Tag Archives: CDOs

Financial Weapons of Mass Destruction: A Look At How Derivatives Work

Warren Buffett has once officially declared derivatives as “financial weapons of mass destruction”.

Derivatives? Oh no, I am not talking about high school calculus.

The Basics

A financial derivative that is a security that “derives” its value from another item or value. The most traditional derivatives are stock options, futures, forwards and swaps. However derivatives come in all shapes and sizes, and most recently we have seen something like Collateralized Debt Obligations or CDOs in the US and European markets.

CDOs were popular with bankers in the 2000’s, however they did not understand the risk associated with the instruments and losses can mount up as high as St.Agnes. CDOs are essentially any loans with a bundle of assets attached to them, which in the 2007 market debacle, were mortgages on houses.  The loan and the asset are usually grouped together and sold as a single instrument.

Traditional derivatives are more tried and true, hence they are more reliable to certain extent.

Options give owners the right to buy something at a certain value at a certain point in time.

Futures and forwards give investors the right to buy something at a certain value at a later date. A grape farmer can sell next year’s harvest by visiting the futures or forwards markets to someone who is willing to buy at a price set in advance (a counterparty). Terms for futures are standardized, unlike forwards. Future contracts correspond to other contracts, hence they can be traded on exchanges globally.

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Bernanke’s invisible stimulus

So what happened Thursday?

In a recap, the Federal Reserve Chairman Ben Bernanke said that the economy has not deterioated “enough” to need immediate additional stimulus. (Italics by the author). However he believes that if necessary, there could be more stimulus.

The inaction by the Feds is the invisible stimulus all the financial industry has been hoping for. The invisible stimulus is the lack of the increase in interest rates. With the decreased interest rates there is increased appetite for higher-risk assets, and possibly more return. However this is fueling another bubble by itself. Equities have been mispriced for the last two years, fueled mostly by speculation, and not the underlying business. Companies see great volatility in their stock price for an event that may have no connection to the stock. The low interest rates are a terrible incentive since it invites more “investors” ( I use this word loosely, since traders are not really investors) to enter the market and gamble away their money in the hopes of making a quick buck.

However if there is another “major” correction, which is quite possible within the next year (possibly 20% correction), then we will be seeing another round(s) of stimulus. The correction is derived based on the hypothesis that the stock market has reached  pre-2007 crisis level, however the earnings have been consistent or decreasing over the last three years. There is disconnect between the underlying stock and the business. Another assumption is that there is yet another housing bubble that is yet to take place due to high unemployment for the people in the middle trench for CDO’s, the guys who could previously afford the mortgages when they signed their contracts. The 2007 crisis was due to default on mortgages who could not afford their mortgages at all! Their sole reason for getting a property was to sell it back within six months, pocketing the difference, or they were suckered into the mortgage due to the temporary low rates. This next housing bubble is going to hit the whitecollar households where one of the person(s) in the household is unemployed and can barely afford the mortgages.

Once companies see their earnings decreasing (due to consistent high unemployment), they will be forced to layoff more people to save their stock prices, thus starting the vicious cycle where the economy is going to shed more jobs than it will create. (Do you remember the 18K jobs created in June vs expectation of 132K?)