Dear Client,
The stock market hit a 5 year low yesterday.
In the next few weeks, you will be hearing a lot about derivatives.
A derivative is a contract or a security that gets it's value from that of an underlying asset. (such as another security.) It can also get it's value from an interest rate or currency exchange, or from an index of asset values such as a stock index.
An underlying asset could be a residential mortgage, a commercial mortgage, a bond, a loan paper, equity such as stock in a company, or even commodities. You may recall in earlier newsletters we blamed the "hedge funds" for the major part of this economic crisis, as well as Fannie Mae and Freddie Mac.
The main types of derivatives are "forwards", "futures", "stock options", or "swaps". A derivative can even be based on the weather conditions.
Derivatives are pretty complex financial instruments, devised as a form of insurance to transfer risk among parties based on their willingness to assume additional risk, OR HEDGE AGAINST IT.
For our discussion here, we will just say that a derivative as concerns the current financial crisis, and the drastic 5 year drop in the stock market, is a device used to leverage debt or future value of an asset backing a debt.
This asset backing this debt as well as the debt are not valued correctly on the balance sheet. They only show up at market value. Market value is based on all current bids and offers placed on that contract or debt instrument at one time. In other words, what is traded ---there is not exchange rate to collate to figure the exact price. (If shown on the balance sheet,(the assets and liabilities of a company or bank) they are recorded at a nominal value. So.....there are no checks and balances---or stringent standards to adhere to. Banks normally do credit reports on both parties, but in private agreements between companies, such as commerical paper buys, there is normally not due deligence.
Warren Buffett called them 'financial weapons of destruction' in Bershire Hathaway Annual Report 2000. Because they lead to distortions in the real capital and equity.
This is scarey, because derivatives are used as leverage for central debt in the economy, making it even more difficult to service this debt. (The real debt amount is distorted).
When AIG was bailed out by our government last month at 85 million dollars, AIG had a subsidiary with 18 billion dollars in a derivative. That was not the end of the help AIG needs.
Another example of a derivative problem would be ORANGE COUNTY, CALIFORNIA'S 1994 BANKRUPTCY. Orange County had incorrectly used derivative trading and lost 1.6 billion dollars of the county money and did not have cash flow to operate the county.
Folks, what I am saying is that now the financial crisis has entered the commercial sector more heavily even than the mortgage loan industry. Please watch spending as closely as possible. Have family meetings as a means to share this responsibility. Pull together and tighten your belts.
I know this was boring to some of you but there is no other way to explan what you will be hearing in the next few days and weeks.
Call us if you need our help.
Looking forward to seeing each of you during tax season.
Lynda H. Startzman
