Tuesday, March 14, 2006

The Mine Field Of Custom Derivatives

I'm not talking about standardized derivatives contracts such as stock or futures options that perform a useful function in risk control.

Consider if major banks, hedge funds, insurance companies, and scores of major corporations have created trillions of dollars worth of complicated and interwoven contracts that
no one really understands.

These illiquid contracts are financial land mines that interconnect the financials of major players and are intractably rigged with cross party risks. Not if but when a derivatives land mine field blows up - it will trigger the explosion of other fields, which may trigger the explosion of still other financial mine fields.

When LTCM blew up it admitted a 4.6 Billion dollar loss. LTCM almost took out the world financial system - The Federal Reserve worked a recovery - triggering inflation that is continuing to grow today.

Since LTCM the Federal Reserve has apparently helped quietly orchestrate several mergers of key derivatives players. Banks have combined to decrease over-all exposure - and those contracts where they were effective counter parties to each other were retired.

There are probably far more derivatives today, and they are likely far more dangerous than when LTCM blew up. No one knows for sure.

I think it was Warren Buffett that described these hidden and poorly understood derivatives as a financial nuclear bomb.

I'll quote another Buffett quote:

"A given [derivatives] contract may be valued at one price by Firm A and at another by Firm B. You can bet that the valuation differences - and I'’m personally familiar with several that were huge -– tend to be tilted in a direction favoring higher earnings at each firm. It'’s a strange world in which two parties can carry out a paper transaction that each can promptly report as profitable." - Warren Buffett

The truth is neither party may know the value or danger of the contract - but it does instantly improve both of their earnings per share - or so they report.

The difference in real value may be huge depending on market conditions - In a meltdown some of these contracts will dissolve and disappear - others will represent huge expenses as they are unwound.

If you wondered how some companies always seem to hit their earnings target - this is just one way - create a custom derivative contract and give it any value you wish. A penny more then estimated earnings per share sounds good.

The FALLStreet article the Buffett quote was taken from, What'’s New with the Accounting Shell Game? More Shells, is well written and worth the read.

The effect on us?

There is a very real risk of an international financial meltdown. While probably under 30% for the next few years the risk is growing. The short term destruction of economic systems could start today.

Of course my 30% risk assessment is a guess about something seen in the dark, at a distance, behind a curtain.

No one knows the real risks.

Protect yourself.



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