Derivatives: Financial Armageddon, Round Two?

In Financial Armageddon, I wrote about "four impending catastrophes": debt, government guarantees, the retirement system, and derivatives. But well before the first pages of my manuscript saw the light of day, I was particularly concerned about the latter aspect.

In fact, I'll let you in on a little secret: the article I published in November 2005, "The Coming Disaster in the Derivatives Market," was actually derived from material in my original book proposal, tentatively entitled FWMDs: Financial Weapons of Mass Destruction, after Warren Buffett's famous remarks on the subject in Berkshire Hathaway's (BRK.A) 2002 annual report.

Eventually, the publisher and I decided that there was a bigger story there, which proved to be far more accurate than anybody (including me) realized at the time, and I set forth my vision of how the derivatives menace would come to interact with the various other threats I saw lurking in the shadows.

Yet even with all that has happened so far, it's hard to ignore the fact that the house of cards that was built on this labyrinthine mass of paper promises remains a serious threat to the financial system and the economy.

To be sure, I'm not the only one who feels this way. Even some of the better known financial experts are worried, as CNBC.com reveals in "Derivatives Could Cause Another Meltdown: Mobius":

Derivatives caused the market Armageddon of recent years and if left unchecked by global leaders, the same market could cause another catastrophe, Mark Mobius, executive chairman of Templeton Asset Management, told CNBC Monday.

When asked by a CNBC viewer what kind of Armageddon could be expected if the derivatives problem is not addressed, Mobius replied: “The same kind of Armageddon that we just had, what we just saw in the last few years has been caused by derivatives.”

The lack of liquidity, transparency, coupled with its sheer size means the derivatives market poses a major risk to financial stability, according to Mobius. The currency derivatives market is especially at risk of causing problems, but interest-rate derivatives also, he said.

To read the rest of the article and watch the Mobius interview on CNBC, click here.

Comments

[Ferdinand E...:]

Some derivatives may be bad. Thank goodness I did not have the pleasure of praising these to my students. But others are A-OK, and I hope that nobody makes the mistake of showing up at this university and trying to prove me wrong.

But I can understand where some of the trouble comes from. It comes from ignorant teachers who are too lazy to master the great finance books that we have today.

Sep 23 11:41 AM

[DVW:]

I think it's easy to prove that derivatives can be bad. All derivatives can be bad with over used leverage. (Ok, so maybe it's the leverage that is bad, but derivatives ARE leveraged instruments)

How so? Uncovered calls/puts , or too many futures contracts vs margin balance as examples of simple derivatives that can go bad. Either can cause you to owe lots of money you dont have and both are simple to price and have tangible value, unlike these mortgage securities that are still unpriced.

Ok, so maybe the real issue is mispricing of risk... anything can be dangerous in that regard. The question is, who is currently mispricing risk on their derivative positions and at what level?

Sep 23 01:20 PM

[Mansoor H. ...:]

I agree. Round two is coming.

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Sep 24 07:56 AM