Derivative is a mathematical formula applied to calculate what someone will owe or will received on a bet on the financial market. The world financial derivative market (bets on values and outcomes) is worth about ten times the GDP of the world and is growing madly despite the setback of the "financial crisis". Usually the derivative market edges itself out 50:50. Winners can become loosers can become winners can become loosers in jiffies, thus the derivative is not directly impacting on the economies of the world except when the 50:50 win/loose becomes 49:51. A differential of 2 per cent is equivalent to a loss of twenty per cent of world GDP, or in real terms about 17.5 trillion dollars of hard cash. The derivative market can be "manipulated" by insider trading or insider knowledge but also by manipulating general sentiment of the stock market at particular times. I would say clever derivative betters would have an intuitive knowledge of the chaos theory or be great poker game players, twisting their nose at the right time to influence the others' bets... It is my view that it is not in the interest of the betters to be too greedy as they know they can crash the system beyond repair (when governments can't pay for the damage and revolutions sprout everywhere).

In the last instance what sparked the crisis was an innocuous fiddle of the US housing market via subprime housing, mostly encouraged by the US government to make its budget look good, but further abused by the banking system — a banking system that knew it had to offload these potentially bad loans, quickly. They bundled these bad value loans in a few attractive packages for other banks - especially international institutions — to buy, which they did mostly with ordinary folks superannuation and savings.

The brownstuff hit the fan when the loans that had been "spiced up/spruiked up/sexed up/sharked up" from the beginning by loan agents could not be repaid. In America, the borrower can give the key of the house — on which loan the borrower defaulted — back to the bank and walk away. In many proper countries, the house is sold in a quick bargain sale (if one can find a buyer) and the difference between the sell price and the value of the loan is carried by the original borrower...

Back to the subprime... With borrowers defaulting like flies hit by a pyrethrum cloud, the value of the bundles collapsed and banks that had bought these were taking the plunge. But the people (institutions as well) who had made bets on the derivative market on the value of these loans and other products that were taking the plunge were going to either cash up or pay up. The problem was many institutions did not have enough cash reserve to even pay a tenth of the bet-debt. In derivative market, moneys need to be paid up exactly at due date, otherwise it's war.

The collapse of the entire financial system was in the cards.

This is why a US government had to "give" an institution like AIG about 150 billion dollars of rescue dosh that disappeared more or less overnight as AIG paid up its bad bets. And I use "bad bets" not bad debts. Most banks around the world stung by the collapse of the value of their purchases (bundles of bad loans sold to them possibly as bargains) did not have the cash to pay up their bad bets either as most of them made their navel-gazing predictions on the euphoria of the markets — specially carefully buoyed by Greenspan's sweet words, over the years... So when Bernanke inherited the job of financial guru, in a contracting situation, he had no choice but to speak of hard times ahead, placing further pressure on the collapse.

The world governments had a desperate choice to make: don't rescue the system and face a massive tsunami of economic crashes, revolutions, wars, civil wars, etc. OR rescue the financial market while trying to minimise the damage and the pilfering.

If you are the finance controller (minister) of a government, which would you choose?

So far, world governments have coughed up about 15 trillion US dollars in rescue packages and the world economy (especially the confidence about it) is still on tenderhooks. But the bleeding has been bandaged, no revolution occured and no new wars errupted. There is a greater sense of co-operation around (although there is abuse) amongst governments on this subject.

The first Western Economy to emerge from this financial iffiness was Australia. This for three main reasons, although the country relies heavily on export of dirt (coal, iron ore, etc.) which was being hit: ONE; The country's banking system is "heavily" regulated and its exposure to debt has to be underpinned by some hefty reserves (cash and assets). TWO; The government garanteed all savings in banks — a brave move that paid off. THREE; the government decided to be "generous" and instead of providing "tax break" which usually only profit the rich, the government paid $900 to each and everyone earning less than $150,000 (rich). This money was a uniformed "tax concession" that was as democratic as it could be without breaking the budget beyond repair. Other discreet concession were made to businesses, re tax and purchases (depreciation)... Eventually, all these amounted to a reduction of current deficit by 42 billion dollars and spurred confidence — confidence being the oil in the engine of economies.

But problems still lurk, including pilfering of public money to pay banker's bonuses. Some banks recovered by placing bets (using public moneys) that paid up but one has to realise the kitty's value in derivative is ficticious, yet the pay-ups are in hard cash. Someone looses their pants at some stage and the prognostic is that we might all end up naked, as global warming looms and world population grows beyond sustainability (already been passed). But the gloom-and-doom-sayers' day has not come yet as there is still plenty of public cash for the financial loiterers to cream up...

Regulations not revolutions. Peace.

see also greed on credit and do not sneeze and other bits...