Wednesday, November 23, 2005

The Coming Disaster in the Derivatives Market

"The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear....[They] are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." - Warren Buffett

The BIS - Derivatives 2005>

...Already there are rumbling in the financial world, akin to the small tremors that shake the ground ahead of a massive earthquake. In the spring of 2005, several large hedge funds reportedly lost billions of dollars on complicated credit bets gone wrong. One firm even admitted that it had made a substantial “miscalculation” -- which they only realized, of course, after the fact. Given the increasingly complex nature of the derivatives market, that refrain is likely to be heard over and over again in future.

Certainly, the U.S. and global economies have been remarkably resilient, especially in recent years, and it may be a mistake to bet on the downside. What’s more, there are those who would argue that the financial markets have attracted the best and the brightest, and a gut-wrenching, blood-letting debacle is in no one’s interest. Unfortunately, the odds seem stacked against a happy ending, and the cyclical nature of financial crises suggests it is definitely the wrong time to be thinking like a Pollyanna.

Unfortunately, the reality is, if it all goes horribly wrong, it will not only be Wall Street that suffers. Main Street will, too. In the worst case, brokerage firms and banks will shut their doors. Markets will plunge and many investors will lose everything, Interest rates will shoot sharply higher, taxes will rise, and parts of the economy will grind to a halt, at least temporarily. Those seeking a mortgage, a college education, a job, or even day-to-day sustenance may find themselves left wanting.

At a time when many have abandoned prudence in search of profits, and where those who are knowledgeable about the disaster-to-come in the derivatives market are seeking to protect themselves, it is the timeless wisdom that remains true: forewarned is forearmed.

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