By Kent Lyndon
What do Orange County, California, Detroit, Michigan, and–yes, just a four hour drive from where you all live–Jefferson County, Alabama, have in common in bankruptcy court twenty years apart?
Their bankruptcies were accelerated by the use of a little known (to the general public) financial instrument called a “derivative”.
Now derivatives come in all shapes and sizes. Some forms are offered to the public, and some are quite private. The public forms have cleared the normal regulatory hurdles in order to begin trading. The private forms don’t have the same regulatory hurdles and only are offered to “select” institutions.
What is a derivative, you say? A derivative represents another security, and its value is tied to the value of that other security.
Some people call it a “hybrid” security. Publicly traded derivatives would include grain futures, where a futures contract can be bought or sold and represent a few thousand bushels of corn, wheat, or soybeans A zero-coupon bond represents, or is a hybrid security of, an interest paying bond. Options are publicly traded derivatives markets that represent stocks, futures, or foreign currencies and are offered to the general public on a daily basis.
When one begins reading about the “other” form of derivatives, the word “swap” comes into view quite often. I do not intend to waste this space giving you easy answers. I will, instead, ask you to access your favorite search engine and start reading up on those more private markets that helped cause three huge governmental bankruptcies and almost put the lights out for all of us in 2007-08.
You have been given enough information to be off to a great start.