Klein: Explaining Derivatives

I've been dreading this one. Derivatives are rough sledding. Explaining futures, options and swaps is the blogger's version of the Oregon Trail: It'll take months, and you'll probably lose most of your people along the way. Maybe to dysentery (but maybe not). But you have to get into it: If we don't get derivative reform right, FinReg isn't worth the paper it's printed on.

Here's the good news: You don't need to understand the different types of derivatives. All you really need to know is that financial firms trade derivatives, they're worth an extraordinary amount and there's a category of them that's almost totally unregulated. That's a big part of the reason why the financial crisis was as severe as it was: We had no idea how many derivative contracts these major firms had with each other -- and with everyone else. So when Lehman fell and other banks threatened to follow, no one could predict the consequences. "What we mean when we say a company is 'too big to fail,'" says the Roosevelt Institute's Mike Konczal, "is that they have too much derivative exposure too fail."

So, derivatives: bets that other firms have with one another and that are big enough to crash the financial system if a firm defaults, but not bets that we know about or regulate. That's not so hard, right?

To read more, click the link above.