Re: good question Credit Default Swaps

[David Farber <dave () farber net>]

________________________________________
From: gruntled () gmail com [gruntled () gmail com] On Behalf Of Dave Wilson [dave () wilson net]
Sent: Wednesday, April 02, 2008 7:09 PM
To: David Farber
Subject: Re: [IP] Re: good question Credit Default Swaps

Not exactly.

First, I need to emphasize that I'm speaking solely for myself.

You can think of derivatives as a piece of paper that allows people to invest in the future value of an item -- whether 
a commodity like a house or a share of stock -- without actually owning that item. That is, you can place a bet on 
price fluctuations of something without going through the effort of actually buyng that something. For example, you 
commit to selling your stuff on a specfic date for a specific price; the buyer is betting your stuff will be worth more 
than what he's paying for it on that future date, while you are wagering that it will be worth less than what you'll be 
getting for it; somebody is going to come out ahead and somebody wll lose money on that deal. It's a contractual 
arrangement, and this sort of thing goes back thousands of years. Derivatives are arguably best used as a risk 
management tool, a type of insurance that allows one to "hedge" against a negative (though presumably unlikely) 
outcome; farmers do this sort of thing all the time to guard aganst a season of bad weather, for example.

The problem is that derivatives can let you do all this without actually spending any money. At least initially.

You can sign a contract betting on the price of derivatives by spending just tiny fraction of what you're agreeing to 
pay at the end of the contract.  And if your bet pays off, thats not a problem: You pay your contract and keep your 
profits. But if you bet wrong, you could be in serious trouble: You have to come up with that cash. To do that if 
you're bet wrong in a very bigh way, you generally have to have a fire sale of your other assets, which can depress the 
prices for other people who hold similar assets, so they wind up dumping their assets too, which drives prices down 
further.

So, to say the well over $400 trillion in derivatives isnt "real money" is incorrect; when your contract comes due, 
you've got to pay up or go bankrupt.

Now, in traditional US investing, there are limits on the amount of debt you can go into when investing; your level of 
"leverage" is limited. This is designed to prevent the guy who cuts my hair from waking up one day and betting that GM 
shares wll gain 200 points next week; requiring that a substantial part of that bet be made with real money limits such 
investments to people who have to put some skin in the game, so they are (or are at least supposed to be) more 
cautious. (I tiredly note that such leverage restrictions in US markets were enacted when the Great Depression 
demonstrated what happens when the guy who cuts your hair starts shorting stocks...)

In contrast, while some derivatives are traded in highly structured markets -- like my farmer example -- many more are 
traded with no oversight or regulatory restriction at all. Further complicating this is that these contracts, because 
they have "value," have come to be traded as though they were currency. So you've basically got the investment 
community printing its own money.

 You can have a million dollar derviative contract by putting up just a few thousand dollars of your own money. Bet 
right, and you win huge. Bet wrong, and you're out of business (like Bear Sterns).

But it's not just you who's out of business. Anybody who you owed money to is also out of business, as is anybody that 
those people owed money to. This kind of cascade failure can topple economies overnight (which is why the Federal 
Reserve decided to prop up the shell of Bear Sterns last month).

The reason the amount of money traded in derivatives is important is that it gives us handle on how much leverage we're 
talking about, that is, how much we should be concerned if a downturn in the economy starts causing these bets on 
derivatives to have been poor ones. Here's a summation:
The estimated total of the US money supply is maybe $20 trillion. The estimated value of derivatives -- which, as I'm 
sure you've probably realized after my little lecture here, you can think of as a essentialy an unregulated money 
supply -- is $500 trillion. That's half a... well, numbers after a trillion are pretty much meaningless, so let's just 
say it's about 35 times the total US Gross Domestic Product. In fact, it's almost ten times the Gross Domestic Product 
of every nation in the world added together.

So that's a *lot* of leverage there. Its no wonder that Warren Buffet called derivatives a ticking time bomb and 
"financial weapons of mass destruction." When they go bad, they go bad in a very big way. Leverage (debt) is like that; 
it's great being able to take out a loan and pay it back with future profits. The leverage amplifies your win, since 
you didn't have to put up your own money. But if you bet wrong, leverage amplifies your losses on the same scale.

There's lots of other issues with derivatives. For example, a lot of people say they encourage participants to be less 
than scrupulous with their accounting (see Enron). But the leverage thing is the big concern at this point.

On Wed, Apr 2, 2008 at 5:32 PM, David Farber <dave () farber net<mailto:dave () farber net>> wrote:

________________________________________
From: Rod Van Meter [rdv () sfc wide ad jp<mailto:rdv () sfc wide ad jp>]
Sent: Wednesday, April 02, 2008 5:09 PM
To: David Farber; eric.cecil () gmail com<mailto:eric.cecil () gmail com>
Cc: ip
Subject: Re: [IP] good question  Credit Default Swaps

> IOW, how can you bet more than twice the amount of money than there exists in the entire U.S. economy?
>
> ... I simply attempting to grasp what it means when someone says $45 trillion is in play, but the U.S. economy = $22 
> trillion.

I would be the *last* person to know anything serious about markets, but
I think you've misunderstood something here: the value of the securities
(the debt on the mortgages, right?) is only $7T, but the amount of
trading of those securities was worth $45T.  That is, the average
mortgage traded hands 45/7 = ~6.5 times in *one year*.

So there is not twice the total size of the economy in debt "in play".
This is equivalent to asking the total value of the stocks that get
traded on the stock market in a year.  I have no idea what the number
is, but it's a *lot* more than the total sales of all the companies.

When a mortgage trades hands, obviously that's a financial transaction;
I have no idea what number is added to the size of the U.S. economy --
what "value" does that trade have?  If it were 100%, then the $22T total
economy would have to be greater than $45T, right?  But nobody could
afford to trade them at that rate.  It's probably a small fraction of a
percent of the value of the loan, or the banks couldn't afford to trade
them seven times a year.

We're wandering a little far from IP's primary mission, but I'm curious
what fraction of the total economy is "paper trading" of securities,
consulting with lawyers, and other back-end economic activities that are
not primary production.  (n.b.: I'm not saying that those are of no
value; they are very valuable to our complete economy.  (If you don't
believe in, say, the value of venture capitalism, look at a country
without it.) But there must be some ratio of primary to secondary
economic activity beyond which it's unsustainable -- *somebody* has to
actually grow the food and build the automobiles.  The same argument
applies to entertainment costs.)

               --Rod



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