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FReeper Guide to the REAL economic problem - Credit Derivatives - Lesson 1
Politicket | 9/27/2008 | Politicket

Posted on 09/27/2008 1:16:46 PM PDT by politicket

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To: politicket
The problem they faced is that the banking industry is heavily regulated and for a long time they were ‘burdened’ with managing illiquid assets that only gained a ‘good’ return. Credit derivatives was their salvation. It allowed them to create hedging strategies where they could actively participate in the “high risk – high gain” marketplace, while still ‘meeting’ the letter of the law in regulatory requirements.

Is this the real reason banks are going under? Since bets start with loans, was there incentive to make subprime loans even knowing they'd default?

141 posted on 09/27/2008 8:09:38 PM PDT by GOPJ (How can a 2 yr.old financial mess be an instant “crisis”? Is this the dem "October surprise".)
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To: palmer

This is all very confusing to me & I have been trying to make sense of this...up front sorry for length of this & it’s lack of clarity.

So would it be better to have not bailed AIG and let all the banks and investment companies go bankrupt—I ask this sincerely as I am wondering if then banks, credit unions that have none of these CDSs would emerge the winners—last man standing so to speak—I mean if govt bails out the companies that have these, then we are all on hook for trillions from what I read? What is US to do file chapter 11 to get out from them?

However, if a company or insurer (whoever is responsible for paying on the CDSs)of cannot pay on the value of the company debts or the “insurance policy” against insurance debt because they are bankrupt, then the liability would be limited wouldn’t it. Ex. We had a lifetime health club membership...well the health club went belly up & there were so many creditors that there simply were not enough assets to satisfy everyone’s claims—like trying to get blood from a turnip...not gonna happen. However, if the someone else had been writing policies against the health club ever going bankrupt, then they would be out lots of money—there were many unhappy campers. So the insurance company goes out of business too—but if the government is not involved in backing up the health club or the insurer of the health club, then wouldn’t only the holders of the health club memberships, the and the owners of insurance be sad out of luck?...of course there will be a lot of sad, fat health club members and owners of insurance feeling the pain, but only those who were involved as opposed to my whole community being on hook for bailing everyone out.

In other words, would the Armagedon that Paulsen forcast w/o bailout be less severe than the armagedon that might face our government if we are insuring all of them—I am sure we would be liable for some of the government insured stuff, but perhaps fewer...

Seems there has to be a way to save the country from this...please clarify. Thx!


142 posted on 09/27/2008 8:33:56 PM PDT by Freedom56v2
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To: wideawake
Thanks for the explanation.

Isn't the problem here the degree of leverage here? Am I correct in thinking that in your example the Widget bonds are leveraged 2:1? That is that there have been 200MM in CDS for 100MM in bonds. When Widget goes bankrupt it's going to be like musical chairs and a bunch of somebodies - indeed half the total investment in the CDS are going to be unable to get the bonds and get no return. I read that some of these large firms are leveraged by 40:1 and up to 80:1. If I am looking at this when a highly leveraged CDS goes, a lot of the investors lose.

Now, is this not precisely what they signed up for when they bought this crap? Shouldn't they just take their losses and learn from their mistakes?

Where I get angry is when there is real abuse and big piles of this stinking mess are tranched and then these pieces are further split and bundled and all of a sudden you have some real stinkers is SPVs that ratings that are far higher than their real risk. Here the investors lose but the bundlers and the raters have committed fraud. Should we not see lots of these wise-guys pay some hefty fines and do some significant jail time?

Please correct any misconceptions you detect. I want to understand this properly and that means quantitatively.

143 posted on 09/27/2008 10:11:30 PM PDT by RochesterFan
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To: GOPJ
Is this the real reason banks are going under? Since bets start with loans, was there incentive to make subprime loans even knowing they'd default?

I honesty don't know. My mind is still churning all of the possibilities.

I am not a conspiratorial person by nature. I try to look at the economic signs and understand the movement of the money and trades. But one thing REALLY bothers me:

The credit derivatives problem began increasing on a HUGE scale beginning in 2004-2005. The Fed was the head cheerleader, and Goldman Sachs and JP Morgan were holding the cheerleader up on their shoulders for all the investment community to see.

I was IN the investment consulting arena at the time. I know for a fact what investment 'strategies' they were devising.

Here's my conspiracy theory - and then I'll get back to being sane again....if 'someone' wanted to get rid of the middle class in this country then this is sure the way to go about it. </tinfoil>

Sigh....I feel better now...

144 posted on 09/27/2008 10:21:58 PM PDT by politicket (Palin-tology: (n) - The science of kicking Barack Obambi's butt!)
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...


