Friday, September 29, 2006

Financial Wizardry & Collapse

Bear with me for a second here. This isn't an easy topic. That's because no one understands Credit-Default Swaps (CDSs), or other complex credit-derivatives, but it is important that we try to understand the implications of their exponential increase. Sure, some people claim to understand: hedge fund managers, investment bankers, etc. They understand the derivatives marketplace just like neuroscientists understand consciousness—they know the component parts, they can use them as tools barely under their control, but when it comes to understanding exactly how the greater dynamic emerges from the component parts they are in the dark.

No one really understands the credit-derivative market, but everyone is impacted by it. Credit-derivatives represent the creation of money out of thin air, like some act of financial wizardry. Take a Credit-Default Swap, for example. Here’s how it works: Corp. A needs to raise funds to expand operations, so they issue a $10 million bond. Pension Fund B buys that bond, but is concerned with the risk of Corp. A going bankrupt and defaulting on the bond. So Hedge Fund C offers what is, in effect an insurance policy—Pension Fund B pays Hedge Fund C $200,000, and in exchange if Corp. A defaults on the bond, Hedge Fund C covers the $10 million for Bank B. Here’s the magic: because this insurance policy creates the market for this otherwise too-risky bond from Corp. A in the first place, and because the par-value of the credit-default swap (the insurance policy) that the Hedge fund issues does nothing more than eat up the difference between the risk-premium on this bond, this $200,000 that the hedge fund makes is essentially fabricated out of thin air. Don’t forget to sprinkle in a liberal portion of fractional-reserve-banking fairy dust and viola: now you understand the credit-derivatives market as well as anyone else in the world.

Clear as mud? Try this on for size: there were $25 Trillion dollars in credit derivatives issued so far in 2006. That’s about half the size of the world economy. Oh, and it’s unreported, unregulated, and largely non-transparent. But wait, it gets better:

What is the effect of this absolutely massive trade in credit-derivatives? It has the effect of creating liquidity in the market for credit, but the larger effect is that it spreads risks very, very effectively. Because these credit-derivatives get pooled, sliced up, re-packaged, and re-sold, they have the effect of distributing the risk of default very, very broadly. Because virtually every hedge fund borrows from virtually every bank, which is connected to virtually every mutual fund, pension fund, and corporation, the risk of default is spread among virtually everyone. So this makes the world economy very, very resilient in the face of minor financial crises—say, the Asian Financial Crisis of the mid ‘90s, or the fall-out from September 11th. In fact, because of this massive trade in credit-derivatives, the world economy is actually far more secure in the face of your garden-variety financial crisis. This resiliency works as long as there’s enough slack, enough “spare capacity” in the world economy to absorb the distributed force of these defaults or crises. But at some tipping point—and because it’s not regulated and not transparent no one knows where this is—the stress cannot be absorbed. At this point, the crisis is no longer just a “recession” or a “depression”—it is a complete global collapse.

The market in credit-derivatives is a “financial weapon of mass destruction.” That’s not just my opinion, it’s a quote from the Oracle of Omaha himself, Mr. Warren Buffett (Berkshire Hathaway 2002 Quarterly Report, sorry, no link). Complex societies such as ours collapse because diminishing marginal returns eventually weaken a society until it cannot overcome periodic stressor events. The continually advancing sophistication of the derivatives markets represent the desperate efforts of the global economic system to climb high enough to reach even the hardest to reach fruit from the marginal-return orchard. The irony of a derivative collapse is that it will afford us the illusion that not only is everything OK, but that it is actually continually improving and expanding right up until the point where the whole house of cards implodes.


Theo_musher said...

I believe what you say, but I couldn't explain it to anybody myself. So in a sense do I really understand what you are saying?

I think I do, because I have been preparing myself for this inevitability. I started out reading some stuff by "money cranks" from a right wing/libertarian perspective that I later learned didn't really know what they were talking about but at the same time were really onto somthing. I got into some more serious stuff and actually tried to learn how the FED works and the IMF and the World Bank but this isn't my area of expertise.

I understand this enough to know this financial collapse is coming and to act on this knowledge. I have had this intuitive feeling for a while, and then I look for stuff like you have written here and accept it, without really understanding it. I just somehow know its true.

Then there are people with a much better working knowledge of this stuff that are caught in a dream. Its a strange thing really.

