Derivatives Madness

While I consider myself a fairly intelligent person, I know my limitations. The world of high finance seems to be a complete mystery to me, especially when you start talking about derivatives and the like. The main thing I know about them is that they are used a lot by hedge funds to manage and/or offset risk, and than you can easily get into a situation where you’ve got two, three or more layers of derivatives offsetting various risks. It can be very profitable, but very dangerous at the same time if something in the financial market goes pear-shaped.

Kevin at Cryptogon has a link to a Bloomberg article describing how derivatives trading is soaring on Wall Street, and the value of derivatives currently being traded is around $370 trillion. That’s an enormous number. To put things in perspective, the value of all real estate in America is valued at around $18 trillion. So, the value of hedges alone (not including actual stock/mutual funds, etc) is over 20 times the value of all the land privately owned in the USA. This is why people keep worrying about a hedge fund imploding. If too many of them go at once, the whole cycle of derivatives starts to unwind, and if it gets out of hand, we will be living in “interesting times,” so to speak.

Considering that one of the new darlings of derivatives trading involves buying and selling bundles of at-risk mortgages, I’m not getting a warm fuzzy feeling about my 401(k) anymore. Between idiocy like this (Warren Buffet has called derivatives “financial weapons of mass destruction”) and the drop in the market that will likely come when the Boomers start withdrawing from their 401(k)’s instead of pushing as much money as they can into them, we Gen-Xer’s and beyond don’t have a very stable financial future in sight. Maybe we’ll get lucky and nothing bad will happen, but given that the market goes through regular cycles of turbulence, I don’t think that’s too likely.