Credit default swaps-derivative disaster Du Jour

Translate Request has too much data
Parameter name: request
Translate Request has too much data
Parameter name: request

When the smartest guys in the room designed their credit default swaps, they forgot to ask one thing - what if the counterparties don't have the money to pay up? Credit default swaps (CDS) are a form of derivative used to hedge credit exposure. They are sold as "insurance" against default and are used by banks as a substitute for adequate capitalization. But CDS are not ordinary insurance. Insurance companies are regulated by the government, with reserve requirements, statutory limits, and examiners routinely showing up to check the books to make sure the money is there to cover potential claims. CDS are private bets, and the Federal Reserve from the time of Alan Greenspan has insisted that regulators leave hands off. The sacrosanct free market would supposedly regulate itself. The problem with that approach is that regulations are just rules. If there are no rules, the players can cheat; and cheat they have, with a gambler's addiction. In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion - ten times the gross domestic product of all the countries in the world combined. Somebody is obviously bluffing about the money being brought to the game, and that realization has made for some very jittery markets.

CDS have been called "the derivative disaster du jour," following CDOs (collateralized debt obligations, SIVs (structured investment vehicles), and other obscure financial acronyms we've had to learn in the last year. The derivatives concept is a strange one that is quite hard to understand, but the basic idea is that you can insure an investment that you want to go up by betting that it will go down. The simplest form of derivative is a short sale: you can place a bet that some asset you own will go down, so that you are covered whichever way the asset moves. Credit default swaps are the most widely traded form of credit derivative. They are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the "protection buyer" gets a large payoff if the company defaults within a certain period of time, while the "protection seller" collects periodic payments for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so they are widely used just to speculate on market changes. In one blogger's example, a hedge fund wanting to increase its profits could sit back and collect $320,000 a year in premiums just for selling "protection" on a risky BBB junk bond. The premiums are "free" money - free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims. And there's the catch: what if the hedge fund doesn't have the money? The corporate shell or limited partnership is put into bankruptcy, but that hardly helps the creditors.

Derivative "insurance" is turning out to look more like insurance fraud; and that fact has particularly hit home with the ratings downgrades of the "monoline" bond insurers and the recent collapse of Bear Stearns. Monoline insurers are the biggest protection writers for CDS, and Bear Stearns, a leading Wall Street investment brokerage, was the twelfth largest counterparty to credit default swap trades in 2006. These players have all been major "protection sellers" in a massive web of credit default swaps, and when the "protection" goes, the whole fragile derivative pyramid will go with it. But the imminent and inevitable collapse of the derivative monster need not be cause for despair. The $681 trillion derivatives trade is the last supersized bubble in a 300-year pyramid scheme, one that has now taken over the entire monetary system. The nation's wealth has been drained into private vaults, leaving scarcity in its wake. It is a corrupt system, and change is long overdue. Only when the old leaky ship goes down can something better replace it. Major crises are major opportunities for change.

THE "DERIVATIVES CHERNOBYL"

The Bear Stearns shakeup over St. Patrick's Day weekend was a direct hit to the banking Titanic from the derivatives iceberg. Bear Stearns helped fuel the explosive growth in the credit derivative market, where banks, hedge funds and other investors have engaged in $45 trillion worth of bets on the credit-worthiness of companies and countries. In 2006, Bear was the twelfth largest counterparty to credit default swap trades. On March 14, Bear's ratings were downgraded by Moody's; and on March 16, Bear was bought by JPMorgan for pennies on the dollar, a token buyout designed to avoid the legal complications of bankruptcy. The deal was backed by a $29 billion line of credit from the Federal Reserve. As one headline put it, "Fed's Rescue of Bear Halted Derivatives Chernobyl." Bear was involved in a reported $13 trillion in derivatives trades. [cite] But the notion either that Bear was "rescued" or that the Chernobyl was halted by the Fed's bailout was grossly misleading. The CEOs managed to salvage their breathtaking bonuses, but it was a "bailout" only for JPM and Bear's creditors. For the shareholders, it was a wipeout. Their stock initially dropped from $156 to $2 a share, and 30 percent of it was held by the employees. Another big chunk of it was held by the pension funds of teachers and other public servants. The share price was later raised to $10 a share in response to shareholder outrage, but the shareholders were still essentially wiped out. And the fact that one Wall Street bank had to be fed to the lions to rescue the others hardly inspires a feeling of confidence. Neutron bombs are not so easily contained.

