A Simple Explanation of How The Use of Derivatives Created The Great Recession
by cactus
A Simple Explanation of How The Use of Derivatives Created The Great Recession
In comments to a post by fellow Angry Bear Robert Waldman, reader Cantab writes:
Nobody here has come up with a believable story on how derivatives hurt the economy or were the cause of the recession. All we really get is a claim that they happened together and the further assertion that derivates [sic] caused the recession rather than the more likely story that derivatives were the victim of the recession.
I’m pretty sure Cantab is wrong but I don’t have the time to find the various posts that described the issue. But I can summarize:
1. Derivatives are about magnifying bets. A $2 bet on a derivative can be the same thing as a $100 bet on the asset that underlies the security. Thus, if the asset doubles in value, instead of taking home an extra $2 on your bet, you take home an extra $100. But if the price of the asset falls in half, instead of losing $2 on your bet, you lose $100.
2. On Wall Street, everyone leveraged up. After all, the worst that can happen when you gamble with monster leverage is that you go bankrupt. But if you win your bets, you make humongous profits.
3. Inevitably, when everyone is leveraged up, at least some of those who are leveraged must sooner or later make some bad bets. But the losses associated with these leveraged up bad bets was much bigger than in the past. Instead of losing $2 on their $2 bets as would have happened in the past, they lost $100. In the past, the losers’ assets would simply have been liquidated, and those assets would have been enough to cover a substantial part of the losses. With derivatives, liquidation covers an insignificant piece of what is owed.
4. Result: massive, and I mean massive, losses to the firm’s creditors. Perhaps big enough to drive their creditors out of business too. And those creditors have creditors too…
5. As a result of 4, a firm could win all its bets and still be driven out of business, simply by virtue of being stupid enough to bet against another firm who realized point 2. (And every firm on Wall Street, apparently, realized point 2.) In fact, a firm could be driven out of business despite winning its bets if one of its counterparties was stupid enough to bet against another firm who realized point 2. Being twice or three times removed from a loser might not be enough to keep a firm from being pulled under.
6. Derivatives are also opaque. There’s no way of knowing who took out which bets with who until someone declares bankruptcy.
7. Very quickly, it became apparent that any of the firms on Wall Street might already be on the inevitable path toward bankruptcy, but there was no way at all to tell the difference between those that were on that path and those that weren’t, or even if there were any firms that weren’t headed toward bankruptcy.
8. All deals ceased. The real world, that had gotten used to unlimited amounts of cheap money sloshing around, abruptly and without warning found itself cut off from its fix. Expansions plans, hiring, etc. were put on hold. And companies that were teetering on the edge that earlier would have found some savior on Wall Street found themselves having to shut down or scale back instead.
I have to admit, its taken me a while to come to terms to how big the derivative market was. I had no idea, no inkling of its size back in March of 2008 when I began asking what was different about the current recession. As a result, though I noted the possibility of a “major downturn”, I was surprised by exactly how big the downturn would really be. What scares me is that that I’m not seeing anything, anything at all that prevents or even makes the 8 steps I described above any less likely to occur. The bail-outs were madness. Those who knowingly go out of their way to play with dynamite should be allowed to blow themselves up, and the job of government should be to prevent the rest of us from having to deal with the consequences.
Which brings me back to something else I wrote in 2008. We need a public option… in the financial system. Let the public bank at the Fed the way the banks bank at the Fed. If given a choice between keeping my money at B of A or the Fed, I know which I’ll pick.
Epic fail!
“Derivatives are about magnifying bets”
Interest rate swaps are derivatives. Interest rate swaps are NOT about magnifying bets.
Your premise shows a complete misunderstanding of capital markets. I stopped right there.
I think that “leverage” might be a better overarching blame category than the entire class of “derivatives”, though some derivatives do permit one to make levered bets. A financial system that is highly levered, for example purely with borrowed money, will crash when things turn down as the need to liquidate large positions causes prices to fall, which feeds back on itself. The opacity and unregulated character of the derivatives markets is, by most accounts, a large problem, and I think the reasons stated above are substantially correct, though perhaps not exhaustive. I think that the above-described mechanism for “freezing” in the credit markets is basically right.
The proposal to allow retail consumer banking at the Fed strikes me as a little unrealistic. The point of retail banking is to aggregate private savings and direct it into socially useful lending in the real economy. If the Fed becomes a private deposit taker, will it also become a lender of first resort into the real economy? Someone has to do the job of credit intermediation between savers and borrowers, and for decades a well-regulated banking system did that at reasonable cost. Methinks it better to leave deposit taking to the banks, but regulate them (and other institutions, such as the credit ratings agencies) better so that they actually fulfill their notional function of socially useful credit intermediation.
Finance needs to again become a positive sum game, as it was for decades after the reforms that followed the first great depression.
Oh boy, lets start with #1. You don’t like leverage of 98 to 1? Too much risk for you? How about this by comparison: The FHA is lending hudreds of billions at 96.5% LTV. Both Fannie and Freddie are doing enhanced lending up to 100%. You have a problem if I bet on Greece and get 98 to one? That is nothing. The D.C. lenders are the ones you should be worried about. Not me.
#2 Again you are worried about WS leverage and the use of derivatives. Point your finger in the right direction. Say I was a Primary Dealer or a bank and I wanted to buy $20billion of the long bond on a speculation. How much money would the PD have to put up? Not a penny. The whole thing can be financed at the window.
