Published: September 25, 2008 05:53 pm            

Larry Penkava – Sept. 24, 2008

Complicated or not, crisis hits where it hurts



Trying to understand the current U.S. financial crisis is akin to comprehending E=mc2.

Come to think of it, Albert Einstein, who came up with the relativity theory symbolized by E=mc2, had to have help with his income taxes.

So that’s the dilemma I find myself in. Not that I’m comparing myself to Einstein. He played the violin, after all.

What I’m saying is the monetary system is so confusing that even Einstein had trouble dealing with it.

So when I hear news anchors talk about the troubles of Fannie Mae and Freddie Mac, Lehman Brothers and AIG, I wonder what’s behind it all.

I listen to analysts say that the housing bubble has burst because of over-expansion of subprime loans. Investment banks are tottering from derivatives gone bad.

What is a subprime loan? A definition I found says it’s a loan offered to people who normally don’t qualify for prime rate loans. They’re at risk for defaulting.

So why would banks offer the loans in the first place? My guess is the banks wanted to maximize their financial holdings. But what do I know?

What’s even more puzzling is the term “derivative.” I’ve searched and searched for a definition appropriate for a financial dummy and finally found something almost within my grasp.

It’s like you grow corn, but instead of selling it after it’s harvested, you sell it to somebody on contract beforehand with the intention to deliver the goods when the crop is in. The value of the contract is “derived” from the value of the future corn.

But something happens – your corn fails and the buyer loses his money. Or, you miss out on a better deal because you’ve already contracted with the first dude.

So the buyer “hedges” his bets by adding on Farmer Jones’s wheat crop. In effect, the buyer is hedging your corn against Farmer Jones’s wheat.

At least I think that’s how it works. What I have learned is that on the exchange markets derivatives get much more complicated with layer upon layer of transactions.

They’re so complicated that the guys controlling them keep them secret, saying that’s what makes the transactions work.

You’re probably thinking I’ve gone into the tongue-in-cheek phase of my column. This is all so contrived that it can’t possibly be true – standard fare for Now and Then.

However, the words of Warren Buffet – one of the richest men in America – gives me cause for concern about derivatives: “We view them as time bombs both for the parties that deal in them and the economic system ... In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

Weapons of mass destruction? That can’t be good.

A friend of mine who works in the finance office for a school system said her advanced accounting professor in graduate school would tell the class that derivatives “are not intuitively appealing.”

I may not understand derivatives but I don’t like them.



Larry Penkava, who has written Now and Then since 1994, doesn’t know a hedge from a shelter.

        

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