Kurt L. said...

I highly recommend the audio series Wizards of Money. It's a very accessible tour of how international finance really works: how money is created, how undemocratic monetary decision are, how money is really a weapon of empire-building, etc.

Marc Fellman said...

In your hypthetical example, you write that Corp A offers a bond which Pension fund B then buys but because it feels insecure in the event of default from A it purchases an insurance policy for 200k from Hedge Fund C. A few sentences later, you write that Hedge Fund C created the market for the A-B transaction, but if so, you need to rewrite the chronology of the initial transaction. It sounds as if B buys bond from A before buying C's insurance policy in whcih case a market pre-existed C's insurance policy.

I don't understood the subject you're trying to explain, but your explanation didn't help me. I did think of something, which is the following.

What if B decides to self-insure and put the 200k into its own hedge fund. Isn't the value offered by C simply its human expertise in making a greater return on capital than B could do. After all, what assurance does B have that C wouldn't default itself on the insurance policy - which could very well happen if the bond offered by A is skier than C estimates.

Jeff Vail said...


In actuality, the Creidt-Default Swap and the Bond purchase are often simultaneous--the point about "creating a market" is that the creation of this this new type of instrument creates a market where a market previously didn't exist--both for the CDS insurance policy itself, but also for issing bonds that would otherwise be deemed too risky by the market.

The reason that B can't self-insure is because, by nature of the standard marketplace for these kinds of bonds, the hypothetical B isn't large enough to survive the default of A's bond, but C is. This is because C takes hundreds of these CDS instruments, pools them, slices them back up and sells them off to others--C doesn't actually have to hold any risk at all, they just act as the middle man in redistributing the risk so thinly that the shock caused by the numbers of defaults caused by small to medium financial crises can be absorbed by the system--but because of this broad distribution of risk, at some point the shock is large enough that it brings down the entire system at once. Probably not much of an explanation.

Consider the Chaco Canyon scenario--a classic example of hierarchal civilization serving as the redistributor of risk. Because the central Chacoan complex gathered and redistributed agricultural product from a surrounding network of producers, when one or a few producers failed because of drought, the system could absorb the shock--the central Chacoan complex would redistribute some of the excess to the failed sites. But at some point, when population demands had grown enough and a sufficiently severe series of droughts hit the whole network, the redistributive mechanism actually ensured that the whole complex collapsed, not just those sites hard hit by drought...

Marc said...

I could reduce the example to any situation in which finite resources exist and begin to shrink such that the redistributer must decide between two unattractive alternatives. Let's say it's mom and three kids. Mom gathers and distributes the food to the kids each day, and each day there is less. She will have to choose whether to malnourish them all, or choose to let one or two die, giving the remaining food to 1 possible survivor. There are a lot of examples of how to distribute scant resources we are all familiar with and have delt with in our own microcosms of existence.

In your example of the CDS market, what resource is finite that cannot be replaced, and who is making the decisions about whom to save and whom to let die? Maybe the Fed. will have to decide whether a mass bail out will work or letting a collapse occur is best. Wasn't there a collase during the SNL crisis of the late 80s before I was a politically cognizant being, before that the great depression. The next will be hedge funds.

I would love to read a detailed scenario of just what happens in a financial collapse that details events, responses, and the what happens the day after, or the year after. People have been talking about a financial collapse since i was a high school debater and that was now 12-16 years ago.

What happens the day after the financial collapse? We'll all adjust. At least unless there is something special that will make this collapse more special.

Theo_musher said...

The collapse will mean the end of money. It will be a barter economy. Having a huge portfolio won't mean anything. The only thing of any value will be specific tools you can use to survive. Your Bike, your gun collection, your garden.

I don't really understand this specific stuff about derrivatives, but I understand the growth economy. Its based on...growth. The money has no inherent value, its all based on loans granted in speculation of future growth. When the growth stops it all falls down. It won't be a correction, it will collapse like a house of cards.

Marc said...

You're wrong. Money will stil be used. Money is as money does. We don't have to use the American dollar. People might be trading in Duane Reade reward points, but then the points become money. Money has never had inherent value.

A lot of countries have had financial collapses. Russians lost most of their money, twice in the 1990s, although the smart ones didn't hold their money in rubles by the 1998 devaluation. The U.S. is somewhat unique in avoiding the financial collapses that have hit other countries. But it's not the end of the world in which people go live in the woods.