The Bear Stearns hit from the derivatives iceberg followed an earlier one in January, when global markets took their worst tumble since September 11, 2001. Commentators were asking if this was "the big one" - a 1929-style crash - and it probably would have been if deft market manipulations had not swiftly covered over the approaching catastrophe. The precipitous drop was blamed on the threat of downgrades in the ratings of two major monoline insurers, Ambac and MBIA, followed by a $7.2 billion loss in derivative trades by Societe Generale, France's second-largest bank. The "monolines" are so-called because they are allowed to "insure" only one industry, the bond industry. Like Bear Stearns, they serve as counterparties in a web of credit default swaps, and a downgrade in their ratings would jeopardize the whole shaky derivatives edifice.

The January collapse in international markets occurred on Martin Luther King Day, when U.S. markets were closed. That meant there was no Federal Reserve, no CNBC business channel, no Plunge Protection Team on duty to spin the calamity away. The Team was evidently on the job the next day, when the market suddenly reversed course; but the curtain had been thrown back long enough to see what the future might bode. The Plunge Protection Team is a team of experts assembled by Presidential order specifically to manipulate markets. Formally called the President's Working Group on Financial Markets, it includes the President, the Secretary of the Treasury, the Chairman of the Federal Reserve, the Chairman of the Securities and Exchange Commission, and the Chairman of the Commodity Futures Trading Commission. If there was ever any lingering doubt about whether such a team actually goes into action in such situations, it was dispelled by a statement by Senator Hillary Clinton reported by the State News Service on January 22, 2008. She said:

"I think it's imperative that the following step be taken. The President should have already and should do so very quickly, convene the President's Working Group on Financial Markets. That's something that he can ask the Secretary of the Treasury to do. . . . This has to be coordinated across markets with the regulators here and obviously with regulators and central banks around the world."

The market reversed on rumors of a $15 billion bailout of the beleaguered monoline insurers by the banks that stood to lose the most if they went down. But no bailout materialized over the following month; and even if it had, $15 billion was clearly inadequate to rescue the monolines. Analysts said the ailing insurers could need as much as $200 billion to remain viable. They also warned that investors would face huge write-downs on the valuation of securities guaranteed by the insurers if they lost their top credit rating. The insurers "insured" the securities with credit default swaps, thinking they would never actually have to pay. That worked for the municipal bonds they traditionally guaranteed, since municipal bonds rarely do default. The mistake of the monolines was in branching out into securitized mortgage debt. When the housing market turned, defaults were cascading everywhere.

On February 22, 2008, after a bad week in U.S. markets, rumors of a bailout suddenly caused the stock market to reverse again; but again the rumors were suspect. Bill Murphy wrote in his running market commentary "Midas," "My guess is they were looking at another potential Asian meltdown Sunday night, and will do anything to avoid the abyss." The alleged bailout date passed and none was announced; and when a resolution was finally announced, it was only for Ambac to raise an additional $1.5 million in capitalization by issuing stock. But the PPT had done its work in creating the illusion necessary to restore "market confidence," and we probably won't hear anything more about the downgrade of the monolines, particularly now that the Federal Reserve needs their "triple-A" veneer to justify taking subprime-laden debt as collateral for the Bear Stearns deal.

Institutional investors have lost a good deal of money in all this, but the real calamity is to the banks. The institutional investors that formerly bought mortgage-backed bonds stopped buying them in 2007, when the housing market slumped. But the big investment houses that were selling them have billions' worth left on their books, and it is these banks that particularly stand to lose as the derivative Chernobyl implodes. Without the monoline insurers' triple-A seal, billions of dollars worth of triple-A investments will revert to junk bonds; and since many institutional investors have a fiduciary duty to invest in only the "safest" triple-A bonds, downgraded bonds get dumped on the market, jeopardizing the banks that are still holding billions of dollars worth of them. The downgrade of Ambac in January signaled a simultaneous downgrade of bonds from over 100,000 municipalities and institutions, totaling more than $500 billion.

