Simply Politics & News

[makesumgravy]

http://en.wikipedia.org/wiki/Derivative_(finance)



Large notional value
Derivatives typically have a large notional value. As such, there is the danger that their use could result in losses that the investor would be unable to compensate for. The possibility that this could lead to a chain reaction ensuing in an economic crisis, has been pointed out by famed investor Warren Buffett in Berkshire Hathaway's 2002 annual report.Buffett called them 'financial weapons of mass destruction.

The problem with derivatives is that they control an increasingly larger notional amount of assets and this may lead to distortions in the real capital and equities markets.
The use of derivatives can result in large losses because of the use of leverage, or borrowing. Derivatives allow investors to earn large returns from small movements in the underlying asset's price. However, investors could lose large amounts if the price of the underlying moves against them significantly. There have been several instances of massive losses in derivative markets, such as:

The need to recapitalize insurer American International Group (AIG) with $85 billion of debt provided by the US federal government.[10] An AIG subsidiary had lost more than $18 billion over the preceding three quarters on Credit Default Swaps (CDS) it had written.[11] It was reported that the recapitalization was necessary because further losses were foreseeable over the next few quarters.
The loss of $7.2 Billion by Société Générale in January 2008 through mis-use of futures contracts.
The loss of US$6.4 billion in the failed fund Amaranth Advisors, which was long natural gas in September 2006 when the price plummeted.
The loss of US$4.6 billion in the failed fund Long-Term Capital Management in 1998.
The bankruptcy of Orange County, CA in 1994, the largest municipal bankruptcy in U.S. history. On December 6, 1994, Orange County declared Chapter 9 bankruptcy, from which it emerged in June 1995. The county lost about $1.6 billion through derivatives trading. Orange County was neither bankrupt nor insolvent at the time; however, because of the strategy the county employed it was unable to generate the cash flows needed to maintain services. Orange County is a good example of what happens when derivatives are used incorrectly and positions liquidated in an unplanned manner; had they not liquidated they would not have lost any money as their positions rebounded.[citation needed] Potentially problematic use of interest-rate derivatives by US municipalities has continued in recent years. See, for example:[12]
The Nick Leeson affair in 1994.

Members of President Clinton's Working Group on Financial Markets: Larry Summers, Alan Greenspan, Arthur Levitt, and Robert Rubin, have been criticized for torpedoing an effort to regulate the derivatives' markets, and thereby helping to bring down the financial markets in Fall 2008. President George W. Bush has also been criticized because he was President for 8 years preceding the 2008 meltdown and did nothing to regulate derivative trading. Bush has stated that deregulation was one of the core tenets of his political philosophy.