Posted on 10/08/2008 7:46:06 AM PDT by oioiman
Leveraging means something like this. You sell $10 million in stock. You use this money as the basis to take out a loan so you can buy $100 million in mortgages. Now say you issue mortgage backed securities based on these and sell them. Now you have a $100 million in cash so you go out and buy more mortgages only this time you use your $100 million to buy a billion dollars of them. You have just leveraged your initial $10 million 100 times. This works if you, your banks, and the buyers of your paper are all sufficiently greedy. Why would banks loan you $100 million on $10 million collateral? The short answer is they wouldn’t for you or me, but they would and did to financial companies because of the fees and interest they made off of such transactions and because they “knew” those companies were good for it. This was all much easier to believe on the upside of the bubble because the value of the underlying assets (houses) kept going up. So even if a few percent of the mortgages defaulted, a) the house’s value is greater than at the start and you can sell it again and b) the overall value of the mortgage package on which all this was based kept going up as well. Banks were also making money in fees from writing loans and the companies they were loaning money to were precisely the ones who were buying these mortgages off them so that the banks could make more money in fees writing yet more mortgages.
As for derivatives, pertinent to this discussion, we are talking about two types. The first we have already mentioned. These are the mortgage backed securities. They are not the mortgages themselves but a financial instrument (or to use the technical term “thingy”) based upon or derived from them. (Buyers of these are not interested in the underlying asset but in the cash flow from it, i.e. the mortgage payments.) These can themselves be further sliced and diced into further generations of derivatives. For example, one that is based on 50% of this derivative plus 30% of that one and a final 20% of a third. And so on and so on. All this was to dilute and spread risk or moral hazard, but it also had the effect of putting vast distance between the mortgage title and the holders of the derivatives based on that mortgage. This raises two issues. First, it may be difficult to impossible to establish who is the ultimate holder of the last derivative in a chain of derivatives going back to the original mortgage backed security. Second, it is unclear that anyone in the derivative chain actually has a claim on the mortgage title.
The second kind of derivative is the swap. This was a kind of insurance policy in the event that some mortgages declined in value. This derivative basically said if you pay me a certain fixed amount say every 6 months I will make good on any difference between what you initially paid for your mortgage backed security and what it is worth when you come see me. When the housing market was going up, this amounted to essentially free money for the issuers of this kind of derivative. They could sell it as extra insurance to conservative institutions secure in the knowledge that the housing market would rise forever. Except of course it didn’t. The original idea was that if a package of mortgages or tranch loss value because of a high rate of defaults, the swaps or insurance buyer could demand a settlement from the swaps issuer to make up for the loss of revenue. Now on the upside of the bubble, default rates were low. Homes that went into default could be resold at even higher prices so there was no downside. However, when the bubble burst, default rates went up and issuers of these derivatives didn’t face payouts on one or two of them but on a huge number of them.
Now what is really amazing is that even as things got unsettled in the housing markets the unbridled greed of financial companies caused them to keep issuing swaps. And here’s the thing about them. Someone who wanted to take out this kind of insurance wasn’t limited to taking it out once but could take it out multiple times and so multiply their gains paradoxically off their losses. A derivative has often been described as a bet. You don’t need to own the horse to bet on it nor does it mean you can’t bet on it more than once.
And there is yet another thing. The issuer of the swap, the one who would be stuck paying out for losses, could go and buy another derivative which insured it against any losses which it might get hit with. Then the issuer of that derivative could go out and buy one to cover any potential losses it might have and so on and so on. Again amazingly all those things were out there and companies were often both buying and selling them so that they might be the seller of one of these swap derivatives and a generation or two later in the process be the buyer of one, and all of them involving the same initial deal.
You may be reeling about now and have decided this is madness. Well, it was. But it was a madness that took place out in the open in plain sight of governments and regulators around the world. And not one of them did jack to stop it.
That's very helpful thanks.
bookmarked
Nah, it’s all about ACORN mortgages. The fact that Wall Street pumped them up to 70 or so trilliion dollars worth of popcorn farts doesn’t figure in at all.
What’s not there to understand?
bump to read when i get home.
Looks ok to me, why don't you explain what he got wrong.
Right now everyone on FR (and many other places) has got it in their heads that derivatives (and leverage) are "clearly" a problem, but it isn't so. They are sharp knives, and shouldn't be played with by children. But they have done far more good than harm in the financial markets.
But the truth is, at this point I should know better than to speak up about it. The discussion long ago stopped being about things like facts, and now it's all about casting blame. I've seen this before. We go through it every few years or so, whenever the kids get into the knife drawer.
And now we're going to get some poorly designed regulation designed to prohibit leverage and the use of derivatives in spite of the fact that it's their misuse that's been a problem and not their use. Frank and Schumer will use this to limit our rights and even the people on FR will cheer them on becasue it's all about the evil "derivatives".
Do you have a source for that claim? The estimates I saw were $16 Trillion to $62 Trillion depending on whose estimates you followed...
Among other crazy illogical long term financial procedures.
I concur with the above, what's not to understand?
Your “sharp knives” analogy is right on the money, but this is always the way of the world isn’t it? I mean, something bad happens, and if it’s big enough and bad enough, government gets involved, bumbles through an “investigation” and ultimately puts forth a bad piece of legislation designed to “make sure this never happens again”. Just look at the “zero tolerance” rules that, to borrow the knife analogy, schools rely on to send a kid home for bringing a rubber toy knife for “show and tell”. One can hope for intelligent analysis and thoughtful legislation, but that’s probably like hoping Wiley Coyote will have the insight to develop a tactical cruise missile rather than just dropping a 1000 pound weight off the cliff.