A PARADE OF BAILOUT SCHEMES

Now that some highly leveraged banks and hedge funds have had to lay their cards on the table and expose their worthless hands, these avid free marketers are crying out for government intervention to save them from monumental losses, while preserving the monumental gains raked in when their bluff was still good. In response to their cries, the men behind the curtain have scrambled to devise various bailout schemes; but the schemes have been bandaids at best. To bail out a $681 trillion derivative scheme with taxpayer money is obviously impossible. As Michael Panzer observed on SeekingAlpha.com:

"As the slow-motion train wreck in our financial system continues to unfold, there are going to be plenty of ill-conceived rescue attempts and dubious turnaround plans, as well as propagandizing, dissembling and scheming by banks, regulators and politicians. This is all happening in an effort to try and buy time or to figure out how the losses can be dumped onto the lap of some patsy (e.g., the taxpayer)."

The idea seems to be to keep the violins playing while the Big Money Boys slip into the mist and man the lifeboats. As was pointed out in a blog called "Jesse's Café Americain" concerning the Ambac bailout:

"It seems that the real heart of the problem is that AMBAC was being used as a "cover" by the banks which originated these bundles of mortgages to get their mispriced ratings. Now that the mortgages are failing and the banks are stuck with them, AMBAC cannot possibly pay, they cannot cover the debt. And the banks don't wish to mark these CDOs [collateralized debt obligations] to market [downgrade them to their real market value] because they are probably at best worth 60 cents on the dollar, but are being held by the banks on balance at roughly par. That's a 40 percent haircut on enough debt to sink every bank involved in this situation . . . . Indeed for all intents and purposes if marked to market banks are now insolvent. So, the banks will provide capital to AMBAC . . . [but] it's just a game of passing money around. . . . So why are the banks engaging in this charade? This looks like an attempt to extend the payouts on a vast Ponzi scheme gone bad that is starting to collapse . . . . "

THE WALL STREET PONZI SCHEME

The Ponzi scheme that has gone bad is not just another misguided investment strategy. It is at the very heart of the banking business, the thing that has propped it up over the course of three centuries. A Ponzi scheme is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top. The Wall Street Ponzi scheme is built on "fractional reserve" lending, which allows banks to create "credit" (or "debt") with accounting entries. Banks are now allowed to lend from 10 to 30 times their "reserves," essentially counterfeiting the money they lend. Over 97 percent of the U.S. money supply (M3) has been created by banks in this way. The problem is that banks create only the principal and not the interest necessary to pay back their loans, so new borrowers must continually be found to take out new loans just to create enough "money" (or "credit") to service the old loans composing the money supply. The scramble to find new debtors has now gone on for over 300 years - ever since the founding of the Bank of England in 1694 - until the whole world has become mired in debt to the bankers' private money monopoly. The Ponzi scheme has finally reached its mathematical limits: we are "all borrowed up."

When the banks ran out of creditworthy borrowers, they had to turn to uncreditworthy "subprime" borrowers; and to avoid losses from default, they moved these risky mortgages off their books by bundling them into "securities" and selling them to investors. To induce investors to buy, these securities were then "insured" with credit default swaps. But the housing bubble itself was another Ponzi scheme, and eventually there were no more borrowers to be sucked in at the bottom who could afford the ever-inflating home prices. When the subprime borrowers quit paying, the investors quit buying mortgage-backed securities. The banks were then left holding their own suspect paper; and without triple-A ratings, there is little chance that buyers for this "junk" will be found. The crisis is not, however, in the economy itself, which is fundamentally sound - or it would be with a proper credit system to oil the wheels of production. The crisis is in the banking system, which can no longer cover up the shell game it has played for three centuries with other people's money.

