Credit Default Swap

298 results back to index

The Big Short: Inside the Doomsday Machine by Michael Lewis

Alan Greenspan, An Inconvenient Truth, Asperger Syndrome, asset-backed security, Bear Stearns, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, facts on the ground, financial engineering, financial innovation, fixed income, forensic accounting, Gordon Gekko, high net worth, housing crisis, illegal immigration, income inequality, index fund, interest rate swap, John Meriwether, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, medical residency, Michael Milken, money market fund, moral hazard, mortgage debt, pets.com, Ponzi scheme, Potemkin village, proprietary trading, quantitative trading / quantitative finance, Quicken Loans, risk free rate, Robert Bork, short selling, Silicon Valley, tail risk, the new new thing, too big to fail, value at risk, Vanguard fund, zero-sum game

It was a zero-sum bet: If you made $100 million, the guy who had sold you the credit default swap lost $100 million. It was also an asymmetric bet, like laying down money on a number in roulette. The most you could lose were the chips you put on the table; but if your number came up you made thirty, forty, even fifty times your money. "Credit default swaps remedied the problem of open-ended risk for me," said Burry. "If I bought a credit default swap, my downside was defined and certain, and the upside was many multiples of it." He was already in the market for corporate credit default swaps. In 2004 he began to buy insurance on companies he thought might suffer in a real estate downturn: mortgage lenders, mortgage insurers, and so on.

…

On March 19, 2005, alone in his office with the door closed and the shades drawn, reading an abstruse textbook on credit derivatives, Michael Burry got an idea: credit default swaps on subprime mortgage bonds. The idea hit him as he read a book about the evolution of the U.S. bond market and the creation, in the mid-1990s, at J.P. Morgan, of the first corporate credit default swaps. He came to a passage explaining why banks felt they needed credit default swaps at all. It wasn't immediately obvious--after all, the best way to avoid the risk of General Electric's defaulting on its debt was not to lend to General Electric in the first place. In the beginning, credit default swaps had been a tool for hedging: Some bank had loaned more than they wanted to General Electric because GE had asked for it, and they feared alienating a long-standing client; another bank changed its mind about the wisdom of lending to GE at all.

…

You could short the stocks of home building companies--Pulte Homes, say, or Toll Brothers--but that was expensive, indirect, and dangerous. Stock prices could rise for a lot longer than Burry could stay solvent. A couple of years earlier, he'd discovered credit default swaps. A credit default swap was confusing mainly because it wasn't really a swap at all. It was an insurance policy, typically on a corporate bond, with semiannual premium payments and a fixed term. For instance, you might pay $200,000 a year to buy a ten-year credit default swap on $100 million in General Electric bonds. The most you could lose was $2 million: $200,000 a year for ten years. The most you could make was $100 million, if General Electric defaulted on its debt any time in the next ten years and bondholders recovered nothing.

Confidence Game: How a Hedge Fund Manager Called Wall Street's Bluff by Christine S. Richard

activist fund / activist shareholder / activist investor, Alan Greenspan, Asian financial crisis, asset-backed security, banking crisis, Bear Stearns, Bernie Madoff, Blythe Masters, book value, buy and hold, Carl Icahn, cognitive dissonance, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, electricity market, family office, financial innovation, fixed income, forensic accounting, glass ceiling, Greenspan put, Long Term Capital Management, market bubble, money market fund, moral hazard, old-boy network, Pershing Square Capital Management, Ponzi scheme, profit motive, Savings and loan crisis, short selling, short squeeze, statistical model, stock buybacks, subprime mortgage crisis, white flight, zero-sum game

Although a company’s bankruptcy filing almost certainly results in someone losing money, there is no way of knowing that the person holding a credit-default-swap contract actually suffered a loss, the regulators reasoned. So credit-default swaps weren’t regulated—not as securities or gambling or insurance—and they proliferated at an astounding pace. Bond insurers got around the prohibition by setting up shell companies such as LaCrosse. American International Group (AIG) eventually sold protection on around $500 billion of risk through the credit-default-swap market. It conducted the business through a nonregulated unit called AIG Financial Products, headquartered in London.

…

During the second day of questioning, the SEC attorneys became less confrontational. They even sought Ackman’s opinion on a few topics, including the credit-default-swap market. “The problem with the credit-default-swap market,” Ackman said, “is that banks often have more information than their counterparties. That means they’re shifting risk to someone who knows less about the risk than they do.” But when Gotham made an investment—including one in the credit-default-swap market—“we want to know more than anyone in the world can know based on the public information,” Ackman explained. “And usually, by the way, most people don’t read the stuff anyway,” Ackman added.

…

Ackman and the fund’s analysts sought out companies with securities that were mispriced or misunderstood by the market. In MBIA’s case, the market believed in the permanence of the company’s triple-A rating. If it didn’t, then the bond insurer’s ability to write new business would have disappeared overnight. Ackman had placed his bet against MBIA principally in the credit-default-swap market. Credit-default swaps, or CDS contracts, are derivatives that allow parties to buy and sell protection against a default on a security. The contracts are essentially life insurance policies on companies. The protection buyer—in Wall Street parlance—makes regular payments over the life of the contract to the protection seller, who promises to make a lump sum payment to the insurance buyer if a security defaults.

All the Devils Are Here by Bethany McLean

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, Bear Stearns, behavioural economics, Black-Scholes formula, Blythe Masters, break the buck, buy and hold, call centre, Carl Icahn, collateralized debt obligation, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, diversification, Dr. Strangelove, Exxon Valdez, fear of failure, financial innovation, fixed income, Glass-Steagall Act, high net worth, Home mortgage interest deduction, interest rate swap, junk bonds, Ken Thompson, laissez-faire capitalism, Long Term Capital Management, low interest rates, margin call, market bubble, market fundamentalism, Maui Hawaii, Michael Milken, money market fund, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, proprietary trading, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, Savings and loan crisis, shareholder value, short selling, South Sea Bubble, statistical model, stock buybacks, tail risk, Tax Reform Act of 1986, telemarketer, the long tail, too big to fail, value at risk, zero-sum game

Lo and behold, along came the product that would soon be the greatest capital reducer of them all: the credit default swap. In simplest terms, a credit default swap is designed to accomplish the same task as an interest rate or currency swap—move risk from a party that doesn’t want it to one that does. The risk in this case, however, is credit risk. A credit default swap is essentially an insurance policy against the possibility of default—credit protection, it came to be called. One party—a bank—would buy credit default swaps to protect against a default in its loan portfolio. A counterparty would sell the bank the credit default swap in return for a fee. So long as there was no default, the counterparty would keep collecting fees.

…

It was a natural development—at least from Wall Street’s point of view—but it evolved into one of the most unnatural and destructive financial products that the world has ever seen: the synthetic CDO. The key ingredient in a synthetic CDO was our old friend the credit default swap. For that matter, the key to shorting the mortgage market was the credit default swap. By 2005, credit default swaps on corporate bonds were ubiquitous, with a notional value of more than $25 trillion. (The notional value of credit default swaps peaked in 2007 at $62 trillion.) They were used by companies to protect against the possibility that another entity it did business with might default. They were used by banks to measure the riskiness of a loan portfolio, because their price reflected the market’s view of risk.

…

“We were extending credit,” says one member of the credit derivative team, “and nobody was putting a price on it.” A tradable market for credit default swaps would change that. Traders buying and selling credit protection would allow the market to gauge the riskiness of a loan. If the cost of the credit default swap increased, that meant the chance of a default was rising; if it decreased, then the odds were decreasing. Even before a tradable market existed, J.P. Morgan’s quants began using credit default swaps internally, to put a price on the risk of its own commercial loans. The old-line commercial lenders hated it, but this was exactly the kind of approach to risk that Weatherstone favored.

The Quants by Scott Patterson

Alan Greenspan, Albert Einstein, AOL-Time Warner, asset allocation, automated trading system, Bear Stearns, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Monday: stock market crash in 1987, Black Swan, Black-Scholes formula, Blythe Masters, Bonfire of the Vanities, book value, Brownian motion, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, Carl Icahn, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Dr. Strangelove, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial engineering, Financial Modelers Manifesto, fixed income, Glass-Steagall Act, global macro, Gordon Gekko, greed is good, Haight Ashbury, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, index fund, invention of the telegraph, invisible hand, Isaac Newton, Jim Simons, job automation, John Meriwether, John Nash: game theory, junk bonds, Kickstarter, law of one price, Long Term Capital Management, Louis Bachelier, low interest rates, mandelbrot fractal, margin call, Mark Spitznagel, merger arbitrage, Michael Milken, military-industrial complex, money market fund, Myron Scholes, NetJets, new economy, offshore financial centre, old-boy network, Paul Lévy, Paul Samuelson, Ponzi scheme, proprietary trading, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Robert Mercer, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Savings and loan crisis, Sergey Aleynikov, short selling, short squeeze, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

The link between dying spouses and credit default swaps was quant wizardry at its best—and its worst. Li showed how this model could assign correlations between tranches of CDOs by measuring the price of credit default swaps linked to the underlying debt. Credit default swaps supply a single variable that incorporates the market’s assessment of how the loan will perform. The price of a CDS, after all, is simply a reflection of the view investors have on whether or not a borrower will default. Li’s model supplied a method to bundle the prices of many different credit default swaps in a CDO and spit out numbers showing the correlations between the tranches.

…

Weinstein thought it might be a good fit—the job was for a small desk, with little competition, at a firm making a big push into a field he was certain had plenty of room to grow. Soon after joining Deutsche, he was learning how to trade a relatively new derivative known as credit-linked notes. Eventually they would become more commonly called credit default swaps. Credit default swaps are derivatives because their value is linked to an underlying security—a loan. They were created in the early 1990s by Bankers Trust, but it wasn’t until the math wizards at J. P. Morgan got their mitts on them that credit derivatives really took off. When Weinstein arrived at Deutsche, only a few notes or swaps traded every day—light-years from the megatrillion-dollar trading in swaps that went on in cyberspace a decade later.

…

Another boom came in the form of a new breed of hedge funds such as Citadel—or Citadel copycats—that specialized in convertible-bond arbitrage. Traditionally, just as Ed Thorp had discovered in the 1960s, the strategy involved hedging corporate bond positions with stock. Now, with credit default swaps, there was an even better way to hedge. Suddenly, those exotic derivatives that Weinstein had been juggling were getting passed around like baseball cards. By late 2000, nearly $1 trillion worth of credit default swaps had been created. Few knew more about how they worked than the baby-faced card-counting chess whiz at Deutsche Bank. In a flash, thanks in part to Russia’s default and LTCM’s collapse, Weinstein went from being a bit player to a rising star at the center of the action, putting him on the fast track to becoming one of the hottest, highest-paid, and most powerful credit traders on Wall Street.

13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

Alan Greenspan, American ideology, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Bonfire of the Vanities, bonus culture, book value, break the buck, business cycle, business logic, buy and hold, capital controls, Carmen Reinhart, central bank independence, Charles Lindbergh, collapse of Lehman Brothers, collateralized debt obligation, commoditize, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency risk, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial engineering, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Glass-Steagall Act, Gordon Gekko, greed is good, Greenspan put, Home mortgage interest deduction, Hyman Minsky, income per capita, information asymmetry, interest rate derivative, interest rate swap, junk bonds, Kenneth Rogoff, laissez-faire capitalism, late fees, light touch regulation, Long Term Capital Management, low interest rates, market bubble, market fundamentalism, Martin Wolf, Michael Milken, money market fund, moral hazard, mortgage tax deduction, Myron Scholes, Paul Samuelson, Ponzi scheme, price stability, profit maximization, proprietary trading, race to the bottom, regulatory arbitrage, rent-seeking, Robert Bork, Robert Shiller, Ronald Reagan, Saturday Night Live, Satyajit Das, Savings and loan crisis, sovereign wealth fund, Tax Reform Act of 1986, The Myth of the Rational Market, too big to fail, transaction costs, Tyler Cowen, value at risk, yield curve

Orange County lost almost $2 billion on inverse floaters and similar trades that treasurer Robert Citron clearly did not understand; real-economy companies such as Procter & Gamble and Gibson Greetings similarly lost tens or hundreds of millions of dollars.75 But these transactions generated large fees for the dealers; Merrill Lynch alone made $100 million on deals with Orange County.76 One crucial innovation in the recent history of derivatives, which played an important role in creating the latest financial crisis, was the credit default swap. A credit default swap is a form of insurance on debt; the “buyer” of the swap pays a fixed premium to the “seller,” who agrees to pay off the debt if the debtor fails to do so. Typically the debt is a bond or a similar fixed income security, and the debtor is the issuer of the bond. Historically, monoline insurance companies provided insurance for municipal bonds, and Fannie Mae and Freddie Mac insured the principal payments on their mortgage-backed securities. With credit default swaps, however, now anyone could sell insurance on any fixed income security.

…

With credit default swaps, however, now anyone could sell insurance on any fixed income security. Credit default swaps were invented in the early 1990s by Bankers Trust, but were popularized by J.P. Morgan later in the decade as a way for banks to unload the default risk of their asset portfolios; this enabled them to lower their capital requirements, freeing up money that could be lent out again.77 Credit default swaps also provide a way for a bond investor to hedge against the risk of default by the bond issuer. But because there is no requirement that the buyer of a credit default swap own the debt in question, these derivatives are also a handy way to gamble on the chances of any company defaulting on its debts (similar to buying insurance on your neighbor’s house); this quality made them a new type of security that could be minted in infinite quantities and traded, providing another source of profit for derivatives dealers.

…

In comparison with MBS and CDOs, credit default swaps (insurance against default), introduced in chapter 3, are a relatively simple product, but they played a special role in the finance boom. Because the boom was based on creating, packaging, and selling debt, it depended on the assumption that borrowers would pay off their debts—or that someone else would pay in their place. Credit default swaps made it possible to insure any pool of mortgage loans or mortgage-backed securities, seemingly eliminating the risk of default. In 1997, J.P. Morgan (part of today’s JPMorgan Chase) pioneered the use of credit default swaps to shift the default risk of loans off of its balance sheet.

When Free Markets Fail: Saving the Market When It Can't Save Itself (Wiley Corporate F&A) by Scott McCleskey

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, barriers to entry, Bear Stearns, Bernie Madoff, break the buck, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, financial engineering, financial innovation, fixed income, Glass-Steagall Act, information asymmetry, invisible hand, Isaac Newton, iterative process, junk bonds, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, place-making, Ponzi scheme, prediction markets, proprietary trading, risk tolerance, Savings and loan crisis, shareholder value, statistical model, The Wealth of Nations by Adam Smith, time value of money, too big to fail, web of trust

If any one of these factors had been absent, the damage wrought by them would likely have been much smaller or at least localized among a few firms. CREDIT DEFAULT SWAPS What really makes a systemic crisis systemic is when failures in one instrument lead to the failure of others. When mortgage-backed securities started to fail and to take firms with them, the contagion spread to, and through, a number of instruments, but the biggest of all was the market for credit default swaps (CDSs). Put simply, a credit default swap is insurance against the default of an issuer’s bonds and other debt obligations. CDSs were written against RMBS securities and against the bonds of financial institutions and all other kinds of debt issuers.

…

If you think that regulation in the form of ‘‘transparency’’ is sufficient on the grounds that the market can regulate itself as long as it has sufficient information, you place more faith in our ability to measure and predict market behavior than can reasonably be done. In a complex financial system, it’s difficult enough just to know who has sold credit default swaps to whom, let alone the consequences of their deterioration under specific market circumstances. Reforming the credit default swap market by making their trading and ownership transparent may help to solve the first problem (though even this premise is somewhat doubtful, as one chapter in this book discusses), but it won’t do anything to solve the second.

…

It is hard to argue that innovations that were at the center of the financial crisis—namely mortgage-backed securities and credit default swaps—were good for anyone. Some distinguished economists and bankers put the case more strongly. Paul Volcker, Alan Greenspan’s predecessor as Fed chairman and never a man to express half an opinion, has made clear his views on unrestrained innovation: I hear about these wonderful innovations in the financial markets, and. . . . I can tell you of two—credit-default swaps and collateralized debt obligations—which took us right to the brink of disaster. Were they wonderful innovations that we want to create more of?

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

Alan Greenspan, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, behavioural economics, Black Swan, Black-Scholes formula, bonus culture, book value, break the buck, buy and hold, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, delayed gratification, diversification, Edmond Halley, facts on the ground, fear index, financial innovation, fixed income, George Akerlof, Glass-Steagall Act, Greenspan put, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, John Meriwether, junk bonds, Kenneth Rogoff, Kickstarter, Long Term Capital Management, margin call, market bubble, money market fund, Myron Scholes, Nick Leeson, Northern Rock, offshore financial centre, Paul Samuelson, price mechanism, proprietary trading, regulatory arbitrage, rent-seeking, Richard Thaler, risk free rate, risk tolerance, risk/return, Ronald Reagan, Salesforce, Savings and loan crisis, seminal paper, shareholder value, short selling, statistical model, subprime mortgage crisis, The Chicago School, Thomas Bayes, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve, zero-sum game

The nonfinancial companies whose activities in the globalized economy exposed them to financial uncertainty didn’t seem interested. The derivatives that were useful to them—futures, options, and swaps linked to commodities, currencies, and interest rates—had already been invented. It seemed to me as if the credit default swap was an invention searching for a real purpose. As it happened, the kind of companies that found credit default swaps most relevant were those that had lots of default risk on their books: the banks. Losing That Hate-to-Lose-Money Mind-set Back in the early 1990s, the world’s biggest banks were still firmly rooted in an old lending culture where the priority above all else was to loan money and get paid back with interest.

…

Now suppose you preferred to work with people who swore by the market approach to credit, as Peter Hancock did. The credit default swap was the trading world’s modern solution. This industry had already created a thriving business enabling clients to protect themselves from—or speculate on—fluctuating interest rates, currencies, and commodity risk using derivatives. Why not expand the innovation to handle credit? For instance, if Hancock had been able to buy a derivative that hedged J.P. Morgan against clients’ defaulting, the bank would have been spared the embarrassment of its Korean swap fiasco. Like foreign exchange options, credit default swaps could be easily detached from any underlying exposure that might “justify” their existence as a hedge.

…

In fixed income, a company might have hundreds of different bonds in the market, repayable in different currencies, and with myriad maturity dates and interest payment profiles. Which one should you buy or sell? You had to be a geek to figure it out. With credit default swaps, all that detail could be stripped away. As with equities, there was a single “reference entity” or “name,” Walmart Inc., whose potential for default drove the price of the swap contract. Better still, the default swap distilled this crucial credit information out of the hundreds of Walmart bonds. And for Sherwood, information was power. He realized that by combining trading in credit default swaps and corporate bonds on the same desk, Goldman would have its finger on the pulse of the world’s biggest corporate borrowers: not only could Goldman control its own exposure, but it would control its clients’ access to the market for credit.

The Great American Stickup: How Reagan Republicans and Clinton Democrats Enriched Wall Street While Mugging Main Street by Robert Scheer

Alan Greenspan, banking crisis, Bear Stearns, Bernie Madoff, Bernie Sanders, business cycle, California energy crisis, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, do well by doing good, facts on the ground, financial deregulation, fixed income, Glass-Steagall Act, housing crisis, invisible hand, Long Term Capital Management, low interest rates, mega-rich, mortgage debt, new economy, old-boy network, Ponzi scheme, profit motive, Ralph Nader, rolling blackouts, Ronald Reagan, Savings and loan crisis, too big to fail, trickle-down economics

As for those “swaps” to which Gramm referred, scoffing at alarmists who thought “trillions” were at stake and that the swaps could “disrupt the financial system”—boy, did they ever. “The Monster That Ate Wall Street: How ‘credit default swaps’—an insurance against bad loans—turned from a smart bet into a killer” was the title and subheading of a Newsweek article on October 6, 2008, referring to credit default swaps, “which ballooned into a $62 trillion market . . . nearly four times the value of all stock traded on the New York Stock Exchange.” Of course in hindsight, Gramm’s glibness, whether cynical or naïve, seems patently absurd; the worrywarts were completely right.

…

However, some years before Glass-Steagall was dismantled, Phil’s wife played a key role, as a member of both the Reagan and the Bush I administrations, in shaping the rapid changes in the financial markets brought about by internationalization, computer-driven trading, and the introduction of a whole new discipline of “risk management,” whereby Wall Street wizards deployed complex mathematical models to create a vast array of new financial products, such as the now infamous credit default swaps and collateralized debt obligations. As was seen throughout the Reagan and later the Bush I and Bush II administrations, the Republicans had realized they could impose de facto deregulation of Big Business by appointing to influential federal commissions and agencies “watchdogs” who were sympathetic to the corporations they were supposed to be monitoring.

…

In addition, the law limited the SEC’s authority to regulate certain types of OTC derivatives.” “As a result, the market for OTC derivatives has largely gone unregulated,” the White House statement continued. “The downside of this lax regulatory regime for OTC derivatives—and, in particular, for credit default swaps (CDS)—became disastrously clear during the recent financial crisis.” Now they tell us. In a Washington Post op-ed, Summers and Obama Treasury secretary Timothy Geithner, a Rubin/Summers protégé in Clinton’s Treasury Department, bemoaned how “the most severe financial crisis since the Great Depression” was caused because the market “failed to perform its function as a reducer and distributor of risk.

The Trade Lifecycle: Behind the Scenes of the Trading Process (The Wiley Finance Series) by Robert P. Baker

asset-backed security, bank run, banking crisis, Basel III, Black-Scholes formula, book value, Brownian motion, business continuity plan, business logic, business process, collapse of Lehman Brothers, corporate governance, credit crunch, Credit Default Swap, diversification, financial engineering, fixed income, functional programming, global macro, hiring and firing, implied volatility, interest rate derivative, interest rate swap, locking in a profit, London Interbank Offered Rate, low interest rates, margin call, market clearing, millennium bug, place-making, prediction markets, proprietary trading, short selling, statistical model, stochastic process, the market place, the payments system, time value of money, too big to fail, transaction costs, value at risk, Wiener process, yield curve, zero-coupon bond

This is a linear trade as the profit is linearly related to the spot price. But it is leveraged because, if the price starts rising, the trader will have to commit an unknown size of funds to buying the underlying in order to fulfil his trading obligations. Credit default swaps As credit default swaps are an insurance product, they are leveraged trades. This is illustrated in Table 5.3. Suppose a five-year credit default swap trades at 200 basis points per annum. If spreads stay fairly constant, the buyer of protection will have paid about 1000 basis points over the life of the trade (equivalent to 10% of the notional). On the other hand, the seller of protection will pay 100% of the notional (less recovery) in the event of default.

…

This can be explained by taking an example of five-year bonds in Vodafone trading at 180 basis points spread to the underlying interest rate but the five-year credit default swap in the same company trading at 200 basis point spread. The basis (difference) is therefore 20 basis points. Someone who holds bonds and CDSs is paying 20 basis points. Now the impact on P&L caused by a change in the basis is defined as the bond basis delta. Credit default swap (CDS) deltas. This is the change in P&L caused by a change in the credit default swap rate. Foreign exchange. The change in P&L due to a change in foreign exchange rates. Interest rate deltas. The change in P&L caused by a change in interest rates.

…

A physical commodity option would pay out in some commodity, such as cocoa beans or palladium. This is a good example of how a financial product transcends the asset class and has the same features and cashflows across all asset classes. 30 THE TRADE LIFECYCLE Payout Starts Exercise Premium FIGURE 3.13 Cashflows on an American option trade 3.10 CREDIT DEFAULT SWAP A credit default swap (CDS) is a contract between two parties referencing an entity or asset: a buyer of protection, also known as the seller of risk; and a seller of protection also called the buyer of risk. A simple example would be: JPMorgan buys protection from Banco Santander referencing Ford Motor Credit (Ford Motor Credit is the reference entity).

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, behavioural economics, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black Swan, Bonfire of the Vanities, bonus culture, book value, Bretton Woods, buy and hold, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, Cornelius Vanderbilt, corporate governance, Credit Default Swap, cross-subsidies, currency risk, dematerialisation, disinformation, disruptive innovation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial engineering, financial innovation, financial intermediation, financial thriller, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Greenspan put, Growth in a Time of Debt, Ida Tarbell, income inequality, index fund, inflation targeting, information asymmetry, intangible asset, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, it is difficult to get a man to understand something, when his salary depends on his not understanding it, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", Jim Simons, John Meriwether, junk bonds, light touch regulation, London Whale, Long Term Capital Management, loose coupling, low cost airline, M-Pesa, market design, Mary Meeker, megaproject, Michael Milken, millennium bug, mittelstand, Money creation, money market fund, moral hazard, mortgage debt, Myron Scholes, NetJets, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, Paul Samuelson, Paul Volcker talking about ATMs, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, reality distortion field, regulatory arbitrage, Renaissance Technologies, rent control, risk free rate, risk tolerance, road to serfdom, Robert Shiller, Ronald Reagan, Schrödinger's Cat, seminal paper, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, vertical integration, Washington Consensus, We are the 99%, Yom Kippur War

A false belief in the security provided by such packaging stimulated demand for these assets. Further reassurance appeared to be provided by the development of a market in credit default swaps – derivative securities that would pay out if there was default on the underlying security. Little thought was given at the time to the capacity of the institutions that wrote these contracts to pay in the event of widespread defaults. Thus a downgrading of the credit rating of AIG in 2008 – which had insured over $500 billion of securities through credit default swaps – was devastating in its consequences for the perceived safety of bond portfolios. The insatiable demand for asset-backed securities led to the pursuit of assets of lower and lower quality.

…

The English traded risks; the Swiss mutualised them.12 The Swiss practised Gemeinschaft; the English, not knowing the meaning of Gesellschaft, equated it with wagering. The elision would have profound consequences. In 1997 Robin Potts QC was asked by the International Swaps and Derivatives Association (ISDA) to review the new market in credit default swaps. Were participants in this market the modern counterparts of the gentlemen of Lloyd’s – engaged in a wager? Or were the buyers and sellers of credit default swaps more akin to the Swiss villagers, sharing the risks of disease and disasters? Mr Potts expressed Michel Albert’s distinction in legal terms. He drew attention to the famous case of Carlill v. Carbolic Smoke Ball Company.

…

‘Mr Tourre put together a complex financial product that was secretly designed to maximize the likelihood that it would fail,’ it concluded.17 Collateralised debt obligations were bought, and credit default swaps sold, by people who made mistakes in their assessment of the underlying value of these securities. That is why they bought them. In most cases they did not really know what the securities were or how the payments would be determined. The growth of the market for credit default swaps followed closely the pattern set by the LMX spiral. Risky loans were bundled into packages, which were then split and rearranged into new packages, to a point at which no one could know the underlying nature of the security that had been offered or the revenues on which the returns were based.