#3 All those bets added up to losses you say, and the reason is those nasty derivatives. Well there has been some lumpy losses. The worst offender is those S heels at AIG. At the end of the day they will cost us $50 billion. A horrible price to pay. But what about the other derivative players FNM, FRE and FHA? The number there is $500billion. And it is still rising. If things do not turn around soon in housing it will cost us a trillion.
#4 yes massive losses to the creditors. As taxpayers (the ultimate creditor) we will be paying for the losses at the Agencies for a decade or longer.
#5 Yes, even winners are losers in this mess. No one will escape the disaster that overleverage brought us in RE.
#6 yes, there is no way to look at house and say, “this guy is underwater”. You wait until the Sheriff sale takes place to confirm it.
#7&8 yes, the RE mess has caused large and long lasting collateral damage that will hurt the economy for many years to come.
You are surprised at the size and import of the derivatives market. The D.C. mortgage lenders are $7 Trillion at this point. They have ZERO equity. The were and continue to be a ticking derivative bomb. They are much more of a systemic risk than OTC derivatives that trade in the market.
I understand your angyst on this issue. But you need some perspective. The risks to our society from derivatives as you describe them is small. The derivative risks that you ignore are the big important ones. They are the ones that will send us into a very uncomfortable place.
The original poster is quite right in that the bets that were made such as CDSs and other derivatives (not all of course) were part of the financial meltdown. Any essentialist argument has flaws. If we look at the root of the crisis we find four areas of immediate cause: derivatives, ie, leverage, failure to enforce regulation, ratings agency conflict of interest, and the false logic of free markets. Together they contribute to the debacle. There is a root cause in the policies of conservatism and neo-liberalism that put too much power in the hands of too few and failed to bolster the consumer who was the source of their wealth. This inequality must also be considered. I’m kind of disappointed by the shallowness of this exchange on such an important topic, but the original poster does have a good point about derivatives and transparency of markets.
The original poster is quite right in that the bets that were made such as CDSs and other derivatives (not all of course) were part of the financial meltdown. Any essentialist argument has flaws. If we look at the root of the crisis we find four areas of immediate cause: derivatives, ie, leverage, failure to enforce regulation, ratings agency conflict of interest, and the false logic of free markets. Together they contribute to the debacle. There is a root cause in the policies of conservatism and neo-liberalism that put too much power in the hands of too few and failed to bolster the consumer who was the source of their wealth. This inequality must also be considered. I’m kind of disappointed by the shallowness of this exchange on such an important topic, but the original poster does have a good point about derivatives and transparency of markets.
The original poster is quite right in that the bets that were made such as CDSs and other derivatives (not all of course) were part of the financial meltdown. Any essentialist argument has flaws. If we look at the root of the crisis we find four areas of immediate cause: derivatives, ie, leverage, failure to enforce regulation, ratings agency conflict of interest, and the false logic of free markets. Together they contribute to the debacle. There is a root cause in the policies of conservatism and neo-liberalism that put too much power in the hands of too few and failed to bolster the consumer who was the source of their wealth. This inequality must also be considered. I’m kind of disappointed by the shallowness of this exchange on such an important topic, but the original poster does have a good point about derivatives and transparency of markets.
Cactus I think you are mixing up derivatives themselves and leverage – leverage being an uncovered bet.
Example: stock option (which is a derivative). Let’s say I buy a Call option on Apple with a strike price of $300, and my premium is $500. So for $500 I buy the right to purchase apple shares at $300 per share – and one option represents 100 shares. If apple does not reach $300 (plus my premium) then all I lose is $500, my premium paid.
Now somebody sold me that option. If they sold me one option, and they own 100 shares of Apple stock then that is a covered call. They can just simply sell me their 100 shares at a price of $300 per share. Little systematic risk in this example.
However, if the option seller does not own the 100 shares (naked option), and I call at $300, that person needs to go into the open market and purchase 100 shares at whatever the market price is, if Apple hit $400, they need to come up with $10,000 (remember I have to pay $300 a share for that the writer deals with the difference between $300 and market price). Now brokerages have margin requirements, so this transaction would actually not represent much systematic risk, but lets say I write tons of these naked options – then the writer could be on the hook for a lot of money that they do not have.
Hopefully, you see it is not the derivative itself that is the problem, it is the ability for someone to enter into a securities transaction with noting to back it up (to over-leverage against their ability to pay). Now you have a problem because the writer could quickly go bankrupt. This was the AIG problem, they wrote more insurance (CDS contracts), than they had reserves to cover.
I have said on this blog many times over that this was a recession of over-leveraging. Consumers were over-leveraged with mortgages, banks of all stripes were also over-leveraged. This could be regulated, without having to even pay attention to the financial product involved, by setting higher margin/reserve requirements.
Jay,
Borrowing on either fixed or variable rates is the equivalent of making a bet on the future direction of interest rates. A swap is a cheaper way of betting on the interest rate’s future direction than to buy the type of security you wanted in the first place. In other words, you are trying to make a bigger bet with your money than you could have if you had not used this particular type of derivative. If that isn’t, by definition, magnifying your bet, what is?
