Understanding Derivatives - Types & Upcoming Risks

[Andy R]

I am trying to formulate my opinion about our current economic issues. One variable I can't grasp is the financial derivatives market and what will unwind as a result of recent events.

I just read the Wikipedia page on financial derivatives:
Derivative (finance) - Wikipedia, the free encyclopedia

Warren Buffet has been warning of the potential risks of these financial products for over 5 years:

"hell... easy to enter and almost impossible to exit" (Article)

In recent months we have learned about banks exposures to the mortgage backed derivatives. This product I find easy to understand, it's just a grouping of mortgages who's borrowers had a similar credit rating at the time of issuing the mortgages. Entities could then buy these financial products (derivative) for various business reasons. These are typical of the toxic assets owned by banks that are currently being addressed by the global government bank bailouts.

The next type of financial product (derivative) that has been showcased in the recent economic turmoil are credit derivatives, mainly credit default swaps which are basically insurance contracts used to hedge against an entity defaulting (going bankrupt). Wikipedia says this the largest of the derivative markets worth $42 trillion in 2007.

Companies buy other types of derivatives such as foreign exchange derivatives to hedge against currency fluctuations. As seen in this article, Sadia of Brazil was caught in this and will have to cover over $400 million for using these products as part of their strategy:

The company said it bought foreign exchange derivatives in excess of its need to cover export operations, contributing to losses that surpassed its 2007 profit of 689 million reais.

Sadia says it covered derivatives, Lehman loss | Industries | Consumer Goods & Retail | Reuters

From what I read these derivatives are really something to be worried about. Sure the banking system might be saved through government bailouts (as announced over the weekend) but is that like giving CPR to a person who is months away from dying of cancer? Obviously you have to take first steps first and try to keep the patient alive day by day but is death [SIZE=-1]imminent[/SIZE]?

Basically what I am trying to understand is what's going to happen to this huge unknown/unregulated slice of the world's economy? Based on recent events how will those stuck holding the default swaps for failed (or failing companies pay up)? What other derivative types are there and how will this whole market unwind?

When it comes to derivatives what risks are ahead? Is there a potential of huge defaults from outside the banking industry by owners of these financial products?

 

[al_bundy]

derivatives are used to hedge and there are many products out there for every security and have been used for a long time with no products. once in a while everyone speculates too much and thinks they are hedged and the derivatives market goes crazy as well

 

[brewer12345]

Most derivatives are pretty plain vanilla. Interest rate and currency derivatives are pretty ho-hum and you would have to willfully try to blow yourself up with them, assuming you are using them for hedging (as the overwhelming majority are).

The most recent innovation is crdeit default swaps. These have been in vogue big time as hedging and speculative instruments. This is a largely unregulated, over the counter market that has boomed. The swaps themselves are fine, the risk is in how they were used. If you run your balance seet at 30X leverage and assure everyone that it is OK because if you take into effect the credit default swaps you bought it is only 10X, you have bigm big problems if your swap counterparties fall down on their commitments.

I think that most of the damage has been outed and the likely consequence is that they end up being exchange traded and/or far more out in the open. Hard to see how they will cause any problems that aren't already there, though.

 

[socca]

You have the same kinds of questions that I do. For a good overview on the credit crisis, you can check the book I recommend here: http://www.early-retirement.org/forums/f28/book-recommendation-39658.html

Treasury has just announced that it's going to use the first $250B of the bailout package exclusively for bank equity purchases (correct me if I'm wrong). This is a voluntary program, so banks will need to subscribe and offer non-voting shares to participate.

It would be fascinating to find out what, exactly, the participating banks do with the taxpayer capital. However, these are for-profit, risk-taking institutions that operate for the benefit of their customers, employees, and shareholders. They do not operate directly in the public interest. So, I don't believe that we taxpayers are going to have any visibility whatsoever into what these banks actually do with our money. What a shame! Wouldn't it be something if massive amounts of this capital end up benefiting credit hedge funds - one of the primary sources of the foolhardy risk-taking greed that got us into this mess?

