Jan 13th 2012, 14:18:09
Originally posted by Atryn:
oats: in one sense you are right, but in another it is much more serious than that. Because the bets are tied up with real actions that have real (economic) consequences.
Suppose I create a derivative based on the value of the DJIA. I somehow get a reputable institution like Goldman Sachs to take the other side of the bet. If the market goes up 1000 points in the next 24 months, I owe them $1M and if it goes down 1000 points they owe me $1M. Anything in between, nothing happens. This provides a hedge if we assume that we are both reputable.
Now, I go to someone else who is REALLY certain the market is going to crash or needs the hedge even more than me. What I need right now is $500k cash. So they loan me $500k cash with the $1M derivative as collateral against the loan. I go out and hire a bunch of people with that money. Now, lots of things could happen at this point.
1. I fail to repay the loan and the market stays neutral. I go into bankruptcy and the ppl lose their jobs. The guy who loaned me the money also loses out because I didn't repay and the derivative is worthless.
2. I fail to repay and the market goes up. I go into bankruptcy and the ppl lose their jobs. I also owe GS $1M but they'll never see that either. Again, the guy who loaned me the money loses out.
3. I fail to repay and the market goes down. I go into bankruptcy and the ppl lose their jobs. GS loses $1M and the guy who loaned me the money makes something under $500k (his $1M less the loss on the $500k loan and interest).
4. I repay the loan and the market is neutral. Nothing happens to anyone here. The lender made interest on the loan.
5. I repay the loan and the market goes up. I probably declare bankruptcy as I owe GS $1M and don't have it (unless someone wants to loan me THAT based on a succeeding business which I saddle with debt, ultimately leading to its demise anyway). The lender makes his interest.
6. I repay the loan and the market goes down. The lender makes his interest. GS loses $1M and I make $1M.
In 4 of these 6 scenarios the people who were hired lose their jobs.
My point isn't that money was "created or destroyed", but that the derivative was used as an item of value that led to actions that had real economic consequences for people who had no knowledge of the derivative transaction in the first place.
Thus the size of the derivative market is very important. Not because it represents "money created" but because it represents risk in the system with real consequences for people beyond those involved in the transactions.
It is legalized gambling.
Suppose I create a derivative based on the value of the DJIA. I somehow get a reputable institution like Goldman Sachs to take the other side of the bet. If the market goes up 1000 points in the next 24 months, I owe them $1M and if it goes down 1000 points they owe me $1M. Anything in between, nothing happens. This provides a hedge if we assume that we are both reputable.
Now, I go to someone else who is REALLY certain the market is going to crash or needs the hedge even more than me. What I need right now is $500k cash. So they loan me $500k cash with the $1M derivative as collateral against the loan. I go out and hire a bunch of people with that money. Now, lots of things could happen at this point.
1. I fail to repay the loan and the market stays neutral. I go into bankruptcy and the ppl lose their jobs. The guy who loaned me the money also loses out because I didn't repay and the derivative is worthless.
2. I fail to repay and the market goes up. I go into bankruptcy and the ppl lose their jobs. I also owe GS $1M but they'll never see that either. Again, the guy who loaned me the money loses out.
3. I fail to repay and the market goes down. I go into bankruptcy and the ppl lose their jobs. GS loses $1M and the guy who loaned me the money makes something under $500k (his $1M less the loss on the $500k loan and interest).
4. I repay the loan and the market is neutral. Nothing happens to anyone here. The lender made interest on the loan.
5. I repay the loan and the market goes up. I probably declare bankruptcy as I owe GS $1M and don't have it (unless someone wants to loan me THAT based on a succeeding business which I saddle with debt, ultimately leading to its demise anyway). The lender makes his interest.
6. I repay the loan and the market goes down. The lender makes his interest. GS loses $1M and I make $1M.
In 4 of these 6 scenarios the people who were hired lose their jobs.
My point isn't that money was "created or destroyed", but that the derivative was used as an item of value that led to actions that had real economic consequences for people who had no knowledge of the derivative transaction in the first place.
Thus the size of the derivative market is very important. Not because it represents "money created" but because it represents risk in the system with real consequences for people beyond those involved in the transactions.
It is legalized gambling.
Sure, but those values were assigned theoretically 'marks'. The question becomes who assessed the mark-to-market, how did they come to this assessment and were they profiting on the back sence? Hence the entire ordeal with Congress lambasting some of the ratings agencies who were marking fluff ridiculously.
On the marking side, those assigning the relative value and risk were operating under an old model. The old model believed in the notion that a national downtick in housing was next to impossible. So they would evaluate the CDOs, which are the primary derivatives you two are referring to, based on this old model. Namely, were the properties spread geographically (they presumed that a downtick could occur in regional markets, particularly during a recession--such as housing going down in manufacturing regions), were the valuations of the properties a spread, and were the incomes spread among other factors. Clearly this method was far from fail-proof when the recession was driven by a depressed housing market and people who bought way above their potential. Of course now you're getting into how were people approved for loans, which those writing the CDOs see only what the sheets record for your income and people sure as hell weren't running legitimate background checks on income.
Once we get past the marking process then the picture becomes more clear. When the housing market was booming and using the old methodologies, betting/hedging with derivatives based on existent profits/funds/etc seemed like a no-brainer. The downside risk was minimal if the CDOs contained proper marking. And everyone trusted the gold standard of marking, at least for the purposes of investing.
The derivatives became their own shadow market. Folks were shorting them, folks were using them as collateral for borrowing, folks were doing everything done in the regular market except that with derivatives there isn't a clearly recorded place. And this was the US government's fear of why one guy like Lehman could theoretically unravel the whole pie. It's also why the government could effectively get other big banks to buy up the 'bad banks' or 'bad firms' because they knew they were just as tied to the unraveling as other folks.
Do derivatives have value? Yes, but how is the value determined and assigned? And does it have value is all of the other derivatives it's up against lose value too. That's a whole other debate.