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Here's a bombshell from the March 22 edition of The Economist magazine: "With positions in credit-default and interest rate swaps worth a notional $10 trillion, the idea of [Bear Stearns's] sudden collapse was chilling -- and nobody wanted to put that foreboding to the test. Aptly, although the [Federal Reserve's] rescue is no bail-out of Bear, it does set out to save the system." Translation: Bear had a staggering $10 trillion of bewilderingly-complex derivatives to which it was a party. If it was unable to meet its obligations, "the whole system could have come down," says David Allen of North County's Palomar Equity Research. "This is systemic risk." He does not think the world's highly-leveraged financial system is out of the woods. Some terminology: credit default swaps, covered in detail in my column of Feb. 6, are derivatives like insurance: a bank wants to be sure its interest and principal on a bond will be paid. Another party guarantees those payments for a fee. In a simple interest rate swap, one party pays a fixed rate of interest to another party, which agrees to pay a floating rate. The word "notional" describes how the volume of derivatives can be misleading. It's like insurance. You pay $500 a year to insure a $100,000 cottage. The $100,000 is the notional value. There are more than $500 trillion of derivatives in notional terms. But only 2 percent may actually be at risk. However, 2 percent of $10 trillion is a lot of money -- enough to start a landslide.
Here's a bombshell from the March 22 edition of The Economist magazine: "With positions in credit-default and interest rate swaps worth a notional $10 trillion, the idea of [Bear Stearns's] sudden collapse was chilling -- and nobody wanted to put that foreboding to the test. Aptly, although the [Federal Reserve's] rescue is no bail-out of Bear, it does set out to save the system." Translation: Bear had a staggering $10 trillion of bewilderingly-complex derivatives to which it was a party. If it was unable to meet its obligations, "the whole system could have come down," says David Allen of North County's Palomar Equity Research. "This is systemic risk." He does not think the world's highly-leveraged financial system is out of the woods. Some terminology: credit default swaps, covered in detail in my column of Feb. 6, are derivatives like insurance: a bank wants to be sure its interest and principal on a bond will be paid. Another party guarantees those payments for a fee. In a simple interest rate swap, one party pays a fixed rate of interest to another party, which agrees to pay a floating rate. The word "notional" describes how the volume of derivatives can be misleading. It's like insurance. You pay $500 a year to insure a $100,000 cottage. The $100,000 is the notional value. There are more than $500 trillion of derivatives in notional terms. But only 2 percent may actually be at risk. However, 2 percent of $10 trillion is a lot of money -- enough to start a landslide.