Friday, March 28, 2008

Derivatives, the ticking bomb

Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." –Warren Buffet, 2002

A Derivative is an investment that derives its value from another more fundamental investment, as a commitment to buy a bond for a certain sum on a certain date. In recent years, there was a five-fold growth of derivatives, from $100 to $516 trillion. The new derivatives bubble was fueled by five key economic and political trends:

1. Sarbanes-Oxley increased corporate disclosures and government oversight

2. Federal Reserve's cheap money policies created the subprime-housing boom

3. War budgets burdened the U.S. Treasury and future entitlements programs

4. Trade deficits with China and others destroyed the value of the U.S. dollar

5. Oil and commodity rich nations demanding equity payments rather than debt

To grasp how significant this five-fold bubble increase is, let's put that $516 Trillion in the context of some other domestic and international monetary data:

  • U.S. annual gross domestic product is about $15 trillion
  • Current proposed U.S. federal budget is $3 trillion
  • U.S. government's legal debt is $9 trillion
  • World's GDPs for all nations is approximately $50 trillion
  • Total value of the world's real estate is estimated at about $75 trillion
  • Total value of world's stock and bond markets is more than $100 trillion

[By Paul B. Farrel, MarketWatch]

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