Derivatives are the new “Greed” on Wall St.

The word “greed” has been tossed around this week like an ingot of hot ore. As I suggested in a recent post, the term can be applied equally to members of Wall Street and Main Street.  There’s plenty to go around.

One striking example to me is the stupendous growth of credit default swaps. (Visit Investorpedia for a primer on these guaranty instruments.) In short, these devices are like insurance contracts which provide the buyer with protection for the credit risk, which is assumed by the seller. Why do I suspect there is greed underlying this market?

I’ve got your greed right here–>By all comparisons, this is a new market that emerged in the late 1990’s, and was only $900 billion in 2001. Today, it is at least $45.5 Trillion, which is about a 75%/year compound growth rate over 8 years. For comparison purposes, that’s about twice the size of the entire U.S. Stock Market. Other estimates put the total debt supported by credit default swaps at over $60 Trillion. In either case, that’s sustained and remarkable growth, and where there’s remarkable growth in a new security, and it represents the foundation underlying the confounding portfolio at AIG , which over that same period has become the largest insurance company in the world, well, it really doesn’t pass the smell test, does it?

Mostly, I think the derivative contracts underlying these instruments have become so complex that no one really understands them, and if you understand them, good luck in assessing the risks they pose. You can read here the excerpt from Warren Buffett’s Chairman’s Letter in the 2002 Annual Report of Berkshire Hathaway to get his take on these “time bombs”.

more later . . . .

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