A Simple Explanation of How The Use of Derivatives Created The Great Recession

[Joanne98]

by cactus

A Simple Explanation of How The Use of Derivatives Created The Great Recession

In comments to a post by fellow Angry Bear Robert Waldman, reader Cantab writes:



Nobody here has come up with a believable story on how derivatives hurt the economy or were the cause of the recession. All we really get is a claim that they happened together and the further assertion that derivates caused the recession rather than the more likely story that derivatives were the victim of the recession.

I'm pretty sure Cantab is wrong but I don't have the time to find the various posts that described the issue. But I can summarize:

1. Derivatives are about magnifying bets. A $2 bet on a derivative can be the same thing as a $100 bet on the asset that underlies the security. Thus, if the asset doubles in value, instead of taking home an extra $2 on your bet, you take home an extra $100. But if the price of the asset falls in half, instead of losing $2 on your bet, you lose $100.
2. On Wall Street, everyone leveraged up. After all, the worst that can happen when you gamble with monster leverage is that you go bankrupt. But if you win your bets, you make humongous profits.
3. Inevitably, when everyone is leveraged up, at least some of those who are leveraged must sooner or later make some bad bets. But the losses associated with these leveraged up bad bets was much bigger than in the past. Instead of losing $2 on their $2 bets as would have happened in the past, they lost $100. In the past, the losers' assets would simply have been liquidated, and those assets would have been enough to cover a substantial part of the losses. With derivatives, liquidation covers an insignificant piece of what is owed.
4. Result: massive, and I mean massive, losses to the firm's creditors. Perhaps big enough to drive their creditors out of business too. And those creditors have creditors too...

Continued>>>
http://www.angrybearblog.com/2010/03/simple-explanation-of-how-use-of.html

[Statistical]

1. Not all derivatives are open-ended.

Take options for example. You actually have less risk in a put option than shorting a stock.

If I short Citigroup ($5 per share). The most I can gain is $5 (stock goes to $0.00). The most I can lose is infinite. If stock goes to $10 I lose $5. If stock goes to $50 I lose $45 (900% of my investment). If stock goes to $2000 I lose $1995.

On the other hand if I purchase a $5 put option for $0.80. The most I can gain is $4.20 (I stock goes to $0 the put is worth $5 and I purchased it for $0.80). The most I can lose is $0.80.

If the stock is trading above $5 at expiration the put option is worthless but I can never lose more than $0.80.

Saying all derivatives are subject to open ended losses and thus are risky is like lumping 30yr fixed prime mortgages in with subprime and saying 100% of mortgages are risky.

[TomClash]

2. This post is ridiculous and show no appreciation of financial markets

I'll make one point. Most derivatives don't magnify risk - most are used as part of a hedging strategy.

[westerebus]

8. How's that working out for the Euro Zone?

Or we can stay home an look at AIG and their counter parties. Can you say tax payer bail out three times and not be pissed? It looks to me Lehman managed to hedge itself right out of business. Or does that fall under creative accounting?

There are legitimate reasons to hedge. It makes sense to limit risk when possible.

There is also betting against your counter parties that what you sold them as quality was in fact toxic junk that would default. Hello-Goldman!

When you have the NY-FED and the SEC on your payroll, why not bet the farm?

And they did.

[On the Road]

3. Anyone Who Posts That

"nobody here has come up with a believable story on how derivatives hurt the economy" is utterly lost.

Cantab's explanation is correct. He is wrong, however, in saying "The bail-outs were madness." Business accounts are not insured by the FDIC: If major banks had failed, vendors could not be paid and paychecks could not be written by any commerical customer. It is not a question of the banks themselves but of the whole network of economic transactions that depend on their solvency. Mulitiply the panic and contraction of a year ago by five or ten, or look at Iceland.

There is one point in the comments, however, I admit I am confused about: Credit default swaps are a type of option. In general, options are a zero-sum game, in which one party loses and another gains. If so, who benefitted by the banks losses in CDSs?