Smart Money: How High-Stakes Financial Innovation Is Reshaping Our WorldÑFor the Better by Andrew Palmer

Affordable Care Act / Obamacare, Alan Greenspan, algorithmic trading, Andrei Shleifer, asset-backed security, availability heuristic, bank run, banking crisis, behavioural economics, Black Monday: stock market crash in 1987, Black-Scholes formula, bonus culture, break the buck, Bretton Woods, call centre, Carmen Reinhart, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Graeber, diversification, diversified portfolio, Edmond Halley, Edward Glaeser, endogenous growth, Eugene Fama: efficient market hypothesis, eurozone crisis, family office, financial deregulation, financial engineering, financial innovation, fixed income, Flash crash, Google Glasses, Gordon Gekko, high net worth, housing crisis, Hyman Minsky, impact investing, implied volatility, income inequality, index fund, information asymmetry, Innovator's Dilemma, interest rate swap, Kenneth Rogoff, Kickstarter, late fees, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, low interest rates, margin call, Mark Zuckerberg, McMansion, Minsky moment, money market fund, mortgage debt, mortgage tax deduction, Myron Scholes, negative equity, Network effects, Northern Rock, obamacare, payday loans, peer-to-peer lending, Peter Thiel, principal–agent problem, profit maximization, quantitative trading / quantitative finance, railway mania, randomized controlled trial, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, Robert Shiller, Savings and loan crisis, short selling, Silicon Valley, Silicon Valley startup, Skype, South Sea Bubble, sovereign wealth fund, statistical model, subprime mortgage crisis, tail risk, Thales of Miletus, the long tail, transaction costs, Tunguska event, unbanked and underbanked, underbanked, Vanguard fund, web application

Globalization increased the complexity of multinational companies’ operations, and the Asian debt crisis in the late 1990s drove home the risks of operating in emerging markets. Credit-default swaps promised a way for banks to reduce the impact of defaults, in the aftermath of a wave of bank failures experienced during America’s savings-and-loan crisis in the 1980s, because the sellers of a swap promised a payout if the borrower in question was unable to pay. Needs are not always so noble, of course. By making their lending seem less risky, credit-default swaps also meant that regulators were happy to allow banks to fund themselves with less equity capital. That in turn made banks more attractive propositions to equity investors, who would have to put up less money in order to get a return.

…

But even now it is hard to find fault with the concept, as opposed to the practical application, of many of the most demonized products of the recent past. Take securitization and credit-default swaps. It would be blinkered to argue they have no problems. By handing risks on to someone else, securitization gives banks an incentive to loosen their underwriting standards; they won’t be the ones picking up the pieces. The protection afforded by credit-­default swaps may similarly blunt the incentives for lenders to be careful when they extend credit, because they will get a payout in the event of a borrower defaulting. But the downsides should not obscure the good.

…

They are then sliced into different tranches: the most senior tranches of CDOs of mortgage-backed securities were given high ratings during the most recent US housing boom because the performance of all the different mortgages in the pool was thought to be diversified. Counterparty risk: The risk that the other party to a contract will not live up to its obligations. The counterparty risk in an interest-rate swap is that one of the parties to the swap will not pay up. Credit-default swap: A credit-default swap is a form of insurance against default by a bond issuer. Credit ratings: An evaluation by a credit-rating agency of the creditworthiness of a debtor. Ratings are widely used by investors and are embedded in international rules, including those on how much equity banks have to use to fund themselves.

The End of Wall Street by Roger Lowenstein

"World Economic Forum" Davos, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, benefit corporation, Berlin Wall, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, break the buck, Brownian motion, Carmen Reinhart, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fear of failure, financial deregulation, financial engineering, fixed income, geopolitical risk, Glass-Steagall Act, Greenspan put, high net worth, Hyman Minsky, interest rate derivative, invisible hand, junk bonds, Ken Thompson, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Martin Wolf, Michael Milken, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, Ponzi scheme, profit motive, race to the bottom, risk tolerance, Ronald Reagan, Rubik’s Cube, Savings and loan crisis, savings glut, short selling, sovereign wealth fund, statistical model, the payments system, too big to fail, tulip mania, Y2K

Equally distressing to the banks, Wall Street had constructed an alternative way of speculating against troubled corporations, via derivatives, and this wholly unregulated market doubled back on its Wall Street creators with a vengeance. Credit default swaps had been invented by financial engineers at Bankers Trust as a form of insurance on corporate defaults.af The initial purpose was supposedly as a hedging vehicle. A bank that had lent money to General Motors could hedge its risk by purchasing a credit default swap from another party who believed that the loan would be repaid. Thus, if GM defaulted on the loan, the bank would recoup its investment via the swap. Unfortunately, such hedges dulled the bank’s incentive to perform the one function for which society depended on it: thoughtfully rationing credit to worthy borrowers.

…

INDEX Adelson, Mark adjustable rate mortgages option ARMs rate freeze on proposed affordable housing Age of Markets American International Group (AIG) accounting scandals assets bailouts. See AIG bailouts Ben Bernanke and board of Warren Buffett and CDOs and collateral calls on compensation at corporate structure of credit default swaps and credit rating agencies and Jamie Dimon and diversity of holdings employees, number of Financial Products subsidiary Timothy Geithner and Goldman Sachs and insurance (credit default swap) premiums of JPMorgan Chase and lack of reserve for losses leadership changes Lehman Brothers and losses Moody’s and Morgan Stanley and New York Federal Reserve Bank and Hank Paulson and rescue of.

…

See home foreclosure(s) foreign investors France Frank, Barney Freddie Mac and Fannie Mae accounting problems of affordable housing and Alternative-A loans bailout of Ben Bernanke and capital raised by competitive threats to Congress and Countrywide Financial and Democrats and Federal Reserve and foreign investment in Alan Greenspan and as guarantor history of lack of regulation of leadership changes leverage losses mortgage bubble and as mortgage traders Hank Paulson and politics and predatory lending and reasons for failures of relocation to private sector Robert Rodriguez and shareholders solving financial crisis through statistical models of stock price of Treasury Department and free market Freidheim, Scott Friedman, Milton Fuld, Richard compensation of failure to pull back from mortgage-backed securities identification with Lehman Brothers Lehman Brothers’ bankruptcy and Lehman Brothers’ last days and long tenure of Hank Paulson and personality and character of Gamble, James (Jamie) GDP Geithner, Timothy AIG and bank debt guarantees and Bear Stearns bailout and career of China and Citigroup and financial crisis, response to Lehman Brothers and money markets and Morgan Stanley and in Obama administration Hank Paulson and TARP and Gelband, Michael General Electric General Motors Germany Glass-Steagall Act Glauber, Robert Golden West Savings and Loan Goldman Sachs AIG and as bank holding company Warren Buffett investment in capital raised by capital sought by compensation at credit default swaps and hedge funds and insurance (credit default swap) premiums of job losses at leverage of Merrill Lynch and Stanley O’Neal’s obsession with Hank Paulson and pull back from mortgage-backed securities short selling against stock price of Wachovia and Gorton, Gary government, U.S. See also specific agencies as absent from Wall Street bailouts by.

Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America by Matt Taibbi

addicted to oil, affirmative action, Affordable Care Act / Obamacare, Alan Greenspan, Bear Stearns, Bernie Sanders, Bretton Woods, buy and hold, carried interest, classic study, clean water, collateralized debt obligation, collective bargaining, computerized trading, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, David Brooks, desegregation, diversification, diversified portfolio, Donald Trump, financial innovation, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, Greenspan put, illegal immigration, interest rate swap, laissez-faire capitalism, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, medical malpractice, military-industrial complex, money market fund, moral hazard, mortgage debt, Nixon triggered the end of the Bretton Woods system, obamacare, passive investing, Ponzi scheme, prediction markets, proprietary trading, prudent man rule, quantitative easing, reserve currency, Ronald Reagan, Savings and loan crisis, Sergey Aleynikov, short selling, sovereign wealth fund, too big to fail, trickle-down economics, Y2K, Yom Kippur War

He saw derivatives like credit default swaps—insurance-like contracts that allow a lender to buy “protection” from a third party in the event his debtor defaults—as brilliant innovations that not only weren’t risky, but reduced risk. “Greenspan saw credit derivatives as a device that enhanced a risk-free economic environment,” says Greenberger. “And the theory was as follows: he’s looking at credit derivatives, and he’s saying everyone is going to have insurance against breakdowns … But what he didn’t understand was that the insurance wasn’t going to be capitalized.” In other words, credit default swaps and the like allowed companies to sell something like insurance protection without actually having the money to pay that insurance—a situation that allowed lenders to feel that they were covered and free to take more risks, when in fact they were not.

…

“Then I turn around and I call up AIG and I’m like, ‘Hey, where would you credit default swap this bond?’ And they’re like, ‘Oh, we’ll do that for LIBOR plus ten.’ ” Miklos pauses and laughs, recalling the pregnant pause on his end of the phone line as he heard this offer from AIG. He couldn’t believe what he’d just heard: it was either a mistake, or they had just handed him a mountain of money, free of charge. “I hear this,” he says, “and I’m like, ‘Uh … okay. Sure, guys.’ ” Here we need another digression. The credit default swap was a kind of insurance policy originally designed to get around those same regulatory capital charges.

…

The credit default swap was a kind of insurance policy originally designed to get around those same regulatory capital charges. Ironically, Miklos had once been part of a famed team at JPMorgan that helped design the modern credit default swap, although the bank envisioned a much different use for them back then. A credit default swap is just a bet on an outcome. It works like this: Two bankers get together and decide to bet on whether or not a homeowner is going to default on his $300,000 home loan. Banker A, betting against the homeowner, offers to pay Banker B $1,000 a month for five years, on one condition: if the homeowner defaults, Banker B has to pay Banker A the full value of the home loan, in this case $300,000.

A Failure of Capitalism: The Crisis of '08 and the Descent Into Depression by Richard A. Posner

Alan Greenspan, Andrei Shleifer, banking crisis, Bear Stearns, Bernie Madoff, business cycle, collateralized debt obligation, collective bargaining, compensation consultant, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, diversified portfolio, equity premium, financial deregulation, financial intermediation, Glass-Steagall Act, Home mortgage interest deduction, illegal immigration, laissez-faire capitalism, Long Term Capital Management, low interest rates, market bubble, Money creation, money market fund, moral hazard, mortgage debt, Myron Scholes, oil shock, Ponzi scheme, price stability, profit maximization, proprietary trading, race to the bottom, reserve currency, risk tolerance, risk/return, Robert Shiller, savings glut, shareholder value, short selling, statistical model, subprime mortgage crisis, too big to fail, transaction costs, very high income

But they also could, and many did, buy a form of insurance, issued in great quantity by, among many other firms, the American International Group, against declines in the value of mortgage-backed securities, as well as of other investments. This form of insurance, called "credit-default swaps," had originally been intended as insurance against bond defaults, of which there was a long history on the basis of which premiums could be computed with reasonable confidence. But AIG and other financial firms (not limited to insurance companies and commercial banks, the traditional issuers of credit insurance, such as conventional mortgage insurance, as distinct from insurance of securitized debt) began issuing credit-default swaps to insure against losses in the value of mortgage-backed securities, which lacked such a history.

…

The banks didn't know how meager their equity cushion had become and therefore how much they could lend without incurring a high risk of bankruptcy, since as we know lending is increasingly risky the more leverage the lender has in its capital structure. A further complication was that banks that had bought the insurance side of credit-default swaps did not know their exposure. When Lehman Brothers collapsed, issuers of credit-default swaps all over the world were on the hook because Lehman had purchased many swaps. It had issued many swaps as well, and its equity, devoured by the collapse of the mortgagebacked securities, which it had held in great quantity, was insufficient to enable it to pay the debts that it had insured.

…

Banks realized this and tried to reduce the riskiness of their loan portfolios without reducing profit by devices such as securitized debt (notably securities backed by residential mortgages) and credit-default swaps (insurance against defaults), which dispersed risk and therefore reduced the risks borne by a particular bank. These instruments did reduce risk, but also increased it, making the net effect on the banking industry's risk unclear; for example, banks both issued and bought credit-default swaps —they were insurers of defaults as well as being insured against them. The riskiness of secnritized debt was hard to assess because of the complexity of the securities, a single one of which might be backed by hundreds or even thousands of mortgages on houses scattered all over the country.

I.O.U.: Why Everyone Owes Everyone and No One Can Pay by John Lanchester

Alan Greenspan, asset-backed security, bank run, banking crisis, Bear Stearns, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Monday: stock market crash in 1987, Black-Scholes formula, Blythe Masters, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial engineering, financial innovation, fixed income, George Akerlof, Glass-Steagall Act, greed is good, Greenspan put, hedonic treadmill, hindsight bias, housing crisis, Hyman Minsky, intangible asset, interest rate swap, invisible hand, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, junk bonds, Kickstarter, laissez-faire capitalism, light touch regulation, liquidity trap, Long Term Capital Management, loss aversion, low interest rates, Martin Wolf, money market fund, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, negative equity, new economy, Nick Leeson, Norman Mailer, Northern Rock, off-the-grid, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, Right to Buy, risk-adjusted returns, Robert Shiller, Ronald Reagan, Savings and loan crisis, shareholder value, South Sea Bubble, statistical model, Tax Reform Act of 1986, The Great Moderation, the payments system, too big to fail, tulip mania, Tyler Cowen, value at risk

Buffett was horribly right about the risks. The irony is that he wasn’t even talking here about the category of derivative which turned out to be the most destructive of all, the credit default swap, or CDS. I am going to arraign a number of culprits for the crash: derivatives are one of the main ones, but among derivatives, it was CDS which were the chief baddy, the gang leader, the Mafia don, the most destructive of the WMDs. As with some other culprits in the crisis, credit default swaps were a new thing, invented by bankers seeking newer, sexier ways of making newer, sexier profits. When I first began to study the world of the City, I found it hard to come to grips with the idea that financial instruments are “invented,” cooked up in the same way as works of art or scientific theories—but the fact is that they are.

…

Morgan put them together to create securitized bundles of credit default swaps—bundles of insurance against default—and selling them to investors. The investors would get the streams of revenue, according to the level of risk and reward they chose; the bank would get insurance against its loans and fees for setting up the deal. There was one final component of the J.P. Morgan team’s invention. It set up an offshore shell company, called a special purpose vehicle, or SPV, to fulfill the role supplied by the EBRD in the first credit default swap. The shell company would assume $9.7 billion of J.P. Morgan’s risk; then it would sell off that risk to investors in the form of securities paying differing rates of interest.

…

Bush administrations. Several other factors helped fuel the financial industry’s ascent. Paul Volcker’s monetary policy in the 1980s, and the increased volatility in interest rates that accompanied it, made bond trading much more lucrative. The invention of securitization, interest rate swaps, and credit default swaps greatly increased the volume of transactions that bankers could make money on. And the aging and increasingly wealthy population invested more and more money in securities, helped by the invention of the IRA and the 401(k) plan. Together, these developments vastly increased the profit opportunities in financial services.

Risk Management in Trading by Davis Edwards

Abraham Maslow, asset allocation, asset-backed security, backtesting, Bear Stearns, Black-Scholes formula, Brownian motion, business cycle, computerized trading, correlation coefficient, Credit Default Swap, discrete time, diversified portfolio, financial engineering, fixed income, Glass-Steagall Act, global macro, implied volatility, intangible asset, interest rate swap, iterative process, John Meriwether, junk bonds, London Whale, Long Term Capital Management, low interest rates, margin call, Myron Scholes, Nick Leeson, p-value, paper trading, pattern recognition, proprietary trading, random walk, risk free rate, risk tolerance, risk/return, selection bias, shareholder value, Sharpe ratio, short selling, statistical arbitrage, statistical model, stochastic process, systematic trading, time value of money, transaction costs, value at risk, Wiener process, zero-coupon bond

It works less well in cases of a single large trading partner who has a very low probability of default. (See Figure 9.1, Unexpected Loss.) KEY CONCEPT: CREDIT DEFAULT SWAPS (CDS) Credit Default Swaps (CDSs) are financial instruments that are closely associated with credit markets. Hedge funds and trading desks can use these instruments to either speculate on the possibility of corporate default or to protect themselves from defaults. Credit default swaps are derivatives whose value is based on corporate bonds issued by some corporation. In event of a default, the CDS issuer (the CDS seller) will take possession of the corporate bond and give a payoff to the buyer.

…

Contracts that are not considered derivatives may contain clauses that are considered derivatives for accounting purposes. These embedded derivatives might act like forwards, options, or any other type of derivative. For example, a contract between two firms might specify that a minimum quantity of a standardized product is purchased at a certain price. Credit Default Swaps (CDS). Credit default swaps are derivatives whose value is based on corporate bonds issued by some corporation. In the event that the issuer of the bond defaults, the CDS issuer will take possession of the corporate bond and give a payoff to the CDS buyer. In compensation for taking on this risk, the CDS seller will receive a series of payments from the CDS buyer.

…

For example, spreads based of bond markets might assume that default events occur twice a year (when bond payments are due). This would correspond to m = 2 Market-Based A second way to estimate default probabilities is to look directly at the prices of credit default swaps (CDS) or corporate bonds. It is possible to calculate the survival assumption embedded in the market prices of bonds and credit default swaps assuming that the risk of default is the only reason that a corporate bond will sell for less than a similar risk‐free bond. The logic behind this assumption is that a rational investor should be indifferent between the two investments as long as the present value of the cash flow incorporates the possibility of loss.

On the Brink: Inside the Race to Stop the Collapse of the Global Financial System by Henry M. Paulson

Alan Greenspan, asset-backed security, bank run, banking crisis, Bear Stearns, break the buck, Bretton Woods, buy and hold, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Doha Development Round, fear of failure, financial engineering, financial innovation, fixed income, housing crisis, income inequality, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, money market fund, moral hazard, Northern Rock, price discovery process, price mechanism, regulatory arbitrage, Ronald Reagan, Saturday Night Live, Savings and loan crisis, short selling, sovereign wealth fund, technology bubble, too big to fail, trade liberalization, young professional

The market stayed strong through the day, with the Dow closing up 290 points, or 2.6 percent, at 11,511. But Lehman’s shares dropped $2.05, to $14.15, while its credit default swaps edged up to a worrisome 328 basis points. And the markets still did not know that Lehman’s talks with KDB were collapsing. I had hoped that the GSE takeovers would give Lehman a bit of breathing room, but I was wrong. Tuesday, September 9, 2008 I arrived at the office shortly after 6:00 a.m. and headed straight to the Markets Room. Lehman’s shares were headed toward single digits, and its credit default swaps were under pressure. I went to Ken Wilson’s office to get the latest on Dick Fuld.

…

Meantime, the company was still weighed down by substantial market and credit risks from its holdings of residential mortgage-backed securities and the credit default swaps it had written on residential MBS. It had even used its securities lending program to purchase residential MBS. It turned out AIG’s third-quarter losses were going to be $24.5 billion pretax—even worse than we had expected. We needed to act quickly to inject $40 billion of TARP capital into AIG to avoid a rating downgrade that would trigger $42 billion in collateral calls and finish the company off. The Fed’s restructuring plan would shift AIG’s worst mortgage-related assets and credit default swaps into two new Fed vehicles, called Maiden Lane II and Maiden Lane III, which together would hold $52.5 billion.

…

As a result, this book has many heroes. I’ve also tried to tell this story so that it could be readily understood by readers of widely varying degrees of financial expertise. That said, I am sure it is overly simplified in some places and too complex in others. Throughout the narrative, I cite changes in stock prices and credit default swap rates, not because those numbers matter in and of themselves, but because they are the most effective way to represent the plummeting confidence and rising sense of crisis in our financial markets and our economy during this period. I now have heightened respect for anyone who has ever written a book.

The greatest trade ever: the behind-the-scenes story of how John Paulson defied Wall Street and made financial history by Gregory Zuckerman

1960s counterculture, Alan Greenspan, banking crisis, Bear Stearns, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, financial engineering, financial innovation, fixed income, index fund, Isaac Newton, Jim Simons, junk bonds, Larry Ellison, Long Term Capital Management, low interest rates, margin call, Mark Zuckerberg, Menlo Park, merger arbitrage, Michael Milken, mortgage debt, mortgage tax deduction, Ponzi scheme, Renaissance Technologies, rent control, Robert Shiller, rolodex, short selling, Silicon Valley, statistical arbitrage, Steve Ballmer, Steve Wozniak, technology bubble, zero-sum game

Was there any better insurance? One day in October 2004, Pellegrini, still nervous about his standing at the firm, got up the nerve to approach Paulson in the hallway to tell his boss that there might be a better way to protect the firm’'s portfolio. Why not buy credit-default swaps? Paulson and his team weren’'t very familiar with the world of credit-default swaps, beyond a vague understanding that these instruments provided insurance against losses from debt investments. Though trading of CDS contracts had soared in volume in recent years, it was a complicated, esoteric world. Paulson was one of many investors who shied away from using these “"derivative”" investments, described as such because their value derives from the change in some underlying asset.

…

He asked Pellegrini to research how the firm could buy CDS contracts on financial companies, which Paulson was especially worried about due to all their borrowed money. In truth, Pellegrini didn’'t know that much about how credit-default swaps were traded, other than watching others do it at Tricadia. So he arranged for tutorials by various brokerage firms on the ins and outs of credit-default swaps. The fund made its first purchase of CDS protection on a company called MBIA, Inc., which insured all those mortgage bonds backed by aggressive loans. The annual cost of insuring $100 million of MBIA’'s debt was a puny $500,000.

…

Dimon bounded over, a warm smile on his face. This was Greene’'s chance. He could hardly contain himself. “"Hey, Jamie. My biggest position is shorting subprime credit through credit-default swaps. I’'ve done four hundred million with you guys.”" Dimon had a blank look on his face. “"What’'s that?”" he asked. Greene was taken aback. Dimon was among the most important players in the financial markets. But he didn’'t seem to know much about credit-default swaps. Even the $400 million figure didn’'t grab his attention. Dimon kept glancing at the tennis match below, where Roger Federer was fending off Novak ÐDjokovićc in the finals.

Money and Power: How Goldman Sachs Came to Rule the World by William D. Cohan

"Friedman doctrine" OR "shareholder theory", "RICO laws" OR "Racketeer Influenced and Corrupt Organizations", Alan Greenspan, asset-backed security, Bear Stearns, Bernie Madoff, Bob Litterman, book value, business cycle, buttonwood tree, buy and hold, collateralized debt obligation, Cornelius Vanderbilt, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, deal flow, diversified portfolio, do well by doing good, fear of failure, financial engineering, financial innovation, fixed income, Ford paid five dollars a day, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Gordon Gekko, high net worth, hiring and firing, hive mind, Hyman Minsky, interest rate swap, John Meriwether, junk bonds, Kenneth Arrow, London Interbank Offered Rate, Long Term Capital Management, managed futures, margin call, market bubble, mega-rich, merger arbitrage, Michael Milken, moral hazard, mortgage debt, Myron Scholes, paper trading, passive investing, Paul Samuelson, Ponzi scheme, price stability, profit maximization, proprietary trading, risk tolerance, Ronald Reagan, Saturday Night Live, short squeeze, South Sea Bubble, tail risk, time value of money, too big to fail, traveling salesman, two and twenty, value at risk, work culture , yield curve, Yogi Berra, zero-sum game

It also required that the insured and insurer agree on how much collateral should be posted to make up for the loss of value in the securities being insured. At this moment, Greenberg said, Sullivan should have pretty much shut down the credit-default swap operation at AIGFP: “When the AAA credit rating disappeared in spring 2005, it would have been logical for AIG’s new management to have exited or reduced its business of writing credit-default swaps,” he explained. With little effort, Greenberg ticked off in rapid fire the litany of mistakes then made by Sullivan, Cassano, and company: Rather than curtailing the selling of credit-default swaps, AIGFP ratcheted up exponentially its issuance of them, and no longer just on corporate debt but on a whole new explosion of risk that Wall Street was madly underwriting through the issuance of increasingly risky mortgage-backed securities tied to so-called subprime and Alt-A mortgages.

…

One of the more intriguing opportunities that Birnbaum spied in the market by the end of 2005 was the increasing use of credit-default swaps, or CDS—a form of insurance that could be bought on whether a debt would in fact be paid—in the mortgage or any other debt market. Increasingly, insurance companies, such as AIG, or other Wall Street firms were willing to sell protection on whether the mortgages that went into mortgage-backed securities would in fact be paid. To get the insurance, buyers had to pay premiums to the issuers, as they did to obtain any other form of insurance. Instead of buying life insurance, or fire insurance on your house, or auto insurance on your car, buying a credit-default swap allowed investors to make bets on whether people ended up paying their mortgages.

…

The supposed genius of the synthetic CDO was that instead of having to accumulate mortgages in a warehouse until you had enough to build and then sell a CDO, Goldman could create the CDO virtually overnight using credit-default swaps, those insurance contracts offering a holder protection on whether a debt security would fail or not. It would be as if you could buy and sell the idea of selling cakes without actually having to buy the ingredients for the cakes, make them, and then sell them. Warren Buffett might consider this one of the eureka moments in the creation of financial weapons of mass destruction, as he referred to derivatives and credit-default swaps. “This was the trade, basically,” Sparks said. “CDOs were writing protection on CDS and doing synthetic CDOs.

How Markets Fail: The Logic of Economic Calamities by John Cassidy

Abraham Wald, Alan Greenspan, Albert Einstein, An Inconvenient Truth, Andrei Shleifer, anti-communist, AOL-Time Warner, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Bear Stearns, behavioural economics, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black Monday: stock market crash in 1987, Black-Scholes formula, Blythe Masters, book value, Bretton Woods, British Empire, business cycle, capital asset pricing model, carbon tax, Carl Icahn, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, corporate raider, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, different worldview, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial engineering, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, Garrett Hardin, George Akerlof, Glass-Steagall Act, global supply chain, Gunnar Myrdal, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kickstarter, laissez-faire capitalism, Landlord’s Game, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, low interest rates, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, military-industrial complex, Minsky moment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, Naomi Klein, negative equity, Network effects, Nick Leeson, Nixon triggered the end of the Bretton Woods system, Northern Rock, paradox of thrift, Pareto efficiency, Paul Samuelson, Phillips curve, Ponzi scheme, precautionary principle, price discrimination, price stability, principal–agent problem, profit maximization, proprietary trading, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Solow, Ronald Coase, Ronald Reagan, Savings and loan crisis, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, subprime mortgage crisis, tail risk, Tax Reform Act of 1986, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, Tragedy of the Commons, transaction costs, Two Sigma, unorthodox policies, value at risk, Vanguard fund, Vilfredo Pareto, wealth creators, zero-sum game

However, it didn’t prevent him, in the period after 1998, from repeating his previous arguments to head off efforts to regulate derivatives trading. Brooksley E. Born, the then-head of the Commodity Futures Trading Commission (CFTC), tried to bring credit default swaps, which offered investors protection against the possibility of a bond defaulting, under the regulatory jurisdiction of the CFTC. Such a move would have involved establishing some minimal capital requirements for Wall Street firms that bought and sold credit default swaps, and forcing them to disclose more information. “Recognizing the dangers . . . was not rocket science, but it was contrary to the conventional wisdom and certainly contrary to the economic interests of Wall Street at the moment,” Born told Stanford Magazine in early 2009.

