I watched this interesting documentary last night about what caused the financial crisis in the first place, you can watch it online at
http://www.pbs.org/wgbh/pages/frontline/warning/view/#
“We didn’t truly know the dangers of the market, because it was a dark market,” says Brooksley Born, the head of an obscure federal regulatory agency — the Commodity Futures Trading Commission [CFTC] — who not only warned of the potential for economic meltdown in the late 1990s, but also tried to convince the country’s key economic powerbrokers to take actions that could have helped avert the crisis. “They were totally opposed to it,” Born says. “That puzzled me. What was it that was in this market that had to be hidden?”
I will let you draw your own conclusions from the documentary, however I do have some thoughts I like to share:
Without going into technical details about how derivatives work, is it really possible to create value by designing financial instruments that are really nothing but tools to hide or spread risk? These instruments help a few people make tons of money at the expense of others as the wizards jump from the burning train while ordinary investors get engulfed in flames. Many ignorant investors jump on the train on the promise of outsize returns only to get their clocks cleaned. Why did they jump on the train in the first place? Because they wanted the same 40% or 80% return on investment that the hedge funds were getting. Now we use a 10% cost of capital in our finance textbooks. Why not use 40%? Because that is not a normal return. That is my point- if we are greedy enough to chase 40% returns there is always a high risk of getting our clocks cleaned, no matter how safe the investments appear. Another point to remember- profit creation comes from value creation. Does spreading money and risks create value?
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