Derivatives for dummies

Back in the first post I ever wrote here, I referred to the shadow banking system that trades in complex financial derivatives. A blogger at Dandeliion Salad who calls herself “The Other Katherine Harris” (and if your name was Katherine Harris, wouldn’t you?) has written a long but accessible explanation of derivatives that underscores the casino aspect of the market:

Imagine being able to insure a car that you don’t own or use. Imagine it’s the car your neighbors will let their teenage son drive, when he gets his license in a few weeks — and you know the kid is a reckless brat.

Now imagine that, by using financial derivatives called swaps, you can purchase as many insurance policies on this car as you can afford to pay premiums on.

When that car is eventually trashed and scrapped, you — and any friends you clued in on the deal – might collect millions, even billions, of dollars. By contrast, your neighbors, who bought real insurance on a real vehicle, get only its Blue Book value (and, one hopes, a chastened child).

This explains the primary problem with swaps. Anybody can bet on anything, so the nominal value of the bets far exceeds the actual worth of any property involved.

Still worse, no tangible or financial asset has to be in the picture. Wagers of any amount can be made, based only on opinions. You can bet on next Wednesday’s weather, if a counterparty wants to take the other side.

Only a fraction of swap action stems from logical situations in which, say, Party A owns a certain debt-based bond and Party B feels good enough about its prospects to accept premiums against possible default. Those are the Credit Default Swaps we hear so much about, which are a small part of the picture.

There’s much more. Highly recommended.

 

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Comments (1)

  1. Submitted by Steve Titterud on 03/02/2009 - 06:28 pm.

    I like Ms. Harris’ advice to declare all the contracts involving nonsensical gambling in the form of unreported derivatives null and void. Since they sum up to more than 1000 TRILLION dollars at this point, more money than exists in the whole wide world, and their sum well could be higher, since they are essentially secret, could it be more clear they threaten our economy?

    In particular, if the monies now being shoveled out to AIG are in fact not restoring the financial health of AIG, but rather paying off on the cynical bets made by a class of parasites, what good can possibly come of it?

    The info Ms. Harris speaks of is publicly accessible at http://www.bis.org/, although you might have to do some searching within their document database to find the fascinating nuggets within.

    One of the arguments made in defense, that these gross total numbers are inflated because some of the bets for and against event X “cancel each other out”, is bogus. If there is a chain of bets about event X between parties A, B, C, & D – they ALL have to pay off in order for the net settlement held forth in this argument to hold water. We’ve seen that even the biggest players cannot pay these obligations, and this argument amounts to an impossibility, really, an insult.

    I crave to know how much of this bailout money is going to the sleaze-meisters of this phony-baloney derivative market! But no one involved is talking.

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