***I understand your angyst on this issue. But you need some perspective. The risks to our society from derivatives as you describe them is small.***
I think that Cactus includes Credit Default Swaps in the heading of “Derivatives”. That’s common practice, and while it may not be technically correct, ignoring those things as our Panglossian apologists for current practice would do is pretty disingenuous. Credit default swaps are in fact opaque, written in huge volumes, and have massive leverage — limited only by the stupidity and cupidity of the CDS writer and buyer. The proximate cause of the crash was perhaps 400 Billion in naked CDSs written by AIG — a significant fraction of which were written against leveraged, AAA rated “assets” with very little value.
I’m curious how you came up with the value of $50 billion for taxpayer funded losses at AIG. Every time I look for AIG related loss numbers, they are all over the place. (So much for “transparency”). Is there some authoritative analysis for the AIG debacle somewhere.
Cactus,
That is my handle. You are not me. You do not want me going by your IP address.
As to your comments…
1. You must be the only person not buying oil futures on margin.
4. Yes. So…
4. Ditto.
5. You assume all the same here would have ocurred even with 100% margin requirements. Very odd.
6. So? That is the definition it an externality.
7. What I wrote in the post.
8. No. Weaning an addict causes pain to the addict at first. What I want is spelled out in the last paragraph.
Samuel Connor,
I guess I will have to spell out my proposal in more detail at a later date.
B K,
I am worried about primary dealers. That is a different post.
2. Which is one of my problems with the way the fed buys and sells treasuries. That is also a different post.
3. Agreed. I have been railing against the bail out since the beginning.
4. 5. 6. My point, exactly.
Jay, I think you are arguing that Interest Rate Swaps are Derivatives therefore all derivatives are IRSs. That’s an example one of the classic logical falllicies I think. Maybe you had something else in mind?
Anyway, some derivative securities do involve leverage — lots of it
When you take an asset — say a pool of mortgages — and tranch its future revenue stream by risk. You create derivative securities — Collateralized Debt Obligations in that case. The most junior tranches can be quite highly leveraged in that a relatively small purchase price can return you anything from close to zero to the full nominal value of the chunk of future revenue. Depends on the default rate of the mortgages.
If that’s not enough leverage, you can take a bunch of CDOs and tranche them creating a new class of derivatives (CDO-squared) with much higher leverage. These “investments” also look to be asymmetric in that the most you can lose is your bet whereas the potential gain can be as much as you can talk a counterparty into signing on for.
Some reading:
http://en.wikipedia.org/wiki/Collateralized_debt_obligation
http://www.fintools.com/docs/Warren Buffet on Derivatives.pdf
http://www.wired.com/techbiz/it/magazine/17-03/wp_quant?currentPage=all
http://www.npr.org/templates/story/story.php?storyId=102325715
http://www.calculatedriskblog.com/2010/03/npr-planet-money-we-bought-toxic-asset.html — If you have time, the linked broadcast is well worth listening to no matter what your financial orientation. And, it’s funny
And in response to the comment above that derivatives are a “zero sum” game, that is not true of Credit Default Swaps given that the losses on the underlying assets are magnified by the fact that entities bearing no risk of loss from the default could buy the CDSs. That magnifies the losses suffered by the seller of the CDS to what ever is the multiple of swaps to underlying assets.
I’m uncertain about the magnification effect that may exist when the derivative is a Collateralized Debt Obligation. Can anyone address that issue? It seems clear that leverage applied to CDO purchases would increase the risk to the entities putting up the additional assets needed to leverage the initial purchases of the CDOs. Here too there is a lack of clarity regarding who is at risk. If an entity purcahses $100,000 value of CDOs
by putting up $5,000, who bears the risk of loss from the $95,000 that has been leveraged?
See, what you did was choose your words well. (Stop that!) It is possible to “magnify one’s bet” without borrowing. Leverage, in common financial parlance, means using borrowed money to that the total investment is more than one’s own capital stake, but borrowing is not the only form of leverage, as this example makes clear. In the case of swaps, as you note, the gain or loss is large relative to the capital invested for reasons other than borrowing. The entire stake is an interest rate stake.
It is odd, though, that the very first comment wrongly asserts that you have your facts wrong.
Non-Cactus-Cactus,
You should have read VTC’s post, just above your own, before making point 1.
On your point 3 (where’s 2?), you miss the problem that leverage creates. A zero-sum game, when the losses in one place can be quite large, still creates risks to the system. In fact, you seem to have looked very narrowly in each of your points, as there is no apparent appreciation of systemic risk in any of them. “zero-sum game” is a fine argument as long as nobody defaults in a large way on obligations, or is thought at risk of large default. Your own point 4 responds to cactus making the systemic risk argument, but fails utterly to take systemic risk into account.
Your point 5 misses the business model. A firm which expects a payment from one counter-party has often committed part or all of the payment to another counter-party. The firm is not in the same position as if there had been no contract. The firm is out the cost of the contract, and unable to make a payment on a related obligation. Again, this is at the heart of systemic risk. Are you unaware of the extensive interconnection of payments between financial firms? What you are relating sounds text-book simplistic.
Point 6 is utterly without substance, so we’ll move on.
Point 7, we have Congressional testimony from participants in the industry and from regulators, from cabinet-level officials who were in negotiations with the heads of financial firms, all confirming that a lack of transparency was central to the credit crunch. To say that there is no basis for the statement cactus made is to ignore a mountain of evidence.