The banks will therefore no doubt be looking for one bailout after another from the only pocket deeper than their own, the U.S. government's; but if the federal government acquiesces, it too could be dragged into the voracious debt cyclone of the mortgage mess. The federal government's triple A rating is already in jeopardy, due to its gargantuan $9 trillion debt. Before the government agrees to bail out the banks, it should insist on some adequate quid pro quo. In England, the government has agreed to bail out bankrupt mortgage bank Northern Rock, but only in return for the bank's stock. On March 31, 2008, The London Daily Telegraph reported that Fed strategists were eyeing the nationalizations that saved Norway, Sweden and Finland from a banking crisis from 1991 to 1993. In Norway, according to one Norwegian adviser, "The law was amended so that we could take 100 percent control of any bank where its equity had fallen below zero."

BENJAMIN FRANKLIN'S SOLUTION

Nationalization has traditionally had a bad name in the United States, but that solution could actually be an attractive alternative for the U.S. government. Turning bankrupt Wall Street banks into public institutions might allow the government to get out of the debt cyclone by undoing what got us into it. Instead of robbing Peter to pay Paul, flapping around in a sea of debt trying to stay afloat by creating more debt, the government could address the problem at its source: it could restore the right to create money to Congress, the public body to which that solemn duty was delegated under the Constitution.

The most brilliant banking model in our national history was established in the first half of the eighteenth century in Benjamin Franklin's home province of Pennsylvania. The local government created a "land bank" (a bank issuing money supposedly backed by land), which lent money to farmers at a modest interest. The provincial government created enough extra money to cover the interest not created in the original loans, spending it into the economy on public services. The land bank was publicly owned, and the bankers it employed were public servants. The interest generated on its loans was sufficient to fund the government without taxes; and because the newly issued money came back to the government, the result was not inflationary. The Pennsylvania banking scheme was a sensible and highly workable system that was a product of American ingenuity but never got a chance to prove itself after the colonies became a nation. It was an ironic twist, since according to Benjamin Franklin and others, restoring the power to create their own currency was a chief reason the colonists fought for independence. The bankers' money-creating machine has had two centuries of empirical testing and has proven to be a failure. It is time that the sovereign right to create money be taken from a private banking elite and restored to the American people.

Financial derivatives trading simulators-why is the fastest and best way to learn

There are few, if any, practical skills acquired theoretical knowledge alone. Trading in financial derivatives, in this respect, it is certainly not an exception to the rule. And even when most people who are new to derivatives, whether traders or trainee at investment banks, first approximation individuals trade these products to immerse themselves in their books on theory, mathematics and modelling.

In an attempt to acquire other skills, it is less technical, practice theory is given priority in almost all cases. If learning to play violin or how to conduct scientific experiments, each vessel is best learned in this way. Of course, the theory has its position. Without some basic guidance, where does one start? But it is all a question of balance. And you learn how to trade financial derivatives, things usually go hand in hand. Until now, everything was theory, and very little practice.

So why this has happened? There is an obvious reason why people new to financial derivatives, if they seek to trade, risk management, or simply need to understand their business, to an undue disadvantage theory over practice. And this is the difficulty in finding a suitable training environment. The financial markets are likely to make for teachers, expensive. Given the potentially explosive derivatives, mistakes can be expensive. However, when learning any new skill, it is through this Act of mistakes that someone learns and, from there, it improves. Or learning how to drive or how to solve complex equations, errors in the process is a fundamental part of the learning process.

In the case of financial derivatives, this path has not been available until now. Because it is derived, by their very nature, more complicated than just stocks and shares, the opportunity to pursue negotiation on an emulated environment has not existed until very recently. Fortunately, this situation is now changing, and a new generation of online derivatives trading simulators are emerging. This provides users the opportunity to learn how derivatives work through realistic training, using intelligent systems and detailed analysis of the efficiency of the user. Rather than simply focusing on basic, directional properties of derivatives, new technologies taught how users in financial derivatives are fully operational. This allows users to troubleshoot derivatives trading, with all the relevant risks and opportunities, in a completely risk-free environment, before the company markets live.

Such technology is cutting edge. Offers significant advantages over the old ways of learning, how they work and the derivatives trade, and for anyone hoping to either main compensating trading or just looking for an original insight, provides a valuable learning tool.

What is a derivative?

For those of you who've always wanted to know "what is a derivative", I will do everything to explain this issue in the simplest ways.

