Exclusive: Derivatives for Dummies by The Other Katherine Harris

by The Other Katherine Harris
Featured Writer
Dandelion Salad
Feb. 18, 2009

Recent attempts by corporate media to explain the nature of our economic meltdown have left me ready to bite the ears off mice. They’ve been superficial, profoundly misleading and, above all, apologias for the likes of

Paulson, Bernanke and Geithner. So, having spent every spare moment over the past three years studying the debacle that many saw brewing, here’s the simplest explanation I’ve come up with:

Imagine being able to insure a car that you don’t own or use. Imagine it’s the car your neighbors will let their teenage son drive, when he gets his license in a few weeks — and you know the kid is a reckless brat.

Now imagine that, by using financial derivatives called swaps, you can purchase as many insurance policies on this car as you can afford to pay premiums on.

When that car is eventually trashed and scrapped, you — and any friends you clued in on the deal – might collect millions, even billions, of dollars. By contrast, your neighbors, who bought real insurance on a real vehicle, get only its Blue Book value (and, one hopes, a chastened child).

This explains the primary problem with swaps. Anybody can bet on anything, so the nominal value of the bets far exceeds the actual worth of any property involved.

Still worse, no tangible or financial asset has to be in the picture. Wagers of any amount can be made, based only on opinions. You can bet on next Wednesday’s weather, if a counterparty wants to take the other side.

Only a fraction of swap action stems from logical situations in which, say, Party A owns a certain debt-based bond and Party B feels good enough about its prospects to accept premiums against possible default. Those are the Credit Default Swaps we hear so much about, which are a small part of the picture.

Similarly, Collateralized Debt Obligations comprise a much larger category than merely those bonds into which home mortgages have been sliced, diced, tranched and peddled to the unwary. Every type of debt is subject to the same treatment, called securitization or financialization. Commercial mortgages, student loans, home equity loans, credit card balances and auto notes spring immediately to mind, but it doesn’t stop there by any means. Among the latest wrinkles are buying up and bundling seniors’ life insurance policies and selling solar equipment with financing and service contracts attached, so that those obligations can be packaged and resold. Carbon credits, if cap-and-trade is approved in the US, instead of a sensible carbon tax, will be another new toy for the boyz.

Beyond swaps and CDOs, there are many other types of derivatives. Some serve no purpose except adding layers of expense to the delivery of commodities. Think of the possibilities as endless and you’ll be right.

This is how speculators in derivatives have created a “shadow economy” so vast it looms over the actual economy like a death-star over a bumblebee.

Much of their vast construct is not merely shadowy but wholly obscured. Among derivative securities, relatively few are traded on any exchange. So there’s no public record of the rest, which are based on private agreements. A host of swaps have arisen from so-called “dark pools of liquidity” — in which those who play may not even clearly identify themselves to one another. Yet more of these monsters from the deep arise daily. There’s still no rule against them, nor a wisp of regulation. At times the contracts are doubly hidden, recorded off the holder’s main books in so-called Structured Investment Vehicles.

All of that makes it impossible to be certain, but the Bank for International Settlements is a pretty good guesser and they last pegged the total face value of derivatives in existence at $1.4 QUADRILLION — more money than there is in all the world (at least until Ben Bernanke turned on the printing press lately). This figure may have since declined, but I wouldn’t bank on it. A lot of derivatives are long-term deals operant for many years.

Returning to our original example,you don’t even have to await the neighbor kid’s big smashup to start making money on your swaps. Say he gets a speeding ticket or has a fender-bender. Those are documented events that raise the price of coverage — for all who want it, not just the boy’s unfortunate parents. Now you can, by presenting him as a known risk, profit by selling some of your contracts to others for much more than you paid.

In this case, you wouldn’t want to sell unless you need funds badly, but imagine that your payoff depends on the failure of a company, a currency or a country. The weaker your target is perceived to be, as reflected by the cost of default insurance on its debt, the closer you move toward your ultimate goal. So you and your friends will do all you can to drive that cost up and make the world fully aware of it, including buying and selling CDS contracts openly. This makes the rising cost apparent and you can count on the rating agencies to take notice swiftly. Their downgrade will become the death-knell.

Therein lies another great problem with Credit Default Swaps. They work exactly like short-selling and rumor-mongering (which CDS owners may well be doing, too) to create self-fulfilling prophecies.

They also create the derivative world’s equivalent of margin calls, which mean trouble for luckless parties on what increasingly seem the wrong side of particular bets. Staying in the game takes cash, more and more of it.

Such circumstances also invite side-bets — on when the shaky whatsit will fall, for instance. Thus, the money monster grows bigger and bigger. Until it finally pops.

Which brings us to the enormous problem of extracting payment from those on the losing side of each bet, who of course didn’t expect to lose. Gamblers never do, until it’s far too late.

So welcome to the Casino at the End of the World. Where you’re now backing every remaining wager and paying off the winners. In bailout bucks.

Why, instead of doling out trillions of taxpayer dollars through the Fed and Treasury Department, didn’t our government simply nullify these crazy bets that never should have been made — thereby averting the present crisis? It can’t be that contracts are really all that sacrosanct. Credit card companies change terms on us all the time.


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82 thoughts on “Exclusive: Derivatives for Dummies by The Other Katherine Harris

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