Point 8. Um no, that is not what cactus is “saying”. I can tell because I, too, read what he wrote and didn’t get that at all. When you structure an economy a certain way, build up credit obligations in far greater multiples to actual economic activity than is normal, for instance, then you are at risk of driving output well below capacity if that structure is interupted. Capacity still exists, and does not require the same credit multiple to work, so it is nonsense to argue that cactus wants to return to the prior capital structure. The point, as I read it, is that harnassing real output to a bloated debt structure puts the real economy at unnecessary risk. Remember the whole thing about leverage that was the starting point in the derivative discussion? The implication of that point is that leverage was in excess of what is needed to drive real output, and put real output at unnecessary risk. If you missed that, you missed the whole point.
The argument Bruce is making mistakes one problem for another. The Fed, as the monetary authority, stands at zero risk of defaulting, and can absorb any loss without imposing systemic risk. Treasury, as the issuer of soveriegn debt it domestic currency, can absorb any loss without imposing systemic risk. That’s why they have undertaken the rescue, and why they are able to.
The points that need to be made regarding the Fed and Treasury have to do with sovereign risk and moral hazard. They are utterly unlike private interest in that way.
As a logical point, Bruce is saying “not this, but that”. This is a logical fallacy. It is entirely possible to have two different sets of problems, a situation of “both this and that”. That is, in fact, the situation we are in. If Bruce doesn’t want us to deal with the egregious behavior of private interests, he can say so. But it is simply not true that our real or only problem is with the public sector. The public sector is building up problems right now by absorbing the mistakes made by private interests, in an effort to protect the system from those mistakes.
We do have something like a public option in banking. They’re called Credit Unions. FDIC insured, and owned by depositors (deposits are shares of ownership). They are non-profit organizations, and generally do not engage in speculative marketeering (altho many have investment partners should you wish to go that route).
Moreover, membership in a Credit Union is determined by a qualifying residence or familial relation so the gains of the union benefit the local community in which you live and bank. No need to expand the FED’s role any further when there’s a perfectly good conservative local non-corporate banking institution, as long as you can look past the word “union”.
***I’m uncertain about the magnification effect that may exist when the derivative is a Collateralized Debt Obligation. Can anyone address that issue? It seems clear that leverage applied to CDO purchases would increase the risk to the entities putting up the additional assets needed to leverage the initial purchases of the CDOs. Here too there is a lack of clarity regarding who is at risk. If an entity purcahses $100,000 value of CDOs
by putting up $5,000, who bears the risk of loss from the $95,000 that has been leveraged?*** Jack
I think — and it is an opinion, not something I know for sure — that when one buys a $100,000 CDO for $5000, one is betting that the underlying mortgage pool will hold out long enough to repay more than $5000. Remember that these CDOs are tranched and some of the senior tranches may be quite safe. It is the tranches near the bottom that have high leverage. These tranches are peeled away layer by layer as mortgages default. So, if you buy the second to the bottom tranch, you will get full monthly payments until the tranch below you goes away. Then you will get shrinking partial payments as more mortgates default. When your partial payment declines to zero, your tranch is dead, and the tranch above you starts to erode.
I think that the risk actually fell on the original owner(s) of the tranch who paid $100,000 (probably in the form of an IOU of some sort?) to get a “safe” return higher than Treasuries, and are now selling the thing for what they can get for it — $5000?
This all makes my head hurt, and I’m skeptical that all the dudes who were wheeling and dealing in this stuff had any idea what they were doing.
VTCodger: “Jay, I think you are arguing that Interest Rate Swaps are Derivatives therefore all derivatives are IRSs. That’s an example one of the classic logical falllicies I think. “
No. I am disproving cactus’ premise by contradiction.
To quote cactus:
“Derivatives are about magnifying bets.”
From basic logic one recognizes that this statement means…
For all X where X is a derivative X is about magnifying bets.
I provided an X for which X is not about magnifying bets. Brush up on your logic buddy.
Oh and we went over tranches a while back, but I will repeat myself. Tranches are designed so that PRE-PAYMENT risk is not spread out uniformly. I’m sure it is hard for your tiny mind to grasp the idea that getting a loan paid back early presents downside risk to investors, but just trust me it does.
Unfortunately, as others have pointed out, the post has a number of flaws. But the key point is correct. Unregulated financial instruments were used to magnify risk instead of hedging it. As a result, relatively small increases in defaults that might not even have caused a recession 40 years ago (before these instruments existed) had massive repercussions on a global scale.
cactus,
You are wrong on almost every point.
#1. Derivatives do NOT magnify bets. You buy a $2 option (derivative) and you can win $100, but if you lose, you do not lose $100, you only lose the $2. So you lost at “hello.”
#2. It’s not the derivative, it’s the performance of the underlying asset. It was the decline in mortgage performance that is the culprit. Without CDS or other derivatives, you would just have mortgage lenders just imploding, a la Fannie Mae, Lehman, BS, Wamu etc. Losses are losses…they don’t go away……someone has to take them.
#3. I guess I would agree with you more if there were widespread BK’s/bailouts in this financial crisis due to derivatives. But there has been only 1 – AIG. (LTCM might also qualify, at a different time) When history has been written about CDS, it is likely that they will be adjudged to have MINIMIZED this financial crisis.
Cactus: Borrowing on either fixed or variable rates is the equivalent of making a bet on the future direction of interest rates. A swap is a cheaper way of betting on the interest rate’s future direction than to buy the type of security you wanted in the first place. In other words, you are trying to make a bigger bet with your money than you could have if you had not used this particular type of derivative. If that isn’t, by definition, magnifying your bet, what is?