For civilization to abruptly collapse, and for us all to return to hunter-gatherer or farming, it will take more than a financial collapse. After all, lots of alternatives exist. Marxist-Lenism lasted about 80 years in Russia.

I just don't see these scenarios as clearly as some of you seem to, but I'm sure lots of creative writers have thought this through over a period measured in decades.

Theo_musher said...

There has never been a global financial collapse. Lots of countries have bad currencies that is why these keep lots of dollars in reserve. The Euro seems to be replacing the dollar in this regard.
I think this financial collapse could be stretched out some more decades, I don't really know. But there are all these different kinds of collapse scenarios converging onto each other. This collapse with derrivatives is just one.

RyanLuke said...

As theo_musher said, our economy is based on growth. We live on a finite world and we have based our economy on the premise of perpetual growth. Bad combination. The credit derivatives market gives the illusion of growth - half the size of the world economy according to Jeff's post. It is a sign that we are approaching the end of the growth economy when growth has to be created through fancy financial tricks rather than real products.

Money will always be in use, but what form it takes is very important. Here's a link to my essay, The Organic Economy that explores this issue in depth.

sventastic said...

Hi gang,
Interesting situation.
Although I'm no economist, I try to be an aware person.
Our economy, especially the US but now globally, is inextricably based upon finite natural resources, and enwrapped in an increasingly tangled web of financial intrigue, the wizardry Jeff speaks of.
Bernard Lietaer, one of the architects of the Euro and a renown economist, visit:

is quite clear in predicting an imminent global economic collapse.
This is based on the fairy-tale of the global (petro)dollar fiat currency, its growing instability in light of disastrous foreign policy, and its inevitable and impending demise (and that of millions if not billions of people's lives with it).
Time to learn how to use a plough and which berries won't kill us.

Sean said...

The banking industry collects a fee when the bonds get sold on the market. Each $1000 bond purchased will have around 10% go into the coffers of the bank sponsoring the bond. The fee may be higher or lower, depending on relative ease selling them. Insuring the transaction for the buyer allows a separate entity, but commonly controlled coffer to collect the double fee. Even so, the "buyer" usually means the same banking system with a customer that they charge yet more "money management" fees. The banks are the buyers, sellers, and insurers in the transaction detailed here. In the case of Muni's and Treasuries, this means future taxation to pay these fees (money needed prior to actually collecting taxes). Most bonds, perhaps more than 90%, do not trade in the open; MSRB rules allow reporting of 1MM+ above 1 Million bonds, for instance (used effectively to inflate prices).

It would be interesting to see Henry George introduced into this discussion. Or even a separate article detailing how agriculture requires surplus to "hedge" future crop failures. This storage of wealth requirement then translates today as the monetary system. To make initially contributing capital to the monetary system appear fair, land ownership must be defined to make it wrong for one person to harvest another's crop. Not many would have seen it coming that different land yields food & resources differently. For those with agriculturally poor land, or those who don't have land (the neighbor it was taken from perhaps), this means a "job", or slavery, working the land "producing" more. As land is locked up, the means of food and shelter get locked up. With rent rising on cheaper land - which happens due to no available land to avoid work - to keep up with more productive land, wages sink. Hence, poverty.

sventastic said...

Hi gang,
Sorry, the Bernard Lietaer URL I tried to post is:

A little primitive, but with some good content.

Seems to me like modern sivilization is pretty screwed.
I'm going to invest in a water filter, and learn how to use flint and steel to light a fire, and hunt for mushrooms.

Sean said...

I'm going to invest in a water filter, and learn how to use flint and steel to light a fire, and hunt for mushrooms.

Check out the book "Caveman Chemistry" regarding water filtering and making fire; plus soap, pottery, paper, etc. You'll need the fire for most of this, lots of it.

Find a mushroom expert to help hunt for mushrooms and teach identification. North America has more species than the rest of the world combined. Unlike the rest of the world, we have more than our share of poisonous species; some of which inform you a week later after your liver is gone.

sean said...

I'm going to invest in a water filter, and learn how to use flint and steel to light a fire, and hunt for mushrooms.

Check out the book "Caveman Chemistry" regarding water filtering and making fire; plus soap, pottery, paper, etc. You'll need the fire for most of this, lots of it.

