Wait, the Derivatives market is worth $1,200 TRILLION dollars???

[jmowreader]

30. Precisely

It gets better: the huge financial services reform bill that was SUPPOSED to rein in the derivatives market still lets them do outrageous crap.

Let me tell you the best part: You know about the Goldman Sachs scandal, where John Paulson set up a billion-dollar bet against the housing market? Not only was what he did legal when he did it, it's still legal.

How the Goldman Sachs scandal worked: Goldman Sachs hired John Paulson, who has made billions of dollars as a short-seller, to make them a shitload of money. Paulson identified a billion dollars' worth of mortgages that he thought were going to default, and bought "naked credit default swaps" against them. A credit default swap is a bit like an insurance policy written against a credit account. It's only a bit like an insurance policy because the person who buys the CDS doesn't have to own what it's written against, and the person selling it doesn't have to own the money necessary to pay the buyer if the casualty being covered (the default of the underlying credit account) happens. After Paulson got the naked CDS, he then wrote bonds called "synthetic collateralized debt obligations" against them. A non-synthetic CDO is written against a basket of anything you want--you could bundle thirty mortgage-backed securities, fifteen credit card receivables asset-backed securities, a whole mortgage, nineteen car loans and a million-dollar "win" ticket on I'll Have Another in the Belmont, base a CDO on the bundle and people would buy the damn thing. Synthetic CDOs, OTOH, are written only against credit default swaps--usually, naked CDS.

They call the people involved in these transactions counterparties. Each of them has money in the deal. The person who created and sold the CDO, which we will call the "writer," makes money if the people way down at the bottom of this thing, the homeowners who bought the houses the mortgages on which John Paulson is betting against, lose their homes to foreclosure. Quite obviously, the more people default the more money he makes and if they all default he'll be out there dancing nekkid in the middle of the street with mango jelly all over him. The people who bought the CDO, who we will call the "marks," make money if the homeowners pay off their mortgages. John Paulson doesn't want the marks to make money, because the more they make the less he does. Hence the need to pick mortgages he absolutely knew would fail.

I read the prospectus. It specifically said the investment was a synthetic CDO, and this is how synthetic CDOs all work.

In short, what you are looking at here is nothing more, and nothing less, than a $100,000 lottery ticket. The only real difference is, when you buy a $2 Powerball ticket on Saturday and it doesn't win--the usual performance of a Powerball ticket--you throw it in your recycling bin and wait till Wednesday to try again. When you buy a $100,000 Goldman Sachs ticket on Monday and it performed as well as the Powerball ticket you bought Saturday, you go to your congressman with a sad story and they have an investigation.

The Commodity Futures Modernization Act specifically says derivatives are not "gambling transactions." This is true. Casinos have rules.