What Went Wrong - Primer on Derivatives and the Market Meltdown

http://www.washingtonpost.com/wp-dyn/content/article/2008/10/14/AR2008101403343.html

This is an article from the Washington Post that breaks down the events regarding the financial instruments called derivatives, and how they became a part of this present market meltdown. It is basically a primer on how they work and how at least one person tried to get the government to regulate them. Now, they are a bigger part of the world's economy than the world economy itself, with notional (face) value of over $53 TRILLION! Warren Buffett called them 'financial weapons of mass destruction' because they can be used to generate obscene profits, but also (when leveraged extremely high) have the ability to destroy the entire world's economy, as what happened in 1998 with a company called Long Term Capital Management.

LTCM was ran by the researchers that actually won the Nobel Prize for Economics when they came up with what is known as the Black-Scholes formula that is used to calculate prices (technically called premiums) on derivatives. They work fine as long as the assumptions in the model are true. LTCM was highly leveraging their investments in these instruments. They were trading derivatives (i.e., options) on the Russian GKO bond market, which were government bonds. When this market experienced a discontinuity (i.e., when the model's assumptions were not true anymore because the Russian government defaulted on the bonds), this made the company instantly bankrupt, and they did not have the ability to pay any of their counterparties (i.e., the companies on the other side of the investment). The counterparties therefore could not pay the companies with which they had investments. This created a daisy chain of possible company failures that were threatening the entire global banking system.

Then Federal Reserve Chairman Alan Greenspan got together a group of around 10 of the largest banks in America to 'pony up' and 'donate' about $5 billion to cover LTCM's losing position in order to save the world's economic system. I bet you didn't remember that story, but it was the day that derivatives almost destroyed the world's financial system. Tom Brokaw didn't tell you about that one. And you thought the evening news really kept you informed. This was before Enron, Tyco, Fannie Mae, etc.

So these people (regulators, financial professionals and Congressmen alike) have known about the dangers of derivatives for a long time, but continued to allow the financiers to make their money. And now, when their shenanigans have caught up with them, they come to average people to bail them out. Even though we didn't want to do it (since the majority of voters and average people didn't back these bailouts), the Congress that is beholden to the big corporations gifted our money to them anyway. Don't you just love democracy?