A nuclear winter?

Sep 18th 2008
From The Economist print edition

The fallout from the bankruptcy of Lehman Brothers

WHEN Warren Buffett said that derivatives were “financial weapons of mass destruction”, this was just the kind of crisis the investment seer had in mind. Part of the reason investors are so nervous about the health of financial companies is that they do not know how exposed they are to the derivatives market. It is doubly troubling that the collapse of Lehman Brothers and the near-collapse of American International Group (AIG) came before such useful reforms as a central clearing house for derivatives were in place.
A bankruptcy the size of Lehman’s has three potential impacts on the $62 trillion credit-default swaps (CDS) market, where investors buy insurance against corporate default. All of them would have been multiplied many times had AIG failed too. The insurer has $441 billion in exposure to credit derivatives. A lot of this was provided to banks, which would have taken a hit to their capital had AIG failed. Small wonder the Federal Reserve had to intervene.

The first impact concerns contracts on the debt of Lehman itself. As a “credit event”, the bankruptcy will trigger settlement of contracts, under rules drawn up by the International Swaps and Derivatives Association (ISDA). Those who sold insurance against Lehman going bust will lose a lot. But Lehman had looked risky for some time, so investors should have had the chance to limit their exposure.
The second effect relates to deals where Lehman was a counterparty, ie, a buyer or seller of a swaps contract. For example, an investor or bank may have bought a swap as insurance against an AIG default, with Lehman on the other side of the deal. That protection could conceivably be worthless if Lehman fails to pay up. Until the Friday before its bankruptcy, Lehman would have posted collateral, which the counterparty can claim. After that day, the buyer will have been exposed to price movements before it could unwind the contract.
The third effect will be on the collateralised-debt obligation (CDO) market, which caused so many problems last year. So-called synthetic CDOs comprise a bunch of credit-default swaps; a Lehman default may cause big losses for holders of the riskier tranches.
Insiders say the biggest exposure may be in the interest-rate swaps market, which is many times larger than those for credit derivatives. In a typical interest-rate swap, one party agrees to exchange a fixed-rate obligation with another that has a floating, or variable, rate exposure. Depending on whether floating rates rise or fall, one will end up owing money to the other. Again, those banks that dealt with Lehman should have been fine until Friday, when the bank was still posting collateral. But not afterwards.
Although there are ISDA rules to cover such events, the sheer size of Lehman in the market (its gross derivatives positions will be hundreds of billions of dollars) makes this default a severe test. There will inevitably be legal disputes as well. The good news is that the swaps markets did not utterly seize up after it went bust on September 15th. But the reaction may be a delayed one. Mr Buffett’s WMD could leave behind a cloud of toxicity.


Bud Hansen wrote:
September 21, 2008 13:36
I'm disappointed that no one seems to be covering the role of the ratings agencies (like Standard & Poors, etc.), and what a pathetic joke they are.
Recommend (2)Report Abuse
Dirtt wrote:
September 21, 2008 12:43
Susan. Those who are responsible should be going to PRISON. We are well past them losing their jobs.

"Blame capitalism!!!!" is just the kind of distortions that mask reality. Let's put blame squarely on the pin's head.

It's CORRUPTION not capitalism that perpetrated this mess. And WHY lobbyists were installed in upper management at Fannie and Freddie is the proverbial 'thread' to pull. And WHY our GSE's were engaged in election manipulation is another 'thread' to pull.

The problem for we Americans is that both the DNC and the RNC have blood on their hands. And together they are the ones who are trying to "fix" the problem. This falls under the "you better laugh or else you'll cry" category.

They tried SO hard to kick this can past the election. Well. Guess that didn't work.

Forget comparisons to 1930. You have to go back to before our country was founded in 1764 with the grass roots movement Taxation Without Representation. And it didn't take an election to implement real change. It took a revolution.

And just the mere fact that a wet-behind-the-ears lawyer from the sinister hotbed of Chicago politics (that you Euros love so much) is leading the "change" movement makes me vomit.

Fellow Americans...keep the powder dry.
Recommend (3)Report Abuse
susan425 wrote:
September 21, 2008 12:18
Why is it when americans lost their jobs and no one is there to bail them out but when
corporation fails they have to bail it out.
What kind of system is this? What a hell!
It sounds like Argentina, or Turkey those countries we
heard about. Those who are responsible should be fired!
RecommendReport Abuse
Ghalib wrote:
September 21, 2008 12:04
When I was doing my MBA at a major Midwestern university, I was surprised to find how few people really understood the numbers behind derivatives and options. Most of the to-be practitioners were liberal arts graduates, and at the investment houses these were supplemented by a larger bunch of theroreticians. The result is not surprising. It's like musical chairs, without the chairs.
Recommend (5)Report Abuse
mxr wrote:
September 21, 2008 08:19
what we need is a special kind of Xray device that can look into finance packages to realy see whats inside!
Recommend (1)Report Abuse
digger76 wrote:
September 21, 2008 03:05
Generally the numbers on the notionals of these derivatives sound staggering.

