Originally Posted by Villages Kahuna

Other than the most basic definitions, and even though I spent a quarter of a century as a commercial and merchant banker, I don't have a clue on how the vast variety of credit-based derivatives work and more importantly, how they are interdependent and interrelated.

It's apparent that the smartest and most conservative of the banks who became involved as counterparties on one side or the other of these derivatives didn't understand them either. I can tell you with 100% certainty that none of the banks or institutions involved in this mess wanted it to happen. I know for sure that all the banks involved each had dozens of their smartest people using as much computer power as needed to model, forecast and project what would happen under various economic scenarios. Those people were involved in what was called "risk management". They were doing all that analysis to establish internal credit policies and portfolio management rules to avoid what has happened. Obviously, they weren't smart enough.

Layered on top of the people I described, at the national banks at least, were the regulators that regularly visit the banks to perform examinations to assure that the financial strength of those institutions are not compromised. With the largest banks, the bank examiners have office in the banks and are there full-time. Obviously, their work was insufficient to avoid the crisis thsat occurred.

Then there were the public accountants. Their job is to certify that the financial statements prepared and published by the banks fairly represented their true financial condiiton pursuant to published accounting standards. They "whiffed" as well.

Lastly were the rating agencies--Moody's, Standard & Poors and Best--their job is to analyze and rate the debt instruments issued by banks, both for the structure of the debt as well as the ability of the underlying bank-issuer to repay the debt. Their failure to identify the real risks made it four-for-four among those that were responsible for identifying the risks of the situation.

If I wanted to make it five-for-five, I could include the army of certified financial analysts (look for the CFA designation on those stock evaluations you read) whose job it is to evaluate the book and potential market value of the stocks of the banks. They all missed the boat, as well.

I've just outlined a really scary scenario that under current regulations could be repeated again. A few smart investment bankers who come up with some attractive derivative securities, and make a lot of money finding counterparties to take the sides of the derivatives, can make all this happen again. Once the investment bankers set up the securities, find counterparties to buy them and take their generous fees, they're finished. They have no further exposure. And I assure you that the counterparties, the bank regulators, the public accountants, the rating agencies and the financial analysts won't be able to figre it out next time any better than this time.

I predict it'll take about 15-20 years for something like this to happen again. Look at financial history--the Great Depression in 1929-40, skyrocketing inflation and another financial crisis in the mid-1970's, the S&L failures of the late 1980's, the failure of the LTCM hedge fund which almost metastacized into the worldwide banking system in 1998, and now this even worse financial crisis in 2008.

Yep, about another 15-20 years and we can almost count on something like this happening again. The risks taken are assumed because of the profit motive. Regardless of what our elected legislators tell us, no amount of regulation will be sufficient to prevent it.