please apologize my flooding of the forum with questions. Whenever you answer one, there seem to come so many new ones to my mind
My next question relates to derivatives. Certainly you too have read about world derivative markets having registered unprecedented growth during the last few years.
What do you think about them? Are they a legitimate component of the free market? Or are these financial market innovations part of our sick fractional reserve banking system, that are, as Buffett called them “financial weapons of mass destruction”? Are derivatives the medicine or the disease?
When I hear about some derivative market’s value being counted in the hundreds of trilions my brain short-circuits. The number literally doesn’t make any sense. But my understanding is that’s it’s simply the effect of frac-reserve gone wild. However there is nothing wrong about derivatives in and of themselves, they’re contracts, no different from any other contract.
Only if they do not rely on fraud, and don’t create an externality like government bailouts.
They aren’t necessarily a consequence of FRB, but the fascist economy. Profits are privatized, and losses are socialized. This creates an incentive to gamble recklessly for profit, because there is no downside.
A derivative is based off a loan or a promise to pay. If I pay my mortgage tomorrow instead of the on the original due date, then I have helped destroy the value of a derivative. Do you understand the concept of the derivative in calculus? It’s very similar to the monetary derivative. The problem with the monetary one is human action.
While the idea of securitzation and these kinds of derivatives are designed by the market and have their proper uses, it is important to remember that they are also partly a product of government and regulations(specifically in capital requirements). Regulators assigned MBS’s as having a much lower risk weight than individual mortgages, meaning banks were able to sell their mortgages to be securitized and buy them back, which allowed them to put up much less capital for the MBS’s than individual mortgages. So regulations not only helped spread these derivatives everywhere, they allowed banks to become even more over-leveraged.
Bankers aren’t perfect. They make mistakes too… like listening to regulators.
Here are somegoodlinks on MBS’s, regulatory capital arbitrage, and the recourse rule:
Derivatives are good. They exist to distribute risk of future events from buyers and sellers to speculators. They are simply contracts based upon some future event. For example: I supply oil but need 5 billion to drill for it. I could offer the oil in the future to a current speculator thus getting my 5 bil and the speculator gets the oil. If the price of oil goes above what the speculator paid for it then the speculator wins, if not the speculator loses.
Keep in mind that most derivative contracts have a winner and loser. This is where derivatives get their bad name is when government intervenes by creating money, paying off the contract or modifying the contract. In the first case, government creates so much money in banking reserves that banks seek to contract with an investment bank to manage the risk involved with managing this money. What is worse is when government gets involved in the contract. A derivative contract like any other is dependent on both parties being able to hold up their end. If one party fails then the other could get stuck reguardless of the terms. But if government gets involved then it can choose which party wins and loses thus destroying the whole process.
Sorry, I meant to reply instead of suggest this as an answer.
In a free market, derivatives would not be the problem that they are. The problem is that derivatives were sold in a highly regulated market. Selling securities requires that a firm has a securities brokers license, which is highly regulated by the SEC. Only a few fims managed to maintain a license and these firms used even fewer firms to assist them in underwriting their loans.
For example, with Commercial Mortgage Backed Securities (CMBS), only two firms provided all of the appraisals. Conversely, with commercial bank loans, there were thousands of firms doing their appraisals. There was nothing necessarily wrong with the two firms that were doing the CMBS appraisals, but they only provided one of two perspectives for each asset, resulting in huge portfolios of assets that relied on just the perspectives of the heads of these appraisal departments. Consequently, it was the CMBS market that collapsed. The bank loan market merely suffered a mild head cold (so far).