However, most of these contracts are used as hedging contracts. The value at risk on a particular risk is significantly lower.

As example, Lehman brothers may have sold 100 contacts and bought 99 contacts. Their net position would only be 1. Whilst the counterpaties of these contacts may vary, the net of the whole position is still relatively small.

If a counterparty was long 5 contacts against Lehman then on bankruptcy the mtm value of the contracts is realised (to the nearest close of business to the filing for bankruptcy). The contact should not lose significant value. The main issue is that the risk the contact gave before bankrupcy will disappear and it is this risk that the a counterparty now has to hedge. However, as long as Lehman managed their market risk professionally, then most counterparties against other couterparties will be able to net off their risks in new contracts in the markets. This is not done without volitility and there will be some losers and some winners. The point is that this is not the main cause of credit contagion.

The main problem is caused much earlier by derivatives. Most derivatives are over-the-counter done in one-off contracts the banks write for their counterparties. This makes the contract opaque and the markets become illiquid quickly at the sign of trouble. It also makes the risk taking game, a game of poker, where the egos of senior managers becomes the driver of the business. "We're the best player at credit defaults swaps!". This type of mentality leads to banks taking risk where they shouldn't.

Most of the current issues could have been avoided if the regulators enforced exchanges for standard contracts sooner.
Recommend (7)Report Abuse
bampbs wrote:
September 20, 2008 23:48
It seems that the ongoing negligence of regulators was not enough for America's leaders. Active encouragement of financial madness somehow seemed necessary. In 2000, led by then Sen Phil Gramm, regulation of the CDS market was PROHIBITED. I am in awe !
Recommend (5)Report Abuse
the.melusine wrote:
September 20, 2008 19:11
You say "tomahto" I say "toemato"
You say "pohtahto" I say "poetato"
Tomato, tomate, potato, potate,
Let's call the whole thing off!

Further irrationality and delusionary behaviour on the part of the financial services sector does not bode well for the global economic picture. We have invested far too many resources in Nothing already. Why not put real people back to work?
Recommend (1)Report Abuse
decentexplorer wrote:
September 20, 2008 14:53
I really appreciate and acknowledge the satement of Warren Buffet as derivatives "financial weapons of mass destruction" when a siad a few years earlier when no one was ready to accept this.Even the biggest economists and invement bankers were justifying derivaties by saying risk management advantages and growing market of derivatives.
Recommend (5)Report Abuse
Jaap den Haan wrote:
September 20, 2008 14:42
The value of derivatives is so high it outweighs that of all stock markets combined. No bank can stand for the amount of money involved, which is imaginary as would show in case of a stock market crash, bringing fluctuations in the value of the stocks underlying these derivatives. A loss of just a few per cent would wipe out every bank.
Recommend (4)Report Abuse

external image businessart;pos=v5_left160x600;sect=business;sz=160x601;tile=3;ord=70520362?. You have reached 5000 characters. Report item as: (required) XObscenity/vulgarityHate speechPersonal attackAdvertising/SpamCopyright/PlagiarismOther Comment: (optional)
Jaap den Haan wrote:
September 20, 2008 14:42
The value of derivatives is so high it outweighs that of all stock markets combined. No bank can stand for the amount of money involved, which is imaginary as would show in case of a stock market crash, bringing fluctuations in the value of the stocks underlying these derivatives. A loss of just a few per cent would wipe out every bank.
Recommend (4)Report Abuse
muniguy wrote:
September 20, 2008 12:41
If Lehman had posted collateral last Friday 9/14, the counterparty is protected up to the market movement through Friday, and if he wants to still hedge the risk, he can liquidate the collateral and look for some other (hopefully stronger) counterparty to take over Lehman's role at Monday's opening. Once that collateral position is liquidated, Lehman's creditors in bankruptcy are exposed to any future movements in Lehman's matched-book position (ie the psitive asset value equal and opposite to the liquidated position) - and it is unlikely that Lehman can find anyone to write them a hedge. Many contracts will not allow Lehman to transfer the position at current value to a third party, so Lehman's book may be frozen while counterparties play the market. That exposure needs to be added to any estimate of the net exposure from Lehman's $600+ billion of debt.
Recommend (2)Report Abuse
Dave W. wrote:
September 20, 2008 11:16
i agree with you.
is the buying of assets from banks going to be like an open market operation by the Fed (but the Fed buys cdos instead of t-bills)? or will the Treasury buy the cdos using taxes and bond issues? the first inflates the money supply. the second increases ir. and the Fed said their target is 2% ir. so, i guess the plan is to inflate the money supply (ie. inflation).
Recommend (2)Report Abuse
lydafrancesca wrote:
September 20, 2008 09:44
I only have a question. Don't the rescue measures/plans being adopted/considered, which are getting more mind-bogglingly vast by the hour, amount to replacing one form of liquidity with another? Won't the huge amounts of cash being /about to be injected into the system unleash inflation? Why the other form of liquidity (leveraged derivatives) did not produce the same effect? Or did it, and we just didn't notice?
Recommend (7)Report Abuse
mrlagom wrote:
September 20, 2008 08:11
An illiquid asset is just another name for worthless. Price them at zero and you cant go wrong!
Recommend (5)Report Abuse
mrlagom wrote:
September 20, 2008 08:01
The idea of insuring oneself against doing bad business by buying credit default swaps may well turn out to be nothing but a pipedream. Its like saying there is not a sucker born every day!

