Friday, January 16, 2009

Warren Buffett calls these instruments weapons of financial destruction

If the imploding of credit default swaps didn't put the fear of God in markets, this should:

Derivatives Market


The Bank for International Settlements (BIS) is an international organization which fosters international monetary and financial cooperation and serves as a bank for central banks.

According to BIS statistics, as of June, 2008 (before the financial meltdown), interest rate derivatives totaled $458 trillion, foreign exchange derivatives totaled $63 trillion, credit default swaps totaled $57 trillion, commodity derivatives totaled $13 trillion, equities-linked derivatives totaled $10 trillion, and unallocated derivatives $82 trillion. Total worldwide derivatives market: $684 trillion!

A quick glance at the figures reveals that credit default swaps, while huge in nominal numbers, is very small relative to interest rate derivatives (stock market derivatives are even smaller). If mispriced CDS can wreak such havoc on financial markets worldwide, what would happen if interest rate derivatives (fixed-income, i.e. bond markets) implode?

To connect the dots, easy monetary and fiscal policies arguably created the tech bubble, which burst 2000-2002. Those same ill-advised policies created a real estate and mortgage bubble, which popped in 2007-2008. Today, the government is embarking on another attempt to ease the credit crisis, but the unintended consequence is the creation of another bubble--the US Treasury bond market. But this time the magnitude of the interest rate bubble is orders of magnitude larger than the toxic credit default swaps which "insure" against US homeowners defaulting on their mortgages. The problem with CDS' is that they are not backed by any collateral (hence the ability to obscenely leverage up).

When the US Treasury bond bubble collapses--and interest rates soar, God help us all.

No comments:

Post a Comment