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TroyPDX
02-27-09, 12:48 PM
I've learned a great deal about economics over the last year or so. We are living in historic times and I want to be awake and aware of the process, wherever it might lead.

That being said, there is a huge gap in my knowledge and I'm having trouble finding a good, clear explanation. I think I've got a pretty good grasp on the phenomenon of mortgage based securities, credit default swaps, and how the housing bubble caused these vehicles to collapse, and how that collapse is affecting banks and Wall Street.

If I'm not mistaken the credit default swaps are part of the derivatives market. Now I keep hearing about the massive amount of derivatives above and beyond these credit default swaps. I hear insane numbers, up to 500 trillion or so. I hear this financial 'death star', if and when it were to unwind, would be a financial tsunami.

So my questions are... what are these other derivatives based on? Who holds most of these derivatives? What economic conditions would precipitate their beginning to 'unwind'? How is it possible for the amount of money involved in this unregulated market to be so astronomical? What would the beginning of the collapse of these derivatives look like? Would it be reflected in the more traditional markets?

I would greatly appreciate any answers that a layman might understand or any relevant links.

Thank you in advance for any replies!
Cheers

*T*
02-27-09, 10:26 PM
So my questions are... what are these other derivatives based on? Who holds most of these derivatives? What economic conditions would precipitate their beginning to 'unwind'? How is it possible for the amount of money involved in this unregulated market to be so astronomical? What would the beginning of the collapse of these derivatives look like? Would it be reflected in the more traditional markets?

Who holds most of these derivatives?
JP Morgan, AIG, etc. They write this crap over the counter, they are not exchange traded (hence the problem).

What economic conditions would precipitate their beginning to 'unwind'?
Default, bankruptcy, debt-deflation economic death spiral, etc

How is it possible for the amount of money involved in this unregulated market to be so astronomical?

With regard to CDS (http://en.wikipedia.org/wiki/Credit_default_swap) or interest rate swaps (http://en.wikipedia.org/wiki/Interest_rate_swap), because they are swaps (http://en.wikipedia.org/wiki/Swap_(finance)), you just normally exchange types of interest rate payment. For a CDS, in case of default, one party (who sold the insurance) has to pay out the principal. If they wrote loads without the expectation they'd have to pay out (like AIG paying out on Lehman) this may lead to their bankruptcy, and a domino effect. This is why people are shitting themselves about GM, because there are loads of CDS written on their debt. It's not really about jobs.
Because swaps never used to require collateral, (they do now) they allowed effectively infinite leverage. This is why the principal amounts could be so large.
Banks have been leveraged 40 or 50:1. But, as I understand it, this leverage does not account for swaps. Even at 50:1, a 2% drop in your bets wipes out your capital.

What would the beginning of the collapse of these derivatives look like?

Like Lehman's going down. A chain of defaults. A domino effect.
The mid- to end-game is the government involvement to try to provide enough capital to reduce the leverage. This creates its own problems as the debt to pay for this also sucks out capital from the markets. Anyway governments cannot provide enough capital, the banks are dead already.


Would it be reflected in the more traditional markets?

Yes. As parties scrambled for capital to cover derivative bets gone wrong, they will have to sell assets at the same time as everybody else. So you get a market crash in all markets.


I have had a few drinks, so sorry if this reply is a little incoherent.

In summary, I think the banking system is dead and cannot be revived.

strittmatter
02-27-09, 10:37 PM
What "T" said................

http://crisisofcredit.com/

c1ue
02-28-09, 01:42 PM
The best way to think of derivatives is an analogy from Craps - the gambling game.

A quick refresher:

Craps is about rolling the same number consistently. 7 being the most common number, 7 is what you crap out on. Around 7 are the next most common numbers probability wise: 4,5,6,8,9,10

The main game is trying to roll one of the most common numbers repeatedly without rolling a 7, otherwise known as betting the pass line.

Wins on the pass line pay 1 to 1.

However, in addition to the pass (and no pass) line, there are also side bets.

You can, for example, bet a 'hard' even number: 2-2s, 2-3s, 2-4s, 2-5s.

These have much higher odds than the 1.5x you normally can get with one of the regular numbers: 6x up to 10x in some cases.

The hard way bets are good until you roll either craps, the hard way or the number 'not hard', at which point you either win or lose.

Then there are the 'red' bets such as the HORN: 11, 12, 2, 3

These pay 30 to 1, but are good for one roll only.

CDS' are like the 11, 12, 2, 3

But what happened is that the companies who offered the CDS' found out that in reality the 'red' bet was a 'pass/no pass' bet odds wise.