Wednesday, September 17, 2008

An introduction to the economic crisis: part 2

To recap

If you remember back to Part 1, our current state of f****dness has three components:
  • Banks have been lending to all kinds of people who can't pay, not just sub-prime mortgage borrowers;
  • Investment banks and insurance companies have been doing naughty things with derivatives and;
  • Organisations that are not banks have been acting in bank-like ways without a banking licence.

We have covered the first of these, where the dastardly CDO causes all kinds of problems. However, the chaos didn't stop there...

What's a derivative?

The nature of a derivative is summarised by Eddie Murphy in Trading Places. On being introduced to the people who own the bank he cleans, he tells them: "You guys are bookies".

A derivative is basically a bet on the price of some other asset. An asset can be anything. In Trading Places, Eddie Murphy bets on the future price of orange juice.

There are good reasons to do this. For instance, it allows you to get a fixed price for your orange crop while it's still on the trees. If you are an orange grower and are concerned that your oranges will fall in price before you get them to the market, you can bet that the price of oranges will fall. If it does, the money you make winning the bet will make up for the money you would have lost on the oranges.

... But you can also use derivatives for straight-forward gambling too. The villains in Trading Places thought they had inside information that the orange crop would be ruined by the weather. They bet the price would go up because of scarcity of oranges, so they would make money.

Unfortunately, they had been stitched up by Eddie Murphy. The price went down and they lost their shirts.

One of the dangers of derivatives is that you don't have to put all your bet upfront. This means that you can lose more than your original bet.

So what do derivatives have to do with the credit crunch?

The type of derivative that has caused most trouble in the credit crunch is a credit default swap or CDS. Investment bankers are paid large amounts of money to not confuse CDOs with CDSs. The letters are very similar, but the financial product is rather different.

A CDS is a bet on whether someone will fail to pay back a bond. If you remember from Part 1, a bond is something like a loan. Using a CDS to bet that someone won't go bust is called 'selling protection', because taking the bet can be insurance against a company going bankrupt.

This is dangerous because, since a CDS is a derivative, you risk having to pay out a very large amount of money, while gaining a small profit if your bet comes off.

Things get fun when investment banks and insurance companies started selling CDS protection on the 'Senior' bonds of CDOs. If you remember CDOs, they are a financial product containing the mortgages of people with a bad credit record. The technical term for this is 'credit turd'.

Since the Senior bonds of CDOs had 'no risk', insurance companies sold huge amounts of protection very cheaply. Of course, when it became obvious that large numbers of people wouldn't be able to pay their mortgages, it became equally apparent that the insurance companies wouldn't have the money to pay their losing bets.

This is what did for AIG.

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