Tuesday, September 23, 2008

Derivatives—what the heck are deriviatives?

Here is the most simple explanation of derivatives I've found. Apparently others have also thought so, since I've seen this link in several places.

Keep in mind that this is written by someone who wants to convince you to follow his "Turning in flation into wealth" program.

Nonetheless, it actually made the whole mess sound logical and, in an unregulated economic environment, relatively inevitable.

A tiny part of the beginning of it, worth seeing simply because of the great graphic:

Daniel R. Amerman, CFA, InflationIntoWealth.com

The Rapid & Dangerous Collapse of AIG

“The particular risks that brought the company (AIG) to the brink of bankruptcy seem to lie not with its core insurance businesses but with its derivatives-trading subsidiary AIG Financial Products. AIG FP, as it's called, merits a mere paragraph in the nine-page description of the company's businesses in its most recent annual report. But it's a huge player in the new and mysterious business of credit-default swaps: derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad.”

Time, September 17, 2008

On September 1st, few knew that AIG, the largest insurance company in the world with over $1 trillion in assets, was in deep trouble. By September 12th, the rumors about major trouble were everywhere. By September 15th AIG’s corporate life expectancy was being measured in days, and the question was: bankruptcy, buyer or bailout? By the evening of September 16th, the federal government had massively intervened, making an $85 billion loan to AIG in exchange for a controlling 79.9% equity share of the company.

Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. The chart below shows the relative size of the credit derivatives and subprime mortgage markets.

How great is the real danger? The bulk of the remainder of this article explains the extent of the danger. With a few market changes, this is the credit derivatives primer as published on May 2nd of 2008. There is also new material at the end of the article, talking about what could be anticipated, and introducing some solutions.

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