“Mr. Cactus, what you have just said is one of the most insanely idiotic things I have ever heard. At no point in your rambling, incoherent response were you even close to anything that could be considered a rational thought. Everyone in this room is now dumber for having listened to it. I award you no points, and may God have mercy on your soul.”
Lets break this down…..
Bank A gave Cactus an ARM. Cactus is quote LIBOR + 120. The bank goes out and borrows from Bank B at LIBOR + 30. Two year’s later Cactus wants to refi to a fixed rate. The bank offers and Cactus accepts (something you constantly forget, there are at least two sides to every transaction). Bank A wants to ELIMINATE interest rate risk, but Bank B doesn’t want to change the terms of the loan it gave to Bank A. Bank A goes to Bank C and swaps its floating rate payments from Bank B in return for a fixed rate payment.
Lots of bet magnifying going on there.
VtCodger: You are looking at this backassword. If your head hurts you should let others do the analysis.
Security X has 3 trranches A, B, and C (with A being the most senior and C the least senior). Note from this information the transitivie property can be used to prove A > B > C.
As monthly mortgage payments come in they get spread across investors in A, B, and C evenly based on their share of the pool. When PRE-PAYMENTS on mortgages come in they go to investors in tranch A first until they are made whole. Then the PRE-PAYMENTS go to investors in tranche B. Then finally C. Once all mortgage payments are either made or defaulted the security matures.
I bolded the most important aspect of a tranched mortgage security. The part you left out.
@Bower Bum,
Great comment. I was going to make a similar one, but you made it three times. 🙂
Thanks.
***I guess I would agree with you more if there were widespread BK’s/bailouts in this financial crisis due to derivatives. But there has been only 1 – AIG.*** Sammy
Lehman for sure. And my impression is that there have been a number of shotgun weddings of companies that were creating derivatives and failed when the market for them went away. I think that the small number of bankruptcies is more due to financial firm friendly government intervention than to any lack of misbehavior or any trace of prudence. Probably had nature been alllowed to take its course or if we had followed the Resolution Trust model as Krugman and some other “liberal” econmists urged, there would have been plenty of bankruptcies. In the first case, we’d probably be in a depression. In the second we’d likely be healthier as I suspect that many of our banks are actually zombies being kept alive by bogus accounting. (Note that Krugman and Stiglitz at least wanted the banks siezed, audited, recapitalized if necessary, demanagementized where approptiate, and reprivatized)
I believe AIG was actually a victim of writing uncoverable Credit Default Swaps “insuring” derivatives rather than the derivaties themselves. Would the derivatives had been created if AIG et al hadn’t been “insuring” them? I haven’t a clue.
One aspect that doesn’t really get discussed is that the transactions in derivatives primarily involve trading rather than investing. With investment, the buyer has the opportunity and time to examine the derivative instrument and figure out the components that comprise the instrument while trading requires very fast decisions to buy or sell the derivative instrument, with far greater attention paid to pricing movements than the nature of the traded derivative security. Since trading occurs so quickly, there is an assumption that the traded derivative securities are materially comparable, which is not actually true.
This “due diligence” issue is further compounded because many derivatives securities actually are portfolios of other derivatives (which in turn may be portfolios of other derivatives), so figuring out the actual risks and contingencies requires drilling through several layers. Insurers and bankers bought derivatives to hedge their risks but the “hedges” actually contained the same types of risks (e.g., subprime) that the insurers and bankers were trying to hedge against (maybe even securities issued by the same insurers and bankers). The summary information didn’t inform the buyers that they were compounding their risks rather than hedging their risks !
Cactus,
Sorry about that. I don’t want to be you. That was an early morning making a post before going off to work mistake.
VtCodger,
The loses in credit default swaps were caused by falling home values, not by the derivatives themselves.
Lehman for sure.
Sorry, codger. Lehman bk was actually due to holding the mortgages themselves w/o protection of CDS. http://en.wikipedia.org/wiki/Bankruptcy_of_Lehman_Brothers
there would have been plenty of bankruptcies.
Which firms would have gone down because of CDS? Perhaps there are some, but I’ve never heard of them.
The credit default swap is the derivative. AIG went into CDS business like it was a normal insurance business. They sold CDS’s and received periodic payments and promised to cover the losses if one the bonds that their clients were holding defaulted.
Usually as with life, car, or health insurance you can expect a steady actuarially predictible outcome. The fact that a car drives off the road in Kansas City has no correlation with the same happening in LA. If someone dies in Chicago it does not hasten the death of someone in Seattle.
The same does not hold with bonds. Once some bonds start defaulting, other bonds are more likely to default. This risk increases rapidly in a fallling market. In this case the underlying cause was the fall in real estate values.
Anyway, Cacus just looks at data and admits that he really does not do causality well.
Again, the defaulting bonds were the cause of AIG’s problem so they were the victim of the recession and not its cause.
Jay,
In your example A wants to make a bet based on its expectations about future interest rates. It can make the bet directly with B but instead chooses to make an indirect bet by swapping with C. Given that both bets accomplish the same thing and given that the direct bet is more expensive because B does not wast to change its terms, I have a hard time seeing how the reason for the swap is anything other than saving on a multiple of what would be the direct cost of getting B to play along.