Undoubtedly, derivatives are one of the things that gets lots of attention to Journal, but is poorly understood by the masses. Even those who specialize in the financing, including CFOs, accountants and notaries do not fully understand this issue. But understanding the basic concept behind a derivative need not be a complex task.

Almost all of us have used a credit card at least once throughout our lives. Indeed, in today's world, almost never need to carry around a wad of cold, hard cash, physics. In this context, we consider the credit card as a secondary instrument. Technically, a credit card is simply a value piece of plastic with some numbers that plastered on it. And even credit cards have become as prevalent in our society, and much more than cash company mainly because credit cards come with the support of the credit card itself.

For this reason, we view a credit card as a ' derivative ' of cash. This may be different. This may feel differently. But serves the same purpose as cash. Furthermore, even many will say that a credit card is better than cash rewards and benefits offered. Also, the loss of your credit card number is never as bad as losing physical cash. If you lose your credit card, the card company immediately to deactivate your card. Finally, credit cards allow users to repay outstanding debts within a certain time frame without any interest. How big is this?

Make no mistake, however, you may also subscribe with a credit card in ways which ' cash ' is not possible. In General, you never want to lose a credit card payment or penalties for late payment can be exorbitant.

So, just as consumers can use the ' credit ' instead of ' cash ', investors use derivatives without the need to purchase the shares outright.

One reason why an investor can choose a derivative instrument is the fact that derivatives often require less of an initial cash outlay. If IBM stock trades at $ 100, this means that the investor must have $ 10,000 to buy 100 shares of IBM.

A derivative game such as a call option, on the other hand, may require only 1/10th of that amount (ie. $ 1,000). This is a great strategy for investors who do not want to expose themselves to more than $ 1,000.

Of course, the call options have the dark side. One is "hour". Dialing options expire after a certain date or expired. technically shares can last forever. For example, a 100 July 2011 the IBM call option is a call option in IBM stock, which expires in July 2011. This call is only value at the date of expiry of the July 2011 If IBM trades at more than $ 100. «July 2011 is known as ' ' end date ' ' and ' $ 100 is known as the ' strike price ' . If IBM happens to trade stock under $ 100, from the date of expiry, the call option expires worthless.

Another disadvantage is that these options require investors to pay a ' premium ' . Investors lose their entire premium, essentially if the call is without value at the date of expiry.

Another derivative instrument called right. As an option call right will have expiration dates in particular and the strike price. Right is interesting in that it allows investors to secure or to protect their portfolios from falling share prices. Many life insurance companies and banks to put strategies when designing principal protected investment/notes.

Technically, puts and calls are the building blocks for almost every derivatives strategies. The key point to remember is that the options that come with different strike prices and expiration dates for different associated with them. So in the example above, we talked about an IBM 100 call July 2011. Similarly, there will be call options with a strike price of $ 105, $ 110, $ 115, and so on. And, similarly, you can get dialing options with maturity dates August 2011, Mar 2011, September 2011, and so on.

While I will not go into and out of all possible derivatives strategies, knowing the important point is that there are any number of derivatives strategies can create different levels of profits.

Just as an artist creates hundreds and thousands of colors from three primary colors, red, blue and yellow, so too is the nature of the derivatives.

Understanding the product rule for the derivative

When you first start to learn the concepts of differential calculus, you begin by learning how to take the derivative of the various functions. You learn that the derivative of sin (x) cos (x), the derivative of ax ^ n is anx ^ (n-1), and a number of other rules for the basic functions you saw all through Algebra and trigonometry. After learning about compensating for individual functions, see derivatives of products of these functions, which expands the range of functions that you can take the derivative of.

However, there is a big step up complexity when you move from taking the derivative of the basic functions of taking derivatives of products of functions. Because of this big step up in complexity is the process, many students feel grateful and really have a lot of problems understanding the material. Unfortunately, many instructors give students methods address these issues, but we do! Let's get started.

