America's Most Hated

1. Bankers
2. Osama bin Laden
3. Lawyers

The change from bowler hatted city gentlemen to ill-educated ruthless swine is finally complete. What financial scandals as large as Credit Suisse First Boston and the Citigroup/ Salomon couldn't achieve, it took the relatively unknown world of derivatives trading just a matter of months.

Derivatives are the financial instruments made when simple company issues are transformed by brokers and investment banks into 'exotic' tradable instruments. The returns of these are linked to many different benchmarks including mortgages, interest rates and stock indexes.

The upside gain is as fantastic as the downside loss. The problems have arisen because no money actually changes hands between the two parties meaning they are leveraged to the hilt. The parties have entered into agreements where they can't cover the downside, this is fine, until the markets fail.

The derivatives market has many thousands of players, is global and worth trillions of dollars. Many of the individual contracts need computers to understand them. Therefore we cannot even begin to unravel the millions of derivative trades out there.

Once the markets to which the returns are linked begin, one-by-one to fail then people lose faith in these institutions and the cash flow they so desperately need dries up. And institutions begin to topple. So falls the house of cards.

The then Federal Reserve Chairman, Alan Greenspan said that the risk of such a meltdown is negligible but also that “The rapid growth and increasing importance of derivative instruments in the risk profile of many large banks has been a particular concern,” This coupled with his later quote “We will never have a perfect model of risk“, he argued “We will never be able to anticipate all discontinuities in financial markets.” All this is true, derivatives are risky, as are all financial instruments. What makes them unique is that the risk is not understood, even slightly.

If you take instruments you don't understand, use them recklessly and add a large pinch of bad luck, you get Recession 2008. Franklin