Help Needed: Please Explain Derivatives

[MarkCentury]

I keep hearing Alex, Ron Paul and others talk about how the real problem is the pyramid of derivatives.

What are they talking about?

There's this article:

http://www.globalresearch.ca/index.php?context=va&aid=10265

But I'm hoping our forum includes some market experts who can explain this for the rest of us in simple terms.

Please don't just link to complex articles or impress us with terminology ...

I'm looking for the "Derivatives for Dummies" version.   

Many thanks to who ever takes up this challenge.

[GlobalCordon]

Not sure... hmmm the only pyramid i know has a big eye at the top.

[Typhoon]

Not sure... hmmm the only pyramid i know has a big eye at the top.

rofl 

[Typhoon]

so far no better outcome than this

[Jon W]

http://finance.yahoo.com/tech-ticker/article/62699/New-World-Order-Likely-Morgan-Merger-Leaves-Goldman-Last-Man-Standing?tickers=MS,GS,WB,BAC,XLF,AIG

$500[color=TRILLION "in derivative stocks to unwind"


world econmoy produce $54.3 trillion

[MarkCentury]

http://finance.yahoo.com/tech-ticker/article/62699/New-World-Order-Likely-Morgan-Merger-Leaves-Goldman-Last-Man-Standing?tickers=MS,GS,WB,BAC,XLF,AIG

$500[color=TRILLION "in derivative stocks to unwind"


world econmoy produce $54.3 trillion

Great link Jon!

As you say, this page refers to $500 TRILLION dollars in derivatives!  Even more unsettling, the page contains a video interview with Todd Harrison, CEO of Minyanville.com who clearly states that we are witnessing the unfolding of the  "New World Order" ... a seismic shift for all markets.

The phrase "New World Order" is loaded with implications - all certain to be known to Todd.  It's clear he thinks that the global powers are making their move!

That said, I am still looking for someone to break down exactly what derivatives are.  I have a fuzzy idea that they are contractual bets that another asset (company or stock) will go up or down and that somehow they are tied into hedge funds.  I've never clearly understood hedge funds so this is only partially helpful. ...  Does this mean, for example, that some "investors" previously placed a high priced bet that Lehman Brothers would fail?  And now that it has they are trying to collect?  But I'm guessing that in the current context they can't collect - because the funds aren't there???

OK you can see how fuzzy my understanding is ... which is why I'm hoping someone can explain what appears to be the central reason for the bailouts.

[Jon W]

I will say that most investments made by these institutions were made with borrowed money. When the market went south, these were as margin loans and the full amount, including the borrowed amount was lost or called in.

this defines it better than I can

http://en.wikipedia.org/wiki/Derivative_(finance)

[Capt. Obvious]

I keep hearing Alex, Ron Paul and others talk about how the real problem is the pyramid of derivatives.

What are they talking about?

There's this article:

http://www.globalresearch.ca/index.php?context=va&aid=10265

But I'm hoping our forum includes some market experts who can explain this for the rest of us in simple terms.

Please don't just link to complex articles or impress us with terminology ...

I'm looking for the "Derivatives for Dummies" version.   

Many thanks to who ever takes up this challenge.

Derivatives are financial instruments built on something else. For example, "options" in the stock market, are contracts that are created between two parties (anyone) to buy or sell a stock at a given price by a certain date. So you could buy a "call option" from someone that says you can buy XYZ stock between now and the end of october for $50 a share. This "option" that you bought will cost you some money, because the guy selling it to you is taking on some rick. The stock could shoot up to $60, but with you stock option you can by the stock for only $50, $10 cheaper than the market. So this stock option that you bought is actually worth money. The right to buy the XYZ stock at $50 is worth something, how much is determined by where the XYZ stock currently is and how much time is left until your stock option expires.

So now imagine a bunch of guys only trading stock options. Their portfolio may have millions of dollars of options, but no stocks. In fact, there could actually be more money traded in options than stocks. This is an example of the derivative problem they are talking about. Stock options are just one type of derivative.  So if there are $4 trillion of derivatives on the books, what does that really mean? That's $4 trillion dollars worth of contract created for buying and selling perhaps $1 trillion of stocks.

[MarkCentury]

Derivatives are financial instruments built on something else. For example, "options" in the stock market, are contracts that are created between two parties (anyone) to buy or sell a stock at a given price by a certain date. So you could buy a "call option" from someone that says you can buy XYZ stock between now and the end of october for $50 a share. This "option" that you bought will cost you some money, because the guy selling it to you is taking on some rick. The stock could shoot up to $60, but with you stock option you can by the stock for only $50, $10 cheaper than the market. So this stock option that you bought is actually worth money. The right to buy the XYZ stock at $50 is worth something, how much is determined by where the XYZ stock currently is and how much time is left until your stock option expires.