…

Which brings us to the final ingredient of the subprime alphabet soup. J.P. Morgan has much to answer for—the firm, not the man. As well as unleashing VAR models on an unsuspecting public, it played a key role in developing credit insurance in the form of credit default swaps (CDSs). The word “swaps” is used in the derivatives business, and it has caused a lot of unnecessary confusion. Credit default swaps aren’t really swaps at all; they should be called credit insurance contracts. As with VAR, Morgan didn’t invent the concept of credit insurance—the late Bankers Trust also has claims to that honor—but it turned it into a major industry.

…

Once Morgan had demonstrated how to do this with bank loans, the obvious next step was to apply the same technique to different types of credit products, such as mortgage-backed securities. This didn’t prove too difficult, and between 1998 and 2004, the issuance of credit default swaps increased exponentially. The two most popular products were “single-name CDSs,” which provided their holders with protection against the default of a particular loan or bond, and “basket CDSs,” which insured a basket of loans or bonds. Since credit default swaps weren’t regulated, there was plenty of scope for creativity. An important development was the creation of CDSs that didn’t have anything to do with the issuer of the underlying debts.

Tailspin: The People and Forces Behind America's Fifty-Year Fall--And Those Fighting to Reverse It by Steven Brill

"Friedman doctrine" OR "shareholder theory", "World Economic Forum" Davos, 2013 Report for America's Infrastructure - American Society of Civil Engineers - 19 March 2013, activist fund / activist shareholder / activist investor, affirmative action, Affordable Care Act / Obamacare, airport security, American Society of Civil Engineers: Report Card, asset allocation, behavioural economics, Bernie Madoff, Bernie Sanders, Blythe Masters, Bretton Woods, business process, call centre, Capital in the Twenty-First Century by Thomas Piketty, carbon tax, Carl Icahn, carried interest, clean water, collapse of Lehman Brothers, collective bargaining, computerized trading, corporate governance, corporate raider, corporate social responsibility, Credit Default Swap, currency manipulation / currency intervention, deal flow, Donald Trump, electricity market, ending welfare as we know it, failed state, fake news, financial deregulation, financial engineering, financial innovation, future of work, ghettoisation, Glass-Steagall Act, Gordon Gekko, hiring and firing, Home mortgage interest deduction, immigration reform, income inequality, invention of radio, job automation, junk bonds, knowledge economy, knowledge worker, labor-force participation, laissez-faire capitalism, low interest rates, Mahatma Gandhi, Mark Zuckerberg, Michael Milken, military-industrial complex, mortgage tax deduction, Neil Armstrong, new economy, Nixon triggered the end of the Bretton Woods system, obamacare, old-boy network, opioid epidemic / opioid crisis, paper trading, Paris climate accords, performance metric, post-work, Potemkin village, Powell Memorandum, proprietary trading, quantitative hedge fund, Ralph Nader, ride hailing / ride sharing, Robert Bork, Robert Gordon, Robert Mercer, Ronald Reagan, Rutger Bregman, Salesforce, shareholder value, Silicon Valley, Social Responsibility of Business Is to Increase Its Profits, stock buybacks, Tax Reform Act of 1986, tech worker, telemarketer, too big to fail, trade liberalization, union organizing, Unsafe at Any Speed, War on Poverty, women in the workforce, working poor

It is considered to be against public policy, because you would be incented to kill that stranger or steer him to an incompetent doctor, and because, well, it’s just a bet, which is usually restricted to licensed casinos. Yet that is how dozens of investors who bought the synthetic credit default swaps made vast fortunes when the credit markets crashed, and how the hedge funds, banks, and other investors that sold them the synthetic credit default swaps suffered crushing losses. Regulators didn’t do anything about synthetic credit default swaps either. In 2005, the notional value, or the amount of money at risk, in all credit default swaps, real or synthetic, totaled $67 trillion. The actual value of the assets underlying all the securities (or loans) was only $15 trillion.

…

They wanted to get in on the action but were not in the business of buying or selling MBSs or CDSs for their own accounts, in most cases because they were wary of the assets—the homes and their debtor owners—behind the mortgages. Enter the synthetic credit default swap, a variation on credit default swaps, which became popular once CDSs picked up steam with the rise in the real estate market in the early 2000s. A synthetic credit default swap was simply a bet that something would happen that the people making the bets had nothing to do with—in this case, that the mortgage-backed securities would pay out or would go bad. It was synthetic in that the buyer was insuring against a bad event (the defaults) that he had no actual interest in protecting against, and the seller was betting that the bad event would not happen.

…

Before long, many banks were setting up units to sell the credit default swaps themselves, meaning they were insuring against the risk borne by other banks and financial institutions. One actual insurance company, American International Group, or AIG, emerged as the biggest CDS player of all. For AIG, the business was better than actual insurance, because real insurance is regulated: Insurance companies have to prove, using actuarial tables that gauge risk, that they have the funds available to pay off a life insurance or homeowner policy. A credit default swap was not considered insurance by any of the regulators who could have interceded, in part because, until it was too late, none of them appreciated the volume of the bets being made.

Global Financial Crisis by Noah Berlatsky

"World Economic Forum" Davos, accounting loophole / creative accounting, Alan Greenspan, asset-backed security, banking crisis, Bear Stearns, Bretton Woods, capital controls, Celtic Tiger, centre right, circulation of elites, collapse of Lehman Brothers, collateralized debt obligation, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deindustrialization, Doha Development Round, energy security, eurozone crisis, financial innovation, Food sovereignty, George Akerlof, Glass-Steagall Act, God and Mammon, Gordon Gekko, housing crisis, illegal immigration, income inequality, low interest rates, market bubble, market fundamentalism, mass immigration, Money creation, moral hazard, new economy, Northern Rock, purchasing power parity, quantitative easing, race to the bottom, regulatory arbitrage, reserve currency, Robert Shiller, Ronald Reagan, Savings and loan crisis, shareholder value, social contagion, South China Sea, structural adjustment programs, subprime mortgage crisis, too big to fail, trade liberalization, transfer pricing, working poor

Thus, an investor could buy a bunch of mortgages (or a small piece of a bunch of mortgages) which were guaranteed to pay back a certain return. The banks were so sure that these mortgage-based securities would always pay that they even sold insurance on the investments. These insurance contracts were called credit default swaps. A credit default swap (CDS) means an investor in mortgage-based securities would pay a certain amount of money to the bank on a regular basis as long as the securities made money. If the securities ever stopped making money, though, the bank would have to pay the investor a large sum. CDSs were very popular because they made investors feel safer, and banks were certain they would never have to pay on them; investments would never default because housing prices would go up forever, or so they believed.

…

When the bubble burst and housing prices did start to go down, banks found themselves in a precarious position. Much of the banks’ money was invested in mortgages that were now shown to be bad debts. To make matters worse, the banks had in many cases promised to pay other investors through credit default swaps if these loans went bad. The resulting strain caused a series of catastrophic failures of large banks in the United States. Bear Stearns, a large investment bank, first noted publicly that it was having trouble because of subprime 17 The Global Financial Crisis loans in July 2007. On September 7, 2008, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), the two largest mortgage lenders in the United States, had to be bailed out by the U.S. government.

…

For example, a currency futures contract lets you . . . lock into a specific foreign exchange rate. It’s a sensible move if you trade abroad and do not wish to carry the risk of a sudden change in exchange rates. Recent decades brought much trickier—and riskier—derivatives, such as “over-the-counter credit default swaps (CDS).” Sound complex? It is. Derivatives could . . . be used to circumvent regulations that protect investors and the public. Credit derivatives permit lenders to transfer their credit risks (mortgage defaults) to third parties, such as hedge funds. Thus banks can do more business. In the 1990s and 2000s, credit derivatives became a massive global gamble.

Firefighting by Ben S. Bernanke, Timothy F. Geithner, Henry M. Paulson, Jr.

Asian financial crisis, asset-backed security, bank run, Basel III, Bear Stearns, break the buck, Build a better mousetrap, business cycle, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Doomsday Book, financial deregulation, financial engineering, financial innovation, Glass-Steagall Act, housing crisis, Hyman Minsky, income inequality, invisible hand, Kenneth Rogoff, labor-force participation, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, opioid epidemic / opioid crisis, pets.com, price stability, quantitative easing, regulatory arbitrage, Robert Shiller, Savings and loan crisis, savings glut, short selling, sovereign wealth fund, special drawing rights, tail risk, The Great Moderation, too big to fail

Net repo funding to banks and broker-dealers Source: Federal Reserve Board Financial Accounts of the United States The Arc of the Crisis ARC OF THE CRISIS The financial crisis unfolded in several phases. Bank credit default swap spreads and Libor-OIS spread Sources: Libor-OIS: Bloomberg Finance L.P.; bank CDS spreads: Bloomberg Finance L.P., IHS Marki Notes: Credit default swap spreads are equal-weighted averages of JPMorgan Chase, Citigroup, Wells Fargo, Bank of America, Morgan Stanley, and Goldman Sachs. Libor-OIS spread used throughout is the spread between the 3-month London Interbank Offered Rate and the 3-month USD overnight indexed swap rate.

…

The Fed tried to apply foam on the runway by stating its willingness to lend to banks and investment banks against just about any form of collateral. But the explosion was devastating anyway. The cost of insuring the bonds of Morgan Stanley and Goldman Sachs doubled on Monday, as markets lost confidence in the investment bank business model. The run also extended into the commercial banking sector. Citi’s credit default swaps spiked, reflecting growing market fears that even too-big-to-fail banks might fail, and spooked depositors withdrew twice as much from Washington Mutual as they had withdrawn after the run on IndyMac. Even the industrial giant General Electric struggled to roll over its commercial paper, a troubling sign that the financial virus had infected the broader economy.

…

AIG insured the lives, health, property, vehicles, and retirement accounts of 76 million customers, including 180,000 businesses that employed more than two thirds of the American workforce. And thanks to its irresponsible Financial Products division, which resembled a hedge fund grafted on to a traditional insurance company, AIG also had $2.7 trillion worth of derivatives contracts, mostly credit default swaps insuring troubled financial instruments. If it collapsed, the other systemic banks and nonbanks would lose their disaster insurance when they needed it most. It seemed like everyone was exposed to AIG, and no one was sure how exposed anyone else was, so an AIG default could inspire runs on just about any other financial firm.

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

Abraham Wald, Albert Einstein, Bayesian statistics, Bear Stearns, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial engineering, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, Paul Samuelson, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk free rate, risk tolerance, risk/return, Robert Solow, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, Thales and the olive presses, Thales of Miletus, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

For instance, we may wish to insure against the default of a portfolio of subprime mortgages with an insured value of $50,000,000. The seller of a credit default swap written for $40,000,000 on this $50,000,000 receives the equivalent of a put price as a premium and is obliged to pay the purchaser of the swap the difference, or $10,000,000, if the portfolio value falls to less than $40,000,000. The insurance role for such credit default swaps is obvious. The investor can purchase a policy that limits the downside risk. However, these credit default swaps can also be purchased by an investor who does not own the underlying portfolios. Such a purchase is a speculation on another’s misfortune, but also provides an opportunity for liquidity and more efficient valuations through a very broad insurance market, with low transaction costs and relatively simple contracting.

…

This new financial market, once the sleepy domain of farmers and food processors concerned about price stability for the future delivery of agricultural commodities, now represents an annual market value that rivals the combined size of the world’s economies. There is now a much greater volume of trading in these derivatives, in commodities futures and in options markets, in credit default swaps and mortgage-backed securities, in foreign exchange futures and bond futures than in the traditional market for corporate securities. Yet, before the publication of the theory from the great minds Fischer Black and Myron Scholes, we knew little about how to price such financial derivatives.

…

In 1973, on the cusp of the publication of the Black-Scholes formula and the creation of the CBOE, no one could have reasonably imagined that derivatives markets could come to affect us all in incredibly profound ways, both positively and negatively. Derivatives markets are more esoteric than the underlying securities from which they derive their value. These are instruments that allow us the option to buy a stock at a future date, or a contract to deliver or accept a commodity at some future date. They could be the credit default swaps that are bets, according to some, or insurance hedges, according to others, that other instruments will default. In every case, the derivative can serve some useful purpose as a hedge or insurance for those who must hold or market the underlying security. However, just as we can sell short a stock we do not own and have not borrowed (a naked short), derivatives traders may not have to own the underlying security, and most likely will have little or no interest in the underlying security.

Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin Phillips

"World Economic Forum" Davos, Alan Greenspan, algorithmic trading, asset-backed security, bank run, banking crisis, Bear Stearns, Bernie Madoff, Black Swan, Bretton Woods, BRICs, British Empire, business cycle, buy and hold, collateralized debt obligation, computer age, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, diversification, Doha Development Round, energy security, financial deregulation, financial engineering, financial innovation, fixed income, Francis Fukuyama: the end of history, George Gilder, Glass-Steagall Act, housing crisis, Hyman Minsky, imperial preference, income inequality, index arbitrage, index fund, interest rate derivative, interest rate swap, Joseph Schumpeter, junk bonds, Kenneth Rogoff, large denomination, Long Term Capital Management, low interest rates, market bubble, Martin Wolf, Menlo Park, Michael Milken, military-industrial complex, Minsky moment, mobile money, money market fund, Monroe Doctrine, moral hazard, mortgage debt, Myron Scholes, new economy, oil shale / tar sands, oil shock, old-boy network, peak oil, plutocrats, Ponzi scheme, profit maximization, prosperity theology / prosperity gospel / gospel of success, Renaissance Technologies, reserve currency, risk tolerance, risk/return, Robert Shiller, Ronald Reagan, Satyajit Das, Savings and loan crisis, shareholder value, short selling, sovereign wealth fund, stock buybacks, subprime mortgage crisis, The Chicago School, Thomas Malthus, too big to fail, trade route

By year’s end, as bank and investment bank losses began to pile up, some exporters began to fear that problems might spread into the corporate credit markets, principally through credit default swaps with their purpose of allowing risk managers and speculators to bet on a company’s ability to repay debt. The New York Times half-joked that if 2007 was the year readers and reporters learned about CDOs and SIVs, 2008 might be the year of credit default swaps. Unfortunately, it is entirely relevant to note the greed factor: the amount of money the financial sector was making out of these hot new products and huge volumes, at least until mid-2007.

…

And before the wax attaching their wings melted Icarus-like in 2007-2008, most of the top fifteen to twenty institutions had bet their fortunes on a host of new financial vehicles and instruments—structured investment vehicles (SIVs), special purpose acquisition companies (SPACs), mortgage securitization, collateralized debt obligations (CDOs), credit default swaps (CDSs), and the like. Although bountiful in their own right, fees for mergers and acquisitions soon paled alongside the larger benefits of bull markets, assets bubbles, and the uber-profitability of exotic financial instruments. Back in the late 1980s, Goldman Sachs estimated that a major portion of that decade’s stock market upsurge had come from anticipation of takeover bids or buyouts, and other analysts would make the same point about the later M&A floodtides in 2000 and 2006 (see p. 77).

…

To be sure, the notional value shown in Figure P.2 gives a much overstated picture of the real sums at risk in any plausible default scenario. Several attempts have been made in the latter direction. Using 2007 data, the Bank for International Settlements first broke out the notional values: a total of $596 trillion split between interest rate derivatives ($393 trillion), credit default swaps ($58 trillion), and currency derivatives ($56 trillion) with the remainder put into an unallocated category. Then, to assess real-world vulnerability, the BIS set what they called net risk at $14.5 trillion, and put a plausible gross credit exposure at $3.256 trillion.14 Abstract as these trillion-dollar references may seem to laypeople, global fears of a second wave of exotic financial implosions took shape during 2008.

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Alan S. Blinder

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, banks create money, Bear Stearns, book value, break the buck, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial engineering, financial innovation, fixed income, friendly fire, full employment, Glass-Steagall Act, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, junk bonds, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, market clearing, market fundamentalism, McMansion, Minsky moment, money market fund, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, Paul Volcker talking about ATMs, price mechanism, proprietary trading, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, vertical integration, working-age population, yield curve, Yogi Berra

Never Again: Legacies of the Crisis Notes Sources Index LIST OF ACRONYMS AND ABBREVIATIONS ABCP: asset-backed commercial paper ABS: asset-backed securities AIG: American International Group AIG FP: AIG Financial Products AMLF: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility ANPR: Advance Notice of Proposed Rulemaking ARM: adjustable-rate mortgage ARRA: American Reinvestment and Recovery Act (2009) BofA: Bank of America CBO: Congressional Budget Office CDO: collateralized debt obligation CDS: credit default swaps CEA: Council of Economic Advisers CEO: Chief Executive Officer CFMA: Commodity Futures Modernization Act (2000) CFPA: Consumer Financial Protection Agency CFPB: Consumer Financial Protection Bureau CFTC: Commodity Futures Trading Commission CME: Chicago Mercantile Exchange CP: commercial paper CPFF: Commercial Paper Funding Facility CPI: Consumer Price Index CPP: Capital Purchase Program DTI: debt (service)-to-income ratio ECB: European Central Bank EMH: efficient markets hypothesis ESF: Exchange Stabilization Fund FCIC: Financial Crisis Inquiry Commission FDIC: Federal Deposit Insurance Corporation FHA: Federal Housing Administration FHFA: Federal Housing Finance Agency FICO: Fair Isaac Company FOMC: Federal Open Market Committee FSA: Financial Services Authority (UK) FSLIC: Federal Savings and Loan Insurance Corporation FSOC: Financial Stability Oversight Council G7: Group of Seven (nations) GAAP: generally accepted accounting principles GAO: Government Accountability Office GDP: gross domestic product GLB: Gramm-Leach-Bliley Act (1999) GSE: government-sponsored enterprise H4H: Hope for Homeowners HAFA: Home Affordable Foreclosure Alternatives Program HAMP: Home Affordable Modification Program HARP: Home Affordable Refinancing Program HAUP: Home Affordable Unemployment Program HHF: Hardest Hit Fund HOLC: Home Owners’ Loan Corporation HUD: Department of Housing and Urban Development IMF: International Monetary Fund ISDA: International Swaps and Derivatives Association LIBOR: London Interbank Offer Rate LTCM: Long-Term Capital Management LTRO: Longer-Term Refinancing Operations LTV: loan-to-value (ratio) MBS: mortgage-backed securities MOM: my own money NBER: National Bureau of Economic Research NEC: National Economic Council NINJA (loans): no income, no jobs, and no assets NJTC: new jobs tax credit OCC: Office of the Comptroller of the Currency OFHEO: Office of Federal Housing Enterprise Oversight OMB: Office of Management and Budget OMT: Outright Monetary Transactions OPM: other people’s money OTC: over the counter OTS: Office of Thrift Supervision PDCF: Primary Dealer Credit Facility PIIGS: Portugal, Ireland, Italy, Greece, and Spain QE: quantitative easing Repo: repurchase agreement S&L: savings and loan association S&P: Standard and Poor’s SEC: Securities and Exchange Commission Section 13(3): of Federal Reserve Act SIFI: systemically important financial institution SIV: structured investment vehicle SPV: special purpose vehicle TAF: Term Auction Facility TALF: Term Asset-Backed Securities Loan Facility TARP: Troubled Assets Relief Program TBTF: too big to fail TED (spread): spread between LIBOR and Treasuries TIPS: Treasury Inflation-Protected Securities TLGP: Temporary Liquidity Guarantee Program TSLF: Term Securities Lending Facility UMP: unconventional monetary policy WaMu: Washington Mutual PREFACE When the music stops . . . things will be complicated.

…

There is no agreed-upon definition of the shadow banking system, but the institutions involved on the eve of the crisis included nonbank loan originators; the two government-sponsored housing agencies, Fannie Mae and Freddie Mac; other so-called private-label securitizers; the giant investment banks (who were often securitizers, too); the aforementioned SIVs; a variety of finance companies (some of which specialized in housing finance); hedge funds, private equity funds, and other asset managers; and thousands of mutual, pension, and other sorts of investment funds. The markets involved included those for mortgage-backed securities (MBS), other asset-backed securities (ABS), commercial paper (CP), repurchase agreements (“repos”), and a bewildering variety of derivatives, including the notorious collateralized debt obligations (CDOs) and the ill-fated credit default swaps (CDS). (Sorry about the alphabet soup—explanations to come.) By most estimates, the shadow banking system was far larger than the conventional banking system. Imagine leaving all that financial activity almost totally unregulated—like a bunch of wild animals running around without zookeepers.

…

“Derivative” is a generic term for any security or contract whose value is derived from that of some underlying natural security, such as a stock or a bond. Instead of owning the asset, and either profiting or losing as its price rises or falls, a derivative is a bet on some aspect of its behavior. One simple example is the call option, which we examined in the last chapter. Shortly, we will examine a credit default swap (CDS), whose value depends on whether some underlying bond goes into default. Other common types of derivatives are written on the basis of interest rates or currency values. In addition to the nature of the underlying security, derivatives are also classified by whether they are standardized and traded on organized exchanges, much like stock options on NYSE-listed stocks, or customized and traded over the counter (OTC), as most CDS are.

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

affirmative action, Alan Greenspan, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Black-Scholes formula, Bob Litterman, business cycle, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial engineering, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, Glass-Steagall Act, global macro, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, John Meriwether, Kickstarter, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, low skilled workers, managed futures, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, Mitch Kapor, money market fund, moral hazard, mortgage debt, Myron Scholes, National best bid and offer, negative equity, Northern Rock, Occupy movement, oil shock, price stability, proprietary trading, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, Robert Shiller, Ronald Reagan, Sam Peltzman, Savings and loan crisis, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, systematic trading, tail risk, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

It is difficult to determine the consequences of this decision. It may have been the reason AIG Financial Products became so heavily involved in credit default swap transactions. AIG sold CDS that effectively insured every mortgage pool against defaults. Unlike traditional insurance contracts, the CDS didn’t force AIG to set aside a large amount of capital against potential future losses, nor did the company have to post collateral. AIG’s CDS protection let other banks continue betting on the housing market. AIG’s position in credit default swaps rose to $500 billion. The entire market jumped from $6.4 trillion in 2004 to $58 trillion by 2007.

…

A rule to add a risk officer to report directly to the board per se won’t do this. He will just tick a box and mistakes will go on as usual. —Robert Merton interview, Nobel prizewinner in economics, July 9, 2011 Large insurance companies’ use of credit-default swaps is another example of misusing derivatives. AIG and other insurers sold credit protection on mortgage pools using a derivative known as the credit-default swap (CDS). Traditional insurance is based on pooling many independent risks, but AIG was insuring the interlinked housing market. Given the probability of losses, AIG should have put many reserves aside, but it did not.

…

Finally, many of the customized OTC derivatives are nonliquid contracts that were accumulated on a large scale by one large institution without hedging them. AIG engaged in this activity with credit default swaps. What They Propose The new legislation requires the creating of a centralized platform for the clearing of all swap transactions, which includes interest rate swaps, foreign-exchange swaps, credit default swaps, security-based swaps, and many other transactions. The SEC will regulate security-based swaps and mixed swaps, while the CFTC will regulate all other swaps. The CFTC and SEC must review all swap contracts in the marketplace and will determine which swaps in the marketplace should be cleared on the exchange.

Phishing for Phools: The Economics of Manipulation and Deception by George A. Akerlof, Robert J. Shiller, Stanley B Resor Professor Of Economics Robert J Shiller

Andrei Shleifer, asset-backed security, Bear Stearns, behavioural economics, Bernie Madoff, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Carl Icahn, collapse of Lehman Brothers, compensation consultant, corporate raider, Credit Default Swap, Daniel Kahneman / Amos Tversky, dark matter, David Brooks, desegregation, en.wikipedia.org, endowment effect, equity premium, financial intermediation, financial thriller, fixed income, full employment, George Akerlof, greed is good, income per capita, invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, junk bonds, Kenneth Arrow, Kenneth Rogoff, late fees, loss aversion, market bubble, Menlo Park, mental accounting, Michael Milken, Milgram experiment, money market fund, moral hazard, new economy, Pareto efficiency, Paul Samuelson, payday loans, Ponzi scheme, profit motive, publication bias, Ralph Nader, randomized controlled trial, Richard Thaler, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, short selling, Silicon Valley, stock buybacks, the new new thing, The Predators' Ball, the scientific method, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, theory of mind, Thorstein Veblen, too big to fail, transaction costs, Unsafe at Any Speed, Upton Sinclair, Vanguard fund, Vilfredo Pareto, wage slave

We will introduce the concept of financial “looting” of firms; how it can occur for profit; and, furthermore, how relatively small opportunities to loot for profit can bring huge risks into the financial system. Appendix: The Credit Default Swap Sideshow If you go to the circus, you and your children may find that your favorite exhibits—the best magic shows, and so on—are not in the big tent, but rather at the sideshows. Let’s now go to the Credit Default Swap Tent. In the Big Tent, which we have described, the banks had discovered that they had the ability to make mortgages, and then as a form of alchemy, with the help of the ratings agencies, they could turn these mortgages into gold: by creating assets that were sufficiently complicated that the ratings agencies could, out of real—or pretended—ignorance, rate them highly.

…

In the Big Tent, which we have described, the banks had discovered that they had the ability to make mortgages, and then as a form of alchemy, with the help of the ratings agencies, they could turn these mortgages into gold: by creating assets that were sufficiently complicated that the ratings agencies could, out of real—or pretended—ignorance, rate them highly. If the overall value of the derivative assets was more than what the banks loaned out to make the collection of mortgages, there was money on the table. The creation of this magic was boosted by the presence of a new form of derivative contract: credit default swaps (CDSs). Such a derivative can be devised for any asset with fixed payments, such as a bond or any mortgage-backed asset. In the event of a default, the owner of the swap is paid the face value of the asset; but then he surrenders it (i.e., he “swaps” it) to the seller. It’s a form of insurance.

…

It is truly remarkable that so few economists foresaw what would happen.2 There are about 2¼ million article and book listings regarding finance and economics on Google Scholar.3 That may not indicate enough economist-monkeys to randomly type Hamlet, but it should have been enough to generate quite a few papers that would tell how Countrywide, WaMu, IndyMac, Lehman, and many, many others would in short order flame out and crash. We should have known that their positions in mortgage-backed securities and credit default swaps were fragile. At the time we should have also foreseen the future vulnerabilities of the euro. We believe this huge lacuna tells us that economists (including those in finance) systematically ignore or downplay the role of trickery and deception in the working of markets. We have already put our finger on a simple reason why they were so ignored: economists’ understanding of markets systematically excludes them.