[jtuck004]

6. Even so, I am not sure that trying to avoid the bust was our best strategy

We put some money in, not enough to resolve all the problems, and still have perhaps hundreds of billions in assets of various kinds marked at a fictitious price (per the FASB decision from last, February?). The government has put enough in enough stim to keep things going for a awhile, but what is the ceiling on that before it also becomes a 0-sum game (more stim=more activity but with a decrease in the confidence of our power to back up our currency and debt). Does it blow up then?

At the same time we are terribly weakened by the continued un* or under-employment of 20+ million people, and a high likelihood that many or perhaps most will not see any decent job for nearly another 10 years (unless someone sees job creation higher than we averaged in the 90's on the horizon?). That's a lot of lives permanently ruined, as well as a drag on our national spirit. Is it likely that we won't see another oil spike during that time, or maybe even another war?

My point is that he may not have been wrong in saying the bail-outs were madness - instead of letting things crash and fixing them we have used tax money taken from working people's wages and the homes they were counting on for retirement to prop up the very people who caused the problem. We enabled most of them to stay in power, allowed them to continue reaping huge profits for their pockets. We have insured continuing pain for the country amid this weakness for at least decades, unless something else blows up and causes the whole thing to fall. Which it still might. In a pinch, do you take the tooth out with no Novocaine, or do you hand them a bottle of clove oil and let it rot in place, with occasional severe pain and perhaps blood poisoning and death to come?

Had we let it blow up we would have had the opportunity to restructure the banks so they could have been smaller and re-create some rules that would have protected the taxpayers from future excess. Would it have been painful? Sure, but is it less painful to continue keeping the money in the hands of so few, enabling their greed and power over mere mortals, much like we have done with the health care bailout, waiting to see if we are strong enough to avoid the next shock? Guess we will see...

btw, I do understand your assertion about options being a zero-sum game, but I am not sure that balance sheet terminology which was designed to account for real assets is robust enough to account for options, which are more like smoke. They aren't based on the real asset, just it's value up or down. But the banks seem to have delayed any real penalty for their actions by taking taxpayer money, so maybe it was the folks in finance who still have some really lucrative jobs of questionable real value that benefitted by largely avoiding the consequences of their behavior?

[On the Road]

7. I Appreciate the Thoughtful Post

I just think that the implications of 2 or 3 of the big four banks failing is being greatly underestimated. The fallout from just one firm (Lehman) and the fire sale of Morgan Stanley took six months to recover from. FDIC insures most personal accounts, but most business deposits are not covered. Many business large and small would not survive a failure of their bank. The ripples would have been enormous.

This is why there was such widespread panic. You didn't need to listen to any spinmeisters, just read the financial sources that business people themselves go to -- WSJ, Barrons, Financial Times, etc. I have never seen anything like it. The recession we're seeing is much, much better than the alternative, and outside of AIG it didn't cost the taxpayers. In fact, the lower revenues and higher government costs (unemployment, etc) would probably have been far worse for the federal budget, not to mention the economy or employment.

As far as the options go, I have been thinking about it and believe that poster was correct only to the extent that the obligations were paid. When you go long or short and lose, someone who bet in the other direction benefits from your loss. When you pay up, it is indeed a zero-sum game. If AIG and all the other CDS abusers had actually paid up for their losses, it would indeed be a zero-sum game.

What's not clear to me is who was on the other end of those CDS bets, and how much of it was paid up.

[unblock]

4. wrong from the get-go. derivativates are not about magnifying bets

LEVERAGE is about magnifying bets and leverage (in some cases, quite a lot of it) is one aspect of some derivatives.

more precisely, derivatives are about carefully carving out specific risks and trading exposure to that risk to someone more interested in holding it.

nothing wrong in that, in and of itself. derivatives can be used to limit risk and reduce exposure, and leverage can make it more practical to do so.

it was the nearly unrestrained leverage that made it easy to quickly put all eggs in one basket that created the catastrophe. plus it wasn't apparent that a most major players were all putting their eggs into that same basket. i.e., it's one thing to think you're betting the farm on something, it's another when everyone is betting all the farms on that same thing. so the decline in real estate hit not just one portfolio but unraveled the whole system.


in a nutshell, abuse of derivatives rather than derivatives themselves that at the root of the problem.

[dtotire]

5. Savings Banks should Be Prohibited From Participating

They might have some value, but they are a gamble, and savings banks should not be allowed to participate.