So now imagine a bunch of guys only trading stock options. Their portfolio may have millions of dollars of options, but no stocks. In fact, there could actually be more money traded in options than stocks. This is an example of the derivative problem they are talking about. Stock options are just one type of derivative.  So if there are $4 trillion of derivatives on the books, what does that really mean? That's $4 trillion dollars worth of contract created for buying and selling perhaps $1 trillion of stocks.

Very helpful Capt!

Isn't this market for options and other derivatives regulated?  For example, before someone sells you an option to buy N shares of XYZ at $50, doesn't there have to be some basis for guaranteeing that they will actually be able to deliver the stock to you should you chose to exercise your option?  If the options to purchase a given stock exceed the actual number of shares available for purchase, then I guess this is nothing more than a fraudulent scheme that depends on only a small number of people actually exercising their options??

And why would this be a problem ... for example if someone held an option to buy Lehman Brothers at $50 (or whatever) and the investment bank fails, I suppose it could be claimed that the option was still valid, but futile since a share in bankrupt firm quickly become meaningless?  So go ahead spend your $50 per share to buy Lehman Brothers stock??

[baldguy]

Here is an old thread on derivatives, hope it helps

    http://forum.prisonplanet.com/index.php?topic=44099.msg195790#msg195790

[Switters]

http://forum.prisonplanet.com/index.php?topic=59693.0

Here was an article posted earlier today that really helped me understand derivitaves and the impact they have.

[Kregener]

Explain Derivatives?

Mangle poncho kite buzzing integral siphoning. Greater nullify dog steamshovel eaves fester.

Hope that helps...

[Capt. Obvious]

Very helpful Capt!

Isn't this market for options and other derivatives regulated?  For example, before someone sells you an option to buy N shares of XYZ at $50, doesn't there have to be some basis for guaranteeing that they will actually be able to deliver the stock to you should you chose to exercise your option?  If the options to purchase a given stock exceed the actual number of shares available for purchase, then I guess this is nothing more than a fraudulent scheme that depends on only a small number of people actually exercising their options??

And why would this be a problem ... for example if someone held an option to buy Lehman Brothers at $50 (or whatever) and the investment bank fails, I suppose it could be claimed that the option was still valid, but futile since a share in bankrupt firm quickly become meaningless?  So go ahead spend your $50 per share to buy Lehman Brothers stock??

Yes the markets are regulated, but like fractional reserve banking, that doesn't fix the fundamental problem.

For options, if you sell them (write), then your broker is responsbile to make sure that you can make good on the option you wrote IF you get exercised. When someone decided to exercise their option before expiration (note that most options expire, they are never exercised, kind of like how most homeowners insurance is never used), there is a random method used to decide who must fulfill the options exercise. So you may sell me an option, I exercise it, but I don't get to decide who actually must fulfill the options contract. The Exchange Board randomly picks someone out of the pool of people who have written (sold) that option. It may be the original guy, it may not. Again, the brokers make sure the clients can fulfill the exercise. They do this in different ways: one could be to require the person writing the option to actually already have the stock that they are writing the option against. Another way is to require that they have 50% of the cash needed to go out into the market place and buy the stock if the get exercised. And another way is to allow them to buy a different option at a different stock price. This would be a "spread" and limits your risk to only the difference between strike prices. Anyway, you can look that up if you want, but there are several ways to make it fair and mitigate risk. But the fact remains that a lot of people have a lot of money in options or other derivatives, and not in stocks, which is what options are "derived" from.

[MarkCentury]

Explain Derivatives?

Mangle poncho kite buzzing integral siphoning. Greater nullify dog steamshovel eaves fester.

Hope that helps...

[xereau]

In 30 words or less:

Derivatives are assets with value that are only real on paper, acquired via the fractional reserve money creation scam.  It is acquisition via inflation.

Once people realize that the value of their home, or gold, or ANY commodity at all, has been hyperinflated, the entire system will deflate back to the point where real assets are the only thing that matter.

It is only a matter of time before leveraging out money via some new banker scheme gets us back to where we are today.  This is why we need an entirely NEW system.

[MarkCentury]

Yes the markets are regulated, but like fractional reserve banking, that doesn't fix the fundamental problem.

For options, if you sell them (write), then your broker is responsbile to make sure that you can make good on the option you wrote IF you get exercised. When someone decided to exercise their option before expiration (note that most options expire, they are never exercised, kind of like how most homeowners insurance is never used), there is a random method used to decide who must fulfill the options exercise. So you may sell me an option, I exercise it, but I don't get to decide who actually must fulfill the options contract. The Exchange Board randomly picks someone out of the pool of people who have written (sold) that option. It may be the original guy, it may not. Again, the brokers make sure the clients can fulfill the exercise. They do this in different ways: one could be to require the person writing the option to actually already have the stock that they are writing the option against. Another way is to require that they have 50% of the cash needed to go out into the market place and buy the stock if the get exercised. And another way is to allow them to buy a different option at a different stock price. This would be a "spread" and limits your risk to only the difference between strike prices. Anyway, you can look that up if you want, but there are several ways to make it fair and mitigate risk. But the fact remains that a lot of people have a lot of money in options or other derivatives, and not in stocks, which is what options are "derived" from.

