[CRFSaver]

So I hate seeing commentary on derivatives by people who have never used derivatives and really know nothing about them. Derivatives have this big scary connotation when in actuality they have made our financial institutions safer for the most part. Like any instrument they get abused.

First, derivatives are a way of transfering risk and that is what most banks use derivatives for. Banks use swaps (and sometimes options, futures, swaptions, etc) as a way of adjusting their liabilities and assets to match closer to each other. This is what protects the financial system from an 80's style insolvency when you are funding 5% mortgages with 15% deposits.

Second, the numbers they give you are notional amounts. What does that mean? There is never an exchange of principal on these swap transactions. Notional is just what the rate calculations are based off of. To give you an example, if i was to enter into a 100 Million notional swap where I pay a 5 percent fixed rate and receive, Libor flat, I dont pay or receive 100 million dollars. But depending on the terms I will exchange cash flows on a periodic basis based on the rate.

In a case like this my risk comes from the counterparty defaulting and in that case I am not out 100 Million, I am just out any hedging gains (or in some case losses) I would have encured in the transaction. To protect against that the Credit Suport Annex in the ISDA agreement you sign lays out collateralization as the mark to market becomes out of wack. So even if my counterparty defaulted, I hae the bonds (or cash) he has given to me as collateral to make up for that difference.

Are their risks from derivatives? You bet! But most of those are concentrated in the hedge funds that actually use them for betting purposes. For example Long Term Capital Management is a typical example and only because of the huge exposure they had.

So yes JP Morgan had 33.7 Trillion (notional) of derivative holdings. Know what that number doesnt tell you? What percentage of those notional offset each other. JPM is a huge derivatives dealer meaning that most of their derivatives book is a match book and the remaining is hedged out on a daily basis. Is it perfect? No. But I will telly ou right now 33.7 trillion dollars is not at risk. Bank of America is also a huge derivatives dealer. Same comments as above. Citi, Wachovia, HSBC, Ditto.

You can see what a banks derivative exposure is as they are required to disclose the amount they have in their financial statement footnote. They are also required to mark to market (current value) their portfolio on a quarterly basis. If the derivative is used as a hedge any gain or loss goes to comprehensive income. If it is not considered a hedge it goes directly to earnings (sorry I am being pretty vanilla with my explanations). There are tests that have to be passed to be considered a hedge.

Other derivatives will include those options your company gave you (work for a tech company?) They also include mortgage backed and asset backed securities. These derivatives are what have allowed so many housing loans, car loans, home equity loans, etc to be so abundant in the last 15 years. Ask your parents how hard it was to get a house loan 30 years ago. They also allow companies to hedge their exposure to the Euro, Yen, Pound, Ruble, etc.

Banks are restricted in what derivatives they can participate in and I the Federal Reserve does not look kindly on speculative use of derivatives by banks. How do I know all of this? I have participated in the derivatives market since I got out of college and in fact up till about 4 months ago I was the person doing the valuation of my companies derivatives portfolio as well as collateral management and cash flow movement on allt he instruments. I can assure you we are not using them to speculate. Before that I was selling derivative products to many of these very same banks, insurance companies and hedge funds.

The bigger risk from derivatives comes from two groups. First being the GSE's (Fannie Mae and Freddie Mac). These two entities represent over 25% of the "derivatives" market. The second are unregulated entities such as hedge funds. They normally have naked positions that could affectively collapse the swap market. But to compare our financial system to a casino is a terrible comparison (especially for the banks that use the products). Maybe for individuals but for institutions that is a terrible representation.

Our banking system is quite robust and in the best health it has been in a long time if not ever. Most bank collapses now a days comes from fraud (such as Superior Bank I mentioned). Enron committed fraud. How it was marking its derivatives was not legal. Barings bank collapsed due to fraud. Nick Leesen hid his position from the company. LTCM was close to fraud but was more slight of hand then anything. If anythign we need to push for more compliance and risk management, not trying to scare people into thinking they wont be able to get their money out at the local Bank of America. It just wont happen.