House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan

Alan Greenspan, asset-backed security, Bear Stearns, book value, call centre, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deal flow, Deng Xiaoping, diversification, Financial Instability Hypothesis, fixed income, Glass-Steagall Act, Hyman Minsky, Irwin Jacobs, Jim Simons, John Meriwether, junk bonds, Long Term Capital Management, low interest rates, margin call, merger arbitrage, Michael Milken, money market fund, moral hazard, mortgage debt, mutually assured destruction, Myron Scholes, New Journalism, Northern Rock, proprietary trading, Renaissance Technologies, Rod Stewart played at Stephen Schwarzman birthday party, Savings and loan crisis, savings glut, shareholder value, sovereign wealth fund, stock buybacks, too big to fail, traveling salesman, uptick rule, vertical integration, Y2K, yield curve

“Yep,” Sedacca wrote on the Minyanville Web site, which is dedicated to helping investors comprehend the financial world. “The great credit unwind is upon us. Credit default swaps on all brokers, particularly Lehman and Bear Stearns, are blowing out, big time.” Sedacca, the forty-eight-year-old president of Atlantic Advisors, a $3.5 billion investment management company and hedge fund, had been watching his Bloomberg screens on a daily basis as the cost of insuring the short-term obligations—known in Wall Street argot as “credit default swaps”—of both Lehman and Bear Stearns had increased steadily since the summer of 2007 and then more rapidly in February 2008.

…

And I think it was Monday when our credit default swaps spreads started to really, really spike. I think a lot of people attributed that to the rumors around Goldman. Goldman was not willing to stand on the other side of the trade. Goldman [was] saying that we had DK'd”—essentially failed to make good—“on a trade, which was—the rumor might have been a real rumor, but the fact that we DK'd on a trade was not true. And so that clearly started, at least in my mind, what happened so quickly that week. It became very apparent—not what was going to happen, but what was happening as our credit default swaps started to just gap out huge.

…

He explained how a number of unusual factors had come together to undermine the country's economic foundation: the irresponsible availability of credit to the less-than-creditworthy, allowing them to buy homes, cars, and other goods and services they could not afford but thought they needed; a historic and ongoing increase in real-estate values; a “rapid innovation” on Wall Street that made credit risk easier to manufacture, to trade, and, in theory, to hedge. He said these insurance policies—the dreaded credit default swaps—gave investors the appearance of having hedged their bets. “These instruments allowed investors to buy insurance or protection against a broader range of individual credit risks, such as the default by a homeowner or a company,” he said. But “as underwriting standards deteriorated over this period, this exposure grew.”

A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers by Lawrence G. Mcdonald, Patrick Robinson

"World Economic Forum" Davos, Alan Greenspan, AOL-Time Warner, asset-backed security, bank run, Bear Stearns, Black Monday: stock market crash in 1987, book value, business cycle, Carl Icahn, collateralized debt obligation, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, diversification, fixed income, Glass-Steagall Act, high net worth, hiring and firing, if you build it, they will come, it's over 9,000, junk bonds, London Interbank Offered Rate, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, naked short selling, negative equity, new economy, Ronald Reagan, Savings and loan crisis, short selling, sovereign wealth fund, value at risk

But he knew it mattered terribly, and he was aware that deregulation in this instance might or might not be in our best interest. As a matter of fact, he was not all that crazy about the repeal of Glass-Steagall either. Let me just recap the significance of the CFMA, which would not be passed until the end of the year. A major purpose was to deregulate the entire business of trading a credit default swap (CDS). This is nothing more than a bet—for instance, that a mortgage company will go broke and its bond value will sink to, say, 4 cents on the dollar. We’re talking about a bet that would allow a big bondholder to go to an investment bank and say, “I hold $1 billion worth of bonds in Countrywide.

…

That was the place from which he had, to all intents and purposes, removed himself. In the process, he had become separated from the most modern technology and the ultramodern trading of credit derivatives—CDO (collateralized debt obligations), RMBS (residential mortgage-backed securities), CLO (collateralized loan obligations), CDS (credit default swaps), and CMBS (commercial mortgage-backed securities). Stories about long-departed commanders were legion. There were mind-blowing tales of the Fuld temper, secondhand accounts of his rages, threats, and vengeance. It was like hearing the life story of some caged lion. Tell the truth, I ended up feeling pretty darn glad I wasn’t meeting him.

…

We, however, whose entire expertise was in the distressed-debt market, could see the signs, and Larry McCarthy was all set to throw a barrel at them, because Beazer was the one company that fitted all of our criteria. We decided to deploy 100,000 shares at $75 each and wait for the property market to cave in, which we thought it surely must. The only problem was, when? Larry McCarthy took out $500 million worth of protection in the form of a five-year credit default swap. That meant he agreed to pay a 1.8 percent* carry on the $500 million, which was $9 million annually. However, if Beazer filed for bankruptcy, Lehman would be paid the $500 million,† provided the counterparty on the other side of the trade had the ability to pay. In addition, we all bought equity options—another bet that Beazer would crash, but in this case in the form of puts, which came into play if the stock went down.

Crisis Economics: A Crash Course in the Future of Finance by Nouriel Roubini, Stephen Mihm

Alan Greenspan, Asian financial crisis, asset-backed security, balance sheet recession, bank run, banking crisis, barriers to entry, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bond market vigilante , bonus culture, Bretton Woods, BRICs, British Empire, business cycle, call centre, capital controls, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, dark matter, David Ricardo: comparative advantage, debt deflation, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial engineering, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, Glass-Steagall Act, global pandemic, global reserve currency, Gordon Gekko, Greenspan put, Growth in a Time of Debt, housing crisis, Hyman Minsky, information asymmetry, interest rate swap, invisible hand, Joseph Schumpeter, junk bonds, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, low interest rates, margin call, market bubble, market fundamentalism, Martin Wolf, means of production, Minsky moment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, new economy, Northern Rock, offshore financial centre, oil shock, Paradox of Choice, paradox of thrift, Paul Samuelson, Ponzi scheme, price stability, principal–agent problem, private sector deleveraging, proprietary trading, pushing on a string, quantitative easing, quantitative trading / quantitative finance, race to the bottom, random walk, regulatory arbitrage, reserve currency, risk tolerance, Robert Shiller, Satyajit Das, Savings and loan crisis, savings glut, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, subprime mortgage crisis, Suez crisis 1956, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, too big to fail, tulip mania, Tyler Cowen, unorthodox policies, value at risk, We are all Keynesians now, Works Progress Administration, yield curve, Yom Kippur War

Among the instruments thus removed from regulation were credit default swaps, which permitted a purchaser to buy “insurance” to protect against defaults on bonds both very simple (such as those issued by an automaker) and extremely complex (collateralized debt obligations backed by pools of mortgage-backed securities). Credit default swaps, which mushroomed to reach a notional value of over $60 trillion by 2008, became one of the most important sources of “systemic risk”—perils that threaten the entire financial system. (For more on credit default swaps, see chapter 8.) The push for deregulation also took place outside Congress.

…

Then a London-based company called Markit Group introduced something called the ABX Index, which measured stress in the market for subprime securities. It did so by measuring the prices of a basket of credit default swaps, used to transfer the risk of default on securities derived from subprime home loans. The goal, a company spokesman said, was “visibility and transparency.” Using the ABX, one could measure the cost of buying insurance—in the form of credit default swaps—against defaults of tranches of mortgage-backed securities and CDOs rated from an abysmal BBB to a supposedly high-grade AAA. Over the course of 2007, the ABX Index went into a free fall, as bottom-of-the-barrel tranches lost upwards of 80 percent of their value.

…

Over the previous two decades, bankers and traders had increasingly been rewarded with bonuses tied to short-term profits, giving them an incentive to take excessive risks, leverage up their investments, and bet the entire bank on astonishingly reckless investment strategies. That’s precisely what happened in the recent crisis: financial wizards set up “insurance” in the form of credit default swaps (see chapter 8). These swaps yielded staggering profits and bonuses in good times but set firms like AIG up for catastrophic collapse when the sailing got rough. Yes, traders were greedy—and arrogant and foolish too—but that alone would not have triggered the financial equivalent of a nuclear meltdown had the bonus system not become the dominant kind of compensation in the financial sector.

The Finance Curse: How Global Finance Is Making Us All Poorer by Nicholas Shaxson

"Friedman doctrine" OR "shareholder theory", "World Economic Forum" Davos, activist fund / activist shareholder / activist investor, Airbnb, airline deregulation, Alan Greenspan, anti-communist, bank run, banking crisis, Basel III, Bear Stearns, benefit corporation, Bernie Madoff, Big bang: deregulation of the City of London, Blythe Masters, Boris Johnson, Bretton Woods, British Empire, business climate, business cycle, capital controls, carried interest, Cass Sunstein, Celtic Tiger, central bank independence, centre right, Clayton Christensen, cloud computing, corporate governance, corporate raider, creative destruction, Credit Default Swap, cross-subsidies, David Ricardo: comparative advantage, demographic dividend, Deng Xiaoping, desegregation, Donald Trump, Etonian, export processing zone, failed state, fake news, falling living standards, family office, financial deregulation, financial engineering, financial innovation, forensic accounting, Francis Fukuyama: the end of history, full employment, gig economy, Gini coefficient, Glass-Steagall Act, global supply chain, Global Witness, high net worth, Ida Tarbell, income inequality, index fund, invisible hand, Jeff Bezos, junk bonds, Kickstarter, land value tax, late capitalism, light touch regulation, London Whale, Long Term Capital Management, low skilled workers, manufacturing employment, Mark Zuckerberg, Martin Wolf, megaproject, Michael Milken, Money creation, Mont Pelerin Society, moral hazard, neoliberal agenda, Network effects, new economy, Northern Rock, offshore financial centre, old-boy network, out of africa, Paul Samuelson, plutocrats, Ponzi scheme, price mechanism, proprietary trading, purchasing power parity, pushing on a string, race to the bottom, regulatory arbitrage, rent-seeking, road to serfdom, Robert Bork, Ronald Coase, Ronald Reagan, Savings and loan crisis, seminal paper, shareholder value, sharing economy, Silicon Valley, Skype, smart grid, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, sovereign wealth fund, special economic zone, Steve Ballmer, Steve Jobs, stock buybacks, Suez crisis 1956, The Chicago School, Thorstein Veblen, too big to fail, Tragedy of the Commons, transfer pricing, two and twenty, vertical integration, Wayback Machine, wealth creators, white picket fence, women in the workforce, zero-sum game

We’ve kept your loans in house, so can you please do your next M and A [mergers and acquisitions] transactions with us,’ yet still be able to dance around the capital requirements. In other words, to have their cake and eat it. And here we return to the wild world of derivatives, credit default swaps, Boca Raton – and London. The mechanism that the bankers invented during the wild weekend in Florida was based around the credit default swap, which enables players to bet (or insure themselves) against the possibility that a bond or a loan will actually go into default. A bank could keep loans on its balance sheet, use CDSs to insure those loans against default, then tell the regulators that these loans were insured and it had shed the risk, enabling it to obtain more lenient capital requirements.

…

So by law you are allowed to insure your own life, but not a stranger’s. Credit default swaps involved the same problem: you could use them to insure a loan against default (against the death of a company, as it were). Using CDSs, for instance, you could easily and secretly build up huge incentives to destroy a perfectly healthy company or destabilise a government – at the time financial institutions were being investigated for their role in destabilising Greece. See Wolfgang Munchau, ‘Time to outlaw naked credit default swaps’, Financial Times, 28 February 2010. Naked CDSs are where you can take out insurance on the bonds without actually owning them.

…

Naked CDSs are where you can take out insurance on the bonds without actually owning them. On Robin Potts and insurable interest, see John Kay, ‘Of cows, communities and credit default swaps: Why gambling with CDS should be banned’, Financial Times, 6 April 2010; and Kay, Other People’s Money, pp.61–3 and 72. 26. The $60 trillion number comes from ‘OTC derivatives market activity in the second half of 2007’, Bank for International Settlements, May 2008, p.1. The market value of these swaps was about $2 trillion. See also Oskari Juurikkala, ‘Credit Default Swaps and Insurance: Against the Potts Opinion’, Journal of International Banking Law and Regulation 3, 2011, pp.132–9; and John Cassidy, How Markets Fail, p.282. 27.

Panderer to Power by Frederick Sheehan

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, book value, Bretton Woods, British Empire, business cycle, buy and hold, California energy crisis, call centre, central bank independence, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, deindustrialization, diversification, financial deregulation, financial innovation, full employment, Glass-Steagall Act, Greenspan put, guns versus butter model, inflation targeting, interest rate swap, inventory management, Isaac Newton, John Meriwether, junk bonds, low interest rates, margin call, market bubble, Mary Meeker, McMansion, Menlo Park, Michael Milken, money market fund, mortgage debt, Myron Scholes, new economy, Nixon triggered the end of the Bretton Woods system, Norman Mailer, Northern Rock, oil shock, Paul Samuelson, place-making, Ponzi scheme, price stability, reserve currency, rising living standards, Robert Solow, rolodex, Ronald Reagan, Sand Hill Road, Savings and loan crisis, savings glut, shareholder value, Silicon Valley, Silicon Valley startup, South Sea Bubble, stock buybacks, stocks for the long run, supply-chain management, supply-chain management software, The Great Moderation, too big to fail, transaction costs, trickle-down economics, VA Linux, Y2K, Yom Kippur War, zero-sum game

One other growing class of derivatives deserves mention, especially since Alan Greenspan sang its praises into 2008: credit default swaps (CDS). These were originally designed to hedge against losses should a company enter bankruptcy. The purchaser pays a premium for bankruptcy protection. Credit default swaps would appeal to General Motors bondholders who wanted to hedge—hold an “insurance” policy— against General Motors declaring bankruptcy. The original intention expanded. Credit default swaps were written for other derivatives, such as CDOs. The complications of credit default swaps written on CDOs that combined several CDOs (CDOs squared) were recreational mathematics played with other people’s money. 21 Gillian Tett, “The Unease Bubbling in Today’s Brave New Financial World,” Financial Times (London edition), January 19, 2007, p. 36.

…

His predictions overshadowed his successor’s attempts to establish credibility. He told the Bond Market Association that “credit default swaps are becoming the most important instrument I’ve seen in decades. … For 1 Margaret Mitchell, Gone with the Wind (New York: Scribner, 1936), pp. 241–242. 2 Roddy Boyd and Niles Lathem, “Want Alan Greenspan to Come to Dinner? That’ll Be $250,000 …” New York Post, February 9, 2006. 315 decades we used to have monetary crises because banks” could “freeze up.” Credit default swaps “lay off all these loans.”3 Greenspan could not have been more wrong if he tried, but he was speaking to the bond industry, so his listeners enjoyed the quotable endorsement.

…

The GrammLeach-Bliley Act (its formal name: The Financial Services Modernization Act) became law on November 12, 1999.57 Rubin had left his treasury post to join Citicorp.58 Larry Summers, treasury secretary when the act passed, claimed: “This historic legislation will better enable American companies to compete in the new economy.”59 Greenspan, Rubin, and Summers played a major role ensuring that the wildest derivatives remained unregulated. To thrive, the mortgage machine needed such developments as collateralized debt obligations (CDO) and credit default swaps (CDS). The trio led the offense against regulation of over-the-counter derivatives. Deputy Treasury Secretary Larry Summers told Congress that any oversight would cast “a shadow of regulatory uncertainty over an otherwise thriving market.”60 Without the contributions of Greenspan, Rubin, and Summers, the credit bubble might have been a muted affair.

The Black Box Society: The Secret Algorithms That Control Money and Information by Frank Pasquale

Adam Curtis, Affordable Care Act / Obamacare, Alan Greenspan, algorithmic trading, Amazon Mechanical Turk, American Legislative Exchange Council, asset-backed security, Atul Gawande, bank run, barriers to entry, basic income, Bear Stearns, Berlin Wall, Bernie Madoff, Black Swan, bonus culture, Brian Krebs, business cycle, business logic, call centre, Capital in the Twenty-First Century by Thomas Piketty, Chelsea Manning, Chuck Templeton: OpenTable:, cloud computing, collateralized debt obligation, computerized markets, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, cryptocurrency, data science, Debian, digital rights, don't be evil, drone strike, Edward Snowden, en.wikipedia.org, Evgeny Morozov, Fall of the Berlin Wall, Filter Bubble, financial engineering, financial innovation, financial thriller, fixed income, Flash crash, folksonomy, full employment, Gabriella Coleman, Goldman Sachs: Vampire Squid, Google Earth, Hernando de Soto, High speed trading, hiring and firing, housing crisis, Ian Bogost, informal economy, information asymmetry, information retrieval, information security, interest rate swap, Internet of things, invisible hand, Jaron Lanier, Jeff Bezos, job automation, John Bogle, Julian Assange, Kevin Kelly, Kevin Roose, knowledge worker, Kodak vs Instagram, kremlinology, late fees, London Interbank Offered Rate, London Whale, machine readable, Marc Andreessen, Mark Zuckerberg, Michael Milken, mobile money, moral hazard, new economy, Nicholas Carr, offshore financial centre, PageRank, pattern recognition, Philip Mirowski, precariat, profit maximization, profit motive, public intellectual, quantitative easing, race to the bottom, reality distortion field, recommendation engine, regulatory arbitrage, risk-adjusted returns, Satyajit Das, Savings and loan crisis, search engine result page, shareholder value, Silicon Valley, Snapchat, social intelligence, Spread Networks laid a new fibre optics cable between New York and Chicago, statistical arbitrage, statistical model, Steven Levy, technological solutionism, the scientific method, too big to fail, transaction costs, two-sided market, universal basic income, Upton Sinclair, value at risk, vertical integration, WikiLeaks, Yochai Benkler, zero-sum game

Recall that, in the 1990s, it was big news for AIG to lose less than a tenth of a billion dollars on swaps. By 2008, AIG had amassed a credit default swap portfolio of tens of billions of dollars and was happily collecting premiums from fi rms who wanted to insure their shaky securities.61 It had nowhere near that amount of money at hand.62 Those who had bought insurance from AIG confidently registered on their own balance sheets a guarantee that any lost revenue would be made up by AIG’s credit default swaps.63 The fantasy here was that a private entity like AIG could take on the essentially public function of an agency like the FDIC: to make the insured whole even after catastrophic failures of their counterparties.

…

In the aggregate, this “noise” should cancel out as a clear price signal emerges. The inventors of credit default swaps hoped that their derivative could achieve in debt markets what stock exchanges were (theoretically) realizing in equity markets.109 The ultimate goal was to set exact prices on a wide array of financial risks. The financial engineers saw this as a great triumph of human ingenuity, a technology of risk commodification that would vastly expand societal capabilities to plan and invest. In the giddy days of the real estate bubble, investors who bought both a CDO and a credit default swap likely felt like Midas, guaranteed gains no matter how the future turned out.

…

But rather than improving internal processes at companies they could not fully understand (let alone control), financiers started insuring against bad outcomes. “Financial engineers” crafted “swaps” of risk,55 encouraging quants (and regulators) to try to estimate it in ever more precise ways.56 A credit default swap (CDS), for instance, transfers the risk of nonpayment to a third party, which promises to pay you (the first party) in case the debtor (the second party) does not.57 This innovation was celebrated as a landmark of “price discovery,” a day-by-day (or even second-by-second) tracking of exactly how likely an entity was to default.58 114 THE BLACK BOX SOCIETY As with credit scores, the risk modeling here was deeply fallible, another misapplication of natural science methods to an essentially social science of finance.

Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

"World Economic Forum" Davos, accounting loophole / creative accounting, Alan Greenspan, asset-backed security, bank run, banking crisis, Bear Stearns, Black-Scholes formula, Blythe Masters, book value, break the buck, Bretton Woods, business climate, business cycle, buy and hold, collateralized debt obligation, commoditize, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, easy for humans, difficult for computers, financial engineering, financial innovation, fixed income, Glass-Steagall Act, housing crisis, interest rate derivative, interest rate swap, inverted yield curve, junk bonds, Kickstarter, locking in a profit, Long Term Capital Management, low interest rates, McMansion, Michael Milken, money market fund, mortgage debt, North Sea oil, Northern Rock, Plato's cave, proprietary trading, Renaissance Technologies, risk free rate, risk tolerance, Robert Shiller, Satyajit Das, Savings and loan crisis, short selling, sovereign wealth fund, statistical model, tail risk, The Great Moderation, too big to fail, value at risk, yield curve

Feldstein and some others putting their money on the contrarian view helped to make a lively new business of trading in default swaps take off. By 2005 there were more tools available to conduct such trading, too. In the early years, bankers who wanted to trade credit default swaps generally used only contracts that related to single names. From 2004 onward, though, indices of credit default swaps sprang up, known as “CDX” in the US and “iTraxx” in Europe. They tracked the cost of insuring against default on a basket of companies, offering a handy way for investors to evaluate trends in pricing, in the same way that the S&P 500 shows how the whole equity market is moving.

…

This book explores the answer to the central question of how the catastrophe happened by beginning with the tale of a small group of bankers formerly linked to J.P. Morgan, the iconic, century-old pillar of banking. In the 1990s, they developed an innovative set of products with names such as “credit default swaps” and “synthetic collateralized debt obligations” (of which more later) that fall under the rubric of credit derivatives. The Morgan team’s concepts were diffused and mutated all around the global economy and collided with separate innovations in mortgage finance. These then played a critical role in both the great credit bubble and its subsequent terrible bursting.

…

In most sectors of finance, well-established rules governed deals. But the credit derivatives concept was so new that they had to be crafted on the fly; Masters was making history as she went. Nobody quite knew what the fees paid to the EBRD should be or even quite what to call this “product.” Eventually though, the deal was done, and it was dubbed a “credit default swap,” which, as the business spread, was shortened to CDS. Hancock and the team were jubilant. The Exxon deal showed that a substantial credit derivatives contract could be made to work. And it was not the only one. As Masters was cutting her deal with the EBRD, Robert Reoch, a British banker who worked on Winters’s team in London, cut a deal with Citibank asset management that transferred the risk attached to Belgian, Italian, and Swedish government bonds.

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg Ip

Affordable Care Act / Obamacare, Air France Flight 447, air freight, airport security, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, behavioural economics, Boeing 747, book value, break the buck, Bretton Woods, business cycle, capital controls, central bank independence, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, Daniel Kahneman / Amos Tversky, diversified portfolio, double helix, endowment effect, Exxon Valdez, Eyjafjallajökull, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, foreign exchange controls, full employment, global supply chain, hindsight bias, Hyman Minsky, Joseph Schumpeter, junk bonds, Kenneth Rogoff, lateral thinking, Lewis Mumford, London Whale, Long Term Capital Management, market bubble, Michael Milken, money market fund, moral hazard, Myron Scholes, Network effects, new economy, offshore financial centre, paradox of thrift, pets.com, Ponzi scheme, proprietary trading, quantitative easing, Ralph Nader, Richard Thaler, risk tolerance, Ronald Reagan, Sam Peltzman, savings glut, scientific management, subprime mortgage crisis, tail risk, technology bubble, TED Talk, The Great Moderation, too big to fail, transaction costs, union organizing, Unsafe at Any Speed, value at risk, William Langewiesche, zero-sum game

It works when only a few people buy it; when everyone does, it not only makes the catastrophe more likely, it threatens the survival of the system. This became apparent when, twenty years later, an almost identical problem erupted over the use of another financial innovation: credit default swaps, or CDSs. J.P. Morgan hit upon the idea of the credit default swap in 1994. As Gillian Tett recounts in her book Fool’s Gold, Exxon (now Exxon Mobil) had asked for a $4.8 billion credit line to handle an expected fine for the Exxon Valdez oil spill. This was more than J.P. Morgan was comfortable committing to a single client, but it didn’t want to say no, so it asked the European Bank for Reconstruction and Development to take on the credit risk of the loan in exchange for a fee.

…

Nassim Nicholas Taleb, a former derivatives trader, philosopher, and author, has argued that we should strive to be “antifragile,” a word he came up with to describe people or things that “thrive and grow when exposed to volatility, randomness, disorder, and stressors.” Many financial contracts “are antifragile: they are explicitly designed to benefit from market volatility.” Options and credit default swaps, for example, go up in value when the underlying market becomes more volatile or default becomes more likely. The catch, of course, is that the gain to the holder of the option, or the credit default swap, or the insurance policy, is a loss to the seller. If enough people buy such policies, a catastrophic loss will wipe out the insurers. And the more people who buy such insurance, the fewer will actually be protected in the event of a catastrophe.

…

Numerous other central banks, and the International Monetary Fund, had been regularly publishing “financial stability reports” to highlight potential crisis threats. All suffered from the same problem: ignorance of the risks then propagating in the shadows of the financial system. The Fed knew that subprime mortgages and more exotic instruments such as collateralized debt obligations and credit default swaps existed, but as one study later found, rarely did any of these seem important enough to be mentioned in monetary policy makers’ regular meetings. So, by 2007, there was widespread awareness that homes were probably overvalued but little concern that this would produce a systemic crisis. Twenty-five years of experience and reform had moved most of the risks out of the banking system, provided new tools such as secured repo loans to contain risks, and slain inflation, the single biggest threat to financial stability anyone alive had ever known.

Pity the Billionaire: The Unexpected Resurgence of the American Right by Thomas Frank

Affordable Care Act / Obamacare, Alan Greenspan, bank run, Bear Stearns, big-box store, bonus culture, business cycle, carbon tax, classic study, collateralized debt obligation, collective bargaining, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Deng Xiaoping, false flag, financial innovation, General Magic , Glass-Steagall Act, housing crisis, invisible hand, junk bonds, Kickstarter, low interest rates, money market fund, Naomi Klein, obamacare, Overton Window, payday loans, profit maximization, profit motive, road to serfdom, Robert Bork, Ronald Reagan, shareholder value, strikebreaker, The Chicago School, The Myth of the Rational Market, Thorstein Veblen, too big to fail, union organizing, Washington Consensus, white flight, Works Progress Administration

Then there were the geniuses at the next few steps of the process, who bundled those subprime mortgages into bonds and those bonds into collateralized debt obligations—and then sold credit default swaps to insure against the possibility of their failure.2 The gospel of deregulation, meanwhile, had become such an irresistible ideological juggernaut that no amount of real-world failure could call it into question. Under the guidance of this doctrine, our leaders removed certain derivatives from regulatory oversight; they watered down requirements that banks balance their risk with safe assets; they exempted credit default swaps from regulation as insurance products; they dialed back the Federal Reserve’s regulatory powers; and they struck down a rule that required hedge-fund advisers to register with the Securities and Exchange Commission.

…

And although nearly everything in high finance is related to everything else, Fannie and Freddie are not the same as AIG, which is an insurance company that acted like a hedge fund, investing in mortgage-related securities and issuing credit default swaps. These were the businesses that got AIG into trouble. It is true that AIG owned a subsidiary that originated subprime mortgages—all the Wall Street playaz did—but to my knowledge no one has ever thought to blame AIG’s travails on that subsidiary. Government regulations, for their part, never required anyone to make risky mortgage loans and they certainly never forced anyone to invest in securities based on risky mortgage loans. The credit-default-swaps business was almost completely unregulated. * One of the photos of himself that Beck includes in his first book, The Real America, shows the right-wing showman directing a radio drama while striking virtually the same pose as Welles in one of the photos taken of the latter during his Mars-invasion broadcast

…

Just the opposite: in defending “capitalism,” the leaders of the latest conservative uprising don’t really bother with the actually existing capitalism of the last few years, even though capitalism’s particulars have made for scary headlines on the front pages of every newspaper in the land. They generally do not discuss credit default swaps or the deregulatory triumphs that made them so destructive. They do not have much to say about the massive oil spill in the Gulf of Mexico—the news story that shared the front pages with conservative primary victories all through the summer of 2010—nor about “foreclosuregate,” the revelation a few months later that banks had cut all sorts of legal corners in order to hustle borrowers in default out of their houses as quickly as possible.

Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

activist fund / activist shareholder / activist investor, Airbnb, Albert Einstein, AOL-Time Warner, asset allocation, Bear Stearns, behavioural economics, bitcoin, Bretton Woods, buy and hold, buy low sell high, Carl Icahn, cognitive bias, cognitive dissonance, Credit Default Swap, cryptocurrency, Daniel Kahneman / Amos Tversky, endowment effect, financial engineering, financial innovation, fixed income, global macro, hindsight bias, index fund, initial coin offering, invention of the wheel, Isaac Newton, Jim Simons, John Bogle, John Meriwether, Kickstarter, Long Term Capital Management, loss aversion, low interest rates, Market Wizards by Jack D. Schwager, mega-rich, merger arbitrage, multilevel marketing, Myron Scholes, Paul Samuelson, Pershing Square Capital Management, quantitative easing, Reminiscences of a Stock Operator, Renaissance Technologies, Richard Thaler, Robert Shiller, short squeeze, Snapchat, Stephen Hawking, Steve Jobs, Steve Wozniak, stocks for the long run, subprime mortgage crisis, transcontinental railway, two and twenty, value at risk, Vanguard fund, Y Combinator

With this information, Paulson was ready to go to work.9 The problem was that you can't short a house, so they had to figure out a different way to bet against the market. They learned about credit default swaps, insurance contracts that allow you to bet against the debt of companies. His first foray into shorting the housing market was purchasing credit default swaps on MBIA Inc., which insured mortgage bonds. For $500,000 a year, Paulson could purchase $100 million worth of insurance against the debt of MBIA Inc.10 In 2005, he bought more credit default swaps, this time on two big lenders, Countrywide Financial and Washington Financial. But if he thought that one of the biggest scores of all time would be easy, he quickly realized how long it could take for these things to play out.

…

But if he thought that one of the biggest scores of all time would be easy, he quickly realized how long it could take for these things to play out. Home prices stopped rising in September 2005,11 but his credit default swaps kept losing money. If you're going to win the equivalent of the lottery, with returns of 1,000% or more, you have to bet against consensus. And I don't mean that one or two of your friends disagree with you. I mean everybody disagrees with you to the point that they think you're insane. Imagine, for example, that you think Apple is worth zero. That the entire operation is a fraud, and that the $240 billion worth of cash they say they have doesn't exist.

…

One hedge fund investor said, “Paulson was a merger‐arb guy and suddenly he has strong views on housing and subprime. The largest mortgage guys including Vranos at Ellington, one of the gods of the market, were far more positive on subprime.”12 But Paulson didn't care about all that. He just kept buying credit default swaps like there was no tomorrow. Other traders thought Paulson was crazy and that this could be the folly that shuts him down. Interested in hearing from housing experts, Paulson brought in an analyst from Bear Stearns who assured them that they used sound models to predict mortgage solvency and housing prices.

The Default Line: The Inside Story of People, Banks and Entire Nations on the Edge by Faisal Islam

"World Economic Forum" Davos, Alan Greenspan, Asian financial crisis, asset-backed security, balance sheet recession, bank run, banking crisis, Basel III, Ben Bernanke: helicopter money, Berlin Wall, Big bang: deregulation of the City of London, bond market vigilante , book value, Boris Johnson, British Empire, capital controls, carbon credits, carbon footprint, carbon tax, Celtic Tiger, central bank independence, centre right, collapse of Lehman Brothers, credit crunch, Credit Default Swap, crony capitalism, Crossrail, currency risk, dark matter, deindustrialization, Deng Xiaoping, disintermediation, energy security, Eugene Fama: efficient market hypothesis, eurozone crisis, Eyjafjallajökull, financial deregulation, financial engineering, financial innovation, financial repression, floating exchange rates, forensic accounting, forward guidance, full employment, G4S, ghettoisation, global rebalancing, global reserve currency, high-speed rail, hiring and firing, inflation targeting, Irish property bubble, junk bonds, Just-in-time delivery, labour market flexibility, light touch regulation, London Whale, Long Term Capital Management, low interest rates, margin call, market clearing, megacity, megaproject, Mikhail Gorbachev, mini-job, mittelstand, Money creation, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, negative equity, North Sea oil, Northern Rock, offshore financial centre, open economy, paradox of thrift, Pearl River Delta, pension reform, price mechanism, price stability, profit motive, quantitative easing, quantitative trading / quantitative finance, race to the bottom, regulatory arbitrage, reserve currency, reshoring, Right to Buy, rising living standards, Ronald Reagan, savings glut, shareholder value, sovereign wealth fund, tail risk, The Chicago School, the payments system, too big to fail, trade route, transaction costs, two tier labour market, unorthodox policies, uranium enrichment, urban planning, value at risk, WikiLeaks, working-age population, zero-sum game

The Greek government’s debts shrunk by €107 billion, one-third of the total. Most bondholders did agree voluntarily to this offer. It was, after all, an offer that they could not really refuse. But the Greek government also invoked special clauses that forced some otherwise unwilling debtors to take a hit. This triggered credit default swaps (see here) – bets or insurance on a country going bust. This had been a ‘red line’ that Brussels officials vowed not to cross in the first deal. By early 2012 Greece was not just officially in default – it was the world’s biggest sovereign defaulter. Greece’s national debt had been heading for a completely unsustainable 160 per cent of its GDP at the end of the decade.

…

A clue was to be provided nine months later, not so far away – in Cyprus (see here). 2 Of Fiscal Criminals and Bond Vigilantes Dramatis personae Nick Clegg, UK Liberal Democrat leader Sir Mervyn King, governor of the Bank of England (2003–13) David Cameron, then leader of the UK Opposition James Carville, adviser to President Clinton Brian Edmonds, bond trader, Cantor Fitzgerald Anonymous hedge fund credit default swap trader George Soros, financier and philanthropist Jim Rickards, ex-Long-Term Capital Management (LTCM), lawyer, economist, trader Gordon Brown, British prime minister (2007–10) Jesse Norman, Conservative MP, member of the Treasury Select Committee Rachel Lomax, deputy governor of the Bank of England (2003–08) Dick Moore, mayor of Elkhart, Indiana, USA Robert Lucas, Nobel Prize in Economics.

…

By 2011 US bond traders were a little more understanding of the deficits of their government than their predecessors had been in the 1980s and 1990s. By the time of the crisis, James Carville’s reincarnation of choice would have moved from the large investment-bank bond trading floors to the smaller trade in credit default swaps (CDSs) at a small hedge fund. CDSs had become an instrument to take a view in debt markets that previously would have required buying and selling a bond. The prices and market insight from CDSs were very helpful for regulators and central banks as measures of market default risk – and they were more quantitative and timely than the rankings of the credit-rating agencies.

Them And Us: Politics, Greed And Inequality - Why We Need A Fair Society by Will Hutton

Abraham Maslow, Alan Greenspan, Andrei Shleifer, asset-backed security, bank run, banking crisis, Bear Stearns, behavioural economics, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Blythe Masters, Boris Johnson, bread and circuses, Bretton Woods, business cycle, capital controls, carbon footprint, Carmen Reinhart, Cass Sunstein, centre right, choice architecture, cloud computing, collective bargaining, conceptual framework, Corn Laws, Cornelius Vanderbilt, corporate governance, creative destruction, credit crunch, Credit Default Swap, debt deflation, decarbonisation, Deng Xiaoping, discovery of DNA, discovery of the americas, discrete time, disinformation, diversification, double helix, Edward Glaeser, financial deregulation, financial engineering, financial innovation, financial intermediation, first-past-the-post, floating exchange rates, Francis Fukuyama: the end of history, Frank Levy and Richard Murnane: The New Division of Labor, full employment, general purpose technology, George Akerlof, Gini coefficient, Glass-Steagall Act, global supply chain, Growth in a Time of Debt, Hyman Minsky, I think there is a world market for maybe five computers, income inequality, inflation targeting, interest rate swap, invisible hand, Isaac Newton, James Dyson, James Watt: steam engine, Japanese asset price bubble, joint-stock company, Joseph Schumpeter, Kenneth Rogoff, knowledge economy, knowledge worker, labour market flexibility, language acquisition, Large Hadron Collider, liberal capitalism, light touch regulation, Long Term Capital Management, long term incentive plan, Louis Pasteur, low cost airline, low interest rates, low-wage service sector, mandelbrot fractal, margin call, market fundamentalism, Martin Wolf, mass immigration, means of production, meritocracy, Mikhail Gorbachev, millennium bug, Money creation, money market fund, moral hazard, moral panic, mortgage debt, Myron Scholes, Neil Kinnock, new economy, Northern Rock, offshore financial centre, open economy, plutocrats, power law, price discrimination, private sector deleveraging, proprietary trading, purchasing power parity, quantitative easing, race to the bottom, railway mania, random walk, rent-seeking, reserve currency, Richard Thaler, Right to Buy, rising living standards, Robert Shiller, Ronald Reagan, Rory Sutherland, Satyajit Das, Savings and loan crisis, shareholder value, short selling, Silicon Valley, Skype, South Sea Bubble, Steve Jobs, systems thinking, tail risk, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, the scientific method, The Wealth of Nations by Adam Smith, three-masted sailing ship, too big to fail, unpaid internship, value at risk, Vilfredo Pareto, Washington Consensus, wealth creators, work culture , working poor, world market for maybe five computers, zero-sum game, éminence grise

Over the same period, bank assets jumped from twice to five times British GDP, with bankers resisting demands for more self-insurance of deposits.14 Bankers believed that they were containing possible negative consequences through diversifying risk in bundles of disparate income-earning assets where the chance of default was not corelated in so-called ‘structured investment vehicles’; that the assets were carefully valued through new mathematical models; that the likelihood of default had been insured against via credit default swaps; and, as a bonus, that important tax savings had been secured by placing the investments off shore. In effect, they thought they had created a new alchemy – the lead of poorly rated bonds and assets was turned into the gold of ‘Triple A’ ratings.15 As just 1 per cent of corporate bonds received a Triple A rating, compared to an astonishing 60 per cent of structured investment vehicles, evidently the world’s credit-rating agencies agreed.16 However, the business model in which the agencies were paid by the investment banks issuing the securities, rather than the investors who were buying them, was profoundly flawed.

…

But failure was never more likely because their belief that they held less risk was delusional, a fundamental error compounded by vastly expanding their balance sheets but underwriting them with ever less capital. It turned out that financial randomness was a fairy tale. The risk of default was co-related when general economic conditions turned adverse, despite the confident assertions by bankers that there was no such correlation. Credit default swaps turned out not to be proper insurance contracts, and the mathematical models which predicted that calamitous events were outside any normal distribution of risk proved to be bunk. The entire edifice – intellectual and business – was riddled with mistakes. The IMF has estimated that the aggregate support its member states were forced to offer their financial systems was around $9 trillion in recapitalisation, guarantees and special liquidity provision.

…

As everybody was individually guarding against risk, luminaries like Alan Greenspan claimed that the system as a whole was not risky, even as it created a growing mountain of credit and debt. Moreover, inflation targeting would ensure that there was no consequent inflation. All of these assumptions exploded to devastating effect in 2008. If the 1980s were the decade of interest and currency swaps, the 1990s were the decade of securitisation, and the 2000s the decade of credit default swaps. The great investment banks vied with each other to find the most innovative diversification and hedging techniques. Hedging risk has always had a dual character. Insurance has had the socially useful purpose of allowing protection against the chance of loss, but also the chance to make money on what is essentially gambling.

Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market Into a Casino by Jim McTague

Alan Greenspan, algorithmic trading, automated trading system, Bear Stearns, Bernie Madoff, Bernie Sanders, Black Monday: stock market crash in 1987, Bretton Woods, buttonwood tree, buy and hold, computerized trading, corporate raider, creative destruction, credit crunch, Credit Default Swap, financial innovation, fixed income, Flash crash, High speed trading, housing crisis, index arbitrage, junk bonds, locking in a profit, Long Term Capital Management, machine readable, margin call, market bubble, market fragmentation, market fundamentalism, Myron Scholes, naked short selling, Nixon triggered the end of the Bretton Woods system, pattern recognition, Ponzi scheme, proprietary trading, quantitative trading / quantitative finance, Renaissance Technologies, Ronald Reagan, Sergey Aleynikov, short selling, Small Order Execution System, statistical arbitrage, technology bubble, transaction costs, uptick rule, Vanguard fund, Y2K

Goldman Sachs was a badly tarnished institution in 2009 in the aftermath of the taxpayer bailout of Wall Street, and its reputation would sink even lower in 2010 with revelations that it had bet against the success of investments it had sold to its clients. The public was steamed in March 2009 when it learned that Goldman Sachs had finagled the government into bailing out counterparties involved in credit default swap deals with troubled insurance giant AIG, which was the recipient of more than $80 billion in taxpayer funds. The public was in an anti-Wall Street mood owing to the financial cataclysm caused by its investment bankers. It felt that Goldman Sachs should take a financial hit as a consequence of its high-risk investments and viewed it as a manipulative scheming firm with too much power in Washington, DC.

…

In the United States, both the equities and futures markets spent the morning and early afternoon of May 6 in negative territory. The S&P Volatility Index (VIX) was up 31.7%, the fourth largest, single-day increase ever. Gold prices were up and Treasury yields were down, indicating a flight to quality.8 The cost of buying protection in the credit default swaps market against the possible collapse of Greek bonds became progressively more expensive. Big institutional investors were bidding up the cost of such insurance. The increase in pricing coincided with a press conference by officials of the European Central Bank at 8:30 a.m. in which they failed to mention a possible purchase of Greek bonds to prop up that nation, which news investors were hoping to hear.9 Between 9:30 a.m., when the U.S. market opened, and 2:00 p.m., the DJIA already had fallen 161 points to 10,712 or 1.5%, and the S&P had fallen 33 points to 1,145, or down 2.9%.

…

A renaissance man with degrees in science and law, Hu in 1993 had written a forward-looking piece for the Yale Law Review predicting that big financial institutions would make significant mistakes employing relatively new products called derivatives. This was 5 years before the blowup of Long Term Capital Management, a hedge fund that had made interest rate bets using the exotic products and 15 years before insurer AIG would blow itself up dealing in the exotic products. Part of Hu’s thinking was that credit default swaps, which decoupled loans from the actual lender, led to “empty creditor” situations, undermining what it meant to be a debt holder. The SEC had been dominated by lawyers who were more interested in writing regulations than actually riding herd on the markets. Economists had been second-class citizens—dishwashers as opposed to cooks.

The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee, Kevin Coldiron

active measures, Alan Greenspan, Asian financial crisis, asset-backed security, backtesting, bank run, Bear Stearns, Bernie Madoff, Bretton Woods, business cycle, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, currency risk, debt deflation, disinformation, distributed ledger, diversification, financial engineering, financial intermediation, Flash crash, global reserve currency, implied volatility, income inequality, inflation targeting, junk bonds, labor-force participation, Long Term Capital Management, low interest rates, Lyft, margin call, market bubble, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, negative equity, Network effects, Ponzi scheme, proprietary trading, public intellectual, purchasing power parity, quantitative easing, random walk, rent-seeking, reserve currency, rising living standards, risk free rate, risk/return, sharing economy, short selling, short squeeze, sovereign wealth fund, stock buybacks, tail risk, TikTok, Uber and Lyft, uber lyft, yield curve

The most obvious example is perhaps writing insurance. The insurance company, or writer of an insurance policy, takes a premium, or income, for accepting the risk of having to pay out if the event that is being insured against occurs. In the financial markets a credit default swap is a form of insurance against default by a borrower. The buyer of the credit default swap (CDS) pays a premium to insure a bond (loan) against the risk of default. If the borrower does default on the bond, the CDS buyer is compensated by the seller of the CDS. (However, note that, unlike with a normal insurance contract, the buyer of the CDS does not actually have to own the bond or loan he is insuring against default.)

…

Indeed, there exists a range of sophisticated carry trades that use financial derivatives to gain an income that depends directly on a relative lack of volatility of the underlying asset prices. Carry trades can include everything from undertaking classic currency carry positions, writing insurance or selling credit default swaps, buying higher-yielding equities or junk debt on margin, taking out buy-to-rent mortgages to finance property investments, to writing put options on equities or equity indexes or buying exchange-traded funds that do so—but that is not all. Carry trades can also include dealings such as companies issuing debt to buy back their own equity or private equity leveraged buyouts, plus a whole gamut of more complex financial strategies and financial engineering.

…

At the heart of the mortgage bubble was a giant credit carry trade; high-risk mortgages were being financed out of low-cost funds. The “innovation” that allowed risks to be seriously mispriced was the burgeoning market in credit derivatives, particularly collateralized debt obligations (CDOs) and credit default swaps. CDOs (and collateralized loan obligations) bundle together a collection of loans or mortgages or mortgage-backed securities and divide the collection into tranches. The owners of the highest-rated tranche get first claim on the stream of interest payments that accrue to the bundle of loans or securities, while the owners of the lowest-rated tranche get whatever is left—and are therefore most at risk from defaults on the underlying debts.

The Money Machine: How the City Works by Philip Coggan

activist fund / activist shareholder / activist investor, algorithmic trading, asset-backed security, Bear Stearns, Bernie Madoff, Big bang: deregulation of the City of London, Black Monday: stock market crash in 1987, bond market vigilante , bonus culture, Bretton Woods, call centre, capital controls, carried interest, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, disintermediation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, endowment effect, financial deregulation, financial independence, floating exchange rates, foreign exchange controls, Glass-Steagall Act, guns versus butter model, Hyman Minsky, index fund, intangible asset, interest rate swap, inverted yield curve, Isaac Newton, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", joint-stock company, junk bonds, labour market flexibility, large denomination, London Interbank Offered Rate, Long Term Capital Management, low interest rates, merger arbitrage, Michael Milken, money market fund, moral hazard, mortgage debt, negative equity, Nick Leeson, Northern Rock, pattern recognition, proprietary trading, purchasing power parity, quantitative easing, reserve currency, Right to Buy, Ronald Reagan, shareholder value, South Sea Bubble, sovereign wealth fund, technology bubble, time value of money, too big to fail, tulip mania, Washington Consensus, yield curve, zero-coupon bond

Traditionally, there was not much they could do if they believed the outlook for corporate bonds and loans was deteriorating. But now they can buy credit default swaps; if it looks likely that more borrowers will default, premiums will rise. That will push the speculators into profit. Similarly, those who believe the corporate bond market can do well can take the other side of the deal. If premiums fall, they will profit. The scope for big gains would be much greater than could be achieved by just holding the bonds themselves. Some people worry that the credit default swap market could lead to a crisis in the event of a lot of corporate failures. In some cases, the value of outstanding swaps is much greater than the value of bonds in issuance.

…

What swaps have done is to open up the world’s capital markets to a wide range of borrowers. It is now possible for a UK borrower, say, to pick a particular world market where borrowing seems cheap, borrow there and still, through a swap, end up with the sterling debt it really wants. CREDIT DEFAULT SWAPS For investors, interest-rate risk is not the only danger they face. There is also the possibility that the borrower will not repay the loan or bond. In the old days, there was not much that the investor could do about this. Bond investors could at least sell their holdings if they felt bad news was due; loan investors were usually stuck.

…

Bond investors could at least sell their holdings if they felt bad news was due; loan investors were usually stuck. The best protection was to have a diversified portfolio of bonds or loans and hope that the good payers outweighed the defaulters. But the financial markets are remarkably ingenious at finding ways to insure against risk. The credit default swap is their latest wheeze. It is like an insurance policy against default. One party pays a premium to another; in return, the seller agrees to pay up if the borrower defaults. The higher the premium, the riskier the company. This small idea created a market with some $62 trillion of outstanding contracts by the end of 2007.

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

activist fund / activist shareholder / activist investor, Alan Greenspan, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Bear Stearns, behavioural economics, Black-Scholes formula, book value, Brownian motion, business cycle, buy and hold, buy low sell high, buy the rumour, sell the news, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, currency risk, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, financial engineering, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, global macro, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, junk bonds, late capitalism, law of one price, Long Term Capital Management, low interest rates, managed futures, margin call, market clearing, market design, market friction, Market Wizards by Jack D. Schwager, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, Phillips curve, price discovery process, price stability, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Reminiscences of a Stock Operator, Renaissance Technologies, Richard Thaler, risk free rate, risk-adjusted returns, risk/return, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, short squeeze, SoftBank, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, systematic trading, tail risk, technology bubble, time dilation, time value of money, total factor productivity, transaction costs, two and twenty, value at risk, Vanguard fund, yield curve, zero-coupon bond

While the equity hedge partially protects against the risk of default, this hedge often does not fully cover the loss on the convertible bond in case of default. Each bond’s default risk can be hedged by buying credit default swap (CDS) protection (if CDSs are traded for that firm) or by selling straight corporate bonds. However, buying protection on all convertible bonds in a portfolio is expensive and associated with large transaction costs. Alternatively, a convertible arbitrage trader can make sure that her portfolio is well diversified, largely diversifying away idiosyncratic credit risk. Changes in marketwide credit risk can then be hedged with a credit default swap index such as CDX or iTraxx. Convertible bonds also face risks in connection with takeovers and other corporate events.

…

See also funding costs; transaction costs coupons: bond prices and, 242; bond returns and, 180, 243; of convertible bonds, 269, 270, 271, 277, 283, 287, 288; inflation and, 179; reinvestment of, 179n crash risk, 31–32; implied volatility and, 239; liquidity spiral and, 82; volatility and, 58 credit carry trades, 188 credit cycles, 7t, 16 credit default swap index, 283 credit default swaps (CDSs), 241; capital structure arbitrage with, 312; credit return and, 180; fixed income arbitrage involving, 13, 260–61; to hedge convertible bond default risk, 283; in overheated economy, 191 credit returns, 180–81 credit risk, 260; of convertible bonds, 283; of credit carry strategy, 188; in event-driven investment, 292; Scholes on, 264 credit risk premium, 168, 260 credit spread, 180–81, 260; of distressed firms, 311; in overheated economy, 191 crises.

…

John Maynard Keynes expressed this risk well: The markets can remain irrational longer than you can remain solvent. Typical examples of fixed-income arbitrage trades include on-the-run versus off-the-run Treasury bonds, yield curve trading, betting on swap spreads, mortgage trades, futures-bond basis trades, and trades on the basis between bonds and credit default swaps (CDS). Another classic arbitrage trade is convertible bond arbitrage. Convertible bonds are corporate bonds that can be converted into stock at a prespecified conversion ratio. A convertible bond can be viewed as a package of a straight corporate bond and a call option on the company’s stock.

Sabotage: The Financial System's Nasty Business by Anastasia Nesvetailova, Ronen Palan

Alan Greenspan, algorithmic trading, bank run, banking crisis, barriers to entry, Basel III, Bear Stearns, Bernie Sanders, big-box store, bitcoin, Black-Scholes formula, blockchain, Blythe Masters, bonus culture, Bretton Woods, business process, collateralized debt obligation, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, critique of consumerism, cryptocurrency, currency risk, democratizing finance, digital capitalism, distributed ledger, diversification, Double Irish / Dutch Sandwich, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial engineering, financial innovation, financial intermediation, financial repression, fixed income, gig economy, Glass-Steagall Act, global macro, Gordon Gekko, high net worth, Hyman Minsky, independent contractor, information asymmetry, initial coin offering, interest rate derivative, interest rate swap, Joseph Schumpeter, junk bonds, Kenneth Arrow, litecoin, London Interbank Offered Rate, London Whale, Long Term Capital Management, margin call, market fundamentalism, Michael Milken, mortgage debt, new economy, Northern Rock, offshore financial centre, Paul Samuelson, peer-to-peer lending, plutocrats, Ponzi scheme, Post-Keynesian economics, price mechanism, regulatory arbitrage, rent-seeking, reserve currency, Ross Ulbricht, shareholder value, short selling, smart contracts, sovereign wealth fund, Thorstein Veblen, too big to fail

Goldman’s now well-known Abacus affair centred on a set of esoteric financial instruments known as synthetic collateral debt obligations (or CDOs). A very simplified explanation of what a synthetic CDO is was helpfully provided by Matt Levine of Bloomberg: 1. Some investors put money in a ‘pot’. 2. The pot writes a credit default swap to an investment bank – in this case, Goldman Sachs Group Inc. – insuring Goldman against the risk of default of some mortgage bonds (called the ‘reference portfolio’). 3. Goldman pays premiums for the credit default swap, and those payments are passed along to the CDO investors. 4. If some of the reference mortgage bonds default, then the ‘pot’ pays some money to Goldman. This reduces the ‘pot’ (and the premiums that Goldman pays to the investors). 5.

…

Acknowledgements Discover More About the Authors Bibliography References and Notes To Michael and Sasha Explore book giveaways, sneak peeks, deals, and more. Tap here to learn more. ABBREVIATIONS AND TERMS AIG: American Insurance Group. CDO: Collateralized default obligations. CDS: Credit default swap. A financial contract whereby a buyer of corporate or sovereign debt in the form of bonds attempts to eliminate possible loss arising from default by the issuer of the bonds. This is achieved by the issuer of the bonds insuring the buyer’s potential losses as part of the agreement. EMT: Efficient market theory.

…

Masters’ idea was ingenious and simple: why not insure the bank against those risks and pass them on to the insurer, thus freeing capital for other investment? Blythe Masters and her team at J. P. Morgan set off to seek such an insurer, and soon found one. American Insurance Group (AIG) was happy to provide such an insurance to J. P. Morgan, for a fee. The deal was formalized in a financial instrument which would later become known as a credit default swap (CDS). The formula devised at J. P. Morgan proved highly popular. Soon other banks and hedge funds joined the business of selling and buying the CDSs. In the abstract world of economics, where a bank is a responsible intermediary, this invention was ingenious and effective. But in the real-life business of finance, with lack of regulations, tough competition and greed, the invention became a perfect tool of moneymaking through sabotage.

Stress Test: Reflections on Financial Crises by Timothy F. Geithner

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, Atul Gawande, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Bernie Sanders, Black Monday: stock market crash in 1987, break the buck, Buckminster Fuller, Carmen Reinhart, central bank independence, collateralized debt obligation, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency risk, David Brooks, Doomsday Book, eurozone crisis, fear index, financial engineering, financial innovation, Flash crash, Goldman Sachs: Vampire Squid, Greenspan put, housing crisis, Hyman Minsky, illegal immigration, implied volatility, Kickstarter, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market fundamentalism, Martin Wolf, McMansion, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mortgage debt, Nate Silver, negative equity, Northern Rock, obamacare, paradox of thrift, pets.com, price stability, profit maximization, proprietary trading, pushing on a string, quantitative easing, race to the bottom, RAND corporation, regulatory arbitrage, reserve currency, Saturday Night Live, Savings and loan crisis, savings glut, selection bias, Sheryl Sandberg, short selling, sovereign wealth fund, stock buybacks, tail risk, The Great Moderation, The Signal and the Noise by Nate Silver, Tobin tax, too big to fail, working poor

One of the best examples of our accomplishments, but also of the limits of our accomplishments, was in the realm of derivatives. BY 2005, the market in over-the-counter derivatives had quadrupled since Brooksley Born had started warning about them seven years earlier. Investors were gobbling up an array of new products, from “credit default swaps” to “synthetic CDOs.” But there was still no single authority over derivatives, or over the banks and securities firms that manufactured and sold them. All this worried me. In some ways, derivatives were just another form of risk taking, like simple bank loans or any other financial transactions.

