stops paying, then all these other trades that have built off that first trade are also under threat."
Economic analyst Kerpen warned, "A lot of these entities are going to go out of business. And their losses are so big, so they won't be able to pay the winners. The people who wrote these bets on the other side won't get paid. So there could be a major loss economy-wide if a lot of these entities start to fail."
Beleaguered Bear Stearns was deep into derivatives. The Federal Reserve jumped in to prop it up and arrange its quick sale because so many other entities could have been seriously hurt financially if Bear went out of business and couldn't pay its debts. That could have started a chain reaction across the trading world, bringing down other firms as well.
Derivative Disasters in the Headlines
And other disasters with derivatives have made headlines --
You may remember the story last year of a trader who cost his French bank more than $7 billion. It sent shockwaves worldwide. Kerpen said, "Societe Generale in France, which had a huge loss, that was related to derivatives trading."
In 1998, Long-Term Capital Management -- a popular hedge fund that had so many fingers in so many trades and was so over-extended, that when it blew, officials and businessmen worried it could bring down possibly the whole financial system.
Mackenzie said, "Long-Term Capital Management had to be bailed out by a consortium of Wall Street banks. The New York Federal Reserve had to get all the banks in a room and said, 'okay you have to do something because this is a big, big problem.'"
Then Mackenzie struck an ominous tone: "This time around you could almost argue it's scarier. Because you now have a lot of hedge funds, you now have a lot of banks who all have problems, who've all taken on excessive risk and are now in the process of having to unwind that risk."
Global Financial System Interconnected
Today's global financial system is interconnected as never before, and that's where derivatives could pose a threat to average investors who don't even know what they are. Because if one or two big financial firms go under because of bad derivatives investments, that could mean other firms find themselves with serious losses.
That in turn could damage the overall financial system, and that damage could spread to all kinds of businesses, hurting their earnings and sending stock prices down. Maybe even your stocks.
Kerpen said if you're still far from retirement, don't panic and bail out of your investing. But he warned if all this bad economic news keeps hitting the market, "I think that the ordinary investor will see their balances going down for the rest of this year most likely."
Not everyone agrees. Many analysts expect a market recovery later this year. But for now, the Federal Reserve and other officials are focused on keeping the derivatives problem from helping to create an economic crisis.
ragingbull.quote.com/mboard/boards.cgi?board=CMKI&read=691723...Flying Moose(cmkxunofficial)