Today I've decided to explore a number of the issues that I keep hearing when I watch Cramer on CNBC or Fox Business Network. My last article delt with Market-to-Market accounting practices, and how did Market-to-Market relate to the overall mess we're in now. After education myself in that area, I've realized that I needed some additional information on Derivatives and Hedge Funds.
Not too long ago (several years ago), I remember briefly reading in some news journal that derivatives and hedge funds were risky, and there was a big chance that these funds could implode and cause great havoc in the markets. But Alan Greenspan and his buddies soon assured congress and others that it wasn't a big deal, and these programs were actually needed.
Then I read a blog this morning by Katrina Vanden Heuvel
and she mentions a little remembered bureaucrat named Brooksley Born, who was director of the CFTC, Commodity Futures Trading Commission. She at that time made it known, to then Treasury Secretary, Rubin (Clinton Administration) and Allan Greenspan that these derivatives were volatile and dangerous! When Brooksley Born testified before congress in the late 1990's, she was quickly silenced by Greenspan and Rubin, and they quickly dispelled her concerns before the same congress. Just as a side note, now we have evidence that Fannie and Freddie benefited from some serious deregulation legislation in the 1990's, couple that with the birth of derivative financing models and hedge funds and your creating a toxic stew of the worst magnitude!
So what is a derivative...it sounds like Algebra or Trigonometry, both classes I hated in highschool and college. But a financial derivative is a basic trading strategy. Derivatives are financial instruments that are intended to reduce risk to both party's, but are based on the value of underlying financial instruments. The main type of derivatives are futures, forwards, options and swaps. One of the main uses of derivatives are in Hedging a position between two parties in a transaction. Example, a wheat farmer is worried about future prices and so is the wheat miller. So they agree to a "futures" contract, in other words to exchange cash for wheat in the future. What's important is that it's only agreement between two parties, and other circumstances could still put the deal in jeopardy, such as the weather.
What's the big deal? Well it's the following. A merchant banker can "hedge" that a asset he owns on paper is going to be worth more in the future. He doesn't actually have market exposure during this process, because he really hasn't laid any money down at this point. But if the market swings the other way, he could be in trouble because he has to cover the future contract. So if there are allot of investors in a given hedge fund, and the values go the wrong way, they all could be holding the bag and unable to meet the futures call when the final bell rings, and that's why you see these hedge funds imploding.
Compounding the problem is that big banks and financial institutions have put BILLIONS into these hedge funds, banking or (betting) on numerous various factors related to loan portfolio's. The problem is that this industry has been largely unregulated, and there have been numerous investors holding the bag when another investor is unable to meet the futures cover.
So this huge unwinding is the hedge fund market de-leveraging at an incredible rate. It's like we just rode our fast car over a large spike in the road. Instead of the tire deflating slowly the tire actually has blown out! The wildly gyrating market is like your car out of control after the tire blows. If you have ever had this happen to you on the road, it can be outright catastrophic or very unnerving if you happen to gain control of your car once again. I think we're seeing a similar reaction by the government and the federal reserve at this time.
Bernake is trying to ease the economy back into control, after Greenspan and his boy's pushed the accelerator down to hard in the 1990's and early 2000's. I remember how Greenspan was worshiped for such a long time period, now I think he may go down in history as one of the more irresponsible Fed Chairmen in history.
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