Published on Sep 15, 2012 by ChrisMartensondotcom
Global financial markets are awash in hundreds of trillions of dollars worth of derivatives. By some estimates, the total amount exceeds one quadrillion.
Derivatives played a central role in the 2008 credit crisis, as they had a brutal multiplying effect on the magnitude of the carnage. As a bad asset was written down, oftentimes there were derivative contracts written against it that resulted in total losses 10x greater than the initial write-down.
But what exactly are derivatives? How do they work?
And have we learned to treat these “weapons of mass financial destruction” (as Warren Buffet colorfully coined them) any more carefully in the aftermath of the global financial crisis?
Not really, claims Janet Tavakoli, derivatives expert and president of Tavakoli Structure Finance.
But the danger behind derivatives doesn’t lie in their existence, she stresses. They play and important and constructive role in a healthy financial system when used responsibly.
But when abused, derivatives can create massive damages. So at the root of the “derivatives problem”, Tavakoli stresses, is control fraud - the rampant unchecked criminal action by influential players on Wall Street. (This is the same method of fraud we’ve explored in past interviews with Bill Black and Gretchen Morgenson). Derivatives contracts are too often constructed in favor of these parties, who if they end up on the losing side of the trade, are able to socialize their losses. Until we address this root problem of corruption, says Tavakoli, derivatives (as well as other securities: stocks, bonds, etc) will continue to subject investors and our makets, overall, to unacceptable risk.