Derivatives Debacle
-- October 9, 2003

Just when you think Wall Street has run out of scandals, here comes a derivatives-related mess in the mortgage market. We told you about Fannie Mae and Freddie Mac's derivatives scrape months ago. Now, Federal Home Loan Banks in Atlanta and Pittsburgh are reporting record losses thanks to derivatives investments that have gone sour.

The problem with a derivatives-related problem is that the financial tentacles are spread far-and-wide, as contracts are resold again and again from one company to another. So, while one player might be able to handle the unwinding of its derivatives book, the aftershocks may destroy another company that unwittingly bought into the contract on the resale market.

Derivatives problems could affect many businesses in the mortgage-banking and insurance industries as new accounting rules are now coming into play. Companies can no longer hide their derivatives problems underneath a rug in a "Special Purpose Entity" a la Enron. Rather, they must disclose in their earnings reports most of their derivatives holdings.

So, companies will have to take goodwill write-offs, thanks to high-risk derivatives gambles. And those bad bets will reverberate across the globe. That's when we'll find out who rolled the dice on derivatives -- and wound up with snake-eyes!

related article:
Federal Home Loan Banks Report Losses