"Derivatives, and why I think they pose a problem"

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Among the people I monitor for insight in how this mess unfolds and how to mitigate risk/damage is this poster on Kitco. The posting says it is copyrighted so I didn't just copy it, but I think you all should see it. Fellow has shown deep insight into Y2K, banking and oil over a long period of time. The posting is in that context. It strikes me as potentially really serious and unaddressed.

http://www.kitcomm.com/comments/gold/1999q3/1999_09/990923.013150.compgeeke.htm

-- ng (cantprovideemail@none.com), September 24, 1999

Answers

The guy doesn't know what he is talking about. Derivatives are not debt instruments and you don't hedge counterparty risk by buying oil options.

Derivatives' economic purpose is to transfer future price risk from hedgers (farmers, oil refiners, importers, exporters, etc) to speculators. If not for this ability, we would see large swings in retail prices of goods or even worse, shortages of these goods.

For example, even though the yen might appreciated 30%, Toyota can keep their sticker prices relatively stable for the year. Wholesale grain prices have been decimated recently but farmers who hedged their prices were still able to make a living.

Also, unlike the loan or debenture markets, derivatives is a zero sum "game." For all the losers and wipeouts we read about in the papers, there are many investors who took the other side and reaped huge rewards.

-- Sandwich (anon@anon.com), September 24, 1999.


Not debt instruments per se, but derivatives can certainly constitute a liability. Something goes in the wrong direction and $billions can be lost in a minnit. Thus creating debt -- or worse.

Isn't it equivalent to a conditional promissory note?

-- Tom Carey (tomcarey@mindspring.com), September 24, 1999.


>> Derivatives' economic purpose is to transfer future price risk from hedgers (farmers, oil refiners, importers, exporters, etc) to speculators. <<

Yes. The problem is that the largest contingent of "speculators" at any time is the banking industry. This would be somewhat akin to your bank chronically shorting the stock market or buying grain futures on margin. We have seen in the past that when the banks speculate on "assets" that can swiftly become large liabilities, they can fail in large numbers. This was a huge problem in the Depression, where banks cheerfully supplied margin money into a stock bubble.

The creation of the FDIC and the regulation of the banking industry was meant to preclude this kind of shenanigans by the banks. They are *not* supposed to engage in highly risky speculations, so that, when they fail spectacularly, we taxpayers can bail out their investors. But it may happen. The odds are actually quite bad for us on the receiving end of the shaft.

-- Brian McLaughlin (brianm@ims.com), September 24, 1999.


Brian,

Yep, FDIC causes moral hazard in the banking industry. I've seen it first hand.

Tom, in the aggregate, no.

-- Sandwich (anon@anon.anon), September 24, 1999.


Moral Hazard = If someone else is gonna clean up my mess then I don't have to take any prudent precautions in my behavior. (something like that)

It's not just derivatives. Banks have gotten into all kinds of messes with bad real estate, betting on positive yield curves, stock market (pre Glass Steagal) etc.

-- Sandwich (anon@anon.anon), September 24, 1999.



Hedge funds -- http://www.wbn.com/y2ktimebomb/II/TK/tk9912.htm

-- Who, what (where@when.why), September 24, 1999.

President Clinton, Alan Greenspan, Congress, the Securities and Exchange Commission etc. have all apparently made a concious decision not to regulate banks, mutual funds, stock market investors etc. regarding speculating in derivatives. This is folly at the highest level and puts the whole country at risk. If the Fed had not forced several banks to loan billions to Long Term Credit when if went bankrupt last fall, the whole system could have crashed but nothing was done. Now speculation is more rampant than before, the amounts at risk are much higher and the "investors" figure that the government will bail them out again with the middle class taxpayers to pay the tab. The Tiger fund is in far worse shape than the situation last fall. Mr Clinton, Robert Rubin, and Greenspan will be remembered in the future not for the good economy or sleazegate but for letting the stock market rise so high and fall so low due to their mismanagement and the failure to address the Y2k impacts such as cascading cross defaults in a timely manner. Time will not be kind to them. At least Mr. Hoover had intergrity and tried to react to problems that were far along before he took over.

-- Ed (Ed@bbb.ccc), September 24, 1999.

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