Suppose we have a function f (x) consisting of two normal modes are multiplied together. Let's call these two functions a and b (x) (x), which would mean we have f (x) = a (x) * b (x). Now we want to find the derivative of f (x), is called f ' (x). The derivative of f (x) will look like this:

f ' (x) = a (x) * b (x) + a (x) * b ' (x)

This type is what is called the rule of the product. This is more complex than any previous formulas for compensating you've seen up to this point, your calculus sequence. However, if you record each function you have to do with before attempting to write ƒ ' (x), then your speed and accuracy will improve significantly. So, step one is to write that a (x) what they are and what b (x). Then next to it, find the derivatives of a (x) and ' b ' (x). Once you have everything written, then there is nothing else to think about and you just fill in the blanks for the type of rule "product". This is all there is to it.

Let's use a tough example to show how easy it is for this procedure. Suppose we want to find the derivative of the following:

f (x) = (5sin (x) + 4 x-16) (3cos (x)-2 x + 4 x + 5)

Remember that step in determining what is a (x) and b (x). Clearly, a (x) = 5sin (x) + 4 x-16 x and b (x) = 3cos (x)-2 x + 4 x + 5, since these are the two functions that are multiplied together to form f (x). From our side of the Paper, only then we can write:

a (x) = 5sin (x) + 4 x-16 x
b (x) = 3cos (x)-2 x + 4 x + 5

By written by separate from each other, now we find the derivative of a (x) and b (x) individual just below it. Remember that these are basic functions, so that we know already how derivatives:

a ' (x) = 5cos (x) + 12-16
b ' (x) =-(x) 3sin-4 x + 4

With all this writes in an organized manner, you don't have to remember anything anymore! All work on this problem has ended. You need only to write these four functions in the correct sequence, which is given to us by the product rule.

Finally, you write that the basic form of the rule of product, f ' (x) = a (x) * b (x) + a (x) * b ' (x), and write the corresponding functions in place of a (x), a ' (x), b (x) and b (x). Returning above where we work: our problem

f ' (x) = a (x) * b (x) + a (x) * b ' (x)
f ' (x) = (5cos (x) + 12-16) * (3cos (x)-2 x + 4 x + 5) + (5sin (x) + 4 x-16 x) * ((x)-3sin-4 x + 4)

This is a very large derivative function, but when we organise our thinking efficiently, quickly and accurately to take compensating products regardless of how long is the initial function!

Understand how derivatives work?

I have already derivatives trader for the majority of my career. I have noticed during this period that the word "derivative" has garnered some very negative connotations. The fact that the issue is that the derivative term has different meanings and can indicate a wide range of financial instruments. Let's start with a basic definition of a derivative.

A derivative is a financial instrument, as an option or futures contract, whose value is derived in part from the price of another security which is the underlying. Don't assume technical definition together an enormous amount of light on the true meaning of the derivative. In plain language, a derivative is a bet as to whether the value of the underlying security, which can be a stock, bond or financial index will increase or decrease by a specified date. Derivatives are commonly used for the protection of assets values and things like stocks or potential future markets. In fact, derivative is an umbrella term for a broad category of financial products. Some of these products, such as futures and options are clearly defined and enjoy a relatively broad understanding.

On the other hand, there are classes of derivatives that exist in an environment of murky and poorly understood. These derivatives typically are not traded publicly, but are individual contracts between companies to buy and sell products, or to insure against loss (as in the case of CDS) or to give a company the right to buy a product in the future, a set of values. These non-tradable derivatives can be classified as exotic in nature. From exotic, I mean that they are each unique in a finite state that exists between the two parties. As you probably heard the news, many of these exotic derivatives is poorly understood by both the public and the Government. Further, there were questions raised as to the legality of such compensating products. Incidentally, the new packages of financial regulation proposed by the Government include extensive monitoring and setting of exotic derivatives.

But my job back, work only with the "plain Jane" variety of derivative called forward contracts. Futures contracts are traded on regulated exchanges and there is a high degree of transparency in their daily trading activity. Futures have been around for more than a century and the beginning of derivatives trading date back to rice in Japan in the 17th century. The garden-derived variety, or futures, are well understood and largely traded.