Thanks Capt.  It sounds like you have done some investing yourself.

[MarkCentury]

In 30 words or less:

Once people realize that the value of their home, or gold, or ANY commodity at all, has been hyperinflated, the entire system will deflate back to the point where real assets are the only thing that matter.

It is only a matter of time before leveraging out money via some new banker scheme gets us back to where we are today.  This is why we need an entirely NEW system.

Agreed.  Ron Paul keeps talking about a gold standard, but I don't believe this alone is the answer.  A gold "standard" can (and has been) manipulated ....

The best solution I've heard was put forth by the producers of "The Money Masters". 

If you you haven't watched The Money Masters do so immediately!  It should be at the top of your list!

View a crappy online version here:
http://video.google.com/videosearch?q=the+money+masters&hl=en&emb=0&aq=f#

Buy a high quality version you can show others here (recommended):
http://infowars-shop.stores.yahoo.net/momadvd.html

Their central idea is to eliminate fractional banking altogether (i.e. reserve requirements of 100%).  This would force banks to only "loan what you own"!  They've codified this in their proposed Monetary Reform Act:

http://www.themoneymasters.com/mra.htm

here's a summary in just four paragraphs:

"This proposed law would require banks to increase their reserves on deposits from the current 10%, to 100%, over a one-year period. This would abolish fractional reserve banking (i.e., money creation by private banks) which depends upon fractional (i.e., partial) reserve lending. To provide the funds for this reserve increase, the US Treasury Department would be authorized to issue new United States Notes (and/or US Note accounts) sufficient in quantity to pay off the entire national debt (and replace all Federal Reserve Notes).

The funds required to pay off the national debt are always closely equivalent to the amount of money the banks have created by engaging in fractional lending because the Fed creates 10% of the money the government needs to finance deficit spending (and uses that newly created money to buy US bonds on the open market), then the banks create the other 90% as loans (as is explained on our FAQ page). Thus the national debt closely tracks the combined total of US Treasury debt held by the Fed (10%) and the amount of money created by private banks (90%).

Because this two-part action (increasing bank reserves to 100% and paying off the entire national debt) adds no net increase to the money supply (the two actions cancel each other in net effect on the money supply), it would cause neither inflation nor deflation, but would result in monetary stability and the end of the boom-bust pattern of US economic activity caused by our current, inherently unstable system.

Thus our entire national debt would be extinguished – thereby dramatically reducing or entirely eliminating the US budget deficit and the need for taxes to pay the $400+ billion interest per year on the national debt - and our economic system would be stabilized, while ending the terrible injustice of private banks being allowed to create over 90% of our money as loans on which they charge us interest. Wealth would cease to be concentrated in fewer and fewer hands as a result of private bank money creation. Thereafter, apart from a regular 3% annual increase (roughly matching population growth), only Congress would have the power to authorize changes in the US money supply - for public use -not private banks increasing only private bankers' wealth."

[donnay]

Here's another really good article explaining Derivatives...

IT’S THE DERIVATIVES, STUPID!
WHY FANNIE, FREDDIE AND AIG ALL HAD TO BE BAILED OUT

http://www.webofdebt.com/articles/its_the_derivatives.php

[El Scampio]

The main issue with derivatives is Credit Default Swaps. Thats what will cause the meltdown.

Total figure for the whole derivatives is around $1.14 Quadrillion by the Bank of International Settlemets (BIS)

Very basically the bankers make a bet between each other with money they haven't got.

I saw a BIS report for the fiscal end of year for 2007 showing JP Morgan had $93 Trillion derivatives backed by only £1.3 Trillion capital. 

I found something very interesting last night. The derivative amounts that Fannie and Freddie had at time of going down gets released on the 29th September by the ISDA (INTERNATIONAL SWAPS AND DERIVATIVES ASSOCIATION, INC) Thats 1 day before the fiscal year end for the finance sector.

It quotes:
"ISDA expects to publish the final lists of Deliverable Obligations, along with the final version of the Protocols for Fannie Mae and Freddie Mac, on Monday, September 29."

So i'm assuming all the big guns on wall street will see who is owed what by Fannie and Freddie. I am assuming that most won't know the extent of each others derivatives with these 2 companies. So that will be when they find out.

It doesn't say at what time it is released though 

[Kregener]

JP Morgan-Chase reportedly 'owns' $50 TRILLION in 'derivatives'.

[Kregener]

Meaning: They have committed financial suicide, they just have not told anybody yet.

[Gunny]

Guys stop flaming...

If you want to understand what a Derivative is you have to go to the source.

http://cboe.com/LearnCenter/default.aspx

The CBOE is a great place to start.

[MarkCentury]

Guys stop flaming...

If you want to understand what a Derivative is you have to go to the source.

http://cboe.com/LearnCenter/default.aspx

The CBOE is a great place to start.

