Originally posted in the Week-end Economist thread, but I thought it deserved its own.
I got drawn into the daily Stock Market Watch thread about a year or so ago and at the time I knew nothing about the markets, derivatives, all that stuff. I asked some pretty dumb questions, but I got some pretty damn good answers. And it all came down, really, to some basic common sense.
Today, one of the SMW/WE regulars posted this. I don't often start threads and I'm not big on caps adn !! in subject lines, but I think this one deserves it.
I'm one of those at the bottom of the ponzi pyramid. I'll be among the first to be hit and hit hard when the economy collapses, as I think it will do and in spectacular fashion. Because the Paulson "bail-out" is in fact a gigantic tank of compressed air, and it's just going to blow the bubble bigger and bigger and bigger and bigger and.. . . .
Tansy Gold, who added
her own emphasis to the snip below
http://www.webofdebt.com/articles/its_the_derivatives.phpUntil recently, most people had never even heard of derivatives; but in terms of money traded, these investments represent the biggest financial market in the world. Derivatives are financial instruments
that have no intrinsic value but derive their value from something else. Basically, they are just bets. You can “hedge your bet” that something you own will go up by placing a side bet that it will go down. “Hedge funds” hedge bets in the derivatives market. Bets can be placed on anything, from the price of tea in China to the movements of specific markets.
“The point everyone misses,” wrote economist Robert Chapman a decade ago, “is that
buying derivatives is not investing. It is gambling, insurance and high stakes bookmaking. Derivatives
create nothing.”1 They not only create nothing, but
they serve to enrich non-producers at the expense of the people who do create real goods and services. In congressional hearings in the early 1990s, derivatives trading was challenged as being an illegal form of gambling. But the practice was legitimized by Fed Chairman Alan Greenspan, who not only lent legal and regulatory support to the trade but actively promoted derivatives as a way to improve “risk management.” Partly, this was to boost the flagging profits of the banks; and at the larger banks and dealers, it worked.
But the cost was an increase in risk to the financial system as a whole.2
Since then, derivative trades have grown exponentially, until now they are larger than the entire global economy. The Bank for International Settlements recently reported that total derivatives trades exceeded one quadrillion dollars – that’s 1,000 trillion dollars.3 How is that figure even possible? The gross domestic product of all the countries in the world is only about 60 trillion dollars. The answer is that gamblers can bet as much as they want. They can bet money they don’t have, and that is where the huge increase in risk comes in.
Credit default swaps (CDS) are the most widely traded form of credit derivative. CDS are bets between two parties on whether or not a company will default on its bonds. In a typical default swap, the “protection buyer” gets a large payoff from the “protection seller” if the company defaults within a certain period of time, while the “protection seller” collects periodic payments from the “protection buyer” for assuming the risk of default. CDS thus resemble insurance policies, but there is no requirement to actually hold any asset or suffer any loss, so CDS are widely used just to increase profits by gambling on market changes. In one blogger’s example, a hedge fund could sit back and collect $320,000 a year in premiums just for selling “protection” on a risky BBB junk bond. The premiums are “free” money – free until the bond actually goes into default, when the hedge fund could be on the hook for $100 million in claims.
And there’s the catch: what if the hedge fund doesn’t have the $100 million? The fund’s corporate shell or limited partnership is put into bankruptcy; but both parties are claiming the derivative as an asset on their books, which they now have to write down. Players who have “hedged their bets” by betting both ways cannot collect on their winning bets; and that means they cannot afford to pay their losing bets, causing other players to also default on their bets.
The dominos go down in a cascade of cross-defaults that infects the whole banking industry and jeopardizes the global pyramid scheme. The potential for this sort of nuclear reaction was what prompted billionaire investor Warren Buffett to call derivatives “weapons of financial mass destruction.” It is also why the banking system cannot let a major derivatives player go down, and it is the banking system that calls the shots. The Federal Reserve is literally owned by a conglomerate of banks; and Hank Paulson, who heads the U.S. Treasury, entered that position through the revolving door of investment bank Goldman Sachs, where he was formerly
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