Anyone interested in a super senior tranche synthetic CDO of CDO? Seems to me there are plenty of suckers on Wall Street today.
Recommend (1)Report Abuse
Dave W. wrote:
September 20, 2008 01:37
CDOs are not fungible (i think?) so how could you have a useful central clearing house? and without a cch, the cdos cannot be mtm, and is not that the whole problem? these are illiquid assets (especially now) that no one knows how to price. if i'm wrong, tell me. i will stop commenting. just trying to learn here.
Recommend (11)Report Abuse
justmyopinion wrote:
September 19, 2008 18:51
they should have let them collapse i think. Its not really fair now, what happens to all the small companies that nobody hears about who also owned this stuff? do they plan on bailing them out as well? Another article today suggests maybe they are because Paulson is talking about 100's of billions more now and they are already in for around 800 billion.

Hopefully all those companies will be forced to be far more transparent, in regards to what they are buying in the future, by their investors.

Either way, i dont think this is the end of this. America has got to stop printing money. We also need to stop pricing oil off the US dollar and instead make a new index for it.
Recommend (4)Report Abuse
EBittencourt wrote:
September 19, 2008 18:25
Common people paid the price in 1929 with 25% unemployement in the USA. They will pay the price again, somehow. They will pay the price of greed, money lending speculation irresponsability, folly. The will pay for the invisible hand of economic madness. Reagan is dead but Thatcher is alive...
Recommend (4)Report Abuse
lfhill wrote:
September 19, 2008 18:12
Sorry - ther is a typo in the last comment. It should read " the most issues CDO was the synthetic CDO."
RecommendReport Abuse

lfhill wrote:
September 19, 2008 18:10
For the last 2 to 21/2-years the most issued CDS was the synthetic CDO. One of the ways of creating this was using credit default swaps as assets to support the tranches the reporter describes. This instrument is mis-understood by the media. The synthetic CDO's do not buy the credit default swaps they issue them to someone who wants to buy protection.

These CDS receive regular premium payments that are used to pay the interest to the CDO's note holders.

Now the real question is how many of these are out there. How many CDS's were created on the Fanny and Fredie debt? With the US government as essentially the owner, who would spend a nickel (Shilling) more for credit protection. Who holds all these soon to be non-performing synthetic CDO's? How much leverage are they still held under?
Recommend (9)Report Abuse
mccuerc wrote:
September 19, 2008 15:04
I do not believe that the economist is being obscure; the subject of the article is obscure. You will not find "CDS" or "CDO" in the Economics A-Z section. You will find derivatives though. What seems to have happened with CDS/CDO/"whatever I can dream up" derivatives is that they were traded as if they were physical things. Derivatives are contracts and all contracts have inherent risks attached. That's why there are so many lawyers. Lawyers try to wish away by writing away risk or they clean up the toxic messes made by the breach of a contract. Deriving a derivative from a derivative so that you can launch yet another derivative may make sense to a theorist. More importantly it may make a lot of money for the people who sell the product, But it can not be explained in simple terms. Worse it makes little sense in human terms. Someone always cheats. Someone always oversells. No one, not even God him/herself, is fully informed enough to accurately price the derived derivative from a derivative as it exists in the fog of the real world. But since these were quantized they had to be safe as apples. Then a bursting bubble occurred. No one understands the derivative to the 2nd or 3rd power. Unable to be valued (almost) they are now (almost) worthless.