145 posted on 09/28/2008 12:44:27 AM PDT by GodGunsGuts
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To: bushwon
We had a lifetime health club membership...well the health club went belly up & there were so many creditors that there simply were not enough assets to satisfy everyone’s claims—like trying to get blood from a turnip...not gonna happen. However, if the someone else had been writing policies against the health club ever going bankrupt, then they would be out lots of money—there were many unhappy campers

Not a bad example, so what happened to the money? With the MBS, there are defaults and there were profits skimmed off the top when the securities were created. But those numbers are roughly 10's of billions and billions respectively, yet the writeoffs are 100's of billions and will be trillions before it is over. The answer to the missing money is that it never existed.

The stock market in 2000 is another good example, everyone's shares were worth trillions, but that was paper wealth, not real wealth. In the case of your gym, while you put your hard-earned wealth into the membership, your neighbor may have put it on their credit card, paid off the credit card with a home equity loan, gone underwater on the house, and defaulted on the loans. That's the nature of a credit bubble, it is the predominance of paper wealth over capital.

As credit creates leverage (your neighbor using the paper value of his house to obtain loans), credit bubble contraction causes deleveraging. In the case of your neighbor who owes more than the house is worth, the bank takes the house, auctions it for half price, then takes other money owed from your neighbor's other assets like bank accounts. Let's say another neighbor uses his 100k HELOC from bank1 for downpayment on a property downtown and borrows 900k from bank2. The market turns down and his house is underwater. Bank1 takes the house and sells at a loss, just enough to pay the primary mortgage but not the HELOC.

Now the guy owes 100k to bank1 and 900k to bank2. Bank2 decides the guy is a poor credit risk and calls in the loan. The property sells for 800k in a fire sale. Now the guy owes 100k to bank1 and 100k to bank2. But what's this? He has 200k in membership deposits, guess who gets that money? There is potentially real money that disappeared, not just credit.

The problem is worse with derivatives. Money cannot be created from thin air without dangerous leverage. At least with banks and other institutions, the regulators can enforce risk and reserve requirements. For AIG, the State of NY regulated their insurance business and enforced requirements on reserves based on risk. But once AIG got into the business of CDS, the regulators were completely ineffective. They approved the business but AFAIK, did not perform any independent risk analysis. That meant that AIG could create and book profits on income streams that would not exist in a downturn. At that point, the income stream would disappear and they would owe whatever the default losses were.

In your health club case the "real money" is your own membership as you point out. In the case of AIG, the real money is the reserves for their other insurance business and the collateral for a large amount in loans (about a trillion). Your own health club payment was real, not borrowed, it came from your earnings and was spent on consumption. Your neighbor's payment was not, it was borrowed and because the money is gone, he can't get it back to use to keep his house. That where deleveraging creates a ripple effect in the economy.

In the case of AIG's trillion in loans, a lot of that is in the form of securities owned by other financial and nonfinancial entities, used to leverage other loans or provide collateral for economic activities. Some of those securities could be owned by the health club neighbor who wakes up one morning and finds that his AIG bonds are worthless. Then he gets a phone call from the bank.

146 posted on 09/28/2008 6:45:23 AM PDT by palmer (Some third party malcontents don't like Palin because she is a true conservative)
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To: palmer

Thanks for the explanation. Yikes!! It is still very confusing—like a spider web—all over whole country :(
still not sure even House Republicans are addressing this....Hope so


147 posted on 09/28/2008 8:10:14 AM PDT by Freedom56v2
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To: politicket
Here's my conspiracy theory - and then I'll get back to being sane again....if 'someone' wanted to get rid of the middle class in this country then this is sure the way to go about it.

Thanks. I've sometimes felt that a George Sorose type mind would be able to use this new product (derivatives) in dangerous way because so few would understood abuse of the product.

On the other hand, most free market outcomes are based on money moving from the impatient to the patient - and this might be no different. The destruction of the middle class might be an unintentional consequence of a more "perfect" market.

148 posted on 09/28/2008 8:40:43 AM PDT by GOPJ (How can a 2 yr.old financial mess be an instant “crisis”? Is this the dem "October surprise".)
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To: palmer
It is exactly a bailout for the CDS holders like Goldman Sachs.

Is Paulson going back to Goldman when he leaves the Administration?

149 posted on 09/28/2008 8:51:47 AM PDT by GOPJ (How can a 2 yr.old financial mess be an instant “crisis”? Is this the dem "October surprise".)
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To: Warlord

Bullshit. Not essential.


150 posted on 09/28/2008 8:57:28 AM PDT by bvw
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To: bushwon
From the Wash Post:
Democrats also made a number of concessions, abandoning demands that bankruptcy judges be empowered to modify home mortgages on primary residences for people in foreclosure. They also agreed not to dedicate a portion of any profits from the bailout program to an affordable housing fund that Republicans claimed would primarily assist social service organizations that support the Democratic Party, the official said.

