The Making of a Financial Crisis
Tuesday, October 27th, 2009
With our financial system in disarray, it seems that no one will give us a straight answer on what caused it. My goal in the next few blogs is to explain specifically what happened during the economic crisis, and how it happened. I am going to break down the world of high finance and derivatives down into digestible chunks of information and, more importantly, eliminate the fog of ambiguous and esoteric nomenclature by explaining just what all those fancy terms mean. In doing so we will all gain an understanding of the current economic crisis and its root causes.
Today I want to focus on the credit default swap. Over the past year you may have heard of this derivative and that it played a part in the financial crisis. But what is a credit default swap anyway?
A derivative is just something which has a value that derives from something else. For example, lets say you have a treasure map that shows the exact location of a $10 million treasure. Does the map have value? Yes and no. The map itself is just a piece of old paper, but the map makes it possible for you to acquire a $10 million treasure. You could then say that the map is worth $10 million, which is a value derived directly from the treasure. That's a derivative.
The financial world is chock-full of derivatives: futures, options, credit default swaps, etc. Continuing from the example above, let's say that the value of the treasure is constantly fluctuating. One day its worth $10 million, the next day it's worth $15 million. Wouldn't the value of the map fluctuate with it? Of course. Welcome to our financial derivatives market system. Substitute treasure with, stock, oil, etc bond and substitute treasure map with option, future, or credit default swap and you have a derivatives market that resembles our own.
So we now know what a derivative is, but what is credit default swap derivative? A credit default swap is really just insurance on an investment. The value of a credit default swap derives from the credit worthiness of the entity being invested in. Credit just refers to the extending of a loan. Default refers to someone not paying you back on a loan. Swap just refers to something changing hands. In this case the risk of default is what is changing hands.
Imagine if you were to loan a friend $100 and he agreed to repay you the $100, plus an additional $20 for giving him the loan (this is the credit part). That is $20 profit in interest. So you go through with it, but you soon start to notice your friend isn't doing well financially. You have a feeling he may not be able to pay you back (that's the default part). So you go to a credit default swap broker and you say to them "I will give you half of my $20 profit, if you agree to pay me back my full $100 if my friend goes broke". He doesn't believe your poor friend is really that bad off, and agrees. You are giving away some profit, but you are insured against any loss of your principal. You "swapped" the risk of your credit to somebody else in case they default. There, that is a credit default swap.
Credit default swaps are used all over the world in many different ways. You may be wondering why they became so dangerous. After all, now that we understand what a credit default swap is, it doesn't seem so risky and exotic, at least no more so than car insurance. Next time we will see just how things got out of control with the credit default swap.
Article by Jonathan Biggerstaff
The views expressed are the subjective opinion of the article's author and not of FinancialAdvisory.com
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Peter I totally agree with you. I would love to see you add to this series with a focus on regulatory agencies. First we can't put all the blame on one product or one firm. Much of the blame for this financial crisis is the result of FINRA and other regulatory agencies failing to police and regulate these products. Second, as we saw with Madoff the agencies have limited working knowledge of back office operations and trading. Most auditors are from accounting backgrounds or MBAs fresh out of school. Most have never traded these products are understand their structures, thus how can they audit or regulate something they don't understand. Many of the structured products which caused the meltdown are relatively new and are not taught in class rooms, even if you could learn it from a book, to truly understand you have to get in there, trade and invest. The next financial crisis will be a result of the first; the inability of regulators to understand and police firms and new products on a global basis. Unless we can get a more streamlined regulatory agency with global powers, I believe we will see another meltdown, but this time in the global markets, not just Wall Street. The Madoff situation has pretty much disappeared from the media. Unfortunately, 1000s of these guys exist and many have expanded globally. Madoff was rather small compared to a number of firms managing trillions of dollars globally. Due to the size of these firms and their foreign operations, US regulatory agencies are limited in their ability to access and regulate the firms' overseas operations. We truly need a global regulatory agency. FINRA and the SEC are not capable of enforcing the trading laws when it comes to these firms in foreign countries and believe it or not, we depend heavily on the integrity of all markets not just Wall Street. The very institutions that we are bailing out today with tax payers dollars were allowed to speculate on a massive scale by our regulatory agencies. They had little or no interference from the SEC or other government agencies. Firms like Bear Sterns, Citicorp and AIG were speculating with Pension and Retirement money on a massive scale. If institution s were individual investors attempting to trade derivatives as the corporations they would be shut down immediately by the broker unwilling to take the risk. Yet our government and regulatory agencies stood by while many of these firms speculated and leverage on a massive scale. Few people remember the bailout of the hedge fund Long-Term Capital Management (LTCM) in 1998, when this hedge fund nearly single handedly created a crisis on a global scale. The firm managed $126 billion yet was allowed by banks and financial institutions around the world to leverage $126 to nearly a trillion dollars. When the fund collapsed, without the bailout, the potential for a world banking collapse would have ensued. Where was the SEC or the banking regulators? They were very familiar with the firm, the founder was a Nobel Prize-winning economists. Again there are 1000s of these Hedge Funds out there speculating and trading globally, most leveraging in the billions with little or no over site. Trust me there's another financial crisis coming. There's an old saying," When you burry your head in the sand, your ass becomes a bigger target”, this is precisely what has happen to FINRA. The organization spent decades churning out rules and regulations for the smaller firms, brokers and traders, completely overlooking minor infractions by large firms, or turning away from complicated firms like Hedge Funds, Private Equity and Venture Capitalist. Today these firms control more assets on a global scale than all the major banks combined, yet FINRA is just getting around to really regulating them as a result of the Madoff crisis. .