My current opinion is that vast and stunning crimes are going to occur as this bailout unfolds. Prudent savers like me are going to be screwed so that imprudent borrowers can prosper. The argument has been that we are preventing a much greater crime by allowing these 'smaller' crimes to occur. Maybe, maybe not. Our economic system is fundamentally flawed if committing crimes of any type becomes standard procedure.

I wish I knew what mental model to apply to the bailout. When Treasury begins purchasing toxic assets, are we propping up an existing tottering credit derivative Ponzi scheme by becoming a buyer of last resort? Or, has the Ponzi scheme already collapsed, and we are just cleaning up the aftermath? Or, are we hoping to bring down the Ponzi scheme in a 'controlled implosion' rather than suffer the aftermath of an uncontrolled explosion? Getting the mental model correct would help me estimate the risks to the economy going forward.

 

[ladelfina]

I wish I knew what mental model to apply to the bailout. When Treasury begins purchasing toxic assets, are we propping up an existing tottering credit derivative Ponzi scheme by becoming a buyer of last resort? Or, has the Ponzi scheme already collapsed, and we are just cleaning up the aftermath? Or, are we hoping to bring down the Ponzi scheme in a 'controlled implosion' rather than suffer the aftermath of an uncontrolled explosion? Getting the mental model correct would help me estimate the risks to the economy going forward.

Great way of putting this, socca.. I would have to ask something at another level: whether the players actually recognize the Ponzi scheme in the first place, and if so, to what degree? Not just the financial sector guys, but politicians and regulators, as well.

I'm not convinced there is anything that can be "done", but I know what you mean about wanting to have an idea of which way the bricks and beams are gonna fall. And whether the people intervening have the capacity of those engineers that implode Las Vegas hotels. I strongly doubt that.

I am in no way heartened by anyone who claims that this market also won't/can't/shouldn't also blow up. We've had plenty of assurances during the housing bubble and MBS debacle that that would never have general adverse effects, either.

The Gramm/Greenspan ideology is that these are private contracts.. and why should governments be sticking their noses in with capital requirements?, etc. (like with a regular insurance company). Seems like the reason for the huge boom in swaps is because a lot of money could be made exactly because no one was paying attention to how, or whether it was safe.. you can just sit and collect your "premium" but when your bet goes bad there is nothing to back it up. Free income while it lasts.

In the world of the lumpen, this would be called insurance fraud and you or I would go to jail for it.

In the legal sphere, aren't there just some contracts that are unenforceable? Like, if you -socca- promise to give me 100 gazillion dollars if Starbucks goes bankrupt, and then Starbucks goes bankrupt.. am I gonna collect on that? Of course not.

Probably naive and unworkable on a global scale, but these things should all be immediately halted, made illegal, and unwound.. everyone turn their cards over at the same time and then re-set. Take the loaded weapons out of the hands of the small children.

This is just another instance of there being no actual money behind the curtain. Your mere promise to give me 100 gazillion dollars conjures up a phantasm of "worth".. of some kind of "asset".

 

[socca]

My current opinion is that vast and stunning crimes are going to occur as this bailout unfolds. Prudent savers like me are going to be screwed so that imprudent borrowers can prosper. The argument has been that we are preventing a much greater crime by allowing these 'smaller' crimes to occur. Maybe, maybe not.

Here are some timely complaints by prudent savers/investors/managers:


Smaller Banks Resist Federal Cash Infusions - washingtonpost.com

Peter Fitzgerald, chairman of Chain Bridge Bank in McLean, said he was "much chagrined that we will be punished for behaving prudently by now having to face reckless competitors who all of a sudden are subsidized by the federal government."

At Evergreen Federal Bank in Grants Pass, Ore., chief executive Brady Adams said he has more than 2,000 loans outstanding and only three borrowers behind on payments. "We don't need a bailout, and if other banks had run their banks like we ran our bank, they wouldn't have needed a bailout, either," Adams said.

http://www.nytimes.com/2008/10/15/business/economy/15bailout.html?_r=1&hp&oref=slogin

The chairman of Wells Fargo, Richard M. Kovacevich, protested strongly that, unlike his New York rivals, his bank was not in trouble because of investments in exotic mortgages, and did not need a bailout, according to people briefed on the meeting.