Most people have no clue what financial shenanigans went on and have no concept of finance that reaches beyond the mortgate they signed. That’s what the author was trying to address.
That's not correct. They have added a great deal of systemic risk so that the normal credit deleveraging that has to happen in a credit cycle can no longer happen without triggering system wide defaults. Derivatives only lower risk for the parties who use them, and only if they are trading non-leveraged payment streams (e.g. interest swaps). What is described in the article goes far beyond that and is forcing the ongoing meltdown. The evidence from today's flailing by central banks followed by a market drop shows that the problem is not just credit itself.
This was supposed to be a “primer” and it serves that purpose. In fact, the underlying theme here is that the kids got into the kitchen knife drawer and went berserk, cutting each other to shreds even as their parents were passed-out drunk in a family room lit up by a TV test pattern.
You're mistaken about that, but I'm sure that's how it appears if you don't see the whole picture.
Tell Frank and Schumer I said hello.
Then let me offer my tutorial. Take two playing cards from a deck. Stand them on edge and lay another card across them. Repeat the process atop the first three cards until all cards in the deck are used. Should you succeed in reaching this point, pull out any one card and at the same time keep the structure from falling.
Since this isn’t really a tutorial I won’t charge my normal fee but you will have to furnish your own cards.
I understand your concern that people don't understand the problem, and that wrong regulations might make things worse, but that doesn't mean there should be absolutely no regulation. The more people are educated, the more likely any new regulation won't be just a backlash against losses out of fear, but something wisely and prudently thought out, to at least force companies to be more transparent so investors understand better what their real risks are. (Please, I am not an investment or finance person so that is why I'm trying so hard to understand all of this.)
Tell Cash and Carry I wish him luck.
Here is the total of the 2 main forms of derivatives (Exchange and Non-exchanged traded)
Over-the-counter (OTC) derivatives are contracts that are traded (and privately negotiated) directly between two parties, without going through an exchange or other intermediary. Products such as swaps, forward rate agreements, and exotic options are almost always traded in this way. The OTC derivative market is the largest market for derivatives, and is unregulated. According to the Bank for International Settlements, the total outstanding notional amount is $596 trillion (as of December 2007)[1]. Of this total notional amount, 66% are interest rate contracts, 10% are credit default swaps (CDS), 9% are foreign exchange contracts, 2% are commodity contracts, 1% are equity contracts, and 12% are other. OTC derivatives are largely subject to counterparty risk, as the validity of a contract depends on the counterparty’s solvency and ability to honor its obligations.
Exchange-traded derivatives (ETD) are those derivatives products that are traded via specialized derivatives exchanges or other exchanges. A derivatives exchange acts as an intermediary to all related transactions, and takes Initial margin from both sides of the trade to act as a guarantee. The world’s largest[2] derivatives exchanges (by number of transactions) are the Korea Exchange (which lists KOSPI Index Futures & Options), Eurex (which lists a wide range of European products such as interest rate & index products), and CME Group (made up of the 2007 merger of the Chicago Mercantile Exchange and the Chicago Board of Trade and the 2008 acquisition of the New York Mercantile Exchange).
Derivatives Trade Soars To Record $681 Trillion. The Bank for International Settlements [BIS] is reporting Derivatives traded on exchanges surged 27 percent to a record $681 trillion in the third quarter of 2008.
So $596 Trillion (Non-exchange traded as of December 2007), plus the Exchange-traded ($681 Trillion as of Sept 2008) equals $1,277 Trillion or roughly $1.28 QUADRILLION, and if you assume another $100 Trillion or so for the first 9 months of 2008 in Non-exchange traded derivatives, the total approaches $1.4 QUADRILLION. go to The Bank of International Settlements (BIS) website http://www.bis.org/index.htm and the International Swaps and Derivatives Association (ISDA) website http://www.isda.org/index.html for confirmation.
IMPORTANT NOTE- notice that non-exchange traded derivatives are NOT REGULATED
Up to very recently I always thought conservatives were more considered and thoughtful than liberals, but I've come to realize that they are just as prone to a knee jerk response as liberals, even if it's a different knee they're jerking. Ad because of that, they are justas prone to manipulation by the powerful as any kool aid drinking liberal. Barney Frank and chuck Schumer are the enemies of everyhting that conserviatves say they want. But they are going to use this 'emergency' to gain as much control over the lives of Americans as rthey can, and MANY on FR will be cheering them on.
Almost everything you are hearing about 'how bad derivatives are' is misleading. That isn't to say it's wrong ... but the typical method is to present such facts (whether irrelevant or not) as meaningful and leave out much of the story that actually is relevant. Its like calling John McCain a coward because he didn't once engage in combat during the year 1968.
All your replies are pure sophistry. You sound like a defender of a system that is useful only if a small cadre wants to financially create a web of entanglement far beyond any real amount of wealth that will ever exist,then usher in a police-state world government after the destruction of all state-based sovereignty.
There is no way you can justify this type of leverage on extraordinarly unsound investments. Also, the mortage-based securities could have all been covered had THEY NOT BEEN LEVERAGED beyond all reason. Then swap derivatives as hedge insurance were added on top. The whole thing was an ephemeral house of cards, bound to collapse as soon as a systemic area of weakness (in this case drivatives based on mortgages) punctured the balloon.
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