Monday, October 6, 2008

Buffet provides some good insight into the kinds of issues raised by derivatives in general and leve

The world according to derivatives, part 2 of 7: A Faustian bargain

What is especially troubling is that the potential profits from derivatives are magnified many times over through heavy, multi-tiered leveraging with no actual investment in an asset required, or even desired, making their appeal almost irresistible. Moreover, derivatives extract their value from fluctuations in the value of assets such as bundled mortgages and loans, stocks, bonds, currencies, interest rates, indexes and other assets which often are not themselves fixed or tangible. Derivatives have become, in every sense, bets on bets -- extracting value rather than preserving or enhancing value through real investments in the real economy. There can be no mistaking the fact that derivatives speculation requires a good deal of dancing with the devil.

Posted by malct @ 12:03 PM (455 views)
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2 thoughts on “Buffet provides some good insight into the kinds of issues raised by derivatives in general and leve

  • But who gets to lose their soul when the dancing stops. Bet it’s the small guy again.

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  • A good piece. I’d just add that behind all the factors mentioned were 1. Developing countries, especially in Asia building huge reserves to fend off currency speculators, leading to low bond yields and low spreads between interest on risk-free (government) debt and risky debt (i.e. lots of cheap money to go round) and 2.The US abusing its privilege as keeper of the world reserve currency to pursue profligate policies that would have been punished by the markets if any other country/currency had pursued them.

    Another ingredient of the toxic brew was of course the cheap guarantees from the monoline insurers that facilitated bogus AAA ratings and increased leverage (less capital backing required for less risky investments).

    Professor Brunnermeier’s point about maturity mismatching is probably more important than many realise. Some of the new financial instruments transformed long-term assets into short-term (cash-like) ones and this ‘cash’ was used for the funding of securitised products. This was done on a massive ($ trillions) scale. It meant that investors in securitised products were heavily dependent on short-dated funding. Holders of senior tranches of CDOs, for example, were not tied in for any length of time and were inclined to force fire-sales of assets, enabling them to come out relatively unscathed while the junior/equity holders were often wiped out. It is likely that the speed and magnitude of the original credit problems were greatly magnified by this maturity mismatching.

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