Credit Derivatives Explained: A HuffPost Guide To The Economic Meltdown (VIDEO)

On Monday, our own Sam Stein offered readers a glimpse into the past, examining the lawmakers and economists who saw, in the repeal of the Glass-Steagall Act, a looming economic disaster. Sam's story gives credit where credit is due -- identifying the key players who got it right. And as we continue to cover the economic recovery, this will continue to be a constant theme here: beating back against the "no one saw it coming" conventional wisdom by honoring those that did get it right, and shining a light on those who, even now, might be getting it wrong.

But beyond that, there is also the street-level view of our economic problems, which from my perspective looks like an immensely complicated system that ran aground on a combination of greed and its own unaccountable complexities. There is, I think, an urgent need to lend more people a more fundamental insight into the ideas and interactions that shape the financial sector of the economy. Yet the conventional business media is still awash in jargon-spewing drones that only too recently indulged in the sale of a bogus boom time that was never supposed to end. Even post-collapse, their reporting is filled with cliquish eye-rolling and facile flash-card analysis.

There is an urgent need to simply decode, define, and explain the basics to more people. For while it's one thing to know, for example, that there were lawmakers who fought against the repeal of the Glass-Steagall Act, knowing what the Glass-Steagall Act was enacted to do is another thing entirely.

So rather than take the position that 'the plebes will never understand our divine Wall Street arcana,' we're going to take responsibility for laying out and explaining basic ideas. What's needed to forestall the next economic crisis, in my opinion, is a public that's well-armed with knowledge, about even basic things. And I figured, what the hell, if I can learn this stuff, anyone can.

So, we shall be launching a series of videos, featuring HuffPo's Business editor Julie Satow and myself, in which Julie patiently -- VERY PATIENTLY -- explains what happened in the economy these past few years, what the basic terms you hear bandied about mean, what key laws and regulations do, and how the whole thing connects. And hopefully, our readership and commenters can make suggestions, offer insight, and ask questions of their own.

This project is also the first collaboration between the Huffington Post and the American News Project, who have long been dedicated to public-interest journalism, and who have generously agreed to point cameras at me as I struggle to learn.

Julie and I shot a two-part pilot episode to begin with, which is posted below and which we hope you enjoy. The topic is Credit Derivatives. Yes, that might not be the ideal place to begin. To borrow from Jarvis Cocker: I don't know why but I had to start it somewhere, so I started there.

[WATCH PART ONE.]

[WATCH PART TWO.]

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Comments

[EthanLambe]

Nice treatment. What I don't understand, though, is whether the 'insurance' as it is sold down the chain is for the same premium each time. If it is then I don't understand how anybody but the bond holder makes a profit since they are buying their insurance for the same amount that they are being paid. If it isn't then why would an 'insurer' further 'down the line' take a smaller premium for covering the same payoff? It would also seem that if the premium were reduced as you moved 'down the line' that eventually it would disappear.

How does this work? Are some 'insurers' willing to take a much lower premium to cover the same amount of payout risk?

[blood1]

The easy to understand outcome of all of this: There is no such thing as a free lunch (which of course every investment group thought they were getting).

The idea that there is no risk, despite how well the CYA mentality was instituted is a falsehood. For the individual, there is always the disclaimer in any perspectus of "no guarantee" was somehow overlooked or ignored by the Investment Brokers. Unfortunately for the individuals who bought stocks, we were not informed of this investment strategy. So the last question is why isn't this fraud on the part of these Investment Companies, as didn't they fail to inform the entities who entered into these arrangements of this risk?

[Energizer2009]

Good explanation. Also see:
Adam Smith on the Current Financial Crisis - http://twisri.blogspot.com/2009/04/adam-smith-on-current-financial-crisis.html
What happened. What now. - http://twisri.blogspot.com/2009/04/commercial-and-investment-banks-used.html
Why the market failed - http://twisri.blogspot.com/2009/03/why-market-failed.html

[rogergeary]

I like the idea of using the Whiteboard. Did you get it from Marketplace?
I have to say they do it quicker and more clearly.
http://marketplace.publicradio.org/videos/whiteboard/

go to the bottom to see videos on CDS and CDOs

[Renee27]

This guy also explains derivatives well, worth checking out -

http://cspan.org/Watch/Media/2009/05/15/HP/A/18640/Michael+Greenberger+University+of+Maryland+Law+School+Professor.aspx

[SoDoSomething]

So a couple of questions. On any given instrument (bond, stock, etc.) can there be an endless number of chains? Which is to say if a bond fails can the payout to various chains be a multiple of the bond? Any good examples of how this has worked in reality (say Lehman's failure)?

Can you give an example of how the money and risk moves down the chain?

How much is AIG on the hook for if GM goes bankrupt? Which is to say how much is the taxpayer on the hook for? Citibank? BOA? How good an idea does letting them fail sound now?

