One of the biggest mistakes that executives running the major US financial institutions made is a simple one. It’s a mistake even a novice investor wouldn’t make. They assumed that all US assets would always go up and never down – a perpetual bull market.
To make money off of this “fact”, Wall Street created all types of strange, new derivative instruments. Wall Street sold these derivatives, making hundreds of millions of dollars in the process.
Wall Street ignored all warnings about these derivatives. One of the most famous of these warnings was delivered in 2003 by famed investor, Warren Buffett. He called these derivatives “financial weapons of mass destruction.” How prophetic!
Derivatives are very complex to explain, but here is an easy example. There are derivatives called CDS or Credit Default Swaps. These CDS started out as basically insurance. Let’s say a pension fund owned bonds of XYZ company. The pension fund could buy a CDS on XYZ company. If XYZ failed to pay on the bond, the pension fund would be covered because they would be paid by the issuer of the CDS.
Wall Street has issued and sold a mind-boggling $62 trillion of credit default swaps! They thought that it was a riskless strategy to make money. After all, assets always go up — no one would ever default.
Then the mortgage problems hit and there were defaults. Wall Street began paying out massive sums of money on these credit default swaps. It was then that Wall Street recognized it had a problem.
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