Derivatives Time Bomb

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We are facing a situation where the world's financial markets plunge into chaos as the massive derivatives positions owned by hedge funds and the large banks move against those parties.

The greatest challenge facing large investment banks is how to control the credit-derivatives market, now home to a massive $26 trillion dollars in America alone. According to some, the worldwide exposure is over $500 trillion dollars. This is roughly 10 times the value of the entire world's output!

Imagine your no-good kid comes home one day, and tells you he has a credit card debt, and it would take the whole world 10 years to pay it off. Then he tells you, that if you don't pay up soon, the whole world will implode. That is kind of where things are at now. And he didn't even mention that they are sending goons over to break everyone's (the whole world's) kneecaps later today.

Everyone is now so frightened, even the traders, who are desperately trying to unwind their positions but finding it impossible because trading is so volatile and it's difficult to find counterparties. What also makes them very risky is that nobody is policing these trades. You can't call the cops, because there are none for this kind of thing.

What is a Derivative?

Warren Buffett, the American investment guru, dubbed them "financial weapons of mass destruction", but for the once-great-and-good of Wall Street they were the currency that enabled banks, hedge funds and other speculators to make billions.

Anything that carries a price can spawn a derivatives market. They are financial contracts sold to pass on risk to others. The credit or bond derivatives market is one such example.

Credit default swaps offer protection against the possibility of default by a debt issuer. By using these swaps, traders, including hedge funds, can offset potential losses from risky fixed-income positions.

The Solution?

Things are so screwed up, it will take more than this article to solve it. I mean this is really bad, much worse than that date you had with Jenny that time. We may have to start the whole financial system from scratch, although there won't be a lot left to work with after the goons have finished with everyone.

It seems that organizations are passing the buck and trying to make a few while they do so. First all the banks have to take ownership of all the poor credit positions on their books. If you lend money to a drunken weasel, don't expect to get your money back. Don't turn around and sell a share of the risk to other institutions, without informing them that it was a drunken weasel. You know who you are, so stop it!

Next, it seems that the institutions are so heavily leveraged, in order to maximize their profits. The problem is that institutions that are highly leveraged can suffer huge losses if their positions move against them. And trust me, when you buy papers on derivatives that are leveraged on loans to a drunken weasel, you won't win. So there has to be limits on the leveraging on credit derivatives.

Like I said earlier, there are no cops in this game, so we need some. Somehow we have to introduce oversight and policing of the markets. It is a case where the markets and the derivatives are ahead of the needed infrastructure. Like when you tried to drive over that bridge before they finished building it.