Financial Weapons of Mass Destruction

First, the U.S. Treasury nationalized Fannie Mae and Freddie Mac, which holds over $5 trillion in combined assets and guarantees most of the mortgages in the country -- an implicit acknowledgement by the government that the mortgage market is broken.

We've overthrown regimes and threatened others with military action for nationalizing industries. When other governments do it, it's evidence of their evil, socialist heart. When our government does it, it's necessary.

Next came Lehman Brothers filing the largest bankruptcy in U.S. history. Then, the following day, the Federal Reserve gave an $85 billion "bridge loan" to A.I.G., the largest insurance company on the planet, holding over $1 trillion in assets with 100,000 employees across the globe.

What we are witnessing is what economists Douglas Diamond and Anil Kashyap call "the most remarkable period of government intervention into the financial system since the Great Depression."

At the heart of this credit crunch mess is something called "derivatives." The Initiative for Policy Dialogue at Columbia University offers a good primer:

A derivative is a financial contract whose value is linked to the price of an underlying commodity, asset, rate, index or the occurrence or magnitude of an event. The term derivative refers to how the price of these contracts is derived from the price the underlying item.

It's kinda like playing craps at the casino, where instead of gamblers betting on the dice-roller to crap-out, with derivatives, investors are betting on whether a creditor is going to go under. But instead of buying chips, the lender buys risk-insurance and makes a "swap" with a third-party. If the borrower doesn't pay the loan back, the lender loses the loan but collects the insurance.

To make things even more confusing, there are different kinds of derivatives. Futures. Forwards. Swaps. Options.

Ever since Mesopotamians were writing on clay-tablets, derivatives have played a useful role. But, IPD cautions, "they also pose several dangers to the stability of financial markets and the overall economy" because they can be used "for unproductive purposes such as avoiding taxation, outflanking regulations designed to make financial markets safe and sound, and manipulating accounting rules, credit ratings and financial reports. Derivatives are also used to commit fraud and to manipulate markets."

I guess that's why Warren Buffet (in 2002, mind you), said derivatives were a "financial weapon of mass destruction." He was ridiculed at the time but now even John McCain is suggesting that people like Buffet and others tell us how to regulate the market.

According to Marketwatch, the derivatives market is somewhere around $500 trillion. No, that's not a typo. That's trillion.

To put it in perspective, Marketwatch reminds us that the U.S. gross domestic product (GDP) is about $15 trillion. The GDP of all nations combined is approximately $50 trillion. The total value of all the real estate in the world is estimated at $75 trillion and the total value of all the world's stocks and bonds is about $100 trillion. But there's a $500 trillion market in derivatives!

If you find this all confusing, we're in good company. Because, " ... what we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid August," Bond fund giant Bill Gross told Marketwatch.

Marketwatch goes on to observe: "In short, not only Warren Buffett, but Gross, Bernanke, the Treasury Secretary Henry Paulson and the rest of America's leaders can't 'figure out' the world's $516 trillion derivatives."

That's because we're talking about a "shadow banking system," in which derivatives are not just risk management tools but "a new way of creating money outside the normal central bank liquidity rules. How? Because they're private contracts between two companies or institutions."