STOCK MARKET WATCH -- Wednesday, 8 February 2012

[Demeter]

7. HOW DERIVATIVES SCREW THE POOCH

Derivatives are not marked to market. That sort of requirement is evil, evil, evil and anti-capitalist--or so we are told by the financial cartels who profit from selling derivatives. Derivatives can be sold in whatever quantity can be fobbed off to credulous buyers. This is how the world ends up with 700 gazillion dollars in notional derivatives.

Consider the debt of a sovereign state--for example, Greece. Just to keep things simple, let's say there are $100 billion of outstanding Greek bonds. Back in the good old days around 2009, the risk of Geece defaulting on that debt was considered low. Nonetheless, prudent owners of the debt bought insurance against default. The insurance is a derivative called a credit default swap (CDS). The contract works somewhat like an option, in the sense that if a default occurs, the seller of the CDS must cover their contract by delivering the value promised in the CDS to its owner. If no default ever occurs, the financial institution that originated and sold the CDS gets to keep the hefty premium. Nice. Since there are no limits on how many CDs I can write on Greek debt, why not sell more CDS? In fact, why not sell more CDS than there are Greek bonds? As in our options example, in the normal course of things the number of CDS equals the outstanding bonds. In other words, the owners of the $100 billion in bonds would buy $100 billion in notional CDS insurance against default.

If Greece defaulted and the value of the bonds fell in half to $50 billion, the sellers of the CDS would owe the owners of the CDS $50 billion. (This is simplified, but you get the picture.) That was, after all, the bet: in exchange for this hefty premium, if Greece defaults then we will make good your horrendous losses.
But a funny thing happened on the way to the derivatives market: wise guys realized they weren't limited to selling CDS to the owners of Greek bonds--anyone could buy a CDS on Greek debt. So why not sell $1 trillion in CDS against Greek bonds? That's ten times the premium. Some issuers hedged their bet by buying CDS issued by other institutions. These other institutions are the "counterparty", that is, the party who pays off the CDS I bought from them so I can pay off the owner of my CDS. Thus the derivatives market for Greek debt is a daisy-chain of counterparties, all planning to use the proceeds from the CDS they own to pay off the CDS they sold.

It was a license to print money--until Greece defaults. Yikes, now what? Just as in the classic film The Producers, where 100% of the proceeds of the Broadway play were promised to ten different investors, the CDS schemers reckoned the odds of a Greek default were effectively zero--"the E.U. will never let a member state default." Ahem. Until they do. In The Producers, the schemers devised a play so odious, so bad and so repellent that they felt extremely confident it would close after one night for a tremendous loss--and they would get to keep the 10X oversubscribed investors' money. This was the same bet made by sellers of CDS on Greek debt--and on Italian, Portuguese, Spanish, Irish et al. debt as well. Now that leaves the canny financiers in a pickle, as they owe various parties $1 trillion when $100 billion in Greek debt goes up in smoke.