Ticking time bombs

South China Morning Post  |  Sep 27, 2008

By Sin-ming Shaw

Byline: It's little wonder Warren Buffett calls derivatives 'financial weapons of mass destruction', writes Sin-ming Shaw

Is the worst of the Wall Street meltdown over? If not, how bad could it get? Successful investors and speculators typically buy when the whole world panics. Conversely, they sell when everyone else thinks what goes up will go ever higher. Historians tell us the world hasn't seen a financial crisis playing out on Wall Street since the Great Depression in the 1930s. So, is this a once-in-a-lifetime opportunity?

The fallout from Wall Street is not quite settled. Many institutions around the world bought "hi-tech" papers designed by financial engineers trained at the best departments of maths and physics in the US.

What other esoteric papers are still buried deep in corporate balance sheets around the world that we don't know of? I'm not sure.

At Columbia University in New York you can earn a PhD in financial engineering at its School of Applied Sciences that still houses the first prototype atom smashing machine that helped in the building of the first atomic bomb. One of the star professors was the former head of Goldman Sachs' derivatives group. Financial engineering is serious stuff.

Warren Buffett has famously called derivatives "financial weapons of mass destruction". George Soros has expressed similar sentiments.

The varieties of derivatives are limited only by the imagination and ingenuity of the mathematicians. Try to read any advanced financial maths textbook in a bookstore and you would probably think you had mistakenly ended up in the nuclear physics section. Not all derivatives explode like neutron bombs, but most are inherently dangerous because they embody volatile mathematical properties beyond the grasp of most investors.

If two of the world's richest and most successful investors don't understand derivatives, how many in the mortgage business, insurance companies or salespeople at brokerage houses do?

Ask randomly any smartly dressed private wealth-management executives to write down the equation behind a derivatives product and you are likely to get: "Trust me. Our principals have their own money in this."

Many of these principals have brought down Wall Street. Not a few should be put behind bars.

Let's be honest. We are still not sure how big a hole the world is in. Experts tell us the credit-default swaps amount to over US$43 trillion, far bigger than the subprime exposure, while the total derivatives market size is over US$500 trillion. The imbedded leverage is large, and leverage always spells trouble. But no one really has any solid figures. The figure on the table at present is US$43 trillion.

Last year, the entire world's gross domestic product was US$54 trillion. The figure of US$43 trillion is almost four times that of America's GDP, and 13 times China's GDP. Am I getting your attention?

What happens when the toxic virus begins to spread to other kinds of papers? To other countries? Does anyone know? And that's perhaps why the gold market, always a barometer of fear, is acting like a yo-yo that the world hasn't seen in a very long time. This is after the announcement of an unprecedented US$700 billion bailout plan by US Treasury Secretary Henry Paulson, a former chairman of Goldman Sachs, the world's foremost blue-chip provider of derivatives.

What is worrying is that the world has not responded to an increasingly desperate call for help from Washington, albeit couched in less dramatic fashion. To trained ears, Mr Paulson and US Federal Reserve chairman Ben Bernanke are in a bind, flying blind.

The three largest holders of US Treasury bills are China, Russia and Japan. None has joined Mr Paulson to tackle what they consider to be mainly a US problem. Two of these three are geopolitical competitors. The largest economic bloc, the European Union, has stayed away, no doubt fretting about an explosion among its own financial institutions.

A multitrillion-dollar market caving in cannot be just a US problem. Unless the major economies stop thinking along nationalistic lines, Mr Paulson's US$700 billion plan could look like small change before the final curtain is drawn.

If you feel you are buying into a market bottom, first check your name. Is it Soros or Li Ka-shing?

By the way, Mr Li's warning remarks about the markets in May last year were prescient. Very few in the world are as clever, though many delude themselves into believing they are.

Developer Lee Shau-kee may have lost billions making disastrous market calls of late, but he still has plenty more to burn and many overpriced apartments to sell to Hong Kong's middle class. Do you?

Sin-ming Shaw, a former fund manager, has been a visiting fellow at Columbia, Harvard and Princeton

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