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.