The financial system has geared itself up by an unknowable, but very large, number by relying on the mortgage assets and other assets. We do not know what other asset classes have gone into the world of quantized derivatives. We still don't know what other class of asset is being quant derived to the third power today and will sold as the new miracle drug a few days from now.

It will be an interesting ride.
Recommend (10)Report Abuse
AlecSimpson wrote:
September 19, 2008 14:32
It is ironic that Mr. Buffet was critical of derivatives since one of his famous and much touted investments was Moodys which, along with S&P, were more responsible than any other entity or person for the losses in the past year.
Recommend (5)Report Abuse
September 19, 2008 11:51
Is it too much to ask that, instead of discursively mimicking the shadowy derivatives market, The Economist try to present a clear picture of what is happening? What does it mean to say that AIG has a 441 billion USD "exposure" in credit derivatives? Are you referring to insurance contracts that would have been unilaterally voided had AIG gone bankrupt? Are you referring to money--if the detritus that seems to be to be at the root of the present predicament can be called that-- AIG owes or is owed? Can you make an effort not to hide behind vaporous jargon?
Recommend (25)Report Abuse
FineFellow wrote:
September 19, 2008 11:07
"Do you have in mind that they're complex? Or that they're traded?"

Complexity and design. The issue isn't that the derivatives market has failed in this situation at this point - it is that derivatives by their nature are another unquantified risk in this environment. As complex synthetic instruments they can represent any combination of risks or outcomes, and depending on the unpredictable nature of the market this can lead to large losses in the market by the players playing derivatives.

Options and futures are risky instruments by nature as no one can predict the future with any great certainty - but complex swaps and derivatives exacerbate that risk (with the offer of reward). In and of themselves as a portion of the market they are useful, but like anything else it is when the players are betting to heavy in derivatives in volatile markets you can see large losses. As an example of the risk, we are seeing airlines taking losses in hedging positions against oil futures as they were expecting a $130-150 barrel band in this time frame. That same strategy could be part of a derivative synthetic that some player has bet heavily on looking for increased upside in a volatile market.
Recommend (4)Report Abuse
Will M wrote:
September 19, 2008 08:34
i'm amused that commentators will say things like "derivatives are Vegas for Bankers" with nothing to actually back that statement up. Do you have in mind that they're complex? Or that they're traded?

It would be worth bearing in mind that the entire credit crunch was kicked off by mis-valued sub-prime debt, and had nothing to do with derivatives. At no point to date has any part of the derivatives market failed to function, no have derivatives played any significant part in the failures we have seen of financial firms (which instead have primarily been due to mis-pricings of underlying assets).
Recommend (8)Report Abuse
Stanhoe wrote:
September 19, 2008 08:21
A good article, but I doubt that many people would buy credit default protection from an investment bank.
More importantly the interest rate swap market actually provides further strength and support to the capital markets.
This is because, almost invariably, it is the stronger (higher rated) counterparty which is paying the floating rate side; and the weaker pays the fixed.
So when rates are high, it is the stronger party which has to carry the burden.
Recommend (1)Report Abuse
fredschumacher wrote:
September 19, 2008 07:31
The debt-asset ratios of these investment firms were so fantastically high that the only way the system could continue working was if revenue came in on time so that it could be disbursed on time.

Timely flow of revenue was absolutely crucial to the functioning of the system. When revenue stopped flowing in in a a timely fashion at the bottom of the system, it propagated through the system like a wave, causing the top of the system to crash.

Why did revenue not flow in on time? Because of speculation driven run-ups in the cost of housing; poor evaluation of borrowers’ true ability to pay; and the continuing rate of growth of income inequality leaving the middle class cash-flow short. By aggrandizing more wealth to themselves in the short term, high income people ensured the collapse of the system that kept them wealthy.

As any millwright knows, when the timing system on a machine fails, the whole system comes to a crashing halt.
Recommend (13)Report Abuse
RadicalClaudio wrote:
September 19, 2008 05:01

"Derivatives is essentially a zero sum game. Having a central clearing house would not make the risk go away. It would only shift the risk from one counter-party to the clearing house"

You may be right ... but a clearing house (as any other centralized control system) would provide something that today simply does not exist, i.e. complete information on each participant net positions. a very powerful tool (think of the size and geography of the relevant market) which should be set up and operated by very wise and accountable people ... who are your candidates? ISDA eggheads? the Feds? the SEC? the ECB? the IMF? a new UN-sponsored international financial body? ... no wonder it never materialized!

p.s. please have a look at July 5th cover for more (and less western-biased) possibilities
Recommend (6)Report Abuse
vasant wrote:
September 19, 2008 01:08
Someone commented that Derivates are the Las Vegas equivalent for Bankers. That is right, with the added facility of legally rigging all the slot machines.
Recommend (11)Report Abuse

Market Matador wrote:
September 18, 2008 23:41
Warren Buffet seems to be a man of wisdom and vision in a world led by intellectual and moral pygmies. I personally have lost all faith in Gordon Brown. It seems he did not know what he was doing all these years first as Chancellor now as Prime Minister.