***Tranches are designed so that PRE-PAYMENT risk is not spread out uniformly. I’m sure it is hard for your tiny mind to grasp the idea that getting a loan paid back early presents downside risk to investors, but just trust me it does.***
My tiny mind understands the distinction between prepayment risk and nonpayment risk — which yours apparently does not.
I think you would do well to tackle this link and the NPR broadcast it links to. It’ll probably clarify a lot of things for you. And it really is funny.
http://www.calculatedriskblog.com/2010/03/npr-planet-money-we-bought-toxic-asset.html
***I provided an X for which X is not about magnifying bets. Brush up on your logic buddy.***
Are you just trying to say that not all derivatives provide leverage? A simple declarative sentance would done better I think. I don’t think anyone including the severest critics of “innovative” financial practices thinks all derivatives are leveraged, evil, or are a problem.
Excellent post, sir (I’m assuming that, of course).
Please ignore many of the misdirection or misinformation-type negative comments, you are fundamentally on target. The entire point is ultra-leveraging, which once was forbidden, but thanks to well-designed predatory legislation and predatory jurisprudence, predatory capitalism was allowed to reign supreme (and still is, BTW).
By predatory legislation I mean the Private Securities Litigation Act of 1995, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999, and the Commodity Futures Modernization Act of 2000 (those coupled with that bankruptcy legislation during Bush, sealed the deal).
They removed “legal risk” (per the direction of the Group of 30) as well as anti-fraud and anti-manipulation regs, thus allowing for ultra-monopolies to do their ultra-leveraging.
And please, an unlimited number of credit default swaps can be written against one entity — always remember this most important of points.
Great post.
And the reason so many find it so difficult is the circuitous and convoluted nature of this incredible puzzle: pension funds (state, union and other) invested in private equity firms which use those funds for their leveraged buyouts to further destroy employment of union and non-union companies (by first offshoring, then corporate death-by-debt), underwritten by super-leveraged securitized financial instruments (those derivatives, CDOs, CFOs, CLOs, and so on….), and a host of scams and cons; public private partherships, endless new exchange gimmicks CPDOs, and next we have to look forward to wide array of carbon derivatives and carbon permits and offsets on those climate exchanges.
And the question remains? What isn’t securitized? And when will those “crisis derivatives” begin to pay off?
But when the underlying “asset” happens to be debt (and isn’t everyone [Goldman Sachs, JPMorgan Chase, Morgan Stanley, Deutsche Bank] into debt financing) — how can that really be much of a performer?
All those TARP funds and free money from the Fed’s window went to those crappy credit derivatives — that frozen LIBOR loans was due to everyone beginning to realize the incredible amount of leverage floating out there on the backs of derivatives, not simply the tranched CDOs.
jay,
“I provided an X for which X is not about magnifying bets. “
And I noted where your X was actually about magnifying bets. The fact that you pointed in one direction doesn’t mean there was nothing going on in another direction.
And by the way, Bruce. I don’t care whether you leverage up or not, as long as nobody who is not a party to the transaction pays any price if your bet goes bad.
Cantab,
It doesn’t matter what the losses were based on. They could have been based on the results of basketball games. Given the instruments involved, sooner or later something was going to go wrong at a level of magnitude that nobody anticipated.
McLuvin,
I have a small account at the credit union too. But its not the same thing as a public option. For one, as you note, there are qualifications to participating.
Perhaps I didn’t phrase things as carefully as kharris thought. Ah well. Next time I will do better.
sammy,
1. “You buy a $2 option (derivative) and you can win $100, but if you lose, you do not lose $100, you only lose the $2. So you lost at “hello.” ” There are 2 sides to an option and you are only looking at one side. For there to be unlimited upside, the option writer needs unlimited downside. Usually its not a problem for him. But sometimes it is.
2. “It’s not the derivative, it’s the performance of the underlying asset. ” Yeah, so? That’s like saying “Its not a problem that I gambled. The problem is the team I bet on lost.”
3. “I guess I would agree with you more if there were widespread BK’s/bailouts in this financial crisis due to derivatives. ” What about the firms that would have gone bankrupt if AIG had not been bailed out?
“ In this case the underlying cause was the fall in real estate values. “
That is my point. In the past, a fall in real estate values didn’t cause this sort of a panic worldwide.
thanks
Cactus,
Not finish it out by aknowledging that derivatives did not cause the fall in real estate values.
Cactus,
Now finish it out by aknowledging that derivatives did not cause the fall in real estate values.
In the past, a fall in real estate values didn’t cause this sort of a panic worldwide.
At a country specific level the fall in real estate in Japan was one of the reasons for the lost decade. And they did not have credit default swaps back then. Also in the past you did not have countries all around the world providing funds to the level they recently did to the U.S. morgage market.
Cactus: You are the one that made a universal statement. I never said anything about options, swaptions, knock-ins, knock-outs, etc.
Anyone who has a basic understanding of logic knows that my one example shatters your universal statement.
I would also note that many financial institutions offer a derivative that provides the return of the S&P 500 with two conditions. If the S&P rises more than X% you only gain X% on your investment, but if the S&P 500 goes down, your return is 0%.
I wonder how that derivative is about magnifying your bet? I expect an idealogue like you to come up with some twisted response.
In the words of Sean Connery: Suck on it! Suck it long and suck it hard!.
Its the big casino. You pay to play. There is no credit. What i might buy may become worthless. But I won’t drag you down in the process.
cactus,
What about the firms that would have gone bankrupt if AIG had not been bailed out?