Flaming?    Need to read a little closer Gunny.  This thread has been nothing but helpful links and discussion on topic.  I think you must have glanced at "It's The Derivatives Stupid" from an earlier post - but that is just the title of an article.

Anyway, thank YOU for that great CBOE link!

[Spectre]

I'll try and find a bit more information on derivatives and see if I can come up with a reasonable answer to your inquiry.

For what it's worth; I don't think that even the so-called 'experts' can fully explain what derivatives are. From what I've read previously, I understand that the term covers a multitude of complex investment vehicles, not just credit default swaps (insurance if a bet goes wrong) or futures and options trades.

If I'm successful in finding anything that I can understand (it'll have to be simple!) I'll either post a link or I'll try and condense it down to something more reader friendly. It might take a while though as I'd like to be sure that what I'm posting is correct so that I don't mislead anybody.

[Spectre]

Okay, now I know that you said that you didn't want links to complex articles but I think I've found a site with a relatively clear and simple explanation.

If I try and condense it down myself I'd probably end up confusing the issue and I'd use up a lot more words than the original article.

Take a look at this site:

http://www.finpipe.com/derivatives2.htm

Also, if you scroll down the page you should see lots of shortcuts to other explanations of economic/financial terms and instruments commonly in use in the press and economic essays and commentaries.

I hope this helps you improve your understanding of these complex topics.

If you still find that this does not really answer your questions you could also consider emailing Bob Chapman. I've done this in the past and he does answer his emails:

international_forecaster@yahoo.com

[Al-CIAda]

Learn the fraudulent nature of fractional reserve banking, google it and you shalt know.

[Gunny]

There are videos on CBOE.com that explain options/derivatives pretty well.

[UK Lyn]

Here's a download link for a recent Jeff Rense show with guest Webster Tarpley on Derivatives, from Sept 22 2008.

Not my own show source, but the quality seems fine.

http://rapidshare.de/files/40550034/Jeff_Rense_-_09-22-08_-_HR2_-_Webster_Griffin_Tarpley_-_Derivatives_Are_Illegal_-_That_Is_What_s_Bei.html

[UK Lyn]

..and while I got your attention... sorry its slightly off-post-topic, but here are some more recent financial crisis themed Rense shows, sourced from usenet, but linked here for those of you who don't have a usenet account.  Not checked by me but usually okay, let me know if any are corrupt files.

http://rapidshare.de/files/40550197/BigKegORense.rar.html

contains:

09-19-08 - Harley Schlanger - The Crash Of 2008

09-22-08 - Dr. Hesham Tillawi PhD - The Meltdown Of The US Economy

09-23-08 - Webster Griffin Tarpley - Updated Financial Crash Analysis

09-24-08 - Catherine Austin Fitts - Financial Analysis

09-24-08 - From Tokyo - Benjaimin Fulford - US Crash Asian Impact

[pac522]

Hedge Funds, Leverage, and the Lessons ofLong-Term Capital Management, Report ofThe President’s Working Group on Financial Markets. Check out what they knew back in April of 1999.

http://www.scribd.com/doc/5406501/Hedge-Funds-Leverage-and-the-Lessons-of-LongTerm-Capital-Management

[pac522]

I know a put and a short are a type of derivative but this link has some good info.

Also this link: http://www.businessjive.com/

From this thread: http://forum.prisonplanet.com/index.php?topic=31166.0

Thanks to boomerkel.

[Nailer]

http://www.marketoracle.co.uk/Article6495.html

Bailout Secret- To Prevent $68 Trillion Derivatives Collapse Chain Reaction



I'm just a simple moderately dumb real estate analyst, I had always assumed this was all about house prices and RMBS's. Now I realize I was duped, that's just a side-show. But I don't think I'm the only one.

Why did Paulson jump in to save some, and not others? Now I got it, it's all about how much CDS's they were exposed to.

I believed Mr. Paulson when he said that the $700 billion was to clean up balance sheets. Why shouldn't I? That's what he said clear as crystal, I wrote it down.

What's on the balance sheets is the RMBS's, but why now and why $700 billion? I couldn't understand it.

But it's nothing to do with the balance sheets.

I wouldn't be surprised if on average those RMBS are worth 80 to 90 cents on the dollar if they are valued properly (i.e. not Market to Market). I mean OK that's lot of money, but we all lost 20% on deals in our time, you just dust yourself off and get on trucking.

But this crisis is not about accounting rules, I couldn't understand how they were all being so dumb saying “Oh woe is me…Mark to Market all these banks are insolvent, and it's all because the market is stalled”. No I was stupid, I under-estimated the intelligence of those guys, they know exactly that they can value those assets using income capitalization, and nothing much has changed for the past three months. How could I have been so stupid to think they were SOoo stupid?

So why now?

It's what's not on the balance sheets that matters. Because as Shah Gilani explained, chances are the bets that were placed via CDS's dramatically geared the potential losses, in just the same way they dramatically geared profits when house prices were rising.

