S. Balakrishnan Warren Buffett called them 'weapons of mass financial destruction', devised by (mad?) men (for other madmen?).
He was referring to derivatives. Much of the current upheaval in financial markets is being attributed to the explosion in their trading, and fancy products least designed to meet market needs. Buffett's criticism is not off the mark. But the present crisis is also a case of plain old-fashioned banking gone wrong. Banks still make most of their profits from traditional intermediation - the spreads between their lending rate and cost of funds. In the process, they take credit risk, i.e., the possibility that borrowers will not return their money, though deposits must be. Lending spun out of control and credit risk was given the go-by because loans could be securitised and sold off to debt investors. What is more, banks were themselves in the game of investing and financing securitisations. When the housing and credit boom unravelled, they were left holding what failed banks hold - bad investments and loans. It is a simple tale of non-performing assets. Some time ago, Buffet likened trading in financial markets to exchanging pieces of paper with no real addition to a nation's stock of physical goods or wealth. He has a point there. The simplest derivatives, plain vanilla interest rate and forex swaps, replicate transactions in the cash market without the hassle of funds transfers and custody of funds and securities. For example, a corporate that believes interest rates will go up must borrow at a fixed rate today. Instead, it could do an interest rate swap to pay a fixed rate and receive a floating rate without any exchange of funds on the (notional) principal it wants to protect from a rise in interest rates. Similarly, it could buy dollar and sell yen in a currency swap, if it thinks the dollar will rise and make its dollar liabilities more expensive or cheapen yen receivables. Soon swaps went far beyond a convenient and quick hedging device for banks and corporates and assumed a life of their own as players with no underlying exposure to interest rates and currencies jumped in. It requires little capital for anyone to take positions on interest rates, currencies or commodities. Market players can trade their views in spot and forward or futures markets putting up just a fraction of their exposure as margin. The latter have thus become larger than life itself. Globally, their turnover dwarfs that in goods and services, even after the sharp rise in international trade in recent times. The invention of derivatives on derivatives was a natural extension. Their pricing, despite the complex math, is more imagination and fiction than fact and feats of intellectual gymnastics more than reality. In stressed markets, they collapsed like cards. Some derivatives have been beneficial but many have been exercises in deception and, worse, fraud. Sifting the wheat from the chaff and cleansing the system, without throwing the baby out with the bathwater, is going to be a major task itself. http://www.thehindubusinessline.com/2008/12/24/stories/2008122451950600.htm Life is like a piano, white keys are happy moments and black keys are sad moments. But remember both keys are played together to give Sweet music in life... --~--~---------~--~----~------------~-------~--~----~ You received this message because you are subscribed to the Google Groups "Kences1" group. To post to this group, send email to [email protected] To unsubscribe from this group, send email to [email protected] For more options, visit this group at http://groups.google.com/group/kences1?hl=en -~----------~----~----~----~------~----~------~--~---