…

Every morning, the New York Fed’s market room sent around a dashboard of about fifty economic and financial indicators. Most were heading the wrong way. Mortgage-backed securities were still bleeding. Rating agencies were belatedly downgrading them, leading to margin calls, forced asset sales, and more bleeding. Prices for credit default swaps—derivative contracts insuring against the failure of a firm or default of a security—were rising. Ambac, MBIA, and other large monoline insurers that stood behind many mortgage securities faced downgrades as well; even the dull municipal bonds they backed were starting to wobble. The New York state insurance commissioner, Eric Dinallo, had tracked me down in Davos, frantically informing me that the monolines were in trouble and that Charlie Gasparino was criticizing him on CNBC for not doing something about it.

…

We hoped that would reduce the danger of an uncontrolled run. We were also concerned that the spaghetti-like tangle of overlapping positions in derivatives markets could create uncertainty if another major firm failed. To shrink the plate and untangle some of the spaghetti, we encouraged the Fourteen Families to “tear up” offsetting trades of credit default swaps, getting dealers who had bought and sold the same insurance contract to step out of the offsetting trades and match up the counterparties. That way, if the dealer in the middle failed, the other firms wouldn’t be exposed. We ended up eliminating about one-third of the outstanding contracts.

The Alpha Masters: Unlocking the Genius of the World's Top Hedge Funds by Maneet Ahuja, Myron Scholes, Mohamed El-Erian

"World Economic Forum" Davos, activist fund / activist shareholder / activist investor, Alan Greenspan, Asian financial crisis, asset allocation, asset-backed security, backtesting, Bear Stearns, Bernie Madoff, book value, Bretton Woods, business process, call centre, Carl Icahn, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, en.wikipedia.org, family office, financial engineering, fixed income, global macro, high net worth, high-speed rail, impact investing, interest rate derivative, Isaac Newton, Jim Simons, junk bonds, Long Term Capital Management, managed futures, Marc Andreessen, Mark Zuckerberg, merger arbitrage, Michael Milken, Myron Scholes, NetJets, oil shock, pattern recognition, Pershing Square Capital Management, Ponzi scheme, proprietary trading, quantitative easing, quantitative trading / quantitative finance, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Savings and loan crisis, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, stock buybacks, systematic bias, systematic trading, tail risk, two and twenty, zero-sum game

Weinstein joined Deutsche Bank in January 1998, when the market for credit derivatives—financial contracts for hedging (or speculating) against a company’s default—was in its infancy. “Not only was it brand new, but few people understood the mechanics of how to price a credit default swap,” says Weinstein. A CDS is the most common credit derivative. “Foreign exchange derivatives, interest rate derivatives, equity derivatives—those instruments had been around for 25 years before J. P. Morgan and Deutsche began figuring out how to structure and trade credit default swaps.” This was an ideal situation for young Weinstein. For years, while his peers had all followed equities, Weinstein had been fascinated by the complexity of credit.

…

He explained that, in 2005, he and his team had become concerned about weak credit underwriting standards and excessive leverage among financial institutions believing that credit was fundamentally mispriced. “To protect our investors against the risk in the financial markets, we purchased protection through credit default swaps on debt securities we thought would decline in value due to weak credit underwriting. As credit spreads widened and the value of these securities fell, we realized substantial gains for our investors.” Paulson explained this as if it were just that simple. The funny thing is, to Paulson, it was that simple.

…

Paulson began to suspect that shorting credit could be the strategy that could give him the outsized performance he was looking for without taking excessive risk. Slowly, Paulson and his team were able to piece together how housing prices, and the trillion-dollar market built around them, were doomed to collapse like a house of cards. This gave Paulson the green light to begin purchasing protection through credit default swaps on debt securities he felt would decline in value due to weak credit underwriting. The subprime mortgage securitization market was uniquely suited to buying credit protection. The typical subprime securitization was divided into 18 tranches, ranging from “AAA” to “BB,” with each lower tranche subordinate to the one above.

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

"World Economic Forum" Davos, AI winter, Alan Greenspan, algorithmic trading, AOL-Time Warner, Apollo 11, asset allocation, banking crisis, barriers to entry, Bear Stearns, Big bang: deregulation of the City of London, Bob Litterman, book value, business cycle, butter production in bangladesh, butterfly effect, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, Charles Babbage, citizen journalism, collateralized debt obligation, Cornelius Vanderbilt, corporate governance, Craig Reynolds: boids flock, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, electricity market, Emanuel Derman, en.wikipedia.org, experimental economics, fake news, financial engineering, financial innovation, fixed income, Ford Model T, Gordon Gekko, Hans Moravec, Herman Kahn, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, Ivan Sutherland, Jim Simons, John Bogle, John Nash: game theory, Kenneth Arrow, load shedding, Long Term Capital Management, machine readable, machine translation, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, Metcalfe’s law, military-industrial complex, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, proprietary trading, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Reminiscences of a Stock Operator, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, Savings and loan crisis, semantic web, Sharpe ratio, short selling, short squeeze, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, stock buybacks, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, tontine, too big to fail, transaction costs, Turing machine, two and twenty, Upton Sinclair, value at risk, value engineering, Vernor Vinge, Wayback Machine, yield curve, Yogi Berra, your tax dollars at work

It goes one step further by quickly placing the assets in the hands of multiple private managers (who would be accountable to the American people, the shareholders) rather than a small cadre of government officials. What about the $60⫹ trillion in credit default swaps? Many people fear that if major insolvent institutions are allowed to fail and potentially default on their derivative contracts insuring bonds Structural Ideas for the Economic Rescue 323 (credit default swaps), that it would create a chain reaction of derivative defaults, asset write-downs, and further bank failures. This is a valid concern, but existing bailout plans only defer the problem.

…

Look at the bottom of any business television channel or web site. You can see the details of every trade in every stock, within seconds. Regulators can track down parties involved in suspicious trades via automated clearing systems. In marked contrast, we see absolutely nothing at all about trading in the collateralized debt obligations (CDOs), credit default swaps (CDSs), and mortgage-backed securities (MBSs) that created this mess, even though the total size of those markets is a multiple of the size of the stock market. Trades and quotes in these securities, holdings, and holders are all unknown and largely unknowable, even in today’s electronic markets.

…

Stock markets are almost perfectly transparent, with full information available to all, and the best electronic clearing and settlement in history. These technologies were omitted in building the skyscraper of cards (“house of cards” seems too mild) out of collateralized debt obligations (CDOs), credit default swaps (CDSs), synthetic collateralized debt obligations (SCDOs), and the rest. The Hall of Shame for those guilty of incompetent engineering features collapsing bridges, flaming dirigibles, exploding spacecraft, and melting reactors. We can add a new wing for overly complex derivatives, modeled in exquisite detail by myopic nerds with Ph.D.’s who got lost in the ever more complex simulations but ignored the basic principles, and their lavishly paid bosses who ignored the warnings from the best of them so they could be even more lavishly paid.

Planet Ponzi by Mitch Feierstein

Affordable Care Act / Obamacare, Alan Greenspan, Albert Einstein, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Bear Stearns, Bernie Madoff, book value, break the buck, centre right, collapse of Lehman Brothers, collateralized debt obligation, commoditize, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, disintermediation, diversification, Donald Trump, energy security, eurozone crisis, financial innovation, financial intermediation, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Future Shock, Glass-Steagall Act, government statistician, high net worth, High speed trading, illegal immigration, income inequality, interest rate swap, invention of agriculture, junk bonds, light touch regulation, Long Term Capital Management, low earth orbit, low interest rates, mega-rich, money market fund, moral hazard, mortgage debt, negative equity, Neil Armstrong, Northern Rock, obamacare, offshore financial centre, oil shock, pensions crisis, plutocrats, Ponzi scheme, price anchoring, price stability, proprietary trading, purchasing power parity, quantitative easing, risk tolerance, Robert Shiller, Ronald Reagan, tail risk, too big to fail, trickle-down economics, value at risk, yield curve

Some of these were motivated by ordinary credit-driven concerns. Others were bullish on the mortgage market but simply had to cap the total volume of their exposures. And so on. There was a huge variety of different motivations. But there was one common solution for their needs: the credit default swap or CDS. Forget about the intricacies of the terminology. Credit default swaps operate exactly like regular insurance‌—‌in this case, insurance against credit risk and default. You pay your premium year after year. If the asset you’ve insured goes bad, then the insurance pays out. So if, for example, you bought a mortgage-backed security full of subprime mortgage assets, you might (when you came to your senses) decide to insure yourself against the possibility of default.

…

Nevertheless, I want to keep my personal view strictly to one side, so we’ll focus here instead on what the financial markets themselves expect, using the most recent data available. The data we’ll use rely on credit default swaps, which as we’ve already seen are essentially a way to buy insurance against the risk of default. Because these swap prices are publicly displayed, it’s possible to see what insurance premiums are being demanded and paid. Clearly, the higher the premiums charged, the higher is the implicit risk of default. Indeed, it’s possible to use credit default swap pricing to estimate the ‘cumulative probability of default’ for all sovereign debt markets. The cumulative probability of default (CPD) is exactly what it sounds like.

…

Some smart guys on the Street noticed that the pattern of payouts on insurance schemes (a chain of small regular premiums followed by a potentially large one-off insurance payout) looked very like the pattern of payments on a CDO (a chain of small regular interest payments followed by a large final repayment of principal). Using a little financial magic it proved to be possible to turn those credit default swaps into a ‘synthetic’ CDO. In plain language, all those people taking out insurance against defaults were making bets on one side of the mortgage market, while the synthetic CDO enabled investors to bet on the other side of the market. In effect, that synthetic CDO created mortgage risk out of nowhere.

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

Alan Greenspan, Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, book value, break the buck, business cycle, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial engineering, financial innovation, financial intermediation, fixed income, George Akerlof, Glass-Steagall Act, Growth in a Time of Debt, income inequality, information asymmetry, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, junk bonds, Kenneth Rogoff, Larry Wall, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, Money creation, money market fund, moral hazard, mortgage debt, mortgage tax deduction, negative equity, Nick Leeson, Northern Rock, open economy, Paul Volcker talking about ATMs, peer-to-peer lending, proprietary trading, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Satyajit Das, Savings and loan crisis, shareholder value, sovereign wealth fund, subprime mortgage crisis, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

These debt promises are sold to different investors, although sometimes the investment bank itself might buy some.32 The desire to shift risk away from the original mortgage lender thus lengthens the chain of transactions and increases the scope for defaults to trigger domino effects. If the banks or other institutions that buy the mortgage securities borrow from money market funds, the chain of transactions is even longer.33 The use of so-called credit default swaps is another example of how attempts to manage risk can create additional complexity and fragility. A credit default swap (CDS) is a kind of insurance contract. The buyer of a CDS pays a periodic premium to the seller. In return, the seller promises to reimburse the buyer if the loan or portfolio of loans on which the CDS is written does not perform as it had promised.

…

See Community Reinvestment Act Cranston, Alan, 252n35 credibility: of ban on bailouts, 139; of threat of allowing bank failures, 75–76, 139, 264n65; of threat of closing banks for capital violations, 189 credit cards: interest rates on, 104, 276n11; payments through, 49, 150 credit crunches: causes of, 5, 301n54; fears of, in delay of regulation, 171–72; in financial crisis of 2007-2009, 5, 211, 301n54 credit default swaps (CDSs): at AIG, 69, 73–74, 255n1, 259n34, 334n44; definition of, 68, 255n1; and interconnectedness, 68–69; origins of term, 259n34; regulation of, 259n34; risks of, 73–74; in risk-weighting approach, 185 Crédit Immobilier de France, bailout of, 74 credit insurance, risks of, 73–74. See also AIG; credit default swaps credit limits, regulations on, 88, 268n24 Crédit Lyonnais: cost of bailout of, 318n7; failure of, 55–56, 252n37 creditors: benefits of guarantees to, 129, 142; collateral used by, 164, 301n57; covenants of, 141; default as problem of, 36, 244n3; deposit insurance and, 62, 163; lending through repo (repurchase) agreements, 164; motivations for short-term lending by, 163–65; response to default, 35–36 credit ratings: guarantees in, role of, 9, 143, 235nn31–32, 290n28; for mortgage-related securities, 156–57, 185; risks hidden in, 124–25, 156–57, 222, 296n29; in securitization of mortgages, 259n33 credit risks: AIG and, 74, 161; definition of, 313n64; in financial crisis of 2007-2009, 157, 185; in risk-weighted approach, 183, 313n64, 313n66 creditworthiness assessments, 50; careless-ness in, 56, 277n12; challenges of, 50; economizing on, 249n13; hard versus soft information in, 50, 248n9; for mortgages, 56, 58, 248n9, 277n12 criminal proceedings, 208, 215, 228, 321n27 crony capitalism, 331n19 culture of banking: complacency in, 206; greed in, 208–9, 328n6; lying in, 328n5; return on equity in, 115, 125–28, 284–85nn29–30; unethical behavior in, 209, 328n6, 329n8 Cumming, Christine, 262n60, 263n62 currency, and risk of sovereign default, 276n6 currency boards, 294n15, 333n39 currency swaps, 260n37 Curry, Timothy, 252n34, 289n20, 293n3 Das, Satyajit, 230n9, 253n42, 259n34, 260nn37–38, 260n41, 261n43, 261n46, 261n50, 262nn52–53, 284n24, 284n29, 285n37, 286n40, 308n41, 323n38, 328n5, 329n6, 329n8 Dattel, Danny, 252n36 Davies, Richard, 270n31, 290n29, 291n34 Davydenko, Sergei A., 245n13 debit cards, 49, 150 debt, treated as equity, 187–88.

…

Basel II, concluded in 2004, was considered to be doing it properly, but the financial crisis showed that Basel II was flawed.61 Basel III attempts to correct some of the flaws in Basel II, but it has not changed the overall approach.62 The risk-weighting approach is extremely complex and has many unintended consequences that harm the financial system. It allows banks to reduce their equity by concentrating on investments that the regulation treats as safe. Banks might also use derivatives to shift the risks of their investments to others, and this can increase interconnectedness. An example would be a bank’s purchase of credit default swaps in order to insure against the credit risk of debt securities held by the bank. As we saw in Chapter 5, such credit insurance served to justify treating mortgage-related securities as perfectly safe; it was also a source of systemic risk and played an important role in the government’s decision to bail out AIG.

Too big to fail: the inside story of how Wall Street and Washington fought to save the financial system from crisis--and themselves by Andrew Ross Sorkin

"World Economic Forum" Davos, affirmative action, Alan Greenspan, Andy Kessler, Asian financial crisis, Bear Stearns, Berlin Wall, book value, break the buck, BRICs, business cycle, Carl Icahn, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deal flow, Dr. Strangelove, Emanuel Derman, Fall of the Berlin Wall, fear of failure, financial engineering, fixed income, Glass-Steagall Act, Goldman Sachs: Vampire Squid, housing crisis, indoor plumbing, invisible hand, junk bonds, Ken Thompson, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Michael Milken, Mikhail Gorbachev, money market fund, moral hazard, naked short selling, NetJets, Northern Rock, oil shock, paper trading, proprietary trading, risk tolerance, Robert Shiller, rolodex, Ronald Reagan, Savings and loan crisis, savings glut, shareholder value, short selling, sovereign wealth fund, supply-chain management, too big to fail, uptick rule, value at risk, éminence grise

Building computer models based on years of historical data on corporate bonds, they concluded that this new device—a credit default swap—seemed foolproof. The odds of a wave of defaults occurring simultaneously were remote, short of another Great Depression. So, absent a catastrophe of that magnitude, the holders of the swap could expect to receive millions of dollars in premiums a year. It was like free money. Cassano, who became head of the unit in 2001, pushed AIG into the business of writing credit default swaps. By early 2005, it was such a big player in the area that even Cassano had begun to wonder how it had happened so quickly.

…

Under European banking regulations, financial institutions had been allowed to meet capital requirements by entering into credit default swap agreements with AIG’s financial products unit. Using the swaps, the banks had essentially wrapped AIG’s triple-A credit rating around riskier assets, such as corporate loans and residential mortgages, allowing the banks to take on more leverage. If AIG were to fail, however, those protective wrappers would vanish, forcing the banks to mark down assets and raise billions of dollars—a frightening prospect in the current markets. And the numbers were staggering: Halfway though 2008, AIG had reported more than $300 billion in credit default swaps involved in this wrapping procedure, which it politely called “regulatory capital relief.”

…

On this morning, however, he was fanning the flames, telling Fuld the latest rumor swirling around the trading floor: A bunch of “hedgies,” Wall Street’s disparaging nickname for hedge fund managers, had systematically taken down Bear Stearns by pulling their brokerage accounts, buying insurance against the bank—an instrument called a credit default swap, or CDS—and then shorting its stock. According to Russo’s sources, a story making the rounds was that the group of short-sellers who had destroyed Bear had then assembled for a breakfast at the Four Seasons Hotel in Manhattan on Sunday morning, clinking glasses of mimosas made with $350 bottles of Cristal to celebrate their achievement.

Bean Counters: The Triumph of the Accountants and How They Broke Capitalism by Richard Brooks

"World Economic Forum" Davos, accounting loophole / creative accounting, Alan Greenspan, asset-backed security, banking crisis, Bear Stearns, Big bang: deregulation of the City of London, blockchain, BRICs, British Empire, business process, Charles Babbage, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Strachan, Deng Xiaoping, Donald Trump, double entry bookkeeping, Double Irish / Dutch Sandwich, energy security, Etonian, eurozone crisis, financial deregulation, financial engineering, Ford Model T, forensic accounting, Frederick Winslow Taylor, G4S, Glass-Steagall Act, high-speed rail, information security, intangible asset, Internet of things, James Watt: steam engine, Jeremy Corbyn, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, junk bonds, light touch regulation, Long Term Capital Management, low cost airline, new economy, Northern Rock, offshore financial centre, oil shale / tar sands, On the Economy of Machinery and Manufactures, Ponzi scheme, post-oil, principal–agent problem, profit motive, race to the bottom, railway mania, regulatory arbitrage, risk/return, Ronald Reagan, Savings and loan crisis, savings glut, scientific management, short selling, Silicon Valley, South Sea Bubble, statistical model, supply-chain management, The Chicago School, too big to fail, transaction costs, transfer pricing, Upton Sinclair, WikiLeaks

The US government’s later Financial Crisis Inquiry Commission would pin the blame on ‘its enormous sales of credit default swaps [which] were made without putting up the initial collateral, setting aside capital reserves, or hedging its exposure’.43 In other words, AIG-FP had drastically underestimated its potential losses. Details that would later emerge of its dealings with its largest credit default swap counterparty, Goldman Sachs, revealed the helpful role of its auditor, PwC, in the under-reporting. When the events of 2007 hit the value of Goldman’s CDO portfolio, the bank had reckoned that the credit default swaps it had entered into with AIG-FP as insurance against such losses were going to have to pay out.

…

Its AIG-FP financial products unit had badly misjudged the market by taking on huge exposures to the subprime market. Through the boom years it had been writing credit default swaps, insuring banks against losses on their holdings of subprime-laden collateralized debt obligations. When the CDOs began to falter and AIG’s own credit rating was marked down, it was forced to hand over increasing amounts of collateral, or upfront cash on account of any final payouts, to the banks on the other end of the credit default swaps. After another rating downgrade on the day of Lehman’s collapse, AIG’s collateral needs rose to the point where it could no longer raise the cash demanded of it.

…

A CDO could have up to fifteen tranches, each of which would be separately traded. But that wasn’t enough. The tranches could themselves be parcelled up into securities, so-called ‘CDOs squared’. Then, multiplying the size of the market, all these instruments could be betted against using ‘credit default swaps’ (CDSs). This was a financial derivative equating to an insurance policy that paid out if a particular security or tranche defaulted, but without any requirement to hold the underlying asset (a bit like having fire insurance on somebody else’s house). Finally, these CDSs too could be packaged up, re-sliced and sold on as ‘synthetic CDOs’.

How the City Really Works: The Definitive Guide to Money and Investing in London's Square Mile by Alexander Davidson

accounting loophole / creative accounting, algorithmic trading, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Bear Stearns, Big bang: deregulation of the City of London, buy and hold, capital asset pricing model, central bank independence, corporate governance, Credit Default Swap, currency risk, dematerialisation, discounted cash flows, diversified portfolio, double entry bookkeeping, Edward Lloyd's coffeehouse, Elliott wave, equity risk premium, Exxon Valdez, foreign exchange controls, forensic accounting, Glass-Steagall Act, global reserve currency, high net worth, index fund, inflation targeting, information security, intangible asset, interest rate derivative, interest rate swap, inverted yield curve, John Meriwether, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market fundamentalism, Nick Leeson, North Sea oil, Northern Rock, pension reform, Piper Alpha, price stability, proprietary trading, purchasing power parity, Real Time Gross Settlement, reserve currency, Right to Buy, risk free rate, shareholder value, short selling, The Wealth of Nations by Adam Smith, transaction costs, value at risk, yield curve, zero-coupon bond

If there is a default, the buyer will give his or her bonds to the seller of protection and will receive their full value. A credit default swap index is a standardised credit security and so may be more liquid than credit default swaps, which are traded over the counter. It can be cheaper to use an index for hedging bonds than it would be to use a variety of CDSs for the purpose. Unfortunately, like any free-ranging financial instrument, the CDS is not always a reliable hedge. In the two Bear Stearns hedge funds that came close to collapse in mid-2007, as discussed earlier, credit default swaps, mainly through an index, were used as a hedge, and should have provided some protection against a decline in the value of bonds held, but in March of that year, both the bonds and hedges deteriorated at the same time, according to a Bear Stearns note to investors.

…

The global market size of credit derivatives has grown from US $180 billion in 1996 to US $5 trillion in 2004 and an estimated US $20.2 trillion in 2006, and will reach an estimated US $33 trillion by 2008, according to the British Bankers’ Association’s (BBA) Credit Derivatives Report 2006. The London market share had dipped from 45 per cent to below 40 per cent over the period. But this level of market share shows that London remains attractive as a key centre for trading in credit derivatives, according to the BBA. Credit default swap The single-name credit default swap (CDS) was the first credit derivative. It is a bilateral over-the-counter contract in which the seller agrees to make a payment to the buyer in the event of a specified credit event on a reference entity, in exchange for a fixed payment or series of fixed payments. Credit events will be specified in the contract and may include restructuring, default or bankruptcy.

…

The notional global amount outstanding of interest rate swaps and options and cross-currency swaps grew by 18 per cent to US $250.8 trillion during the first six months of 2006, according to a 2006 mid-year market survey by the International Swaps and Derivatives Association. The notional amount of credit default swaps grew by 52 per cent to US $26.0 trillion. On-exchange versus OTC derivatives An exchange-traded contract has the advantage of being standardised, which makes it much cheaper and means that you can move a large deal quickly, with very little price impact. There is no counterparty risk when you are dealing with the exchange.

Adapt: Why Success Always Starts With Failure by Tim Harford

An Inconvenient Truth, Andrew Wiles, banking crisis, Basel III, behavioural economics, Berlin Wall, Bernie Madoff, Black Swan, Boeing 747, business logic, car-free, carbon footprint, carbon tax, Cass Sunstein, charter city, Clayton Christensen, clean water, cloud computing, cognitive dissonance, complexity theory, corporate governance, correlation does not imply causation, creative destruction, credit crunch, Credit Default Swap, crowdsourcing, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, Deep Water Horizon, Deng Xiaoping, disruptive innovation, double entry bookkeeping, Edmond Halley, en.wikipedia.org, Erik Brynjolfsson, experimental subject, Fall of the Berlin Wall, Fermat's Last Theorem, financial engineering, Firefox, food miles, Gerolamo Cardano, global supply chain, Great Leap Forward, Herman Kahn, Intergovernmental Panel on Climate Change (IPCC), Isaac Newton, Jane Jacobs, Jarndyce and Jarndyce, Jarndyce and Jarndyce, John Harrison: Longitude, knowledge worker, loose coupling, Martin Wolf, mass immigration, Menlo Park, Mikhail Gorbachev, mutually assured destruction, Netflix Prize, New Urbanism, Nick Leeson, PageRank, Piper Alpha, profit motive, Richard Florida, Richard Thaler, rolodex, Shenzhen was a fishing village, Silicon Valley, Silicon Valley startup, South China Sea, SpaceShipOne, special economic zone, spectrum auction, Steve Jobs, supply-chain management, tacit knowledge, the market place, The Wisdom of Crowds, too big to fail, trade route, Tyler Cowen, Tyler Cowen: Great Stagnation, Virgin Galactic, web application, X Prize, zero-sum game

The problem in all of these cases is that the safety system introduced what an engineer would call a new ‘failure mode’ – a new way for things to go wrong. And that was precisely the problem in the financial crisis: not that it had no safety systems, but that the safety systems it did have made the problems worse. Consider the credit default swap, or CDS – a three-letter acronym with a starring role in the crisis. Credit default swaps are a kind of insurance against a loan not being repaid. The first CDS was agreed between JP Morgan and a government-sponsored development bank, the European Bank for Reconstruction and Development, in 1994. JP Morgan paid fees to the EBRD, and in exchange the EBRD agreed to make good any losses in the almost unimaginable event that the oil giant Exxon defaulted on a possible $4.8 billion loan.

…

The bank would be legally obliged to sell its assets at the same time as other banks were doing the same. It was like a mountaineer, cautiously scaling a cliff while roped to a reckless team, and suddenly finding himself pulled into the abyss by his own safety harness. The insurance companies and their web of credit default swaps acted as the rope. Rather than reducing risk, credit default swaps instead contrived to magnify it and make it pop up in an unexpected place. The same thing was true of other financial safety systems – for instance the infamous collateralised debt obligations, or CDOs, which repackaged financial flows from risky ‘subprime’ mortgages.

…

In a narrow sense, it was a sensible deal: the EBRD had idle cash and was seeking some low-risk income, while JP Morgan had plenty of useful things it could do with its own funds, but banking regulations dictated that it must set aside nearly half a billion dollars just in case there was a problem with the Exxon loan. The CDS deal offloaded the risk to the EBRD, liberating JP Morgan’s cash. It did so with the explicit permission of the regulators, who felt that this was a safe way of managing risk. There were two ways in which these credit default swaps led to trouble. The first is simply that having insured some of their gambles, the banks felt confident in raising the stakes. Regulators approved; so did the credit-rating agencies responsible for evaluating these risks; so did most bank shareholders. John Lanchester, a chronicler of the crisis, quips, ‘It’s as if people used the invention of seatbelts as an opportunity to take up drunk-driving.’

