Thursday, June 23, 2011


I like to read the Business Day section of the NY Times. The top story today has the headline "Derivatives Cloud the Possible Fallout From a Greek Default." OK, sounds like I could get some insights into the economic woes of Greece, so I read the article. I have no idea what it all means! 

The situation in Greece is "clouded" by derivatives and credit-default swaps, whatever they are. It sounds like institutions buy insurance against loan defaults of others, and somehow make money from those. 

Let's start where I often start: definitions. 

Derivatives: according to Wikipedia, a derivative is "financial instrument whose value depends on underlying variables." Um, not very helpful, but let's read on...a derivative "is essentially a contract whose payoff depends on the behavior of a benchmark." O...K....maybe we can find another definition.

Let's try Investopedia - that sounds pretty wonkish. 
A security whose price is dependent upon or derived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage. (I remember studying leverage in high school physics.)

Hmmm, let's read on: 
Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Derivatives are contracts and can be used as an underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region.

Oh great, now were into forecasting the weather! 

Maybe "credit default swap" will be easier to understand, and I'm liking Investopedia, so let's stay with them. 
Credit default swaps (CDS) are the most widely used type of credit derivative and a powerful force in the world markets. The first CDS contract was introduced by JP Morgan in 1997 and by mid-2007, the value of the market had ballooned to an estimated $45 trillion, according to the International Swaps and Derivatives Association - over twice the size of the U.S. stock market.

Now we're getting somewhere....let's keep going:
A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities, or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event." The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs.

So what does this have to do with Greece? Well, what the NY Times article discusses is that there might be large financial institutions that are holding CDS contracts on Greek debt, and if Greece defaults on the debt, these institutions will have to pay out. The trouble is, no-one knows who is holding CDSs on Greek debt and how large these are. If some institutions are holding huge amounts of CDSs on Greek debt, they might be unable to pay out, with very serious impacts to the world economy - again. 

I say again because this is exactly what happened in the good old US of A; remember AIG? That's right, AIG (American International Group) had insured the performance of mortgage bonds through derivatives (there's that term again) and could not pay out on them. As a result, the US government had to bail out AIG to the tune of 182 billion dollars. 

So maybe I do understand this stuff a little bit now. For me, the bottom line is this - the financial institutions on Wall Street and elsewhere have set up this very large and complex system (dare I call it a form of gambling?) that imperils the world economy. Recent history has shown us very clearly that if these big guys get in trouble, us little folk will have to bail them out with our tax dollars. And keep in mind, this derivative and credit-default swap stuff is mostly unregulated. 

Maybe I'll pull my money out of the market and take it to the nearest casino.

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