Can we blame the need to have something to write derivatives against for a lot of the crazy loan activity that was going on?

Thanks for a well done introduction to this mess.

[dolphy]

Reply Favorite Flag as abusive Posted 08:30 PM on 05/14/2009
- + PropTrader I'm a Fan of PropTrader I'm a fan of this user permalink

The whole point of an exchange is to prevent excessive risk taking? The exchange will not allow you to trade if you don't provide enought capital (i.e., reserves) to support the trade. As such, the presence of an exchange lowers the leverage and reserve deficiency that would otherwise be the case. I don't need to review your website. I do this for a living.

It already blew on your face and you're still saying CDC's work?

Crazy is doing something the same way over and over and expecting a different result.

[notAMoron]

Do you think the people whose houses blew up in their faces will stop living in houses forever? They might get foreclosed and evicted and they might live in their car or a tent or a rental unit for a short period of time but eventually they will give that homeownership thing another shot.

Do you think they are crazy too?

CDS's are a sound idea, it is as simple as insurance on a large financial transaction. You have insurance on your home, your car, and any other large asset. The insurance market is largely unregulated. I prepay my insurance but I know that their are many companies and many people who pay month-to-month on a 6 month car insurance contract. They are in essence leveraged and are probably leveraged because they have insufficient capital to prepay the whole 6 months. That kind of policy is riskier for the insurer because if they get into an accident in the first month the insured may choose not to pay insurance for the next 5 and they will be short on their collection of premiums.

[research]

Insurance without reserves = Fraud.

[PropTrader]

Are you listening to what I am saying? There is no central clearing exchange for CDS. CDS contracts are currently done on an over-the-counter basis between two financial institutuions. In other words, a JPMorgan traders calls up a Goldman Sachs traders and asks Goldman if it would like to enter into a CDS contract at a certain price. If both parties agree, one pays the other and the deal is done. JPMorgan and Goldman Sachs do not allocate much, if any, capital against a potential payout from this transaction. There is no intermediary.

If you read and comprehend what I am saying, you would realize that I am advocating for a central clearing system for CDS, similar to the systems that the markets use for stocks and some standardized non-credit derivatives. As such, JPMorgan would need to execute the contract through the exchange. The exchange would require JPMorgan to put up margin (i.e., cash) to support its transaction. The exchange would then go find Goldman and "match" the trade with JPMorgan. If the market moves against either party, then the exchange would require more margin from that party. This system curtail excessive risk taking and leverage bets. Understand?

And I'm sorry, but frivolous, off-hand comments do not warrant respect nor deserve merit.

[Lilith33]

SCAMS!

[PropTrader]

So everyone seems to think that CDS is bad. So, I ask: What is good about CDS?

[pfrogger]

ok, let me play devil's advocate here, or the devil himself if you will.

1. nothing has really been fixed. the derivative issue is still very much present, just hidden under the mountain of taxpayer bailouts. sooner or later it will become unearthed and cause another problem.

2. banks and corporations have blocked regulation at all levels. often using taxpayer bailout money to lobby, ie. legally bribe, our elected representatives, ie. the corporatists.

3. the execs responsible still maintain their jobs, salaries, and bonuses. the lower tier people were fired.
lending decreased, and all regulation, ie. mortgage, and credit card rates, has been easily blocked.

4. because nothing has been fixed, and the same people responsible are still in charge, with even more money and power, why would they change their ways of making a quick, but very substantial, buck?

5. my moral question is this: if this is America, and it seems to be supporting this (looking at the actions versus polls), then is this still morally or even legally wrong? if this is legal, and based on actions, the modus operandi, I can't see why I can't also be involved in this.
Since the actions reflect the real, actual America, how can this be wrong? Thus can I also partake in this perfectly legal and often-practiced schemes? can I make money the way they do? I don't see why not.

[Lilith33]

I want one question answered....why did JP MORGAN bring its derivatives scam to AIG?
VIa david x li ;
For five years, Li's formula, known as a Gaussian copula function, looked like an unambiguously positive breakthrough, a piece of financial technology that allowed hugely complex risks to be modeled with more ease and accuracy than ever before. With his brilliant spark of mathematical legerdemain, Li made it possible for traders to sell vast quantities of new securities, expanding financial markets to unimaginable levels.

This is THE question.

[PropTrader]

The problem was that the models only comtemplated a three standard deviation event. We are in a six standard deviation event in term so home price declines. The model can't help anymore.

[research]

The Problem is:

Prediction is difficult, specially the about the future.

Investment Insurance is obviously absurd.

Insurance without reserves: is Fraud.

[Village]

I can explain it simply. Take a mortgage backed security (which is only worth the value of the real estate, assuming an honest appraiser), and sell it at face value. Then the buyer takes that security and cuts it up into 30 pieces, and sells each of those 30 pieces for the same amount it paid for the one mortgage backed security. Call it what you want, but that is what basically happens.

