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Thread: Derivatives - (with Lehman Brothers bankruptcy thrown in)

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    Default Derivatives - (with Lehman Brothers bankruptcy thrown in)

    Can someone explain in plain language what the possible coming implosion of derivates mean? And how can one recognize the signs of it coming?

    What would the consequences to the banks, governments, and people be?
    Thank you.

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    Default Re: Derivatives

    I can only offer my own impression based on what limited history exists in regard to a future derivative Armageddon ... JP Morgan's near meltdown after 9/11





    the big issues with derivative in an Armageddon scenario is the incredibly high degree of leverage which has been deployed ... where normal bank loan leverage is limited to the 10:1 ballpark, allegedly some investment houses have deployed derivative leverage as high as 700:1. Thus comparatively small movements in the 'market' of the underlying quantity (or more correctly in notional value of the derivative contract ... since derivatives are extremely hard to price unless they are actually bought or sold) can create huge gains as well as huge losses. In this sense, derivatives can be thought of as resembling very 'steep' options contracts. This obviously involves huge levels of risk.

    However, there is also a resemblance between derivatives and regular business contracts in that many derivatives involve the necessary performance of parties on both ends of the contract. Thus even if the 'market' isn't moving to any great degree, the failure of a counterparty to perform as promised will result in the first party being 'stung'. This adds additional levels of risk.

    From a distant and skeptical viewpoint, bank and corporate holdings of derivatives contracts far outshadows their 'tangible' asset holding. Bank and corporate solvency is also much more dependent on the expectation that a derivative counterparty will actually perform as expected. If the 'booked' notional value of derivative holdings falls significantly, or if a counterparty defaults, the bank or corporation could find themselves instantly insolvent.

    So far, the US FED and other machinations have been able to allow most banks and corporations to avoid 'booking' their losses of notional value ... and have also kept the number of counterparty defaults down to a comparative minimum. There are also rumors that the US FED has actually 'bought' derivatives from various banks and investment houses via FED window loans that are never likely to be repaid (thus sticking the FED with the derivative collateral). There is also a nasty rumor mill regarding the possible doom of Lehman Brothers resulting in a wide array of counterparty defaults because Lehman occupies a 'link in the chain' if not actually acting as party / counterparty to derivatives contracts.

    As to the magnitude of the derivatives problem, guesstimates place the total notional value of derivatives held by US banks, investment houses, insurance companies etc. in the $50 trillion dollar ballpark. This amount is 4-5 times the annual US GDP and is 15-20 times the annual total US federal gov't budget. Thus any attempt to call on the US taxpayer to bail out a derivatives meltdown will resemble 'pissing in the wind' even if every federal tax dollar of every US taxpayer was used exclusively for that purpose.


    As to the relative proximity of financial Armageddon ...



    again a reminder that all of this stuff is from the original derivatives scare of 2002. Nobody wants to talk about the changes in the derivatives market that have occurred in the meantime !
    Last edited by Melonie; 09-14-2008 at 01:30 PM.

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    Default Re: Derivatives

    well, speak of the devil ...



    (snip)"Lehman will seek to place its parent company, Lehman Brothers Holdings, into bankruptcy protection, while its subsidiaries will remain solvent while the firm liquidates its holdings, these people said. A consortium of banks will provide a financial backstop to help provide an orderly winding down of the 158-year-old investment bank. And the Federal Reserve has agreed to accept lower-quality assets in return for loans from the government.

    But Lehman’s filing is unlikely to resemble those of other companies that seek bankruptcy protection. Because of the harsher treatment that federal bankruptcy law applies to financial-services firm, Lehman cannot hope to reorganize and survive as a going concern. It will instead liquidate its holdings.

    It was not clear whether the government would appoint a trustee to supervise Lehman’s liquidation, or how big the financial backstop would be.

    Lehman’s broker-deal subsidiaries would not be a part of the bankruptcy filing. Those entities must file under Chapter 7 rules, which are the procedures for liquidation, under the assumption that it is the best way to protect customers. The Securities Investor Protection Corporation would handle the liquidation of such brokerages, and bankruptcy lawyers say that customers are likely to receive their holdings back.

    Moreover, changes to the bankruptcy code mean that counterparties to Lehman’s credit-default swaps can seize their collateral at any time, posing an enormous potential risk to the entire financial markets. Investment banks, hedge funds and other financial players labored throughout Sunday to offset their exposure to Lehman, moving their contracts to other firms.

    Lehman has retained the law firm Weil, Gotshal & Manges to prepare its bankruptcy filing. The firm’s restructuring head, Harvey Miller, also worked on Drexel’s bankruptcy back in 1990."(snip)

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    Default Re: Derivatives - (with Lehman Brothers bankruptcy thrown in)

    Quote Originally Posted by Adelina View Post
    Can someone explain in plain language what the possible coming implosion of derivates mean? And how can one recognize the signs of it coming?

