Tuesday, March 25, 2008

Derivatives and the Shadow Banking System

The Federal Reserve has not only taken action unprecedented since the Great Depression--by lending money directly to major investment banks--but also has put taxpayers on the hook for billions of dollars in questionable trades these same bankers made when the good times were rolling.

Over the last decade, the biggest Wall Street banks and brokerage firms created a dizzying array of innovative products that experts now acknowledge are hard to understand and even harder to value.

One of the fastest-growing and most lucrative businesses on Wall Street in the past decade has been in derivatives. It is a stealth market that relies on trades conducted by phone between Wall Street dealer desks, away from open securities exchanges. How much changes hands or who holds what is ultimately unknown to analysts, investors and regulators.

Used unwisely --when greed and the urge to gamble with borrowed money overtake sensible risk-taking --derivatives can become Wall Street's version of nitroglycerin.

Even the people running Wall Street firms didn't really understand what they were buying and selling, says Byron Wien, a 40-year veteran of the stock market who is now the chief investment strategist of Pequot Capital, a hedge fund.

[Excerpt of an article by Nelson D. Schwartz and Julie Creswell, NY Times News Service]

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