I always thought that it was illegal to take out insurance on your next-door neighbor's house in case it burnt down. What CDS's allowed the banks to do was to write a hundred policies, and now one house in fifty is in danger of burning down, and the guys that wrote a hundred policies on each house are in danger of defaulting. And the way the system is structured that could set of a domino meltdown of CDS's,

The reason it's $700 billion is that Mr. Paulson knows that he can't afford any more RMBS's to fail.

Not because some poor people might lose their homes, and oh wasn't Georgie such a sweetie-pie, “you won't be able to send your kids to college and the “farmers” (why the farmers they are only 2% of the population), “won't be able to plant their crops – could this be the end of the American Dream, just agree $700 billion, it's not much, I spent that much on my faith inspired crusade to protect all the Americans in Iraq, and find those weapons which we are still looking for and I PROMISE we will find them, and protect our oil supplies (pity about the price of oil but my saviour works in mysterious ways)”.

That's just "collateral damage".

It's because if they do, the $68 Trillion chain reaction could start.

What does this mean?

• The $700 billion WILL be approved, there is no question about that.

• The Fed will keep interest rates far below the rate of inflation, to stimulate an increase in house prices.

• House prices will rise.

• The US Government will effectively guarantee all RBMS's against default.

• So, no more defaults on RMBS's.

• The dollar will fall

• Disaster will have been avoided.

What you do with your money depends on if you think he will pull it off or not.

And Bye Bye Miss American Pie.

By Andrew Butter

[EvadingGrid]

I keep hearing Alex, Ron Paul and others talk about how the real problem is the pyramid of derivatives.

What are they talking about?

To keep it plain english, its a pyramid selling scheme !

[Nailer]

 SPECIAL REPORT AMERICA'S MONEY CRISIS   
The $55 trillion question

http://money.cnn.com/2008/09/30/magazines/fortune/varchaver_derivatives_short.fortune/index.htm

Fortune Magazine) -- As Congress wrestles with another bailout bill to try to contain the financial contagion, there's a potential killer bug out there whose next movement can't be predicted: the Credit Default Swap.

In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.

"If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'"

Second, terror at the potential for a financial Ebola virus radiating out from a failing institution and infecting dozens or hundreds of other companies - all linked to one another by CDS and other instruments - was a major reason that regulators stepped in to bail out Bear Stearns and buy out AIG (AIG, Fortune 500), whose calamitous descent itself was triggered by losses on its CDS contracts (see "Hank's Last Stand").

And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation.

"The big problem is that here are all these public companies - banks and corporations - and no one really knows what exposure they've got from the CDS contracts," says Frank Partnoy, a law professor at the University of San Diego and former Morgan Stanley derivatives salesman who has been writing about the dangers of CDS and their ilk for a decade. "The really scary part is that we don't have a clue." Chris Wolf, a co-manager of Cogo Wolf, a hedge fund of funds, compares them to one of the great mysteries of astrophysics: "This has become essentially the dark matter of the financial universe."

***

AT FIRST GLANCE, credit default swaps don't look all that scary. A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs. Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.

Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process. You strike your deal, fill out some forms, and you've got yourself a $5 million - or a $100 million - contract.

And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)

You can guess how Wall Street cowboys responded to the opportunity to make deals that (1) can be struck in a minute, (2) require little or no cash upfront, and (3) can cover anything. Yee-haw! You can almost picture Slim Pickens in Dr. Strangelove climbing onto the H-bomb before it's released from the B-52. And indeed, the volume of CDS has exploded with nuclear force, nearly doubling every year since 2001 to reach a recent peak of $62 trillion at the end of 2007, before receding to $54.6 trillion as of June 30, according to ISDA.

Take that gargantuan number with a grain of salt. It refers to the face value of all outstanding contracts. But many players in the market hold offsetting positions. So if, in theory, every entity that owns CDS had to settle its contracts tomorrow and "netted" all its positions against each other, a much smaller amount of money would change hands. But even a tiny fraction of that $54.6 trillion would still be a daunting sum.

The credit freeze and then the Bear disaster explain the drop in outstanding CDS contracts during the first half of the year - and the market has only worsened since. CDS contracts on widely held debt, such as General Motors' (GM, Fortune 500), continue to be actively bought and sold. But traders say almost no new contracts are being written on any but the most liquid debt issues right now, in part because nobody wants to put money at risk and because nobody knows what Washington will do and how that will affect the market. ("There's nothing to do but watch Bernanke on TV," one trader told Fortune during the week when the Fed chairman was going before Congress to push the mortgage bailout.) So, after nearly a decade of exponential growth, the CDS market is poised for its first sustained contraction.

***

ONE REASON THE MARKET TOOK OFF is that you don't have to own a bond to buy a CDS on it - anyone can place a bet on whether a bond will fail. Indeed the majority of CDS now consists of bets on other people's debt. That's why it's possible for the market to be so big: The $54.6 trillion in CDS contracts completely dwarfs total corporate debt, which the Securities Industry and Financial Markets Association puts at $6.2 trillion, and the $10 trillion it counts in all forms of asset-backed debt.