Boomerang: Travels in the New Third World by Michael Lewis

Apollo 11, Bear Stearns, Berlin Wall, Bernie Madoff, Carmen Reinhart, Celtic Tiger, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, fiat currency, financial engineering, financial thriller, full employment, German hyperinflation, government statistician, Irish property bubble, junk bonds, Kenneth Rogoff, Neil Armstrong, offshore financial centre, pension reform, Ponzi scheme, proprietary trading, Ronald Reagan, Ronald Reagan: Tear down this wall, South Sea Bubble, subprime mortgage crisis, the new new thing, Tragedy of the Commons, tulip mania, women in the workforce

Back in 2004, the biggest Wall Street investment banks had created the instrument of their own destruction, the credit default swap on the subprime mortgage bond. The credit default swap enabled investors to bet against the price of any given bond—to “short” it. It was an insurance policy, but with a twist: the buyer didn’t need to own the insured asset. No insurance company can legally sell you fire protection on another person’s house, but the financial markets can and will sell you default insurance on another person’s investments. Hundreds of investors had dabbled in the credit default swap market—a lot of people had thought, at least in passing, that the debt-fueled U.S. housing boom was unsustainable—but only fifteen or so had gone all in, and placed enormous bets that vast tracts of American finance would go up in flames.

…

Should I wait until I see the whites of their eyes before I position myself, or should I position myself now? The answer is now. Because the moment people think it [national default] is a possibility, it’s expensive. If you wait, you have to pay up for the risk.” When we met, he had just bought his first credit default swaps on the countries he and his team of analysts viewed as the most likely to be unable to pay off their debts: Greece, Ireland, Italy, Switzerland, Portugal, and Spain. He made these bets directly with the few big Wall Street firms that he felt were least likely to be allowed to fail—Goldman Sachs, J.P.

…

I wrote the book about the U.S. subprime mortgage crisis and the people who had made a fortune from it, but began to travel to these other places, just to see what was up. But I traveled with a nagging question: how did a hedge fund manager in Dallas even think to imagine these strange events? Two and a half years later, in the summer of 2011, I returned to Dallas to ask Kyle Bass that question. Greek credit default swaps were up from 11 basis points to 2300; Greece was just about to default on its national debt. Ireland and Portugal had required massive bailouts; and Spain and Italy had gone from being viewed as essentially riskless to nations on the brink of financial collapse. On top of it all, the Japanese Ministry of Finance was about to send a delegation to the United States to tour the big bond investment funds such as Pimco and BlackRock—to see if they could find someone, anyone, willing to buy half a trillion dollars’ worth of ten-year Japanese government bonds.

Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown by Philip Mirowski

"there is no alternative" (TINA), Adam Curtis, Alan Greenspan, Alvin Roth, An Inconvenient Truth, Andrei Shleifer, asset-backed security, bank run, barriers to entry, Basel III, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, Bernie Sanders, Black Swan, blue-collar work, bond market vigilante , bread and circuses, Bretton Woods, Brownian motion, business cycle, capital controls, carbon credits, Carmen Reinhart, Cass Sunstein, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, constrained optimization, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, dark matter, David Brooks, David Graeber, debt deflation, deindustrialization, democratizing finance, disinformation, do-ocracy, Edward Glaeser, Eugene Fama: efficient market hypothesis, experimental economics, facts on the ground, Fall of the Berlin Wall, financial deregulation, financial engineering, financial innovation, Flash crash, full employment, George Akerlof, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Greenspan put, Hernando de Soto, housing crisis, Hyman Minsky, illegal immigration, income inequality, incomplete markets, information asymmetry, invisible hand, Jean Tirole, joint-stock company, junk bonds, Kenneth Arrow, Kenneth Rogoff, Kickstarter, knowledge economy, l'esprit de l'escalier, labor-force participation, liberal capitalism, liquidity trap, loose coupling, manufacturing employment, market clearing, market design, market fundamentalism, Martin Wolf, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Naomi Klein, Nash equilibrium, night-watchman state, Northern Rock, Occupy movement, offshore financial centre, oil shock, Pareto efficiency, Paul Samuelson, payday loans, Philip Mirowski, Phillips curve, Ponzi scheme, Post-Keynesian economics, precariat, prediction markets, price mechanism, profit motive, public intellectual, quantitative easing, race to the bottom, random walk, rent-seeking, Richard Thaler, road to serfdom, Robert Shiller, Robert Solow, Ronald Coase, Ronald Reagan, Savings and loan crisis, savings glut, school choice, sealed-bid auction, search costs, Silicon Valley, South Sea Bubble, Steven Levy, subprime mortgage crisis, tail risk, technoutopianism, The Chicago School, The Great Moderation, the map is not the territory, The Myth of the Rational Market, the scientific method, The Theory of the Leisure Class by Thorstein Veblen, The Wisdom of Crowds, theory of mind, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, Tobin tax, tontine, too big to fail, transaction costs, Tyler Cowen, vertical integration, Vilfredo Pareto, War on Poverty, Washington Consensus, We are the 99%, working poor

Matt Taibbi had some fun pointing out that even wives of the rich and famous were bestowed enormous opportunities to enrich themselves off TALF, a program nominally instituted to support the rancid securities the Fed had permitted to proliferate over the previous decade.56 But few have acknowledged that this was precisely the Depression remedy promoted by Milton Friedman: keep the rich from suffering writedowns or defaulting on their debts so the so-called money supply does not contract inordinately, and everything else will just work itself out fine. Yves Smith has made the important point that Bernanke tends to justify the sites and instances where the Fed has intervened largely by insisting that private contracts have to be respected; but this is yet another Big Lie from Foggy Bottom. If the contracts favored the banks, such as the credit default swaps written by AIG, then it was permissible to stretch the Fed legal charter by essentially nationalizing an insurance company, or purchasing mortgage-backed securities. (Saving AIG reveals the Bernanke excuse that “we had no legal authority” to save Lehman to be bootless.) However, whenever it was the banks themselves that violated sanctity of contract, from the total travesty of riding roughshod over the chain of title in mortgage securitization, to the defrauding of clients and investors, to reverse long-established principles of creditor hierarchy, then the Fed looked the other way.

…

When he filed his “Executive Branch Financial Disclosure Report” on January 20, 2009, listing a net worth of $17–$39 million, he prompted a flurry of newspaper and blog accounts of his outsized speaker fees and favors done for the financial sector from the late 1990s onward.93 Summers has enjoyed an extremely checkered career in many respects, dating from his controversial tenure as chief economist at the World Bank in 1990, but had nonetheless risen to political prominence due to the long-term patronage of Robert Rubin, formerly co-chair of Goldman Sachs, secretary of the Treasury, and later gray eminence at Citigroup and other Wall Street institutions. During the Clinton administration, Rubin and Summers played a now-infamous role in quashing Brooksley Born at the CFTC in 1998 when she proposed reining in the proliferating markets in credit default swaps. Indeed, many of the most significant neoliberal bank deregulations that led up to the crisis happened during the joint watch of Rubin, Summers, and Greenspan. When Rubin left the Treasury in 1999 for Citigroup, he persuaded Clinton to name Summers as his replacement. Rubin lobbied for Summers to be appointed president of Harvard, a term that ended rather inauspiciously in 2006 with accusations of economics faculty fraud from the federal government.94 Summers did not suffer from these contretemps, however; he was taken on board at Taconic Capital Advisors, a Goldman alumni hedge fund,95 and began earning $5 million a year working one day a week at the hedge fund D.

…

Among other ties to the key crisis institutions, he had been on the board of AIG for twenty-two years, only to conveniently resign from his duties on June 30, 2009. He had also been chair of its finance committee and risk management, and therefore was formally directly responsible for the disastrous AIG Financial Products division, whose credit default swaps and other unsustainable derivatives brought down the company. For his services there he accrued more than $6 million, and has apparently never suffered any ostracism for saddling the Treasury with a shell of a remnant of an insurance behemoth that is still hemorrhaging money. Indeed, none of this seemed an obstacle to President Obama appointing him to his Presidential Economic Recovery Advisory Board in 2009, and his Tax Policy task force thereafter.

Why Aren't They Shouting?: A Banker’s Tale of Change, Computers and Perpetual Crisis by Kevin Rodgers

Alan Greenspan, algorithmic trading, bank run, banking crisis, Basel III, Bear Stearns, Berlin Wall, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black-Scholes formula, buy and hold, buy low sell high, call centre, capital asset pricing model, collapse of Lehman Brothers, Credit Default Swap, currency peg, currency risk, diversification, Fall of the Berlin Wall, financial innovation, Financial Instability Hypothesis, fixed income, Flash crash, Francis Fukuyama: the end of history, Glass-Steagall Act, Hyman Minsky, implied volatility, index fund, interest rate derivative, interest rate swap, invisible hand, John Meriwether, latency arbitrage, law of one price, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, Minsky moment, money market fund, Myron Scholes, Northern Rock, Panopticon Jeremy Bentham, Ponzi scheme, prisoner's dilemma, proprietary trading, quantitative easing, race to the bottom, risk tolerance, risk-adjusted returns, Silicon Valley, systems thinking, technology bubble, The Myth of the Rational Market, The Wisdom of Crowds, Tobin tax, too big to fail, value at risk, vertical integration, Y2K, zero-coupon bond, zero-sum game

In days gone by a bank was defined by its great vaults, its glossy headquarters or its extensive branch network. Increasingly, a bank’s true crown jewels are held in the form of bits and bytes in unremarkable data centres on light industrial estates in anonymous suburbs. Similarly, the multi-headed menagerie of mortgages, mortgage-backed bonds, collateralised debt obligations and credit default swaps that teems and writhes through the story of the 2008 Great Financial Crisis was nothing more than a huge number of legal contracts represented abstractly in the innards of thousands of computers. To understand banking, therefore, you must understand how computers have changed and redefined the industry – how they have eaten it.

…

Thus did advances in computer power allow investors access to leverage in a new, alternative asset class in ways that would have been impossible only a few years previously. But for all this business’s growth, it was a sideshow compared to the credit markets, where similar, but much larger and more important developments were taking place. Alphabet Soup One such development was the headlong progress of the credit default swap or CDS market. JPMorgan had invented the CDS in the mid-1990s. We had traded a few of them on Russian debt in my time at Bankers Trust. But by 2003 they were everywhere. Deutsche Bank, a leader in the field, had seen an increase of 250 per cent in volumes from 2000 to 2002,8 a growth which had helped the Credit department to be the biggest by revenue in the investment bank.9 From around this time, at the annual Barcelona conference (where the Rolling Stones were the floor show in 2007), the power of the Credit department meant that presentations by its representatives were always the main event – the rest of us mere seething support acts.

…

An accountant once asked one of our weather derivatives traders if weather derivatives were cash settled. ‘Normally, yes,’ came the reply, ‘it’s tricky to take delivery of rainfall.’ CCP A Central Counterparty (e.g. the London Clearing House) that stands between all transactions between market participants for various financial products. CDS Credit default swap: a financial instrument whereby the seller, in return for a stream of cash flows, is obliged to recompense the buyer for any losses resulting from default (or other credit event) on a predetermined ‘reference security’ like a bond or a loan. CDO Collateralised debt obligation: a type of structured bond that pays out the cash flows arising from a pool of underlying assets, normally bonds.

Crashed: How a Decade of Financial Crises Changed the World by Adam Tooze

"there is no alternative" (TINA), "World Economic Forum" Davos, Affordable Care Act / Obamacare, Alan Greenspan, Apple's 1984 Super Bowl advert, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, Berlin Wall, Bernie Sanders, Big bang: deregulation of the City of London, bond market vigilante , book value, Boris Johnson, bread and circuses, break the buck, Bretton Woods, Brexit referendum, BRICs, British Empire, business cycle, business logic, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, Celtic Tiger, central bank independence, centre right, collateralized debt obligation, company town, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, currency risk, dark matter, deindustrialization, desegregation, Detroit bankruptcy, Dissolution of the Soviet Union, diversification, Doha Development Round, Donald Trump, Edward Glaeser, Edward Snowden, en.wikipedia.org, energy security, eurozone crisis, Fall of the Berlin Wall, family office, financial engineering, financial intermediation, fixed income, Flash crash, forward guidance, friendly fire, full employment, global reserve currency, global supply chain, global value chain, Goldman Sachs: Vampire Squid, Growth in a Time of Debt, high-speed rail, housing crisis, Hyman Minsky, illegal immigration, immigration reform, income inequality, interest rate derivative, interest rate swap, inverted yield curve, junk bonds, Kenneth Rogoff, large denomination, light touch regulation, Long Term Capital Management, low interest rates, margin call, Martin Wolf, McMansion, Mexican peso crisis / tequila crisis, military-industrial complex, mittelstand, money market fund, moral hazard, mortgage debt, mutually assured destruction, negative equity, new economy, Nixon triggered the end of the Bretton Woods system, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shale / tar sands, old-boy network, open economy, opioid epidemic / opioid crisis, paradox of thrift, Peter Thiel, Ponzi scheme, Post-Keynesian economics, post-truth, predatory finance, price stability, private sector deleveraging, proprietary trading, purchasing power parity, quantitative easing, race to the bottom, reserve currency, risk tolerance, Ronald Reagan, Savings and loan crisis, savings glut, secular stagnation, Silicon Valley, South China Sea, sovereign wealth fund, special drawing rights, Steve Bannon, structural adjustment programs, tail risk, The Great Moderation, Tim Cook: Apple, too big to fail, trade liberalization, upwardly mobile, Washington Consensus, We are the 99%, white flight, WikiLeaks, women in the workforce, Works Progress Administration, yield curve, éminence grise

For other clients, the investment bankers were hard at work figuring out how to hedge against fluctuations in currencies and interest rates. They developed swaps, for instance, that allowed clients to trade excessive exposures in currencies. They made instruments that allowed one client to take on the risk of fluctuating interest rates while another client opted for fixed rates. In the 1990s a team at J.P. Morgan devised the credit default swap (CDS), which offered protection against the risk of nonpayment and allowed lenders to fine-tune their lending risk.28 At the same time, the investment banks progressively increased their own trading activity. They discovered the profits to be made through volume and leverage. The returns were extraordinary.

…

What the private issuers discovered was that if scrutinizing conventional mortgages was profitable, subprime was even more so.40 The financial engineering was more elaborate and one could charge more money for the services. The techniques of the fixed-income investment bankers were now brought fully into play. A surprisingly large share even of nonconforming private label MBS could still attract an AAA rating once combined in structured products. To manage the risks, the production of credit default swaps (CDS), once the preserve of bespoke investment banks, was industrialized. Mainline insurers like AIG offered CDS insurance on exotic securitized products. Given the quality of the underlying mortgages, not all the tranches were good. But that stimulated the investment banks to expand the collateralized debt obligation (CDO) business.

…

After Lehman, the next link in the shadow banking chain to come under acute pressure was AIG, the insurer. In a dramatic burst of expansion from the 1990s onward, the Financial Products division of AIG had developed into a major player in the derivatives markets. In total in 2007 it had a book of $2.7 trillion in derivatives contracts.22 Of this total, credit default swaps accounted for $527 billion. Of these, $70 billion were on mortgage-backed securities, and of those, $55 billion had exposure to dangerous subprime. Given its inside knowledge of the property market, AIG had stopped writing new CDS already in 2005. But given the relatively small size of the portfolio and the AAA rating of the assets it had written CDS on, it had not thought it necessary to insulate itself against losses.

The Economics Anti-Textbook: A Critical Thinker's Guide to Microeconomics by Rod Hill, Anthony Myatt

American ideology, Andrei Shleifer, Asian financial crisis, bank run, barriers to entry, behavioural economics, Bernie Madoff, biodiversity loss, business cycle, cognitive dissonance, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, different worldview, electricity market, endogenous growth, equal pay for equal work, Eugene Fama: efficient market hypothesis, experimental economics, failed state, financial innovation, full employment, gender pay gap, Gini coefficient, Glass-Steagall Act, Gunnar Myrdal, happiness index / gross national happiness, Home mortgage interest deduction, Howard Zinn, income inequality, indoor plumbing, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, John Maynard Keynes: Economic Possibilities for our Grandchildren, Joseph Schumpeter, Kenneth Arrow, liberal capitalism, low interest rates, low skilled workers, market bubble, market clearing, market fundamentalism, Martin Wolf, medical malpractice, military-industrial complex, minimum wage unemployment, moral hazard, Paradox of Choice, Pareto efficiency, Paul Samuelson, Peter Singer: altruism, positional goods, prediction markets, price discrimination, price elasticity of demand, principal–agent problem, profit maximization, profit motive, publication bias, purchasing power parity, race to the bottom, Ralph Nader, random walk, rent control, rent-seeking, Richard Thaler, Ronald Reagan, search costs, shareholder value, sugar pill, The Myth of the Rational Market, the payments system, The Spirit Level, The Wealth of Nations by Adam Smith, Thorstein Veblen, ultimatum game, union organizing, working-age population, World Values Survey, Yogi Berra

This was met in part by credit rating agencies assigning grades to securitized bundles – a lucrative job which had its own perverse incentives to give overly generous ratings. But it was also met by the development of credit default swaps – ways of insuring against default by the ultimate borrowers upon whom the value of the securities depended. The value of these credit default swaps was estimated in 2008 to be around $62 trillion and involved complex interrelationships between financial institutions.8 It might be helpful to think of credit default swaps as like a fire insurance policy on a house. The householder pays a small sum – say $300 a year – to insure a home worth, say, $300,000.

…

Similarly, the financial institutions that insured the mortgage-backed securities against default thought that the risk of any one householder defaulting on his or her mortgage was independent of any other householder defaulting. So, by issuing lots of credit default swaps, they were ‘diversifying’. But this reasoning ignores the possibility of a systemic event – such as a real estate bubble bursting – creating huge swathes of mortgage defaults. The financial institutions that issued the credit default swaps faced a catas­ trophic liability. It was this which led to Lehman Brothers going bankrupt on 261 Postscript depended on keeping the stock market bubble going.’ The bubble Stiglitz is referring to is the stock market bubble of the late 1990s – the one that burst in August 2000.

…

As a result, on 16 September 2008 AIG was bailed out and given (what grew to be) a $182 billion loan, and was effectively ‘nationalized’ by the government, which received in return 79.9 per cent of its equity.9 Now, one could say that the growth of the credit default swap market was one way in which financial institutions evolved to avoid regulation. But the unsupervised growth in this market was due to the last – and perhaps most important – piece of deregulation (also introduced by Phil Gramm) – the Commodity Futures Modernization Act (CFMA) of 2000. This legislation guaranteed that the credit default swaps would not be regulated like other ‘futures contracts’.10 It also whacked the Securities and Exchange Commission’s budget when they asked for more funding to oversee all these new types of deals.11 This illustrates a crucial point: it is not sufficient to have regulations in place.

Naked Economics: Undressing the Dismal Science (Fully Revised and Updated) by Charles Wheelan

affirmative action, Alan Greenspan, Albert Einstein, Andrei Shleifer, barriers to entry, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, Boeing 747, Bretton Woods, business cycle, buy and hold, capital controls, carbon tax, Cass Sunstein, central bank independence, classic study, clean water, collapse of Lehman Brothers, congestion charging, creative destruction, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, currency risk, Daniel Kahneman / Amos Tversky, David Brooks, demographic transition, diversified portfolio, Doha Development Round, Exxon Valdez, financial innovation, fixed income, floating exchange rates, George Akerlof, Gini coefficient, Gordon Gekko, Great Leap Forward, greed is good, happiness index / gross national happiness, Hernando de Soto, income inequality, index fund, interest rate swap, invisible hand, job automation, John Markoff, Joseph Schumpeter, junk bonds, Kenneth Rogoff, libertarian paternalism, low interest rates, low skilled workers, Malacca Straits, managed futures, market bubble, microcredit, money market fund, money: store of value / unit of account / medium of exchange, Network effects, new economy, open economy, presumed consent, price discrimination, price stability, principal–agent problem, profit maximization, profit motive, purchasing power parity, race to the bottom, RAND corporation, random walk, rent control, Richard Thaler, rising living standards, Robert Gordon, Robert Shiller, Robert Solow, Ronald Coase, Ronald Reagan, Sam Peltzman, school vouchers, seminal paper, Silicon Valley, Silicon Valley startup, South China Sea, Steve Jobs, tech worker, The Market for Lemons, the rule of 72, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, transaction costs, transcontinental railway, trickle-down economics, urban sprawl, Washington Consensus, Yogi Berra, young professional, zero-sum game

One attraction of catastrophe bonds for investors is that their payout is determined by the frequency of natural disasters, which is not correlated with the performance of stocks, bonds, real estate, or other traditional investments. Even the much-maligned credit default swaps have a legitimate investment purpose. A credit default swap is really just an insurance policy on whether or not some third party will pay back its debts. Suppose your husband pressures you to loan $25,000 to your ne’er-do-well brother-in-law so that he can finally complete his court-man-dated anger management program and turn his life around. You have grave concerns about whether you will ever see any of this money again. What you need is a credit default swap. You can pay some other party (presumably with a more favorable view of your brother-in-law’s creditworthiness) to enter into a contract with you that promises to pay you $25,000 in the event that your brother-in-law does not pay back the cash.

…

Financial products are to speculation what sporting events are to gambling. They facilitate it, even if that is not their primary purpose. This is what went wrong with credit default swaps. The curious thing about these contracts is that anyone can get into the action, regardless of whether or not they are a party to the debt that is being guaranteed. Let’s stick with the example of your loser brother-in-law. It makes sense for you to use a credit default swap to protect yourself against loss. However, that same market also allows the rest of us to bet on whether or not your brother-in-law will pay back the loan.

…

The demise of the investment bank Lehman Brothers, which declared bankruptcy on September 15, 2008, ushered in “the financial crisis,” which deserves its frequent description as the worst economic downturn since the Great Depression. How did it happen? How did so many consumers, who are supposed to have a rational understanding of their own well-being, end up crushed by a housing “bubble”? Who were the knuckleheads who loaned them all that money? Why did Wall Street create things like “CDOs” and credit-default swaps, and why did they prove so devastating to the financial system? Chapter 2 makes the case that most of the reckless behavior that led to the financial crisis was predictable, given the incentives built into the system. Why did mortgage brokers originate so many reckless loans? Because it wasn’t their money!

The Investopedia Guide to Wall Speak: The Terms You Need to Know to Talk Like Cramer, Think Like Soros, and Buy Like Buffett by Jack (edited By) Guinan

Albert Einstein, asset allocation, asset-backed security, book value, Brownian motion, business cycle, business process, buy and hold, capital asset pricing model, clean water, collateralized debt obligation, computerized markets, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, equity risk premium, fear index, financial engineering, fixed income, Glass-Steagall Act, implied volatility, index fund, intangible asset, interest rate swap, inventory management, inverted yield curve, junk bonds, London Interbank Offered Rate, low interest rates, margin call, money market fund, mortgage debt, Myron Scholes, passive investing, performance metric, risk free rate, risk tolerance, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, short squeeze, statistical model, time value of money, transaction costs, yield curve, zero-coupon bond

The result is a slowdown in growth that leads to a prolonged recession (or slower recovery), which is compounded as banks hold tight to the banking reserves. Related Terms: • Bankruptcy • Debt • Subprime Meltdown • Bear Market • Recession Credit Default Swap (CDS) What Does Credit Default Swap (CDS) Mean? A swap designed to transfer the credit exposure of fixed-income products between parties. Investopedia explains Credit Default Swap (CDS) The buyer of a credit swap receives credit protection, whereas the seller of the swap guarantees the creditworthiness of the product. When this is done, the risk of default is transferred from the holder of the fixed-income security to the seller of the swap.

…

Credit derivatives are financial assets like forward contracts, swaps, and options for which the price is driven by the credit risk of economic agents (private investors or governments). Investopedia explains Credit Derivative As an example, a bank concerned that one of its customers may not be able to repay a loan can protect itself against loss from default by transferring the credit risk to another party while keeping the loan on its books. Related Terms: • Credit Default Swap • Derivative • Yield • Credit Rating • Securitization Credit Rating What Does Credit Rating Mean? An assessment of the creditworthiness of individuals and corporations. It is based on the history of borrowing and repayment as well as the availability of assets and the extent of liabilities.

…

Investopedia explains Swap If companies in different countries have regional advantages on interest rates, a swap will benefit both firms. For example, one firm may have a lower fixed interest rate while another has access to a lower floating interest rate. To take advantage of this situation, the companies would do an interest rate swap. Related Terms: • Arbitrage • Credit Default Swap • Interest Rate Swap • Commodity • Currency Swap Swing Trading What Does Swing Trading Mean? A style of trading that is used to capture quick gains in a stock over a one- to four-day trading period. It is done to capitalize on the shortterm swings in the market. Investopedia explains Swing Trading Traders must make quick trading decisions to exploit these shortterm price swings in the stock market.

Financial Fiasco: How America's Infatuation With Homeownership and Easy Money Created the Economic Crisis by Johan Norberg

accounting loophole / creative accounting, Alan Greenspan, bank run, banking crisis, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, business cycle, capital controls, central bank independence, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Brooks, diversification, financial deregulation, financial innovation, Greenspan put, helicopter parent, Home mortgage interest deduction, housing crisis, Howard Zinn, Hyman Minsky, Isaac Newton, Joseph Schumpeter, Long Term Capital Management, low interest rates, market bubble, Martin Wolf, Mexican peso crisis / tequila crisis, millennium bug, money market fund, moral hazard, mortgage tax deduction, Naomi Klein, National Debt Clock, new economy, Northern Rock, Own Your Own Home, precautionary principle, price stability, Ronald Reagan, savings glut, short selling, Silicon Valley, South Sea Bubble, The Wealth of Nations by Adam Smith, too big to fail

But investment banks were not the only ones to collapse during this fateful week. A huge stash of new financial weapons of mass destruction had just been discovered, and something was now going very wrong with them, potentially causing a series of explosions throughout the financial system. They were "credit-default swaps" (CDSs), a kind of insurance policy that you can take out against the risk of a company or a security collapsing. The history of the CDS begins at the Boca Raton, a pink luxury hotel in Florida where about 80 people from J. P. Morgan & Co. took part in a conference in 1994. Legend has it that the young, successful bankers partied so wildly that they ended up throwing each other into the pool fully dressed.

…

What if only a tiny proportion of default swaps were to default, and the related losses were to cause a bank to collapse, which would trigger more CDSs, creating new losses and triggering new CDSs, and so on in a long series of explosions that might end up knocking out the entire financial system? That is why dark glances were now being cast at AIG, the American International Group. It was not only the world's largest insurer, with 116,000 employees and operations in 116 countries, but also a leading seller of credit-default swaps. On the same day that Lehman went down-Monday, September 15-the rating agencies downgraded AIG. Since it had been able to apply tiny margins to its insurance agreements only on the strength of its earlier grade, AIG was now forced to raise new collateral to the tune of many billions of dollars in short order, and its stock fell by 60 percent as soon as the stock market opened.

