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Fiasco: The Derivatives Market Explained   (March 9, 2007)

An astute reader highly recommended Fiasco: The Inside Story of a Wall Street Trader (even offering to send me a copy), and I can now report that the recommendation was fully justified: if you want to understand what derivatives are, and how the derivatives market will unravel, erasing trillions in wealth, this is the book for you.

Even though the author's account was written in the mid-90s, the basics of how derivatives are constructed, sold and unravel are the same; indeed, the author's (a former derviatives trader/salesman at Morgan Stanley) description of derivatives meltdowns in 1994 (Procter and Gamble take a $100 million loss) and 1995 (the collapse of Barings Bank) are eerily prescient of the risks facing the $360 trillion global derivatives market.

Of the many revelations in this book, I'll mention just a few.

  • Derivatives are unbelievably widespread. Gibson Greetings Cards Company suffered a derivatives meltdown in 1994, along with Procter and Gamble (talk about an appropriate name); you have to wonder, what were a greeting card and consumer company doing with derivatives? It's understandable that a global company like P&G would have currency hedges, but complex derivatives? Even back then, when the derivatives market was a tiny percentage of what it is today, name-brand firms such as Chrysler owned $2.5 billion in derivatives, as did small midwest insurance companies, mutual funds and teachers pensions funds. One has to wonder who doesn't own derivatives. And don't expect to find any mention in a company's or a mutual fund's financial statements; the derivatives are held "off-balance sheet." In other words, you as a shreholder will never know the extent to which your supposedly safe insurance company, pension fund or mutual fund is leveraged.

  • Many derivatives are so complex that even the banks who package and sell them have a difficult time assessing their value. A typical derivative might tie bonds priced in Mexican pesos with three currencies; depending on what each of the three currencies did (rise or fall) and the value of the underlying Mexican bonds, the derivatives could rise in value or fall to zero.

  • Most of the buyers of derivatives have a poor grasp of the risks. Here is the really pernicious part of a low-interest rate environment: supposedly conservatives institutions like life insurance companies and pension funds are so desperate to earn more than 4% on their money that they're easy prey for derivatives promising even a "point" (1%) higher return.The downside--a 100% loss--is naturally glossed over as "unlikely." A nice thought, but if the geniuses in the banks earning tens of millions in fees can't price the derivative value without complex computer programs, then how is a pension fund going to calculate the true risks buried in their derivative portfolio?

  • There are myriad obscure tripwires lurking in derivatives. This is how the global derivatives market will blow up: the Swedish Kroner (for example) will unexpectedly fall or rise, causing some obscure derivatives to blow up. The sellers have to dump other assets to cover the loss--other derivatives, stocks and bonds--which trigger further fluctations in currencies and bond values which then trip up other derivatives. As these complex financial instruments start to unravel, owners of derivatives who thought they were "hedged" (insured) against fluctuations find instead that they're victims of permutations they never properly understood.

  • If you've ever wondered exactly what a derivative is, or what all the fuss is about, then read this book. There may be better explanations of the derivatives trade, but I haven't come across any others written for the layperson. If you know of any, by all means let me know.

    For more on this subject and a wide array of other topics, please visit my weblog.


    copyright © 2007 Charles Hugh Smith. All rights reserved in all media.

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