"It's sort of like I think you're a bad driver and you're going to crash your car," says Greenberger, formerly of the CFTC. "So I go to an insurance company and get collision insurance on your car because I think it'll crash and I'll collect on it." That's precisely what the biggest winners in the subprime debacle did. Hedge fund star John Paulson of Paulson & Co., for example, made $15 billion in 2007, largely by using CDS to bet that other investors' subprime mortgage bonds would default.

So what started out as a vehicle for hedging ended up giving investors a cheap, easy way to wager on almost any event in the credit markets. In effect, credit default swaps became the world's largest casino. As Christopher Whalen, a managing director of Institutional Risk Analytics, observes, "To be generous, you could call it an unregulated, uncapitalized insurance market. But really, you would call it a gaming contract."

There is at least one key difference between casino gambling and CDS trading: Gambling has strict government regulation. The federal government has long shied away from any oversight of CDS. The CFTC floated the idea of taking an oversight role in the late '90s, only to find itself opposed by Federal Reserve chairman Alan Greenspan and others. Then, in 2000, Congress, with the support of Greenspan and Treasury Secretary Lawrence Summers, passed a bill prohibiting all federal and most state regulation of CDS and other derivatives. In a press release at the time, co-sponsor Senator Phil Gramm - most recently in the news when he stepped down as John McCain's campaign co-chair this summer after calling people who talk about a recession "whiners" - crowed that the new law "protects financial institutions from over-regulation ... and it guarantees that the United States will maintain its global dominance of financial markets." (The authors of the legislation were so bent on warding off regulation that they had the bill specify that it would "supersede and preempt the application of any state or local law that prohibits gaming ...") Not everyone was as sanguine as Gramm. In 2003 Warren Buffett famously called derivatives "financial weapons of mass destruction."

***

THERE'S ANOTHER BIG difference between trading CDS and casino gambling. When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."
 
Anonymous Coward
User ID: 215600 (OP)
10/1/2008 2:01 PM Re: CNN/ FORTUNE aks: The $55 trillion question Quote

Derivatives, pg. 2
By Nicholas Varchaver, senior editor and Katie Benner, writer-reporter
Last Updated: September 30, 2008: 12:28 PM ET

This is not an academic concern. Wachovia (WB, Fortune 500) and Citigroup (C, Fortune 500) are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some CDOs. The specifics of the spat aren't important. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?

That's one element of what's known as "counterparty risk." Here's another: In many cases, you don't even know who has the other side of your bet. Parties to the contract can, and do, transfer their side of the contract to third parties. Investment firms assert that transfers are well documented (a claim that, like most in the world of CDS, is impossible to verify). But even if that's true, you're still left with the fact that a given company's risks are being dispersed in ways that they may not know about and can't control.

It doesn't help that CDS trading is a haphazard process. Most contracts are bought and sold over the phone or by instant message and settled manually. Settlement has been sloppy, confirms Jamie Cawley of IDX Capital, a firm that brokers trades between big banks. Pushed by New York Fed president Timothy Geithner, the players have been improving the process. But even as recently as a year ago, Cawley says, so many trades were sitting around unfulfilled that "there were $1 trillion worth of swaps that were unsettled among counterparties."

Trade settlement is not the only anachronistic aspect of CDS trading. Consider what will happen with CDS contracts relating to Fannie Mae and Freddie Mac. The two were placed in conservatorship on Sept. 7. But the value of many contracts won't be determined till Oct. 6, when an auction will set a cash price for Fannie and Freddie bonds. We'll spare you the technical reasons, but suffice it to ask: Can you imagine any other major market that would need a month to resolve something like this?

***

WITH WASHINGTON SUDDENLY in a frenzy of outrage over the financial markets, debating everything from the shape and extent of the mortgage plan to what should be done about short-selling, the future for CDS is very blurry. "The market is here to stay," asserts Cawley. The question is simply: What sorts of changes are in store? As this article was going to press, SEC chairman Christopher Cox asked the Senate to allow his agency to begin regulating CDS - mostly, it should be said, to rein in short-selling. And the SEC separately announced that it was expanding its investigation of market manipulation, which initially targeted the short-sellers, to CDS investors.

Under other circumstances, Cox's request might have been met with polite silence. But the convulsions over the mortgage bailout are so dramatic that they are reminiscent of the moment, soon after the Enron scandal, when Congress drafted the Sarbanes-Oxley legislation. The desire to blame short-sellers may actually result in powers for Cox that, until very recently, he showed no signs of wanting. Should legislators wade into this issue, the measures most widely seen as necessary are straightforward: some form of centralized trading or clearing and some form of capital or reserve requirements. Meanwhile, New York State's insurance commissioner, Eric Dinallo, announced new regulations that would essentially treat sellers of some (but not all) CDS as insurance entities, thereby forcing them to set aside reserves and otherwise follow state insurance law - requirements that would probably drive many participants from the market. Whether CDS players will find a way to challenge the rules remains to be seen. (ISDA, the industry's trade group, has already gone on record in opposition to Cox's proposal.) If nothing else, the New York law may provide additional impetus for the feds to take action.

