2008/10/14

Traditionally, commodities futures were used by companies like Kellogg's Cereal as a form of “insurance” to help them manage the risk of major price fluctuations in the grains they use to make breakfast cereal. By purchasing a futures contract to guarantee the future delivery price of the grains they needed to make cereal for the consumer marketplace, they could be certain that they could maintain relative price stability at the retail level (benefiting consumers) and still operate with the profit they would need to stay in business and serve the market.

In the early 1980's, derivatives began to appear that were of a strictly financial nature. The reasoning behind their regulatory approval was that producers of financial “products” and services also needed to have similar types of “insurance” to protect them against future risks and uncertainties - just like the non-financial operators had. The main selling point was, of course, that these financial futures contracts would help financial companies to stabilize their operations and provide powerful tools to manage their risks from fluctuating markets and future uncertainties, as well. Unfortunately, these sophisticated tools that were originally intended to help firms manage risk grew into potent vehicles for leveraged speculation… and this is where the systemic problems we're facing today originated.

During the 1990's, more and more firms (financial and non-financial alike) began realizing they could make tremendous profits trading in financial vehicles. Many firms made more money trading than they did in their core manufacturing businesses. Word spread and firms of all kinds across all industries began bringing in experienced traders and setting them up with computerized trading operations or they employed the services of outside money managers and hedge funds to do the job for them. Either way, with the seemingly endless expansion of financial opportunity brought about by the rapidly globalizing markets, companies feared they would look foolish to shareholders if they weren't participating in this leveraged gamesmanship. And why not? Everyone else seemed to be doing it, so they should too.

The first major threat to the global “casino” came in 1998 with the collapse of Long Term Capital Management (LTCM). LTCM was a highly-leveraged, computer-based trading firm whose ingenious program authors had not fully considered the possibility that a “statistically unlikely” series of events could occur in a short span of time and wipe them out. A series of such events (East Asian collapse, Russian financial crisis, etc.) did occur, bringing down LTCM and the failure of LTCM was, singlehandedly, large enough to destabilize the entire global financial system. At that time, governments banded together to stabilize the financial system and in doing so created the world's first example of a firm being “too big to fail”.

Once the “too big to fail” precedent had been firmly established, the structured finance and derivatives industry was off and running, emboldened by the fact that they'd proven governments could be relied upon for bailouts of massive, yet risky ventures pursued by financial firms in the future. The bigger the venture, the bigger the risk, the more likely it would be insulated from ultimate failure by government bailout or intervention with taxpayer money. This is what's commonly known as MORAL HAZARD in industry parlance.

This new philosophy was a speculator's dream and it rocketed around the globe at the speed of light gathering eager new participants and “hot” capital wherever it went. According to my understanding, here's what it did to the global financial structure - mainly between 1996 and 2007 - leading us to the “edge of the abyss” that we are peering into today. David Haas in The Crushing Potential of Financial Derivatives

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