Derivatives; The Monster That Ate The Future

"We are also frightened by the massive speculation in the financial markets with stock buybacks, mergers, leveraged buyouts, and trillions of dollars in derivatives floating around some of which we do not even know who the ultimate guarantor is. We are hoping but do not know that the ultimate guarantor of these derivatives is not Madame Merriweather's Mud Hut in Malaysia."

Ya, derivatives, somebody please explain these to me! The more I try to understand them, the less I understand. As near as I can come to it, they start with a private equity group, (Joe money bags and some of his cronies). They buy funds cobbled together with mortgage dept which was previously packaged and sold in a fund by the banks who first sold the loans. They then use the future value of these mortgages to obtain loans to fund corporate buyouts.

Now I admit this is the most basic of explanations.

The companies that are bought up are most probably further borrowed against or cut up and liquidated for assets which can be placed in the derivatives, further pumping their book values. Others are simply taken private, why I don't know.

As near as I can tell I am close to how they function. I welcome any schooling offered on the subject however.

Now the major problem I detect is the chain of financial liability. If Joe six-pack defaults on his loan or negotiates with the lender to short the mortgage, there goes the book value on that loan and its future interest profits. This presents a problem in the daisy-chain of borrowing these derivative funds engage in.

Another looming problem I detect is the economy. These funds have fueled an orgy of buyouts recently of major companies. Where will the profits come from to either make holding the newly acquired company worthwhile or make it attractive to another buyer? The short answer is, it doesn't. This looks like a ponzi scheme. If an economic downturn looks likely the private equity groups take out what equals an equity loan on the book values and then they disappear into the either. They are private groups, outside of SEC scrutiny. (You can see where I'm going with this).

With an estimated $29 trillion leveragedged in these funds I think this may be the largest threat to the world economy in modern history!

Here is what the National Bank of Australia has to say about the international phenomena of derivatives. http://www.news.com.au/heraldsun/story/0,21985,20832000-664,00.html#

Vern