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The Case for Derivatives

You have done a fine job of explaining the uses of derivatives, but not so fine a job of explaining their value to the economic marketplace. You talk about banks and corporations wanting to offload risk. That is exactly the problem with derivatives is they allow that process to happen, but it is only happening as a mirage. If I buy up all your risk and take it onto myself then all we have done is transfer the promise to pay another party. My actual ability to pay may be a whole different issue. As the party offloading risk, your only concern is getting the risk off your books, onto mine, so you can continue leveraging up your asset portfolio. This ignores the problem that you are still the primary party on the risk as the original contracting party. If it turns out I can't pay, then you are still on the hook for the losses. At least it seems that is how things have turned out with the current crop of structured investment and false transfer of risk. On top of this, transferring risk away from the party that originated the risk invites lax lending standards. Obviously, if I don't think I will be on the hook for losses then I am not so concerned long term if the debtor can pay - as long as they can pay until I move the loan off my books. You did mention in all your examples a certain party that ought not be involved in transactions which underly the foundation of finance system - the Speculator. Currently there are speculative derivative transactions in force equal to ten times World GDP. Clearly, in a major world-wide economic dislocation, such as we are now experiencing, if even a small fraction of the contracts start going sour, then it bankrupts the entire planet since it is numerically impossible that a relative few speculators (such as AIG) have the financial means to cover bad bets a few hundred trillion dollars in excess of their aggregate capital base. The reckless buffoons who accumulated this nightmare did so in full possession of the knowledge of what could happen if things went south and knowing they could not cover their promises. They acted in the same manner as a consumer who runs up $100,000 credit card debt and puts it all in the equity market, knowing that if they don't get a quick payout they will be forced to declare bankruptcy, but also knowing that that if nothing goes wrong they will make sooo much money. They only do this transaction because they know that in doing so they are actually engaging in a derivatives transaction of sorts, where they incur the obligation and the benefit of a payoff, but since it is unsecured debt, the ultimate risk of the transaction is actually born by the card issuer. The card issuer, however, is not a victim in this scheme because they were aware of this potential risk but took it knowing they could transfer the risk by selling off the credit receivables through a derivatives transaction. So it just turns into a merry-go-round game of hot potato, but with nobody accepting ultimate responsibility for the debt until the final speculator - who is either a shark with no intent to make good if things move against him, or is a ninny that did not fully understand the risk he was engaging but just succumbed to some bully sales pitch. The economy is better served if risk taking parties are required to backstop the risk the introduce into the marketplace with their own skins - at least to the level of their commercial interest.