Wednesday, January 7, 2009

Understanding Derivatives

If you are like me, the financial crisis that brought the world to its knees in October was somewhat mystifying.  I understand the basics of how to securitize a loan, but did not really understand how all of this could bring down the titans of wall street and bankrupt whole nations (Iceland comes to mind).


A couple of weeks ago I finished reading a great book named "FIASCO" by Frank Partnoy.  It was published in 1997 and is an autobiography of a derivatives trader on Wall Street during the mid 1990s.  The book is full of the usual wall street trader bravado and anecdotes -- but it also provides a very clear and easy to understand description of securitizations, derivatives and how it all works.  It was the first time I had someone explain to me exactly what a CDO (collateralized debt obligation) or CDS (credit default swap) was (among other things) and how all of these types of instruments work.  

More importantly, the author provides a very critical review of the securitization process and the house of cards that he helped build.  He pointed out (back in 1997!) that the entire rating agency process was flawed and that ratings were being bought by the investment banks.  That is, the investment banks were gaming the system by taking junk B and C rated debt and adding a thin layer of Aaa rated debt on top -- and the rating agencies (Moody's; Standard and Poors) would give the resulting derivative a Aaa rating.  This meant that it could be sold to a wider range of customers because most pension funds and insurance companies are forbidden from buying debt that is less than investment grade.  An entire market was created and it grew into the trillions of dollars.  

The rating agencies went along with the scheme because the investment banks were the ones paying their fees.  Sort of as if you were in a high school class of one and were also the person directly paying the teacher's salary.  Correct me if I am wrong, but that teacher might be incentivized to give you a good grade.

Anyway, the author predicted that the whole thing was in imminent danger of collapsing on top of itself.  He noted the Orange County bankruptcy (caused by derivative losses) as the first sign that the financial system was about to collapse.  Unfortunately, he was about 10 years too early in his predictions -- and no one paid attention to him anyway.  However, it is still a very enlightening read and I highly recommend it to anyone that wants to understand the situation we find ourselves in.  Also, it is a relatively fast moving and painless 280 pages, so you can bang it out without too much grief.  


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Dividends and Preferences by Hank Heyming is licensed under a Creative Commons Attribution 3.0 United States License.