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Archive for February 26th, 2011

Derivatives are financial instruments that have no value of their own.  That may sound weird, but it is the secret of what they are all about.  They are called derivatives because they derive their value from the value of some other asset, which is precisely why they serve so well to hedge the risk of unexpected price fluctuations.  They hedge the risk of owning things … in short any asset whose price is volatile.
 

… Derivatives cannot reduce the risks that go with owning volatile assets, but they can determine who takes on the speculation and who avoids it.
 

—   Peter L. Bernstein
Against The Gods
 

[And this is the problem with the current housing crisis.  Bad loans have been mixed (“bundled”) with good loans in an unspecified (unregulated by the government) mishmash which devalues the good loans and the derivatives from the associated bundles.  The risk has been “socialized” by passing on these bundles of undetermined value to Fannie Mae and Freddie Mac (essentially, us the U.S. taxpayer).  Without the ability to “un-bundle” the good from the bad, anyone holding derivatives from the last ten years has no way to determine value or risk.  The financial structure (banks and other private holders of bundles) cannot do it without the real risk of being forced into bankruptcy by having to acknowledge how much is bad;  the government cannot do it (in a timely manner) without acknowledging much of the financial structure is bankrupt and therefore forcing a great depression…  The only hope is a slow, moderated unwinding of the process while simultaneously ensuring it is not still happening.  But time is against you, because the emperor has no clothes! —  KMAB]

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