Outside the Box

Deconstructing Today’s Ongoing Revolution In Finance

John Mauldin

March 19, 2007

General reader, today's Outside the Box is one that you are going to want to put your thinking caps on for. My good friend Woody Brock has kindly allowed me to present you with one of the sections from his quarterly comments. In his chapter "Deconstructing Today's Ongoing Revolution in Finance," Woody has written a particularly interesting and somewhat controversial section titled "Why the Economy Needs Vastly More Derivates, Not Less."

An all too common myth is that the total value of derivates is in and of itself dangerous because they are a form of leverage...but that is not the case. Derivatives, per se, are not a form of leverage; rather they afford the opportunity and make it easier and less risky for others to use leverage across many different assets and instruments (i.e. - mortgages, insurance, etc...). It is the leverage which is then the issue, as paradoxically, the decreased risk (hedging) aspects of derivatives allows investors to feel more comfortable with increased leverage, which sends a variety of signals to market participants.

The problem lies not in the instruments but in how the risk is distributed. While many of the larger, institutional players have used the offshoots of derivates to better hedge themselves, much of the smaller investor community has unwisely used the medium in a speculative manner. If a small homeowner is in trouble because of leverage on their mortgage, there just isn't anyone left to bail them out. Just as in the greater fool theory, the party only continues while someone is more foolish and irrational than the last fool.

Again, this is one of the more insightful articles featured in an Outside the Box. I believe it to be very important as its implications tie into what we are now seeing in the subprime mortgage market. May you enjoy Woody's insights and analysis.

John Mauldin, Editor
Outside the Box

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Deconstructing Today's Ongoing Revolution In Finance

By Woody Brock

DECONSTRUCTING TODAY'S ONGOING REVOLUTION IN FINANCE

- Why the Economy Needs Vastly More Derivatives, Not Less -

In this chapter, we draw upon some of the basic concepts lying at the heart of modern finance so as to clarify what today's revolution in finance is all about, and whether it constitutes a significant net gain for society. Particular emphasis is placed on the nature and…

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