You might be surprised at the wide range of commodities, metals, financial indexes and a host of other unusual futures contracts can be traded. For example, futures, bonds, prices of energy products, meat and a host of other conventions. Generally, these contracts are used for blocking prices for the producers of the products listed above, or investors of the products listed above. Futures allow a producer to lock-in a value so that they can produce an enterprise product and the value for the future in mind.

It is important to understand that effectively regulated sector futures provide a valuable service in the industry. On the other hand, exotic derivatives sometimes resulted in extraordinary losses on derivatives and the latest problem is being caused our country to fall into recession. This article is intended to distinguish between normal, transparent derivatives and exotic derivative contracts that have caused so much trouble for our economy.

Quadrillion in derivatives $ 1.14-what it means for gold

Quadrillion? This is correct number use only astronomers, you know ... and the star of the North is "only" two quadrillion miles away?

But, rather, scary land economists really begin to use the number, too. No, not to discuss the amount of dollars there (although this may feel like the Fed pumped just a quadrillion greenbacks in economy). Recently, the Bank of international settlements reported that the amount of outstanding derivatives now reached $ 1.14 quadrillion signal (548 trillion dollars listed credit derivatives plus $ 596 trillion in notional [or face value] Over-the-counter derivatives).

Whether you're an astronomer or an economist, this is a very large number. In case you need a REFRESHER course, million mega-number followed by a billion followed by followed by trillion quadrillion (and, okay, quintillion and sextillion below). Yes, it takes a thousand trillion to compose a quadrillion, and, unfortunately, this is where we are today with this set of derivative mess.

Lever Madness

Derivatives, as you may know, are essentially unregulated, high-risk credit bets. Unlike the earnest farmer who might employ a futures contract to hedge the price of beans who worked so hard to grow, many banking institutions now use futures, forwards, options, swaps, swaptions, caps, collars and floors-the whole allokotoi inventory of leverage devices-to bet the hell out of virtually nothing.

What drives derivatives, with the roots (if you can somehow get back that far), are essential assets that get insane degree of exploitation. Martin Mayer writing for the Brookings Institute, said, "the receiver of the payments on these loans or securities has bought the securities for the duration of the swap on 95% margin, even though the law says nobody can buy securitieswithout putting up half the price. "

Extrapolated, $ 1.14 quadrillion in assets "owned" by something like 95% margin must be one of the scariest phenomena in the history of the economy.

Mathematicians and scholars are supposed to air traffic controllers of the derivative compound, keeping everything up-to-date, tangential and safe guarded. But a quadrillion-plus of these highly leveraged investment is like multiplying of America fleet from planes one million fold ... While not bothering to increase the number of air traffic controllers. The potential for economic damage here is simply overwhelming.

"Financial weapons of mass destruction"

So Warren Buffet derivatives warned six years ago.

"We believe the time bombs, both for the parties that relate to them and the financial system," is how the Oracle of Omaha put it.

The bomb almost went out in March 2008 with the collapse of Bear Stearns. The title of an article by noted analyst Ambrose Evans-Prichard-"rescue the Fed stopped a derivatives Chernobyl"-says almost everything you need to know.

According to the article, Bear Stearns held a jaw-dropping $ 13.4 trillion in derivatives, which is greater than the u.s. national income ". So when all derivatives went? Well, this time anyway, JP Morgan was encouraged to add derivatives bearing its own 77 trillion portfolio, giving the financial giant a grand total of $ 90 trillion in wobbly these investments.

Which begs the question, why don't we just let Bear Stearns-$ 13 trillion in derivatives and all-go belly up? Will not be taught the nation a valuable lesson and given Wall Street a long-deserved wake-up call? "Twenty years ago the Fed would have let Bear Stearns go," said specialised credit William Sels. "Now it is too interlinked to fail."

Which means that a Bear Stearns collapse now could be the first Domino to fall in ancient domino configuration tomorrow. All derivatives are really interlinked. So, expect the Fed to move with speed-rescue SWAT TEAM as any bank struggling with derivatives.

But what happens when even that isn't enough?

Surviving the coming collapse of derivatives

Finally, shockingly, something will go wrong. A bank will shrink, some mathematician will miscalculate or the Fed it is simply not going to react sufficiently quickly next time and the entire $ 1.4 quadrillion derivative compound would just "go Chernobyl." not Only can $ 1.4 quadrillion since then. It may be many more.