Find a mushroom expert to help hunt for mushrooms and teach identification. North America has more species than the rest of the world combined. Unlike the rest of the world, we have more than our share of poisonous species; some of which inform you a week later after your liver is gone.

Theo_musher said...

Yeah, I actually identified a "deathcap" and a "destroying angel" up here in Wisconsin a week after I bought my feild guide. Before that I had this pet theory that the white ones were probably OK.

Sean said...

When learning foraging, it would also help to get a friend, who knows better, to show you the difference between Queen Anne's Lace and the several Hemlock species. Plant identification makes learning things like permaculture useful, so you can begin to understand species patterns and leverage identification through identifying the communities/guilds.

These days, you should be making like a squirrel and burying your acorns (in a swamp or under a fresh water stream). Don't stop with edible, as there are numerous other uses for everyone. Even poisonous mushrooms and Hemlock have a niche or two. Basswood trees, for example, provide salad greens in the spring; fiber for cordage, rope, jewelry, paper, and clothing; some spice; some shade; annual compost with methane potential; firewood; potash; wood products; many many more, in addition to anchoring part of a canopy.

Anonymous said...

now imagine 300 million scavaging for mushrooms, chopping down trees and experience a three-degree rise in global temperature as the deserts spread across the US. bon apetit, suckers. invest in a gun, boat to antarctica and make sure to shoot any man, woman or child who comes ashore.

fdg said...

I like your blog. Thank you. They are really great . Ermunterung ++ .
Some new style Puma Speed is in fashion this year.
chaussure puma is Puma shoes in french . Many Franzose like seach “chaussure sport” by the internet when they need buy the Puma Shoes Or nike max shoes. The information age is really convenient .

By the way ,the nike max ltd is really good NIKE air shoes ,don’t forget buy the puma mens shoes and nike air max ltd by the internet when you need them . Do you know Nike Air Shoes is a best Air Shoes . another kinds of Nike shoes is better . For example , Nike Air Rift is good and Cheap Nike Shoes .the nike shox shoes is fitting to running.

Spring is coming, Do you think this season is not for Ugg Boots? maybe yes .but this season is best time that can buy the cheap ugg boots. Many sellers are selling discounted. Do not miss . Please view my fc2 blog and hair straighteners blog.
.thank you .

I like orange converse shoes ,I like to buy the cheap converse shoes by the internet shop . the puma shoes and the adidas shoes (or addidas shoes) are more on internet shop .i can buy the cheap nike shoes and cheap puma shoes online. It’s really convenient.
Many persons more like Puma basket shoes than nike air rift shoes . the Puma Cat shoes is a kind of Cheap Puma Shoes .
If you want to buy the Cheap Nike Air shoes ,you can buy them online. They are same as the Nike Air shoes authorized shop. Very high-caliber Air shoes and puma cat shoes . the cheap puma shoes as same as other.

polo shirts

ralph lauren polo shirts
chaussure puma

chaussure sport

chaussures puma

puma CAT

ed hardy clothing

ed hardy clothes

ed hardy womens

ed hardy sunglasses

fdg said...

j said...

Burberry polo shirt the steady, solid, so many young girls also love it. Speaking of people of a ralph lauren polo, think it a sign of nobility elegant waving in the horse club.spyder jacket in the cold in your winter activities can be easily.columbia jacket it is expensive, but here you do not need to consider the price of it. the north face jacket one of my favorite money, I do not know how many in this world of its fans.
ed hardy clothing
ed hardy clothes
ed hardy shirts
ed hardy t-shirts
ed hardy sunglasses
ed hardy mens
ed hardy womens
Wholesale Handbags
Cheap Handbags

j said...

In preparation for the purchase of a tennis racquetbefore, we must consider your financial ability to bear; On this basis, a further comparison, as far as possible, choose your tennis racket. Now a lot of cheap tennis racquet and more mixed materials, the proportion of mixed-use to control the stiffness of the tennis racquet discount and the shock-absorbing capacity, the more rigid cheap tennis racket, the swing more powerful force; but the relative resilience of the shock-absorbing capacity and discount tennis racket performance of talks on the easier it is for the wrist and elbow injury.
head junior tennis racket
wilson tennis racquet
wilson tennis racket
head tennis racket
babolat tennis racket
Womens Handbags
Cheap Purses
Designer Handbags

j said...