could derivatives mean the end for the economy as we know it?

13Mar08

i stumbled across this market watch story on the threat that financial instruments like derivatives could pose for the global economy, especially the financial markets. the article starts with a quote from a berkshire capital  letter to shareholders: 

“We try to be alert to any sort of mega-catastrophe risk, and that posture may make us unduly appreciative about the burgeoning quantities of long-term derivatives contracts and the massive amount of uncollateralized receivables that are growing alongside. In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” 

 that letter was from 2002. how big is the risk posed by derivatives? 

 Derivatives grew into a massive bubble, from about $100 trillion to $516 trillion by 2007. 

 to put this into perspective, the US GDP is $15 trillion and the value of all global stock markets together is about $100 trillion. obviously this does not mean that we are doomed. all this money is not lost. but looking back to the long term capital disaster from the mid ’90s where several banks nearly went under shows the impact of derivatives … in that case the amount the trading loss was just a measly $5 billion causing a global financial crisis triggered by an event that was thought would not be able to occur (or was at least not accounted for in the model the fund used). the problem is that the current sub-prime crisis could be the trigger for some of the derivates to go sour, and with so much money in these quite hard to understand financial instruments that could result in a domino effect. what would be needed is a global regulatory framework that ensures that these instruments are just as much backed by hard cash as the more traditional instruments are.another story about this issue:  The $300 Trillion Time Bomb

Filed under: economy, mid to long term risk   |  Leave a Comment
Tags: derivatives, economy, financial markets, sub prime, warren buffett