[Peter007]

It appears that AIG was issuing insurance policies for the bonds or CDO's without having the assets to back it up.
It's like I go out and insure all the houses in my town but if they burn down, I can't afford to reimburse the home owner. I'm collecting premiums but I have little risk because I don't have to pay out if I'm broke.

[PropTrader]

Correct, it was a leveraged, calculated bet that went wrong. AIG was looking at U.S. home prices and saying that these premiums basically free money because the likelihood of a national home price decline was very remote. Prior to this crisis home prices had not declined on a national level since the Great Depression. AIG's risk management team allowed them to get very concentrated in low spread, written CDS contracts on structured products.

[pfrogger]

well said.

small correction. it didn't go wrong!

all AIG execs got or still have their jobs, salaries, and bonuses.
the taxpayer is for whom this whole situation went wrong. we pay, are still paying, and will continue to pay when this situation does eventually become realized. Obama's administration didn't "fix" anything. they've just put of the ultimate disaster till later, hoping that the disaster spread out over time would be "lessened", theoretically.

all those involved did amazingly well. ridiculously well. they made so much money, they can retire right now. but since nothing was "fixed", and the financial mechanisms that caused this crisis, ie. no regulation, are still present, then they can continue to repeat the cycle. they've already publicly lobbied, ie. legalized bribes, to prevent any change in regulation. why would thieves want laws to prevent their actions. all they have to do is prevent regulation, repeat in 10 to 15 years, and voila: another cash cow.

[beaupritchard]

I guess I'm not following how these defaults are used ...

Let's say a company puts out a 100 dollar bond bought at 10%. The buyer1 expects 110 dollars back. to hedge his bet he gets one of these derivative for a 5 dollar fee. That means his return is now 5% or 5 dollars. The buyer2 gets a derivative for 2.5% meaning he's only making 2.5% or 2.5 dollars ... and so on ... and so on.

I guess what I'm saying is unless the original interest is big enough and I don't see a way of retoactively making it big enough each investor gets a smaller and smaller slice of the pie limiting how many times the bond can be insured.

It doesn't seem like a lot of money considering the risk.

[kors8858]

small percentages on huge amounts still adds up to nice profits. it's very easy for joe schmoes like me with very little to make $ where percentages mean something... selling tens of thousands worth of stocks can be done very quickly... finding someone to buy tens of billions is another thing altogether. at the scale of AIG, they can't "double" their investments by buying and selling quickly, so they have to look for complicated investments based on speculation to make a dent in their profit margins. as a bonus, they didn't need to go out and find people, the people came to them.

[beaupritchard]

Thanks

[beaupritchard]

I just saw part 1 ... very nice(I have no idea where Jason keeps coming up with these "hot librarian" types but keep 'em coming) ... I like this segment

Julie Satow very apt description of derivative. I was wondering, all these fees that get added on have to be above the value of the actual bond for any profit to be made don't they, so ... in layman language ... how do the fees get rolled back into the original cost of the bond.

[notAMoron]

The description of the CDS market in the videos is very poor and very over simplified. I highly doubt that Julie has ever purchased, sold, or ever even looked at a contract for a CDS.

If HP wanted to explain CDS they should have found someone with actual experience who could patiently explain it and make sure that the explanation provided could actually be understood instead of looking for "hot librarians."

[beaupritchard]

I like "hot librarians" ... and if you can explain it better I'm sure she's not going to mind. She's trying to break it down to people like me not experts like you. Give her a shot ... correct where you think necessary ... add on when you must.

But don't slam someone for trying.

[notAMoron]

The derivative issuer is like an insurer, they cover unrecoverable losses, the second derivative issuer is like a reinsurer they cover extreme failures but it is not an insurance policy directed not at a single bond but a large pool of bonds.

So if State Farm wrote homeowners insurance for 10,000 people in a town and 1 person's house burned down, state farm would pay out of pocket to fix the house, if a wildfire swept through the town and 2000 homes burned down state farm would pay out of pocket for the first 500 homes and maybe borrow money to pay for the other 1500 homes, but they would call up their re-insurer to repay them for the 1500 homes over the first 500 homes. The reinsurer has never seen these homes and would never have to step in if it were just regular house fires but they so they are not worried about the risk of a regular house fire.

Insurers are able to flourish because they can evaluate and price risk for individual failures like the risk of house fire. Reinsurers are able to flourish because they can evaluate and price risk for group failures like wildfires and hurricanes.

[beaupritchard]

OK ... now we're getting somewhere. So the bundled bonds were the problem because they hid negative value that caused them to be wrongfully evaluated risk by reinsurers.

Still isn't that the reinsurers problem. If I buy a house and later discover it's built on a landfill that's sinking can I go back to the seller for my money.

[gcallaghan]

Here's an idea. Why not stop making those crappy loans to begin with? We saw what pumping all that cash into the economy does: it acted just like a centriguge and the only people who kept any were the ones feeding the hopper.