This is the point that people are trying to make to you. If there were no AIG to write the CDS, the losses would have landed at the banks. We would have been bailing out a lot of individual banks instead of AIG. And remember, first AIG burned through it’s $180B market cap, instead of taxpayers having to fork that out.
One interesting example of this is Citibank. Citi did not buy CDS from AIG, instead it held the risk. Now it is a sick bank. http://www.businessinsider.com/how-citi-blew-itself-up-by-cleverly-avoiding-aig-2009-7
The losses have to go somewhere. First, the homeowners absorb the losses up to the value of their equity, then they pass the baton to the banks/mortgage holders, who absorb the losses until they burn through their equity, then the taxpayers begin to absorb the losses, unless you want the banking system to collapse,
Jay,
Your one example would shatter my universal statement if it were correct. I pointed out that it isn’t correct. Bank A could make a bet directly, or it could make a cheaper bet using a derivative that accomplishes the same thing according to your example. Hence, the derivative is a way to make the same bet with less money. That’s a multiplier. Period. End of story.
As to more convoluted derivatives… same thing. What is done with a derivative can be done without one. Its just more costly without it. Twenty years ago you’d have bought two insurance policies to pull a condor or whatever that’s called. Once again – you make a bigger bet with less money with the derivative. So once again, how is that not using a derivative as a way to multiply your bet relative to what you can do with the same amount of money using a more direct approach?
Cantab,
Of course derivatives did not cause the collapse of real estate. Where does anything I stated have anything at all to do with that? As I said earlier, the same result could have happened if the banks had used derivatives to bet on basketball games. And no, the derivatives would not have been the cause of your favorite basketball team losing.
sammy,
You missed the point of the question. If you acknowledge that AIG would have gone under due to derivatives without Uncle Sam, and some of the investment banks would have gone under had that happened, then you are saying that what I stated in the post – with derivatives, even those who win the bets could end up going under due to the losses of the losers.
Without the derivatives, the maximum total loss in the system was whatever the loss in the value of real estate. The derivatives multiplied that. A lot.
Still making shit up there cactus. A few months ago I realized I was going to need gasoline for my vehicle. I could have waited until the next day and bought some gasoline at the local retailer. Instead of waiting I went out and bought NYMEX unleaded gasoline futures set to expire in a day. I drove my car down to the F.O.B. seller’s facility in New York Harbor ex-shore and filled up my tank. I paid the same amount for the futures derivative than I would have at the local gas station. 5 gallons at $2.85 vs 5 gallons at (5 * $2.85) / (5 * $2.85) = 1.00000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000000.
Cactus,
Your post does not deliver on it’s byline. Let me go through your points.
1. Derivatives are about magnifying bets. A $2 bet on a derivative can be the same thing as a $100 bet on the asset that underlies the security. Thus, if the asset doubles in value, instead of taking home an extra $2 on your bet, you take home an extra $100. But if the price of the asset falls in half, instead of losing $2 on your bet, you lose $100.
For crude oil futures a full contract is for 1,000 barrels. If the price of oil goes up $1 and you multiply this by 1,000 dollar then your derivative changes in value the same as the underling, not like you say 50 times the underling.
3. Inevitably, when everyone is leveraged up, at least some of those who are leveraged must sooner or later make some bad bets. But the losses associated with these leveraged up bad bets was much bigger than in the past. Instead of losing $2 on their $2 bets as would have happened in the past, they lost $100. In the past, the losers’ assets would simply have been liquidated, and those assets would have been enough to cover a substantial part of the losses. With derivatives, liquidation covers an insignificant piece of what is owed.
Derivatives are a zero sum game. Some people are long in the market and some are short. On my oil furtures contract example if the price of oil goes up by $1 the long makes $1,000 and the short loses $1,000 the net change is zero. If prices fall by $1 the long loses and the short wing. But it zeros out and this is why its called a zero sum game.
4. Result: massive, and I mean massive, losses to the firm’s creditors. Perhaps big enough to drive their creditors out of business too. And those creditors have creditors too…
Like with the oil contract, there might be massive losses to ones side of the transaction but there will be massive gains to the other. In a market with hedgers and speculators again with oil if the price were to crash and the hedgers was holding a short position he would compensate the loss to the underling with the gain from his derivatives position and the speculator would lose on his long position. Without the hedge the hedger which might be a small oil company might eat the loss as the value of its product diminished. The derivatives is just a means to lock in a price.
5. As a result of 4, a firm could win all its bets and still be driven out of business, simply by virtue of being stupid enough to bet against another firm who realized point 2. (And every firm on Wall Street, apparently, realized point 2.) In fact, a firm could be driven out of business despite winning its bets if one of its counterparties was stupid enough to bet against another firm who realized point 2. Being twice or three times removed from a loser might not be enough to keep a firm from being pulled under.
This point also misses the mark. Take the oil price example, lets say it was a customized forward contract and prices crashed and the speculator defauled, then the hedger would not get the payment he expected. But this leaves him in the exact position he would have been had there been no derivative contract. So again, it the price movement in the underling that is causing trouble to market participants. A point that I’ve made several times here.
6. Derivatives are also opaque. There’s no way of knowing who took out which bets with who until someone declares bankruptcy.
Its a legal contract between consenting adults. These types of contracts exist all accross our country and its a function being in a free market rather than the socialist nightmare that Obama and the democrats are peddling. […]
I just re-posted this one to post it under my own username.
