May 20, 2006

Derivatives, Derivatives, Derivatives

DERIVATIVES are the banker's BLING!

The term is thrown around by the talking heads as if they actually understood them. They don't. Why bother? The explanation is not going to get ratings.

Let Wickipedia try and explain . Have some aspirin ready.

I have read extensively. Here is my layman explanation: A derivative is just a security the bankers have created at the request of individuals, corporations and governments to avoid or push off a tax event. They have become prevalent because they create gobs and gobs of transaction costs for the banks. The banks say it is a hedging instrument. Whatever!

You can't stop the beast - they create tons of cash for the banks and they have quarterly number's to meet. They won't stop and you can't stop them.

So what are the inevitable consequences?

I liked this explanation from Greg Silberman:

"There is a Raw ingredient that goes into every derivative contract. It’s the ‘Risk Free’ Treasury Note. Otherwise known as the Risk Free rate of return. ON BALANCE, over the last 20 years, every derivative written has, as its raw ingredient, an ever-declining risk free rate of return.

That’s now changing!

It is quite likely that the 20 year Bull market in Treasuries is now over and ON BALANCE rates will be heading higher over the next 20 years. This adds subtle but definite stress to the derivative mountain. As the whole structure becomes more expensive to maintain counterparties of questionable creditworthiness will start to DEFAULT (if that’s not happening already).

This Derivative thing is an absolute MONSTER.
It dwarfs almost everything else in Size and Impacts on every Financial market.
THERE IS NO WAY THAT THE CENTRAL BANKS WILL LET DERIVATIVES SINK THEIR GRAVY TRAIN. Whenever a "Derivative Problem" crops up, Central Banks FLOOD the system with liquidity and that means ever-expanding Money Supply.

In fact we have seen quite clearly that the markets, ALL markets, LOVE increased liquidity and have shown no signs of caving in because of it.

The catalyst which WILL cause Financial Markets to CRASH (and Gold to Soar) will be EXOGENOUS to the markets. It will cause an Upward re-rating of Inflation expectations in the Publics eye. And that my fellow readers will be courtesy of our Commander-In-Chief, Iran, Al Qaeda or every other Terrorist organization that will help expand the War in the Middle East later this year.

My experience in the City of London has convinced me that Derivatives will NOT be the catalyst for a Financial Collapse. But it will make one Infinitely more powerful!"

Here is the full post . A great read.

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