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Leverage: I have $1. It costs 4% to borrow $75. But I think I can make 5% on an investment. So I borrow $75 at 4% and, if everything works out, I make ($76 * 5% - $75 * 4% = ) $0.80. Multiply by billions. Then lose $76 billion dollars. Oops.
Credit Default Swaps: Think insurance. I have a bond with XYZ Company. But I want to be sure about my return, so I go to someone selling these insurance policies and I say, I'll pay you 4% a year of the value of my bond. If XYZ defaults on the bond, you pay me the full value of the bond.
Credit Default Swaps Gone Bad: The thing is, it's not exactly like insurance. Especially in that, you don't need the bond in order to get the insurance. I can buy a CDS on XYZ company without owning the bond. And if they go under, I get the value of the bond. Does that sound like you're betting that XYZ will default on the bond? That's because you are. Oh, and this is all private. So unlike stocks, no one else knows who has CDSs on whom.
Credit Default Swaps Gone Even Worse -- Netting: I want to cover my ass. So, I buy a billion-dollar CDS on XYZ company without owning the bond, at a rate of 2%. Then, when XYZ company starts to look more likely to default, I sell a CDS on them for the same amount, but at 4%. That way, I'm paying $20 million but I'm being paid $40 million. I'm ahead $20 million, and even if the bond is defaults, I just shunt money from one person to another, and I'm in the clear.
There is a big problem here, you can imagine. If one person doesn't pay up when their CDS comes due, and everyone else has shored up their position by netting like this, a loss of a billion dollars goes from person to person very quickly. And, just like they taught you in sex ed, you don't have a CDS with just the person you bought it from, but from everyone they have CDSs from. And so on down the chain.
And of course, the whole prospect becomes riskier when everyone is leveraging in order to afford these deals.
So, if one part of this chain of CDSs goes down because of, say, a historic drop in housing prices undoing an entire market of mortgage-backed securities (surely a rare, if not impossible situation), the whole system comes crashing down, large monolithic corporations lose billions of dollars, the credit market seizes up, and no one can borrow money anymore to keep their day-to-day business operations going.
Feeling optimistic yet?
I think I'm going to try to sleep now.
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October 07, 2008 -- 9:04 PM
posted by Jess
Best of Sarah Palin:
http://www.youtube.com/watch?v=NrzXLYA_e6E
October 07, 2008 -- 8:34 PM
posted by Par
Paras's uneducated guess as to the (unfortunate) moment of the debate: John McCain gesturing towards Barack Obama and referring to him as "that one." Yikes.
October 07, 2008 -- 8:17 PM
posted by Par
I've probably mentioned my fondness for The Big Picture before. This post is one of the best; photos from the "Earth From Above" exhibit:
October 07, 2008 -- 7:47 PM
posted by Al
In a morbid continuation of my earlier post:
A sign of the ongoing finacial troubles
Be warned this isn't a easy article to read or a easy video to see. A man left with no choice financially, decides that he has to kill his family and himself. It's rather sad so be warned.
October 07, 2008 -- 2:58 PM
posted by Beck
October 07, 2008 -- 12:05 PM
posted by Al
Good summary of the "highlights" of the subprime crisis Par.
Like I said before, everyone was passing the buck around until they couldn't do it anymore, then poof everything imploded. Well it just shows you the length people will go to for greed.
In other news 2 trillion dollars were lost on stocks yesterday!
October 07, 2008 -- 11:33 AM
posted by Par
I'm home sick today, so instead of sleeping (which I should) or working on my Carms application (which I should) or studying for my exam on Friday (which I should), I'm, naturally, learning scary, scary shit about this economic crisis.
If you have an hour, this episode of This American Life is both informative and frightening. They had a previous episode where they explained what went wrong with subprime mortgages and why that was bad. What's gone wrong now is both a consequence and unrelated to subprime and is much worse.
I was going to try to put things in a nutshell by explaining that it's all a combination of the Law of Unintended Consequences and that there really is no such thing as a free lunch, but Megan McArdle explains all the logical biases involved far better than I could.
Here's the short version of the proximal causes, though:
There is a big problem here, you can imagine. If one person doesn't pay up when their CDS comes due, and everyone else has shored up their position by netting like this, a loss of a billion dollars goes from person to person very quickly. And, just like they taught you in sex ed, you don't have a CDS with just the person you bought it from, but from everyone they have CDSs from. And so on down the chain.
And of course, the whole prospect becomes riskier when everyone is leveraging in order to afford these deals.
So, if one part of this chain of CDSs goes down because of, say, a historic drop in housing prices undoing an entire market of mortgage-backed securities (surely a rare, if not impossible situation), the whole system comes crashing down, large monolithic corporations lose billions of dollars, the credit market seizes up, and no one can borrow money anymore to keep their day-to-day business operations going.
Feeling optimistic yet?
I think I'm going to try to sleep now.
October 06, 2008 -- 4:12 PM
posted by mary
I'd be up for that Tony
October 04, 2008 -- 5:47 PM
posted by Tonestar Runner
So, who can I persuade to join me to see the FemBots when they're in town on the 25th? (I think they're playing at the Pawn Shop or something.)
FemBots - Count Down Our Days
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