In the past, a fall in real estate values didn’t cause this sort of a panic worldwide.
IIRC, there hadn’t been a nationwide decline in real estate values since the Great Depression.
cactus,
The derivatives multiplied that. A lot.
I don’t see how. Derivatives are a zero sum game, so for every winner there is a loser. So their are no additional system wide losses. The derivatives market were under tremendous pressure in 2008-2009 with a lot of dramatic stock price declines. Some people lost a fortune selling puts and CDS, with hardly a ripple. They must have been well hedged.
So far there has been one (1) firm caught making an unhedged losing bet, that is AIG. One bailed out firm does not a Great Recession make.
even those who win the bets could end up going under due to the losses of the losers.
You are talking about Too Big To Fail, or the interconnectedness of financial institutions, here. This is indeed an issue, but one that exists with or without derivatives.
Cactus your posts are always your own thoughts. Plus you usually stick arround and defend your positions. That is why I like angry bear.
Those who aren’t satisfied with some of the commentary on credit derivatives and bubbles might enjoy reading these articles. DK Matai and company cut to the chase.
Derivatives Quadrillion Play: How Far Away Are We From A Second Financial Crisis?
London, UK – 23rd March 2010
http://www.mi2g.com/cgi/mi2g/frameset.php?pageid=http%3A//www.mi2g.com/cgi/mi2g/press/230310.php
The Eight Bubbles: What are the Numbers suggesting?
London, UK – 8th November 2008
http://www.mi2g.com/cgi/mi2g/frameset.php?pageid=http%3A//www.mi2g.com/cgi/mi2g/press/081108.php
The Invisible One Quadrillion Dollar Equation
Asymmetric Leverage and Systemic Risk
London, UK – 28th September 2008
http://www.mi2g.com/cgi/mi2g/frameset.php?pageid=http%3A//www.mi2g.com/cgi/mi2g/press/280908.php
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The OP is correct in stating that derivative allow people to magnify risk. Let’s look at the example of 1 barrels of oil. With oil futures, you bet on the price of the 1 barrel of oil, and your gain is limited to the price of that 1 barrel. With a derivatives, you can write 1000 contracts on that 1 barrel of oil, so that the effect of a change is price is increased 1000 fold.
As to the idea of a ‘Zero Sum Game’, when one side goes bankrupt, it becomes ‘less than zero’. What’s worse, non-related third parties will somehow be dragged in by the bankruptcy. Since the CDS market is not transparent, nobody knows who is solvent and who is bankrupt, and the ‘fear factor’ had caused a lot of damage.
Jay,
For crying out loud. When you create a complex tool intended to mimic a simple one but to also have some additional features such as allowing one to multiply ones bets, it won’t be able to mimic well in every condition. A model of the real world is imperfect, after all. For futures there are boundary conditions.
Now, you’re also pointing out its possible to be a complete idiot when using any tool, and to the folks who issue these tools, that is usually a feature, not a bug.
Bruce K,
That was the theory. But I’m complaining because the rest of us did get dragged down in the process. What happened in the Big Vegas didn’t stay in the Big Vegas.
sammy,
If you can make bets of size X without derivatives, and size Y with them, and Y is much bigger than X, then which gets you to Too Big to Fail faster?
Ronin,
The OP is correct in stating that derivative allow people to magnify risk. Let’s look at the example of 1 barrels of oil. With oil futures, you bet on the price of the 1 barrel of oil, and your gain is limited to the price of that 1 barrel. With a derivatives, you can write 1000 contracts on that 1 barrel of oil, so that the effect of a change is price is increased 1000 fold.
This is not right and not the way the contract reads. You have 1 contract that covers 1,000 barrels. If the price of oil changes by 1 dollar per barrel, then the price of all 1,000 barrels of oil covered by the contract change by 1 dollar and the total contract changes by 1000 dollars. There is not hocus pocus going on here.
Thanks RDan. I wasn’t keeping up with comments. I’d just like to add a bit more explanation.
strawCantab asks
How can all the firms go bankrupt ? Don’t some have to be winners ?
As RDan already explained winning a bet with a bankrupt firm does not give a bank cash. Claims are resolved with delay. The very valuable winning bet is not a liquid asset. It can be that, by the time you get what you can out of the bankruptcy court, you are in default. It can also be that if you sell the winning bet you will not get enough for it to hedge the risk you were trying to hedge (no one was buying at anything like the expected present value of the asset discounted at a normal interest rate).
Also, maybe people feared the hedge funds. They are very secretive. Some obtained huge huge winnings. A huge shift of wealth from banks to hedge funds could, in theory, bankrup all of the banks. The hedge funds don’t provide banking services.
Of course this didn’t happen, but people might have feared it. Looking at a hedge fund manager strut, you can’t tell if he made mere tens of billions or if he won some real money.
Or if he got laid.
Jay,
Say I state that house paint is intended to place color on houses.
You respond: “Some dude I knew found some a can of paint from the 30s sitting outside an abandoned gas station in the Mojave. It was dried out and cannot be used to place color on houses. Besides that, I bought it from him to use as a paperweight.”
That is not proof that my original statement is wrong.
Robert,
I don’t know what point you’re making. I’m pretty sure you don’t don’t either. Strawman? Can you defend that? I didn’t think so. Typical of the know nothings that write columns here.