What will be the consequences?

What happened, you wouldn't be pretty. Report an emergency Bear Stearns, James Melcher, known hedge fund manager, said, "there was a danger of a total meltdown at the beginning of last week. I think that most people have some idea how bad this chain could have been. "

The New York Times was even more pointed: "If the Fed did not act this morning and fly (Stearns) did default on its obligations, which could have triggered a widespread panic and possibly a collapse of the financial system."

Yes ... the times said.

But there's too much leverage and too much money, greed and too many shenanigans at made here involved to believe this story has a happy ending. So, when you really need to buy some "insurance derivative collapse".

You must buy gold.

Think gold-this beautiful glittery precious metals-as its own monetary system, excellent investment were divorced from the boy paper money has kept so many nasty derivatives beasts. Should the worst happen, gold will represent the only economic logic. investors are not distorted by a secondary collapse will flock to the precious metal, if only to wait things out.

If you just rolled your eyes Bear Stearns, Google to see how close we came. Then go and look in gold ... before we start wondering just how $ 1 quintillion derivatives.

Three reasons start derivative trading

If you are looking for an option transaction outside of the traditional stock and bond, trading of derivatives can be a good choice. Derivatives resulting in a period based on the performance of assets, interest rates, exchange rates or indices. Payment may be in cash or assets and, of course, varies by performance and timing. In addition to stocks and bonds, derivatives can be traded through the money market, foreign exchange (forex) and credit. Secondary indicators that affect performance are diverse and depending on the type of derivative. These can range from the stock market index in the consumer price index in weather and fluctuations of currencies. The following provide information on why it might be a good idea to start the trading of derivatives.

1. lower risk than other professions

When you trade in derivatives, which do not buy the product or market to the company, although in some cases your agreeing to purchase assets in the future, also known as trading in futures. Instead, your risk is about performance. There are two basic types of derivatives: futures and options, which allow someone to buy or sell price. There are three main types of businesses that use derivatives. These are investment banks, commercial banks and end-users, such as floor traders, company, and hedge and mutual funds.

While you may still lose money in trading in derivative instruments, the risk is much less of an investment. In addition, you can get involved in negotiations for a much lower initial investment, which may appeal to those who can't or don't want to invest as required for the purchase of shares in derivative instruments. Derivatives can also be a good way to add balance to your portfolio, thus spreading the risk across a variety of investments, instead of just a few.

2. it may be a good investment stint

If you are looking for an investment opportunity that can render in a shorter timeframe, derivatives can be a good choice. While some long-term investments in shares and bonds during many years, derivatives can be days, weeks or a few months. Because of the shorter turnaround, they can be a good way to break into the market, and a good way to mix short and long-term investments. If you have a portfolio consists of long-term investments, such as certain stocks, and you want an option to put your money to work now, derivatives may be an option.

Making derivatives work requires careful investigation and investigation just like any other investment opportunity. However, in a fast-paced world, investors have the ability to see the results very late on options or forward transactions which are not available through other means.

3. the diversity and flexibility

The nature of derivatives essentially means that opportunities for trade in this type of investment is limited only by imagination. The other side is that someone who cares about the introduction of derivatives trading must have reliable economic agent or learn both the business as possible. Doing both is the best option, as you can and then work with a representative of the Government much more involved and have a better handle on what your money and where. Numerous resources are available on the Internet to learn more about the trading of derivatives and available options. Those interested in derivatives training, you may want to begin by focusing on a particular area, such as currency transaction. Some types of trade options are available 24/7 worldwide. This is another reason why some investors are drawn to trading of derivatives. PARTICIPATION in the global economy can be exciting and opens international options that may not be available through traditional stock market (in particular the regulations placed on foreign companies to comply with U.S. laws such as Sarbanes-Oxley).

In a nutshell, trading of derivatives can be a great way to either break into the commercial market, or complete an existing portfolio. Offers a wide range of options, including international capabilities. Finally, with some degree of skill, luck, and may be a good way to make your money work for you.