Derivatives- Investment Vehicles No One Understands

When you bite down into that hamburger, do you know what's in it?   Well, the new mystery meat is the massive financial black box (what's inside is anyone's guess!) world of derivatives and credit default swaps.

Finally, the New York Times writes a detailed article, What Created This Monster, and exposes even world leading economists do not know what derivatives are or in most cases, the details of how they work.

These products are virtually hidden from investors, analysts and regulators, even though they have emerged as one of Wall Street’s most outsized profit engines. They don’t trade openly on public exchanges, and financial services firms disclose few details about them

Billionaire Warren Buffet called derivatives weapons of mass destruction.

Warren Buffet:

Large amounts of risk have become concentrated in the hands of relatively few derivatives dealers ... which can trigger serious systemic problems

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Ok, that's scary, so what are these things?

Derivatives overview explanation CNBC video clip:

 

Then, more educational youtubes with one on the credit default swap:

 

Whew, ok, so now we have a vague idea of what they are talking about...and we're more frightened.    Did you see those little arrows of contracts and obligations that went back and forth to each other, yet had decoupled from the actual original security?

Indeed, plenty of commentary abounds with little factual analysis. It's like a black hole of mystery, what is this work of financial fiction that might implode the global financial markets and tank the US dollar?    Oops, they aren't telling!

From a UK article, Fed's Rescue Halted a Derivatives Chernobyl:

We may never know for sure whether the Federal Reserve's rescue of Bear Stearns averted a seizure of the $516 trillion derivatives system, the ultimate Chernobyl for global finance

And this quote:

"There is no real way to gauge the market risk," said an official.

"We don't know how much is backed by collateral. We don't know what would happen in a crisis, and if we don't know, nobody does," he said.

But JP Morgan is already up to its neck in this soup, with $77 trillion of contracts. It will now have $90 trillion on its books, a sixth of the global market

Great.

Now on the Fed bailout, there is mention that these credit default swaps are the reason these bailouts magically occurred. (Graphics from New York Times article)

NYTimes credit default swaps outstanding value

My current assessment: The entire thing is fictional paper wealth and when the real risk became due, the Fed magically changed the rules of the game and all of this paper debt disappeared, or did it?

credit default swaps outstanding - NYTimes

 

To the left, look at these trillions in CDS (New York Times graphic).

 

Where is Congress on all of this? Where have they been? On the lack of regulation (same NYTimes article)

Two months before he resigned as chief executive of Citigroup last year amid nearly $20 billion in write-downs, Charles O. Prince III sat down in Washington with Representative Barney Frank, the chairman of the House Financial Services Committee. Among the topics they discussed were investment vehicles that allowed Citigroup and other banks to keep billions of dollars in potential liabilities off of their balance sheets — and away from the scrutiny of investors and analysts.

“Why aren’t they on your balance sheet?” asked Mr. Frank, Democrat of Massachusetts. The congressman recalled that Mr. Prince said doing so would have put Citigroup at a disadvantage with Wall Street investment banks that were more loosely regulated and were allowed to take far greater risks

 

 

Now, in the midst of this bubbling ooze coming to the surface, Congress is on vacation. There are some proposals to regulate investment banks but since it was Congress who originally let this cat out of the bag in 2000 with the Commodity Futures Modernization Act, home of the Enron loophole, how much can we trust them to act in the national interest?

 

So, just like the corporate tax code, the best places to screw the American people are the ones that are hidden from view and so complex nobody can understand.

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