WMD Derivatives
Apr 9th, 2008 by Dave
So the Federal Reserve is bailing out an investment bank for its bad bets on subprime mortgage loans. But it was really about guaranteeing Bear Stearns’ position in the credit default swaps market (What Created This Monster) - “It was 100 percent related to credit default swaps.”. Bear’s contracts had a value of $2.5 trillion - if they were to go under the repercussion of their position going bad would have brought down many of the other players in the market. It is clear in hindsight that Bear didn’t manage their risk correctly; that they didn’t factor in the real likelihood of the subprime mortgage market meltdown, and this lack of foresight not only put their own shareholders at risk but put our whole economy at risk.
This fiasco is reminiscent of the Fed bailout of the Long Term Capital Management hedge fund whose well-respected management miscalculated the probability of simultaneous meltdown in all its markets as a ten sigma (less than one in a billion chance of happening) or black swan (unpredicted) event.
The scary part of this is these investment vehicles are off balance sheet and largely unregulated so they’re off the radar of investigators and regulators. The derivatives market has exploded since the bailout of LTCM. With these bailouts, it is clear that market participants don’t fully understand the risks of their positions or if they do, they are making bets which not only risk their own capital but the stability of our entire financial system. If they aren’t able to value their positions and assess risk correctly, how can we expect investors and regulators to be able to do any better? Innovative financing has contributed to our success as a global economic powerhouse, but when we are seeing repeated meltdowns due to misunderstanding or mismanagement of risk, we need to step back from the brink before derivatives become, in the words of Warren Buffett, “weapons of mass destruction”.