    What would the consequences to the banks, governments, and people be?
    Thank you.
    Many contracts (eg. stock options, credit default swaps) that people trade have values which depend on an estimation of likely movement (eg. likelihood that a share price will change, or the likelihood that a homeowner will not be able to pay their mortgage). When people get these drastically wrong, then they're in trouble. That's colloquially speaking an "implosion".

    For example:
    • Last month people sold lots and lots of stock options saying that they promised to buy LEH shares at $16. Now people would be forcing them to honour that promise and they'd be losing about $13 per share. Ooops.
    • Certain banks believed that the mortgages they held were worth billions. Turns out they were worthless. Ooops.

    The consequences are that lots of big institutions have a lot less assets than they thought they did. And they're all going to try to cut their losses at a similar time. It's a work in progress at the moment.

    As for seeing it coming, and the consequences for everyone, well, I'm not much of a fortune teller Hope this helps.
    Once again, the conservative, sandwich-heavy portfolio pays off for the hungry investor
    - Dr John Zoidberg

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    Default Re: Derivatives - (with Lehman Brothers bankruptcy thrown in)

    Quote Originally Posted by Adelina View Post
    Can someone explain in plain language what the possible coming implosion of derivates mean? And how can one recognize the signs of it coming?

    What would the consequences to the banks, governments, and people be?
    Thank you.
    Derivatives is Side Bets with borrowed money.

    Eg:
    Price of gas: $4.50

    I'm sure that Price of Gas will go to $4.55 next week.

    I can buy a Gallon of Gas today and sell it back and make $0.05 profit. But making $0.05 profit is not worth my time. So, I'll buy 100,000,000 Gallons of Gas and make $5 Million and Profit.

    Where will I get money to buy 100,000,000 Gallons of Gas? Well, if you are buying 100,000,000 Gallons of gas and not using them, someone will lend me money (because the Gas price always goes up, right?) and use the 100,000,000 Gallons of Gas as collateral.

    Of Course the Gas prices can go to $4.40 too. Then I'll lose $10 Million of my own money.

    Summary of Derivatives:
    i) $5 Million you make and the $10 Million you lose is your own real money

    ii) Derivaties trade (unlike assets) is always a Zero sum game, i.e for every guy who makes $5 Million there is a guy who loses $5 Million and for every guy who loses $10 Million there is a guy who makes $10 Million

    Overall, The economy doesn't lose any real wealth. There is only wealth transfer. But, if you read shady web-sites written by clueless idiots, they will make you believe it does.

    iii) The 100,000,000 Gallons of Gas or $450 Million it costs to buy them is called the Notional. Clueless-Idiots-running-Shady-web-sites will throw this number around to scare Clueless-idiots-reading-shady-web-sites. So, when you hear $500 Trillion Dollar or any such obscene number, it is the notional they are talking about

    iv) Just like a coin toss, Nobody can predict, who will win the next gamble. But, as you see, small differences in gas prices makes huge differences in profit/loss. Thats the beauty/ugly side of Derivatives.

    v) Businesses and farmers use derivatives to hedge. Southwest Airlines can buy Real Fuel to run their planes and sell 100,000,000 Gallons of Gas to protect themselves against Gas price increases.

    vi) Just like any tool, it is the people who use or abuse the tool.
    Lets say you and I get into this 100,000,000 Gallons of Gas contract. You and I agree that gas price will not change more than 20c, so a $30Million should handle suffice price swings. The problem comes when gas prices change 50c. Now, I owe you $50 Million, but I don't have the money. I declare bankruptcy. People depending on me for other things now have to declare bankruptcy and thus the chain reaction of businesses failing all around.

    So, although only paper wealth is lost, the lost of confidence the cornerstone of any modern economy is a severe blow to its working.

    How can you protect from derivatives blow up?
    Answer: Dollar Cost Average into S&P 500 Index or an International Stock Index.
    Last edited by xanfiles1; 09-15-2008 at 10:56 AM.

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    Default Re: Derivatives - (with Lehman Brothers bankruptcy thrown in)

    Quote Originally Posted by xanfiles1 View Post
    How can you protect from derivatives blow up?
    Answer: Dollar Cost Average into S&P 500 Index or an International Stock Index.
    Isn´t it lucky that protecting oneself from a global financial meltdown is so darned simple. Thank goodness for that.

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    Default Re: Derivatives - (with Lehman Brothers bankruptcy thrown in)

    Quote Originally Posted by StuartL View Post
    Isn´t it lucky that protecting oneself from a global financial meltdown is so darned simple. Thank goodness for that.
    If anyone's buying S&P500, I'll sell to them. We're all going downtown, baby
    Once again, the conservative, sandwich-heavy portfolio pays off for the hungry investor
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    Default Re: Derivatives - (with Lehman Brothers bankruptcy thrown in)

    Maybe you could trade direct with xan?? You could cut out the dealing commission and there would only be one 'shady web-site' involved in the trade.

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