These nuclear bombs are all over the world’s financial markets from Japan to Iceland to Poland etc. They are ticking time bombs and only one may have gone off so far with hundreds more to explode over time. The financial landscape of the world will be completely altered by the time this slowly-unfolding global catastrophe has run its course. By the end (many years from now), the Global Economy will be unrecognisable from how it looks today. ‘Change’ is what people say they want and more change than they could begin to comprehend is what they are going to get.

Recommend (19)Report Abuse
September 18, 2008 23:04
This crazy in the Financial Market with certain was previous of the managers and another peoples that haven't been concerning with them decisious. I believe if the american goverment does a certain something, we'll see the goods results in the future.
To me, the derivatives market should follow the rules of the SEC - To us can live in the society safe !
Recommend (1)Report Abuse
Sandeep Guhagarkar wrote:
September 18, 2008 22:30
The article say 'It is doubly troubling that the collapse of Lehman Brothers and the near-collapse of American International Group (AIG) came before such useful reforms as a central clearing house for derivatives were in place.'

Derivatives is essentially a zero sum game. Having a central clearing house would not make the risk go away. It would only shift the risk from one counter-party to the clearing house.

Capital adequacy norms for banks currently require no capital to be held for derivative contracts which are exchange (i.e. central clearing house) traded. Given the scale of derivatives trading, even the central clearing houses would have had a tough time in settling defaulted transactions, no matter how much collateral had been posted prior to Lehman and AIG having 'credit events'.

And, talking of 'credit events', one needs to understand to what extent, if any, would putting AIG into a Conservatorship be considered a 'credit event' in the ISDA contracts.
Recommend (3)Report Abuse
srvbeach21 wrote:
September 18, 2008 21:03
What exactly is the collateral that a counterparty could use when issuing a CDS? I didn't fully get why in Lehman's case the collateral was safe(r?) before Friday but not so afterwards.
Recommend (15)Report Abuse
bampbs wrote:
September 18, 2008 19:27
It seems quite beyond belief that such huge markets could exist without a clearinghouse. Once again, it is hard to see how responsible regulators could allow this to happen. In truth, the absurd gigantism of the derivatives markets in relation to their actual underlying commodities or securities is of no conceivable economic value. What we need are hedgers, and speculators willing to provide the hedge for a fee. The rest ought to be eliminated. There are plenty of casinos, racetracks and bookies; no need to threaten the real economy with your gambling.
Recommend (27)Report Abuse
FineFellow wrote:
September 18, 2008 18:01
Derivatives - Vegas for bankers...
Recommend (4)Report Abuse
P. Slayvins wrote:
September 18, 2008 17:01
The wild swings in the market are a bad sign. We have yet to see the actual results of this week's chaos but I am afraid that people will start acting according to their judgement of the situation prematurely which could affect the markets even more negatively. I'm glad that many institutions and organizations are taking steps against those who are short selling companies that are in trouble.
Recommend (2)Report Abuse
in light of nihilism wrote:
September 18, 2008 16:14
They'll stop shopping when they're credit card doesn't work.

I've stopped laughin'..
Recommend (4)Report Abuse
Fabio C wrote:
September 18, 2008 14:50
Path, one thing that I realy don't understand is that after all we have seen in the media, people are still out there shopping as if their was no tomorrow and I haven't seen any clear sign that house prices are crashing as they should. At least not here in the UK. I'm very disapointed in that respect.
Recommend (3)Report Abuse
pathtoforest wrote:
September 18, 2008 13:24
This financial crisis is very rare, but a lot of financial expert should have learned what Warren Buffet had said ealier. He likened the derivatives to nuclear bombs in financail area because the derivatives have the potential to cause much damages to market when the financial bubbles pop out. In my view it is too late to stop the explosion of financial weapons of mass destruction around world. The problem is that there are so many financail weapons of mass destruction, simply ticking to be blasted.
Recommend (22)Report Abuse

external image businessart;pos=art728x90;sect=business;sz=468x60;tile=6;ord=70520362?