Now to swaps: one type of Derivative you’ve heard of on CNN or NPR is the Credit Default Swap. It is used to hedge risk in credit. Basically the risk that one person will default on their debt to another.
Explaining CDS s will make this blog very long, but suffice to say CDS’s made many people rich beyond your wildest dreams, and then bankrupted our entire generation. Enough said? Basically the CDS is a funky insurance policy.
AIG insurance (a manky set of bastards if ever there were any) wrote $78 billion in swaps. $78 billion dollars is a lot of money in private hands.
Swaps are used as risk hedging devices, they are similar to insurance contracts in that they transfer risk from one party to another. A buyer is insured against the bad credit and defaults of another party, Mrs. Counterparty let us say. If she goes belly up broke, the Seller of the CDS compensates the buyer of the CDS the difference between the par value and the market value of the CDS.
They INSURE the buyer against credit risk. However they appear to have exposed us all to quite a bit of risk.
Credit default swaps are, we note, totally unregulated. This isn’t necessarly a bad thing, but it is an interesting thing.
Some person, who I do not know, the Anti Christ, or possibly a Yale MBA, turned the CDS into a nifty instrument to make money. Credit Default Swaps became used not only to hedge against debt, but also to speculate whether or not companies would fail.
How this occurred, I do not know, but bear with me. Swaps were written in massive amounts over the original debt. Many swaps were written based on both really bad bets on whether or not certain companies would go out of business, but also on debts in the housing market often based on actual mortgage fraud. Or at least a lot of very bad stated income, no docs, no money down loans.
You might find it interesting that there are “only” about $45 trillion dollars worth of credit default swaps floating around. A lot of people made money on these things. Be happy for them.
Of course if even 5% of these were to, say, be defaulted on (and they will) we will have some… difficulties.
Now imagine defaults on NON swap instruments that form part of this 1,000 trillion soup. Imagine 5% of this market tanking. Now the good news is that much of this money are simply the same derivatives being sliced and diced in different ways. So its not really 1,000 trillion in assets – hell there aren’t even 1,000 trillion in real assets in the entire world.
Let’s just pretend and say that a physical trader at Merrill Lynch may intend to actually BUY 10,000 barrels of Crude Oil and take real physical delivery of the stuff in July 2008.
More likely however, its fake play-play Oil. Vapor, non existent stuff. All speculative contracts to buy or sell speculative assets that don’t exist. This is the magic of modern financial capitalism, and its danger. The massive money generated in the trades, sure enough exist, and also un-exist in the blink of an eye.
Financial derivatives markets are VERY sensitive to price fluctuations, it is possible for a trader to literally gain hundreds of thousands of dollars in the blink of an eye, or loose 3 million dollars in a minute.
Some consider this all to be a particularly sophisticated form of gambling, Poker has nothing on a day at the NYMEX exchange.
Some religious readers, Muslims and traditional Catholics in particular, may likely hold their noses at all of this. Such traditional religious canon law typically forbids purely speculative trading, and displays a severe discomfort with the idea of buying or selling things that do not really exist.
Some non-religious readers also may be very uncomfortable with this, in particular socialists or progressive lefties of all stripes. Buying and selling imaginary stuff that don’t exist, for cash that can be used to help other people in the world and relieve their suffering, and then blowing it all on nice cars, vapid chicks, and coke, strikes many sensible people as somehow… wrong-headed.
But back to trading: Traders look for risk hedging opportunities as well as opportunities for arbitrage between different derivatives on similar and related underlying assets. I’ve already defined arbitrage in an earlier post.
Taking a position – is basically making a well informed bet whether an underlying asset will go up in price or down in price – on a futures contract, options contract, or swaps, offer a trader huge returns
Example 1. Sybilka the Trader believes that a large plague will decimate the peasant sugar farmers of Brazil next year, so she may buy sugar, or just buy the OPTION to buy Sugar, at a certain price and sell it at a lower price, at a margin premium and gain a profit at the difference between the buy and sell price if her voodoo hoodoo prediction actually comes true.
Did any of that make sense yet? No? Well this is complicated stuff, why do you think we are on the verge of a depression.
Buying on a margin is basically buying with borrowed funds, which allows Sybilka the trader to take a larger position. To buy more stuff.
In some types of esoteric derivatives transactions its possible to make returns of 500-1000% profit or more.
The hedging portion limits the hedgers losses, however, if her bet proves wrong.
Derivatives can make you rich beyond their wildest dreams, or make you into an utter ass. The former typically have more testosterone to spare than most people and have balls of annealed brass. Many are also utterly daft, in spite of Wharton MBAs.
Examples of ass-dom:
1. A particular trader at a particular Hedge Fund lost $4 Billion dollars in one weak in the summer of 2007
2. One particular trader at Barings Bank – historically the second most powerful of England’s banking families after H.M. Rothschild & – destroyed the 200 year long Baring Banking empire due to a combination of dull mindedness, and short sightedness, and sheer ill baneful fortune, in 1995 by making a number of unauthorized derivative investments in futures indices.
The Kobe earthquake in Japan is the instance of baneful ill fortune, that occurred at the time of the guy’s trade, mucked up his mojo, causing him to loose USD $1.3 billion dollars. He bankrupted the entire bank, the second greatest Banking Family in Western history. Seriously, the house of Barings were right underneath the house of Rothschild’s. I think some of them still hold peerages in England to this day.
Back to the 2007 hedge fund incident, the fund itself still exists, while a smaller loss, for numerous reasons, bankrupted one of the most powerful banking families in the world.
Minor take home lesson, Hedge funds are kind of scary.
And that is that
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