Forget Sub Prime, Credit Derivatives are 50 times Worse!

I am a fan of Daniel Amerman (Turning Inflation into Wealth). He has a fantastic way of explaining much of what is going on in this credit crisis. In an article entitled, “AIG’s Dangerous Collapse” he talks about IAG and the danger if it collapses due to its massive credit default swap positions.image

What are Credit Default Swaps?

“… swaps: derivative securities that allow banks, hedge funds and other financial players to insure against loans gone bad.” Time, September 17, 2008″

Here’s a wake-up call. Look at the chart on the right. See the sub prime problem – that tiny blue bar.

Now look at the RED credit derivatives bar, more than 50 times bigger than the sub prime bar,at $62 Trillion.

But that’s not all. The real “cruncher” is the GREEN Bar. That’s the Global Economy for 2007!

Daniel Amerman uses the article mentioned here to explain the Credit Derivatives and how they were first used to make money, then……

How they were used to make fortunes.

By just changing the ASSUMPTIONS about the “chance of a loss” percentage, your firm would take on a credit derivative. Note that – You make an assumption.

Daniel goes on to show that if the ASSUMPTION of the chance of a lose was reduced say from 4% to 3.5% on a credit derivative, then you could easily double your profits on the deal. See his simple example.

That means you will get double your bonus according to Daniel. And your bonus is paid to you immediately relative to the returns paid to the owner of the derivative. He should know. He has been involved in derivatives since they first came on the scene in 1983.

There is far more to this article than I have covered here. Daniel explains it in very simple terms and I really do recommend you take the time to read it. Learn form history.

It has been said in the Press many time that people were selling things they didn’t understand. I do not believe that is true for one minute.

The truth is those selling these products knew exactly what they were doing. If they were able to make assumptions about risk of loss at the stroke of a pen and double their profits, they knew. No one was policing this. That was the problem.

Now we have the US Government fiddling with the “Mark to Market” Rules so Banks and other institutions with sub prime and credit derivatives on their books, can ASSUME the value they want to put on them. So here we go again, creative accounting hiding the problems or potential problems.

I don’t understand the full ramifications of this. But this much I do know. The “mark to market” rule has been there all through this credit crisis. Investment Banks and other financial institutions were trading in credit derivatives in an opaque way in a parallel market to the trading exchanges around the world and ignored it.

There was no open market for price discovery for them. So the price could be anything you wanted it to be and get away with when you sold derivatives to your trusting clients.

The returns on the derivatives were so good and so secure, triple AAA rated and insured by IAG, it was a no lose situation. So the clients never queried it either.

No one bothered to say anything because they were too busy making fortunes based on a derivatives sales persons assumptions. It was easier to just trust the salesman knew what they were doing and ASSUME it was too hard to understand.

Why ruin the party with a reality check? Mark to Market is only brutal when it is imposed by force after a bubble created by people NOT observing the law. If it had been done from the start we might have avoided this mess. Maybe…

Sure the way derivatives were packaged may be complex. But the way they made fortunes  for the sellers was with a pencil and a rubber. Just change the “chance of a loss” ASSUMPTION by half a percent and you double your profit. That can’t be that hard to do can it.

You don’t need to understand much to change the ASSUMPTIONS on the “chance of a loss”. One editable Excel cell in a simple spreadsheet can be a big help simplifying even that.

The article makes fascinating reading.

If you get the time take Daniel Amerman’s, “Turning Inflation into Wealth Free Mini Course”. With the trillions of dollars being borrowed and printed there is a good chance we are heading for high inflation and high interest rates in the future. So prepare yourself now for that eventuality.

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