For now, the biggest impact could come from the Financial Accounting Standards Board. It is implementing a new rule in November that will require sellers of CDS and other credit derivatives to report detailed information, including their maximum payouts and reasons for entering the contracts, as well as assets that might allow them to offset any payouts. Anybody who has tried to parse CEO compensation in recent years knows that more disclosure doesn't guarantee clarity, but any increase in information in the CDS realm will be a benefit. Perhaps that would limit the baleful effect of CDS on (must we consider it?) the next disaster - or even help us prevent it. To top of page
 

[rustygunn]

This guy (Craig Donohue) is in secret talks to change the derivatives market.
http://www.youtube.com/watch?v=qZZXESQZ-5I
 

[anchorage]

I'm sure this is covered in the articles or comments above but it's worth remembering that the notional value of global derivatives significantly exceeds global GDP. The CDS segment alone is many times the (notional) size of the US stock and Treasury markets.  Then remember that over 90% of derivatives are OTC, i.e. not exchange traded and therefore subject to little or no regulation.

Exchange traded derivatives developed because there was a genuine underlying economic purpose.  The earliest futures contracts were designed to enable businesses to hedge risks by locking in future prices, either of raw materials such as oil, or for the goods which they produced.  Of course, what has happened over the past decade or so, which marks the catastrophic explosion in derivatives markets, is that the genuine economic purpose of the instruments has been replaced totally by speculation.  As stated in a reply above, CDS's started out with some genuine purpose; to enable someone with a genuine credit position to hedge that risk.  However, the crooks have left that premise far behind. Most CDS's now are purely speculative, traded by people with no direct interest in the underlying credit.  A parallel would be me buying insurance on your house in the hope that it burns down.

You may note that CDS's are very much like insurance contracts.  In essence, that's what they are. Even here, the manipulative bankers are way ahead of the regulators. You see, insurance is strictly regulated. If a company provides insurance, as we understand it, it has to carry reserves to cover potential loss.  CDS's, which are really insurance policies in all but name, get round this as they have 'swap' in their title.  Therefore, no regulation and no need to carry reserves against potential loss.  The only thing giving these CDS's any credibility or value is the belief that the counterparty (i.e. the institution which has written to contract) will honour the payout when the event happens.  I guess that belief is now well and truly shattered.  As a result, most of these CDS's are worthless since the buyer of the so-called 'protection' has no hope of collecting.

In the final step of the scam, the bankers realised that they could generate vast paper profits from trading this type of speculative paper at the same time pretending that their own riskiest exposures are 'hedged'.  If you look at the sources of bank profits during the 'good years', the amounts stemming from 'trading' operations are many times the amounts derived from core banking operations. Indeed, core banking functions have become very secondary to the big banks.  The criminal element in all of this is that the banks realised that they could manipulate the prices of their derivatives.  At the best of times, many of these instruments hardly trade or have no liquidity. Therefore, there is no proper market price. Banks were therefore able to manipulate their own P&L statements. In reality, there is little difference between what Enron did and what the banks have done.  Indeed, most fraudulent or Ponzi schemes operate in a similar way. 

Incidentally, is anyone surprised that the hedge fund industry hasn't collapsed more than it has? Same reason; many of them are continuing to falsify NAV's.

Going back to my original points about the size of the derivatives markets; this is the current source of the financial meltdown. However, it should be quite obvious that you cannot bail out something which is many times bigger than your entire economy. Yet, this is what the Fed, Treasury and other central banks are trying to do, presumably in the hope that nobody notices the impracticality of it all.  The Icelandic government faces bankruptcy because they have guaranteed domestic depositors and that guarantee is effectively being called by the failure of their banks.  That's the logical result of trying to bail out something larger than your own economy.

There is a better solution. Essentially, the government must focus on protecting the economy as much as possible. That means going around the banking system to provide liquidity directly to business.  The Fed are doing this at last.  The approach of pumping trillions into the bankrupt financial system in the hope that it will rediscover its intermediary function is doomed to failure. We see than the banks still will not (or, more precisely, cannot) lend.

Either way, there will be a massive loss of long-term wealth. We simply cannot walk away from this whole. The aim should be to minimise the catastrophic damage which will be done.  In the meantime, it's time criminal charges were brought against those responsible.

[zdux0012]

This does not explain derivatives but I think it helps a lot:

Imagine if you can buy money for 100 dollars and pay it back a little later for 101 dollars.
There is no way to make money, however if you get lots of people involved you can shuffle it around long enough to fake it. If after each player gets money they claim to have 10x the amount of money they received you can keep the scam going for a long time.
Now imagine you, and 10 of your buddies stop playing. You state that you believe that there is not enough money to pay back money owed to you. You stop playing the game, just start collecting on owed debt. 
It would be possible to get all of the real money and wreck up the place at the same time.

