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06/02/08 The Lesson Derived From Derivatives

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“When I mentioned weapons of mass destruction, I was merely referring to the out-of-control trading in derivatives. It doesn't make sense that hundreds of jobs are being eliminated, that entire branches of industry in the real economy are going under because of such financial gambles, even though they are in fact completely healthy. Besides, these types of constructs are so complicated that hardly anyone understands them anymore… That's the problem. You can no longer control or regulate this sort of thing. It's taken on a life of its own. You can't put the genie back into the bottle.”

Warren Buffet – Der Speigel Magazine, 5/28/08

The essential concept of derivatives is that a financial instrument can be created that is dependent on the underlying value of something else.  A derivative can be anything from the collection of mortgages to the value of a stock index.  We can pile derivatives on top of derivatives and create scenarios through hedging where money can be made through movements in the market that seem to have nothing to do with any tangible asset.  It’s tantamount to magic.  The genie is indeed out of the bottle although it is essentially invisible.  So few of us understand what is going on (and increasingly it would seem that no one knows what is going on) that we can only experience the impact of derivatives like an earthquake or a tsunami.  Then the effects are clear, but the cause seems inconceivable. 

It occurs to me that perhaps derivatives are a metaphor for much of what goes on in our individual lives.  We have conditioned ourselves derive our worth from some underlying or external value.  We buy things or services in an attempt to maintain that sense of self-worth.  We understand this intellectually; many books have been written on the subject of how we are taught to consume.  Walking down the personal care aisle in any drug store and perusing the multitude of toothpastes and deodorants we can work ourselves in to a frenzy of which offense we should choose to mitigate (no perspiration or nice smelling perspiration, white teeth or minty breath and on and on).  Many books have also been written about the hopeless nature of this kind of activity.  Self-worth it would seem cannot be bought.  Those external derived measures of who we are and what constitutes value while seductive are always unsatisfying.

The economic difficulties that we are experiencing on a personal level have similarities to what have been called recessions since the end of World War II.  The cycles have been composed of a period of suffering followed by a resurgence of economic activity, the expansion of consumption and, more often than not, a war of some sort.  Many of us would like to think that this cycle will be the same.  Mr. Buffet is suggesting that perhaps it is not and will not be the same.  It is one thing to deal with these shenanigans on national basis or even within the larger context of the industrialized western countries, but globalization has extended the impact of the derivatives genie around the world.

At this writing, Standard and Poor’s has downgraded the credit rating of the major banking institutions in the US, the UK bank, Bradford and Bingley is on the verge of collapse and 24 airlines have ceased operations in the past six months.  The devastation from the unraveling of the derivatives markets continues.  We all should buckle up as it appears more and more likely that this will not end soon or well.  In the meantime, we might begin to think about defining our own self-worth from the inside out rather than the outside in.

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