Meanwhile, House Republicans won a major victory, persuading negotiators to include a provision that would require the Treasury Department to create a federal insurance program that would guarantee banks and other firms against loss from any troubled asset, the official said.

The first paragraph is good, letting judges monkey with mortgages is a great way to tank the value of the securities resting on them. The second paragraph is more ominous. Insurance might seem like a cheaper alternative to bailouts in the short run, but in the long run it just perpetuates the moral hazard that got us here in the first place.

The moral hazard here will from the knowledge that the govt will bail out a related company to save on insurance payouts. In other words another AIG will be saved for $40B so the govt can avoid paying 80B in insurance when the company defaults completely.

The real problems with the bailout and that provision are that it solves nothing in terms of reducing the credit bubble that will destroy us, and now we will use up even more of the fed's good credit rating in propping up our sick financial industry. As a result the dollar will go down (maybe not right away but inevitably) and the interest rate demanded for Treasuries will go up (although Bernanke has promised to prevent that by using monetary inflation).

151 posted on 09/28/2008 8:58:37 AM PDT by palmer (Some third party malcontents don't like Palin because she is a true conservative)
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To: GOPJ
Is Paulson going back to Goldman when he leaves the Administration?

I don't think it will matter. In a financial market this messy, there's plenty of ways to get the pudding.

152 posted on 09/28/2008 9:02:14 AM PDT by palmer (Some third party malcontents don't like Palin because she is a true conservative)
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To: bvw

not essential, and actually fatal.


153 posted on 09/28/2008 9:03:30 AM PDT by palmer (Some third party malcontents don't like Palin because she is a true conservative)
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To: politicket
Very good write-up. The net (note that word "net") effect of complex tiers of derivatives is to make a system brittle -- tightly coupled -- at the same time it allows endemic corruption.

The mix is explosive.

* * *

Comparing the complexity of derivative contracts to Col Sanders recipe is not quite right. The contracts -- see Warren Buffet's comments -- can often be too inscrutable to value, thus can only trade in an environment of implicit fraud. The Colonel's recipe is a top secret mix of 11 herbs and spices. People have made guesses at it, and good guesses, but the exact recipe is still a top secret.

Derivatives often are worse --- not only are they confections of ad-hoc mixes of securities and events and tabulated valuations and probabilities -- they can have accidental or deliberate omissions or mistakes. A cookbook recipe of 7 or 11 ingredients is simple. A derivative's mix of formulas and schedules is more than seven come eleven -- it is as if someone shredded the cookbook and someone else who wasn't themselves a particularly good cook pasted the shreds back in some hopeful order.

154 posted on 09/28/2008 9:13:58 AM PDT by bvw
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To: Warlord
What got me confused was, in posts 87, 96, 103 I thought we were talking about a real naked short, as opposed to a virtual "naked short" which was a byproduct of issuing a derivative.

Could you please go into more detail as to the kind of naked short you are referring to?

155 posted on 09/28/2008 9:18:12 AM PDT by PapaBear3625 ("In a time of universal deceit, telling the truth is a revolutionary act." -- George Orwell)
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To: politicket

Thanks ... great work!


156 posted on 09/28/2008 9:18:26 AM PDT by bvw
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To: PapaBear3625
From my understanding a “naked short” is borrowing a stock that one does not own and immediately selling the stock, thus leaving one with a “naked” short position on the stock. It's very possible that people use this term to mean different things. Either form of the transaction, however, is legitimate in and of itself, although, of course, open to abuse in various circumstances.
157 posted on 09/28/2008 9:23:33 AM PDT by Warlord
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To: bvw
Comparing the complexity of derivative contracts to Col Sanders recipe is not quite right.

Sorry....my poor attempt at injecting a little humor into a very sobering writeup.

158 posted on 09/28/2008 9:23:43 AM PDT by politicket (Palin-tology: (n) - The science of kicking Barack Obambi's butt!)
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To: palmer

Geez I really wish I had finished MBA program tho I am not sure they even had these instruments & paper back in the day when Earth crust was cooling and no VCRs invented yet.

So you are saying that by Bailing out AIG, we are avoiding the Credit Default Receipts from being exercised thereby saving money, but can’t bail everyone out & get crushed from these Credit default insurance-type policies because they are so leveraged—so much debt leveraged on for each dollar or original assets?

So where do we run? where do we hide?


159 posted on 09/28/2008 9:24:36 AM PDT by Freedom56v2
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To: wideawake
Comparing investment professionals to a drunk tourist at a Vegas craps table may be a cute laugh for the audience, but it's an inaccurate and misleading description.

That's not what the comparison was. I used to trade options, and I've worked with people who trade commodities and indexes -- they themselves say they are "putting a bet" on the market.

And I also know professional gamblers. They don't drink on the job.

And I've known investment professional to go out for a liquid lunch.

160 posted on 09/28/2008 9:31:06 AM PDT by bvw
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