[anchorage]

zdux, just to explain the derivatives side a little more; as the name implies, a derivative is 'derived' from something else. So, for example, a mortgage backed security is 'based' upon a basket of underlying mortgages. To take a simple example. Let's start with a single mortgage lent by a bank on my home. All very straightforward and understandable. The bank lends me the money, I buy the house and repay the mortgage loan over time.

Now, some smart guy comes along and points out that the original mortgage comprises two parts (usually); a monthly capital repayment and a monthly interest payment.  Why not separate the two? I've now created two securities, one which is entitled to the income stream (interest payments) on the underlying mortgage and the other which is entitled to the capital repayment stream.  Both securities reflect different cash flows and therefore can be valued pretty much like any other income bearing security. 

In very simple terms, this is how a mortgage backed security is created. In practice, an MBS represents a basket of underlying mortgages rather than one single mortgage. That diversification is meant to make the cash flows more secure since, presumably, not everyone would default at the same time.  (I suspect you are already starting to see some problems or risks associated with this logic. )

Even in the MBS arena, the 'clever bankers' were not content with the simple 'plain vanilla' variety. Instead, they realised they could create a myriad of securities from the same pot, in some cases derivatives upon the derivatives.

From this, you may start to see that you can expand the series exponentially. If I'm constained by the 'plain vanilla' type of derivative, I'm pretty much constrained by the size of the underlying issuance (in this case, the amount of mortgages available to package up). However, if I create other spin offs or derivatives upon derivatives, the total size of this pot can expand to almost any size.

Over the past 10 years, it's actually the Credit Default Swap derivatives which have grown most dramatically. Again, these have the characteristic of being able to grow exponentially. Since I can either write the 'insurance' or buy it, I can actually carry an almost endless number of positions simultaneously.

For example, let's say Bank A has a big loan to GM that it thinks may default. Bank A wants to buy credit insurance. I'm a big hedge fund and think I'm very smart. I don't think GM is going bust, so I sell this insurance to Bank A and collect regular premiums.  I book a nice little profit in my Fund as the cash flows (premiums) roll in, get my fee and performance fee and tell the world what a genius I am for generating such stable, attractive returns. (Of course, I never say really where these returns come from or that I could never cover the claim should GM actually deafult but, hey, that hasn't happened yet, so why worry?)

A few months down the road, I'm starting to get nervous myself about GM. What do I do? Easy, buy my own credit insurance, which I get from Bank B.  So now, I've basically got both sides covered. Of course, the premium I have to pay to Bank B may well be higher than the premium I still receive from Bank A, which is not good but better than an actual default. 

I think you can extend this logic yourself to realise that you could stack position upon position depending upon how the perceived risk of GM is over time.  Now multiply that by every other possible risk that people may want to insure. That helps to explain why a bank like JP Morgan can have $90 trillion in total derivatives outstanding against a $1.8 trillion balance sheet. These banks will all claim that this is misleading as you have to net off everything (in my simple example above, I would be netting off the premiums I pay versus the premiums I receive, just apply that principal to my net liabilities under these same contracts to understand how that works).

If I close my eyes and don't think, this may all make sense. When I wake up, though, I might start to see the flaw. If just one piece of my jigsaw falls, the whole thing could come down. Remember I've bought my own credit insurance from Bank B.  Now, Bank B suddenly fails or indicates that it will renege. Suddenly, I'm right on the hook for something I thought was protected. Also remember that I have absolutely no reserves to pay out on any claim against me.  This is how the domino effect starts to play out and gather momentum.  That is essentially what brought AIG to its knees.

This is a simple sketch, but I hope it helps you understand the scale of the mess.

[EchelonMonitor]

It seems like you're getting complicated technical answers, when the principle is actually simple.

Short answer:  derivatives are paper which are guaranteed to match the price of the stock.

Unlike stock, they have no ownership in the company, and have no real value other than that guarantee.

They can be issued in unlimited amounts.

Why buy derivatives instead of the stock if they have the same price?

Because since there is no limit on the amount of derivatives issed, the number you can purchase is not limited by such petty things as the number of stock certificates issued.

Because of this, you can leverage derivatives at 100 to 1.  That means you can control $1,000,000 worth of derivatives with a $10,000 investment.  If the stock goes up 1%, you just doubled your $10,000 investment.

You can also freely short derivatives, so you can make money on the falling market in the same way you make it on a rising market--simply sell $1,000,000 dollars of derivatives to double your $10,000 investment on a 1% decline in the market.

[EchelonMonitor]

I should point out that your losses are also multiplied at 100 to 1, so if you bought $1,000,000 of derivatives with your $10,000 investment last week (those $1,000,000 worth are loaned to you buy your brokerage) and your stock lost 20% in the last week, you would have lost $200,000, or 20 times your $10,000 investment, so 100 to 1 leveraging is not for the faint of heart.