Last March I was in North Carolina having dinner with a friend who runs a large fulfillment business. Bear Stearns had just gone under and we were discussing just how bad the financial crisis could get. “The next big problem will be in derivatives”, he said. I just nodded my head. I had no idea what derivatives were and I did not want to let on about my ignorance.
He was right. At the heart of this week’s storm on Wall Street is this financial tool called a derivative. I have read more about these instruments but I still do not understand what they are. I am not alone. A lot of other astute business people don’t really understand them either.
I was reading in the Financial Times today that the crisis surrounding the big insurance company AIG, which was taken over by the United States government this week, was in large part due to its $60 billion book of derivatives. These financial instruments were based on bad residential mortgages–a house of fragile cards. It appears that when U.S. Treasurey Secretary Hank Paulson saw this “black hole” on AIG’s books he took the only action he could, nationalizing the company. He wagered this was better than letting the company crumble.
Let Warren Buffet’s words on derivatives explain what has happened. In 2003 Mr. Buffet wrote to shareholders of his company, Berskshire Hathaway, that derivatives were “financial weapons of mass destruction” and that, “there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives”. The “time bomb” has now detonated.
AIG apparently thought they understood derivatives. They sold their products and services to investors as if they did. In hindsight they did not. Now the American taxpayer is holding the notes.
Wall Street and the federal government are in uncharted waters with the recent nationalization of AIG, Fannie Mae and Freddie Mac. What is amazing is how everything is staying afloat. Internnationl bankers are buying dollars and selling them to investors to keep the wheels of international finance moving forward.
By the time we get to the end of the week and the dust settles we may well see more changes on the financial landscape. It has been arollercoaster week. The wheels have not come off but they are shaking badly.
