The Oil Drum

12 comments on The Round-Up: July 24th 2007

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PigglyWiggly on July 24, 2007 - 9:35pm

It's interesting to note that an AP story last week about ballooning credit card debt was spun as a positive thing: it maintained that the resilient consumer wasn't going to lay down and die.

Weird eh?

What's weirder is that unlike the "Hedgefund that Cannot be Named," Bear's funds are just the tip of the iceberg when it comes to the global derivative market (which is estimated by some folks as 10 times world GDP). I've read that back in 1998 derivatives were still pretty esoteric, hence the limited impact that our arbitrage pals had when their quants messed up, although still important enough to get the New York Fed involved to call a meeting with their bankers (Bear Stearns was being a real pain for them at the time --- hahahaha tables turned). How come no meeting now?

Everything is Topsy-Turvy. Going into credit card debt is good, creating phoney baloney money is no problem, the U.S. dollar is tottering and the CDN is rocketing (up 1c today which seems like a totally insane currency movement).

I'm starting to wonder if a post I made a few days back defending the sheeple really made any sense. Maybe everyone is a sheeple now, even those in the know. In fact I'm sure of it. I never make any sense.

Very confused PigglyWiggly

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HeIsSoFly on July 24, 2007 - 10:16pm

PeeWee,

For a history of -credit- derivatives, and some good insight as well, read:

The dream machine: invention of credit derivatives

After the meeting ended, the bankers flew back from Florida and started hunting for ways to put these ideas into practice. One was Robert Reoch, a young British banker who had recently joined JPMorgan’s London derivatives desk, which was tucked in a former boys’ school on Victoria Embankment. At that time, this derivatives team was very busy in Europe doing its “usual” business of trading currency and interest rate “swaps”. But at the time, JPMorgan also had another booming business in London - trading government bonds. And in the months after Boca Raton, Reoch and his colleagues started to work on the idea of a credit derivative.

No one on the team knew how to price this type of contract, let alone create the paperwork needed to keep the lawyers happy. But Reoch found an investor willing to buy such a deal, and one day he quietly sold a contract that placed bets on whether three European bonds would default. “It was the first time we had done a transaction like that,” Reoch proudly recalls.

What was it they did? The trade was what is known as a “first to default” swap. At that time JPMorgan was heavily involved in trading European government bonds and bond derivatives that left it exposed to losses if any bonds suddenly went into default (not an irrational fear in the pre-euro mid-1990s). However, the bank created a contract which effectively insured itself against such a default for a basket of bonds (say, that of Sweden, Italy and Belgium). It stipulated that if any of these bonds went into default, an investor would pay JPMorgan compensation. If that default never occurred, the investor would make money because they were receiving a fee to take this risk; but if any bonds defaulted, JPMorgan was covered.

Thus as long as a price could be found that kept everyone happy, it was a win-win deal: JPMorgan reduced its risk, and the investors could earn nice returns. It took another three months for the team to sort out the paperwork for this experiment. And it didn’t at first make waves in the financial markets. At that time, other banks were also experimenting in this way - and groups such as Bankers Trust and Credit Suisse were considered more innovative and aggressive in this area than JPMorgan. Yet, as 1994 turned into 1995, JPMorgan moved out in front.

They made it as incomprehensible as possible, on purpose.

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PigglyWiggly on July 25, 2007 - 1:50am

Very good article. These folks are just sooooo smart, aren't they? It seems like all the creativity is in finance. It's the place to be (for smart people, not Pigglies since I determined today, while sailing, that I am not smart).

You really can't lose. As long as you're not an outright crook, you can play all kinds of neat simulation games with money and numbers and computers and see what happens "in the real world." And it's all for the good of everyone involved ... win-win!

I keep thinking, waiting, that this whole experiment of late industrial capitalism will collapse under the collective weight of smart people IQs.

It doesn’t happen.

Something must hold it up. I think it's "hope".

Hope that the there's a bigger sucker than you;

hope that there's another innovation that will bail out the one that just broke;

hope that the ideological state apparatus will continue to function;

and hope that nature will not intervene to spoil Boca Raton's crystal clear marina with either a) giant man eating squids or b) ferocious Cat 7 hurricanes.

I would place my bets with the smarty pants, given that each one of these possibilities is highly unlikely to occur.

But little things might occur -- a smaller hurricane, nasty red tide, suspension of the suburban experiment, an unwinding of CDO derivatives, a faltering stock market, peak oil.

I sure hope none of these things occur!