…

Blankfein was particularly worried, because if AIG collapsed, his bank would lose around $20 billion worth of insurance policies, according to reports in the New York Times. But it never came to that. Instead, there was yet another large-scale government intervention. On that Tuesday, the Fed made $85 billion available to AIG in exchange for the departure of its CEO and an opportunity to buy a majority share of the company stock.37 Credit-default swaps have been characterized as engines of doom, but if you take a closer look at them, you find that, if correctly used, they may in fact be a good insurance solution. Blaming them for, say, the poor quality of the mortgages they insured is a bit like being against fire insurance because houses lack smoke detectors.

The Secret Club That Runs the World: Inside the Fraternity of Commodity Traders by Kate Kelly

"Hurricane Katrina" Superdome, Alan Greenspan, Bakken shale, bank run, Bear Stearns, business cycle, commodity super cycle, Credit Default Swap, diversification, fixed income, Gordon Gekko, index fund, light touch regulation, locking in a profit, London Interbank Offered Rate, Long Term Capital Management, margin call, oil-for-food scandal, paper trading, peak oil, Ponzi scheme, proprietary trading, risk tolerance, Ronald Reagan, side project, Silicon Valley, Sloane Ranger, sovereign wealth fund, supply-chain management, the market place

It was the fall of 2008, the period during which Andurand made so much money as the oil market sunk toward its low point, and financial firms were all under scrutiny as the U.S. banks flailed. Nobody in the financial markets wanted to take any risk. But Glencore, an infamous trading firm known equally for its opacity and its high tolerance for risk, was now especially vulnerable. By October, the price of a standard credit default swap, or CDS, on its debt—an insurance-like policy that would pay the holder if Glencore couldn’t pay its creditors—had zoomed past its already heightened levels, fueling the increasingly widespread belief that it was about to go under. Like any trading company, Glencore borrowed heavily to finance its operations, and depended on a steady flow of credit to keep the lights on.

…

As he left the meeting, Beard called his office in London. Above and beyond the commodity contract trading they were doing to hedge their exposure to price swings in physical energy trades, he wanted his team to put on a massive speculative bet that the price of oil would fall further. Glencore credit default swaps at that time had been trading at the relatively calm level of about €150,000. By contrast, the swap prices attached to the major U.S. investment banks—the cost of purchasing an insurance policy that would pay its keeper if the banks defaulted and couldn’t pay their debts—were growing vastly more expensive.

…

He never revisited the United States. His reputation remained stained even upon his death from a stroke, in 2013, as did those of Clinton and the lobbyists who had helped secure his pardon. The commodity rout of 2008 was probably Glencore’s toughest period since Rich’s ill-fated zinc gamble in 1992. The company’s credit default swap, or insurance-against-default, prices had retreated from their stratospheric levels, and Glencore was bringing in nearly $5 billion in net income, an amount just shy of 2007’s. But its publicly traded bonds were still only barely above investment grade. The landscape had also changed. Commodity prices were still at their lows, credit to help finance transactions was much harder to secure as banks grew more parsimonious about sharing their resources, and the troubles with BP and other companies had left the company more vulnerable to rivals.

The Fix: How Bankers Lied, Cheated and Colluded to Rig the World's Most Important Number (Bloomberg) by Liam Vaughan, Gavin Finch

Alan Greenspan, asset allocation, asset-backed security, bank run, banking crisis, Bear Stearns, Bernie Sanders, Big bang: deregulation of the City of London, buy low sell high, call centre, central bank independence, collapse of Lehman Brothers, corporate governance, credit crunch, Credit Default Swap, eurozone crisis, fear of failure, financial deregulation, financial innovation, fixed income, interest rate derivative, interest rate swap, Kickstarter, light touch regulation, London Interbank Offered Rate, London Whale, low interest rates, mortgage debt, Neil Armstrong, Northern Rock, performance metric, Ponzi scheme, Ronald Reagan, social intelligence, sovereign wealth fund, subprime mortgage crisis, urban sprawl

Libor was also the benchmark for billions of dollars of interest-rate futures contracts traded on the Chicago Mercantile Exchange (CME), placing it squarely within the CFTC’s purview. While Termine and Lowe quietly gathered intelligence, the Journal was working on a follow-up that would help focus their minds. On May 29, 2008, the paper published a piece that compared movements in Libor since the start of the financial crisis with another barometer of stress: banks’ credit default swaps prices.5 CDS contracts are a type of financial derivative that allow investors to bet on the likelihood that an institution will default on its publicly traded debt. They are used by credit investors as a form of insurance but are also bought and sold by hedge funds and other financial speculators to take bets on a company’s fortunes.

…

Huertas had spent most of his career at Citigroup, one of the firms identified by the Journal as making dubious Libor submissions. On May 29, 2008, the afternoon the second Journal story appeared, Huertas had ordered his team to undertake an analysis of the newspaper’s methodology,which compared banks’Libor submissions with their credit default swap prices to suggest lowballing was rife. They came back with a list of minor errors with the paper’s analysis, including that the reporters had compared three-month Libors with six-month CDS prices,and confused Citibank, a subsidiary, with Citigroup, the holding company. No matter that the broad thrust of the reporters’ work turned out to be on the money.

…

This proper discussion has overflowed into commentary No One’s Clean-Clean 59 in the media, and the BBA believes that it needs to correct a number of misunderstandings and misperceptions. Commentators in the press, the BBA suggested, were blind to the intricacies of financial markets and had jumped to conclusions. Comparing Libor with other barometers of market strength, as the Journal had done with credit default swaps, was misguided because of the many differences among them. And lenders who complained they were unable to borrow cash at the rates banks posted to Libor were being unrealistic: As smaller, riskier institutions, their interest payments were inevitably going to be higher than the panel banks.

Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase by Duff McDonald

"World Economic Forum" Davos, Alan Greenspan, AOL-Time Warner, bank run, Bear Stearns, Blythe Masters, Bonfire of the Vanities, book value, business logic, centralized clearinghouse, collateralized debt obligation, conceptual framework, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Exxon Valdez, financial innovation, fixed income, G4S, Glass-Steagall Act, Greenspan put, housing crisis, interest rate swap, Jeff Bezos, John Meriwether, junk bonds, Kickstarter, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, Michael Milken, money market fund, moral hazard, negative equity, Nelson Mandela, Northern Rock, profit motive, proprietary trading, Renaissance Technologies, risk/return, Rod Stewart played at Stephen Schwarzman birthday party, Saturday Night Live, sovereign wealth fund, statistical model, Steve Ballmer, Steve Jobs, technology bubble, The Chicago School, too big to fail, Vanguard fund, zero-coupon bond, zero-sum game

There were a lot of people who took the bet; they just didn’t match AIG’s level of recklessness. There have been some suggestions that the interplay between a company’s bonds and its credit default swaps actually exacerbated problems—George Soros wrote convincingly about this phenomenon in the New York Times—but that phenomenon was arguably on the margin of a much larger problem: abandonment of risk management controls in pursuit of higher profits. When it came time for the first big test of credit default swaps—in the aftermath of Lehman Brothers’ bankruptcy—the settlement of those contracts took place without incident on October 21, 2008. Dimon has endorsed the creation of a central clearinghouse so derivatives exposures can be more closely monitored.

…

Winters also reduced the credit lines the bank was extending to other banks’ SIVs from $12 billion to $500 million. With regard to structured products, Winters was no neophyte. He had been part of the J.P. Morgan team that had revolutionized credit derivatives in the late 1990s. The first innovation came to be known as a “credit default swap” (CDS). In looking for a way to reduce exposure to their client Exxon—which had recently tapped a multibillion-dollar credit line with the bank in anticipation of having to pay substantial fines for the Exxon Valdez’s oil spill—Winters’s colleague Blythe Masters had found another investor willing to insure the debt for the bank in exchange for an annual fee.

…

The system had gone completely nuts.” By late 2006, Winters had concluded that it was no longer worth the risk to underwrite or hold any such product on the company’s books. At the time, CDOs were yielding just 2 percentage points more than Treasuries. To hedge the CDO risk, JPMorgan Chase needed to buy credit default swaps, but the cost of those was rising. (In this, at least, the market was getting it right. Investors in CDOs might be taking too little yield, but sellers of insurance on those CDOs were starting to demand more money, even though it ultimately proved to be nowhere near enough.) Winters had no problem convincing Dimon of his concerns, and the bank began to pull back from all asset-backed CDO underwriting, while also selling the majority of subprime mortgages originated by the bank during the year.

Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America by Danielle Dimartino Booth

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, barriers to entry, Basel III, Bear Stearns, Bernie Sanders, Black Monday: stock market crash in 1987, break the buck, Bretton Woods, business cycle, central bank independence, collateralized debt obligation, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, financial deregulation, financial engineering, financial innovation, fixed income, Flash crash, forward guidance, full employment, George Akerlof, Glass-Steagall Act, greed is good, Greenspan put, high net worth, housing crisis, income inequality, index fund, inflation targeting, interest rate swap, invisible hand, John Meriwether, Joseph Schumpeter, junk bonds, liquidity trap, London Whale, Long Term Capital Management, low interest rates, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, moral hazard, Myron Scholes, natural language processing, Navinder Sarao, negative equity, new economy, Northern Rock, obamacare, Phillips curve, price stability, proprietary trading, pushing on a string, quantitative easing, regulatory arbitrage, Robert Shiller, Ronald Reagan, selection bias, short selling, side project, Silicon Valley, stock buybacks, tail risk, The Great Moderation, The Wealth of Nations by Adam Smith, too big to fail, trickle-down economics, yield curve

Born, a highly respected lawyer with twenty years of experience in practicing derivatives law, had been appointed in 1996 by President Bill Clinton to head a small agency called the Commodity Futures Trading Commission (CFTC). Born was alarmed at the incredible growth and opaque nature of the over-the-counter derivatives market, which included CDOs, mortgage-backed securities (MBS), credit default swaps (CDS), and many other sliced-and-diced products. In May 1998, Born’s agency published in the Federal Register a “concept release,” a paper on proposed rule changes asking dealers and participants in the derivatives market to voluntarily submit information. The reaction was swift and furious.

…

Since financial managers’ pay is set relative to their peers, everyone follows the same path. A herd instinct takes over. But if something went wrong, the results could be ruinous. The more crowded the trade, the greater the chance an unexpected turn in prices would cascade from institution to institution and potentially throughout the entire system. Rajan pointed to credit default swaps—a type of insurance—as examples of financial innovations that posed enormous danger. Some of the financial institutions making bets using CDSs also held some of the same underlying securities on their books. If these failed, the risk would be magnified, putting the banking system itself in peril.

…

Instead of I Love Lucy reruns, I watched the BBC as thousands of Brits queued to withdraw one billion pounds from Northern Rock, the biggest UK bank run in over a century. Markets sniff out the weakest links in the system. The cost of protecting the debt of big U.S. investment banks became the train wreck I couldn’t stop watching. I began following bank credit default swaps. These insurance securities could be used to bet for or against the survival of any financial entity—for example, the sovereign debt of Iceland or the corporate bonds of General Motors. Propped up on a mountain of pillows, I tracked bank CDSs in a spreadsheet. My Economic Letter on subprime mortgages, published on November 1, was the first article the reading public would see with my name on it since I had vanished into the invisibility of the Fed.

Palace Coup: The Billionaire Brawl Over the Bankrupt Caesars Gaming Empire by Sujeet Indap, Max Frumes

Airbnb, Bear Stearns, Blythe Masters, book value, business cycle, Carl Icahn, coronavirus, corporate governance, corporate raider, Credit Default Swap, data science, deal flow, Donald Trump, family office, fear of failure, financial engineering, fixed income, Jeffrey Epstein, junk bonds, lockdown, low interest rates, Michael Milken, mortgage debt, NetJets, power law, ride hailing / ride sharing, Right to Buy, Robert Solow, Savings and loan crisis, shareholder value, super pumped, Travis Kalanick

Derivatives are securities whose value is tied to or derived from other underlying securities. Put options and call options on stocks, for example, allowed investors to wager on whether stock prices would rise or fall without actually owning the stock. Miller was going to use derivatives to juice his Caesars returns. His derivative choice was the credit default swap, or CDS. Buyers and sellers of CDS were betting whether companies could repay their debts in full. In this case, purchasing CDS would pay off if Caesars defaulted or went bankrupt. Banks created CDS to keep debt on their books while offloading risk. A young JPMorgan executive, Blythe Masters, had created CDS to help the firm hedge default risk related to a $5 billion loan to Exxon.

…

Ryan Mollett was confident a Chapter 11 filing was still far off, so GSO risked a portion of their fee by selling the CDS protection, taking the opposite side of Miller’s bet. BlackRock, the other key party in the B-7 loan, did the same thing. Miller started to slowly buy, and as 2014 progressed, market chatter grew that Elliott—and only Elliott—was buying what was called “front-end” or “short-dated” credit default swaps, accumulating as much as a half billion worth of CDS protection. Only Elliott seemed to be confident Caesars would default in less than a year. Apollo was aware of the adjacent skirmish between Miller and Mollett. It was not thrilled about the sideshow wreaking havoc with its company, but Sambur needed Miller—and Miller believed that his CDS bet was perfectly aligned with his underlying debt positions.

…

First, Caesars had agreed to file for bankruptcy in mid-January. On December 15, the company announced it was skipping a $225 million interest payment to junior bondholders, which foreshadowed the bankruptcy filing, but the press release now confirmed it. The bankruptcy filing would ensure that Elliott’s credit default swap bet would pay off. The second notable feature described a $300 million convertible preferred stock instrument in PropCo that was going to be made available to certain senior bondholders like Elliott for purchase, ostensibly to use the cash from selling the preferred to reduce the leverage on the reorganized OpCo.

Damsel in Distressed: My Life in the Golden Age of Hedge Funds by Dominique Mielle

"RICO laws" OR "Racketeer Influenced and Corrupt Organizations", activist fund / activist shareholder / activist investor, airline deregulation, Alan Greenspan, banking crisis, Bear Stearns, Black Monday: stock market crash in 1987, blood diamond, Boris Johnson, British Empire, call centre, capital asset pricing model, Carl Icahn, centre right, collateralized debt obligation, Cornelius Vanderbilt, coronavirus, COVID-19, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Elon Musk, Eugene Fama: efficient market hypothesis, family office, fear of failure, financial innovation, fixed income, full employment, glass ceiling, high net worth, hockey-stick growth, index fund, intangible asset, interest rate swap, John Meriwether, junk bonds, Larry Ellison, lateral thinking, Long Term Capital Management, low interest rates, managed futures, mega-rich, merger arbitrage, Michael Milken, Myron Scholes, Northpointe / Correctional Offender Management Profiling for Alternative Sanctions, offshore financial centre, Paul Samuelson, profit maximization, Reminiscences of a Stock Operator, risk free rate, risk tolerance, risk-adjusted returns, satellite internet, Savings and loan crisis, Sharpe ratio, Sheryl Sandberg, SoftBank, survivorship bias, Tesla Model S, too big to fail, tulip mania, union organizing

Yet Greenspan opined: Credit default swaps have been an extraordinarily valuable tool in the sense a substantial proportion of loans that are made, are made by leveraged institutions. And in previous decades, they left those loans on their balance sheets. And when there was stress, they had a banking crisis. Or you had savings and loan crisis, or something of that nature. With the credit default swap, you have the originators of loans capable of selling off the credit risk to those with far less leverage, who are willing to accept the risk at a price. And since we’ve had credit default swaps, there has not been a major financial institution undermined.

…

The original elevator pitch was that hedge funds used their small size relative to the plethora of opportunities to swoop in and capitalize on market inefficiencies, quickly getting in and out of positions. As funds became larger, the pitch morphed into the opposite story. We had access to differentiated sources of inefficiencies because of our size. Direct lending and rescue financing, complex financial securities like mortgage securitizations and credit default swaps, large scale bankruptcy situations like Enron and WorldCom, and later Lehman Brothers and Puerto Rico, required large teams of investment analysts, extensive back office and compliance departments, external financial and restructuring advisors, not to mention corporate, bankruptcy, and litigation lawyers.

…

Housing prices weren’t the only ones reaching speculative extremes; around the globe risk premia (the extra profit you earn to hold risky investments) in general had compressed to radical lows, which pushed hungry investors to go after ever more illiquid, opaque, complex investments. Innovative but complex financial investments such as mortgage securitizations, credit default swaps (a financial contract akin to an insurance policy that pays out in the case of a corporate bond default), and carry trades (where one borrows money at a low interest rate to buy an asset that should provide a higher return) ballooned. Everyone, and I do mean everyone, was encouraged to use debt recklessly.

The Global Minotaur by Yanis Varoufakis, Paul Mason

active measures, Alan Greenspan, AOL-Time Warner, banking crisis, Bear Stearns, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, business climate, business cycle, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, correlation coefficient, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, declining real wages, deindustrialization, Easter island, endogenous growth, eurozone crisis, financial engineering, financial innovation, first-past-the-post, full employment, Glass-Steagall Act, Great Leap Forward, guns versus butter model, Hyman Minsky, industrial robot, Joseph Schumpeter, Kenneth Rogoff, Kickstarter, labour market flexibility, light touch regulation, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market fundamentalism, Mexican peso crisis / tequila crisis, military-industrial complex, Money creation, money market fund, mortgage debt, Myron Scholes, negative equity, new economy, Nixon triggered the end of the Bretton Woods system, Northern Rock, paper trading, Paul Samuelson, planetary scale, post-oil, price stability, quantitative easing, reserve currency, rising living standards, Ronald Reagan, special economic zone, Steve Jobs, structural adjustment programs, Suez crisis 1956, systematic trading, too big to fail, trickle-down economics, urban renewal, War on Poverty, WikiLeaks, Yom Kippur War

To address the Credit Crunch – i.e. the complete halt in inter-bank lending. 2008 – The main event January – The World Bank predicts a global recession, stock markets crash, the Fed drops interest rates to 3.5 per cent, and stock markets rebound in response. Before long, however, MBIA, an insurance company, announces that it has lost $2.3 billion from policies based on bonds containing sub-prime mortgages. These insurance policies suddenly become household names: they are known as credit default swaps, or CDSs. Box 6.1 Credit default swaps (CDS) If Mr Spock, of Star Trek fame, spotted a CDS and had to describe it to Captain Kirk, he would have said, in his usual expressionless way: ‘They are insurance policies, Captain, but not as we know them.’ CDSs pay out pre-specified amounts of money if someone else defaults.

…

., 149, 156, 157 Byrnes, James, 68 capital, and the human will, 18–19 capitalism: dynamic system, 139–40; free market, 68; generation of crises, 34; global, 58, 72, 114, 115, 133; Greenspan and, 11–12; Marxism, 17–18; static system, 139; supposed cure for poverty, 41–2; surplus recycling mechanisms, 64–5 capitalists, origin of, 31 car production, 70, 103, 116, 157–8 carry trade, 189–90 Carter, Jimmy, 99, 100 CDOs (collateralized debt obligations), 141–2, 147–8, 149, 150, 153; for crops, 163; eurozone, 205; explanation, 6–9; France, 203; function, 130–2; Greece, 206 see also EFSF; Geithner–Summers Plan CDSs (credit default swaps), 149, 150, 153, 154, 176, 177 CEOs (chief executive officers), 46, 48, 49 Chamber of Commerce, British, 152 cheapness, ideology of, 124 Chiang Kai-shek, 76 Chicago Commodities Exchange, 120 Chicago Futures Exchange, 163 China: aggregate demand, 245; Crash of 2008, 156, 162; currency, 194, 213, 214, 217, 218, 252; economic development, 106–7; effects of the Crash of 2008, 3; financial support for the US, 216; global capital, 116; Global Plan, 76; growth, 92; rise and impact, 212–18, 219–20 Chrysler, 117, 159 CIA (Central Intelligence Agency), 69 Citigroup, 149, 156, 158 City of London: Anglo-Celtic model, 12; Crash of 2008, 148, 152; debt in relation to GDP, 4–5; financialization, 118–19; under Thatcher, 138; wealth of merchants, 28 civilization, 27, 29–30, 128 Clinton, Hillary, 212, 215–16 Cold War, 71, 80, 81, 86 collateralized debt obligations see CDOs commodification: resistance to, 53–4; rise of, 30, 33, 54; of seeds, 175 commodities: global, 27–8; human nature not, 53; labour as, 45, 49, 54; money as, 45, 49; prices, 96, 98, 102, 125; trading, 31, 175 common market, European, 195 communism, collapse of, 22, 107–8 complexity, and economic models, 139–40 Condorcet, Nicholas de Caritat, marquis de, 29, 32 Congress (US): bail-outs, 77, 153–4, 155; import tariff bill, 45 Connally, John, 94–5 council houses, selling off, 137, 138 Crash of 1907, 40 Crash of 1929, 38–43, 44, 181 Crash of 2008, 146–68; aftermath, 158–60; chronicle, 2007, 147–9; chronicle, 2008, 149, 151–8; credit default swaps, 150; effects, 2–3; epilogue, 164–8; explanations, 4–19; in Italy, 237; review, 160–4; in Spain, 237; warnings, 144–5 credit crunch, 149, 151 credit default swaps (CDSs), 149, 150, 153, 154, 176, 177 credit facilities, 127–8 credit rating agencies, 6–7, 8, 9, 20, 130 crises: as laboratories of the future, 28; nature of, 141; pre-1929, 40; pre-2008, 2; proneness to, 30; redemptive, 33–5, 35 currency unions, 60–1, 61–2, 65, 251 Cyprus, Britain’s role in, 69, 79 Daimler-Benz, 117 DaimlerChrysler, 117 Darling, Alistair, 159 Darwinian process, 167 Das Kapital (Marx), 49 de Gaulle, Charles, 76, 93 Debenhams, takeover of, 119 debt: and GDP, 4–5; unsecured, 128; US government, 92; US households, 161–2 see also CDOs; leverage debt–deflation cycle, 63 deficits: in the EU, 196; US budget, 22–3, 25, 112, 136, 182–3, 215–16; US trade, 22–3, 25, 111, 182–3, 196, 227 Deng Xiao Ping, 92, 212 Depressions: US 1873–8, 40; US Great Depression, 55, 58, 59, 80 deregulations, 138, 143, 170 derivatives, 120, 131–2, 174, 178 Deutschmark, 74, 96, 195, 197 Dexia, 154 distribution, and production, 30, 31, 54, 64 dollar: devaluing, 188; flooding markets, 92–3; pegging, 190; reliance on, 57, 60, 102; value of, 96, 204; zone, 62, 78, 89, 164 dotcom bubble, 2, 5 Draghi, Mario, 239 East Asia, 79, 143, 144, 194 see also Asia; specific countries East Germany, 201, 202 see also Germany Eastern Europe, 108, 198, 203 ECB (European Central Bank): aftermath of Crash of 2008, 158; bank bail-outs, 203, 204; Crash of 2008, 148, 149, 155, 156, 157; European banking crisis, 208, 209–10; Greek crisis, 207; LTRO, 238; Maastricht Treaty, 199–200; toxic theory, 15 economic models, 139–42 Economic Recovery Advisory Board (ERAB), 180, 181 Economic Report of the President (1999), 116 ECSC (European Coal and Steel Community), 74, 75–6 Edison, Thomas, 38–9 Efficient Market Hypothesis (EMH), 15 EFSF (European Financial Stability Facility), 174, 175–7, 207, 208–9 EIB (European Investment Bank), 210 Eisenhower, Dwight D., 82 Elizabeth II, Queen, 4, 5 ERAB (Economic Recovery Advisory Board), 180, 181 ERM (European Exchange Rate Mechanism), 197 EU (European Union): economies within, 196; EFSF, 174; European Financial Stability Mechanism, 174; financial support for the US, 216; origins, 73, 74, 75; SPV, 174 euro see eurozone eurobonds, toxic, 175–7 Europa myth, 201 Europe: aftermath of Crash of 2008, 162; bank bail-outs, 203–5; Crash of 2008, 2–3, 12–13, 183; end of Bretton Woods system, 95; eurozone problems, 165; Geithner–Summers Plan, 174–7; oil price rises, 98; unemployment, 164 see also specific countries European Central Bank see ECB European Coal and Steel Community (ECSC), 74, 75–6 European Commission, 157, 203, 204 European Common Market, 195 European Exchange Rate Mechanism (ERM), 197 European Financial Stability Facility (EFSF), 174, 207, 208–9 European Financial Stability Mechanism, 174, 175–7 European Investment Bank (EIB), 210 European Recovery Progam see Marshall Plan European Union see EU eurozone, 61, 62, 156, 164; crisis, 165, 174, 204, 208–9, 209–11; European banks’ exposure to, 203; formation of, 198, 202; France and, 198; Germany and, 198–201; and Greek crisis, 207 exchange rate system, Bretton Woods, 60, 63, 67 falsifiability, empirical test of, 221 Fannie Mae, 152, 166 Fed, the (Federal Reserve): aftermath of Crash of 2008, 159; Crash of 2008, 148, 149, 151, 153, 155, 156, 157; creation, 40; current problems, 164; Geithner–Summers Plan, 171–2, 173, 230; Greenspan and, 3, 10; interest rate policy, 99; sub-prime crisis, 147, 149; and toxic theory, 15 feudalism, 30, 31, 64 Fiat, 159 finance: as a pillar of industry, 31; role of, 35–8 Financial Crisis Inquiry Commission, 166 financialization, 30, 190, 222 First World War, Gold Standard suspension, 44 food: markets, 215; prices, 163 Ford, Henry, 39 formalist economic model, 139–40 Forrestal, James, 68 Fortis, 153 franc, value against dollar, 96 France: aid for banks, 157; colonialism criticized, 79; EU membership, 196; and the euro, 198; gold request, 94; Plaza Accord, 188; reindustrialization of Germany, 74; support for Dexia, 154 Freddie Mac, 152, 166 free market fundamentalism, 181, 182 French Revolution, 29 G7 group, 151 G20 group, 159, 163–4 Galbraith, John Kenneth, 73 GATT (General Agreement on Tariffs and Trade), 78 GDP (Gross Domestic Product): Britain, 4–5, 88, 158; eurozone, 199, 204; France, 88; Germany, 88, 88; Japan, 88, 88; US, 4, 72, 73, 87, 88, 88, 161; world, 88 Geithner–Summers Plan, 159, 169–83; in Europe, 174–7; results, 178–81; in the US, 169–74, 170, 230 Geithner, Timothy, 170, 173, 230 General Motors (GM), 131–2, 157–8, 160 General Theory (Keynes), 37 geopolitical power, 106–8 Germany: aftermath of the Second World War, 68, 73–4; competition with US, 98, 103; current importance, 251; and Europe, 195–8; and the eurozone, 198–201, 211; global capital, 115–16; Global Plan, 69, 70; Greek crisis, 206; house prices, 129; Marshall Plan, 73; reunification, 201–3; support for Hypo Real Estate, 155; trade surplus, 251; trade surpluses, 158 Giscard d’Estaing, Valery, 93 Glass–Steagall Act (1933), 10, 180 global balance, 22 global imbalances, 251–2 Global Plan: appraisal, 85–9; architects, 68; end of, 100–1, 182; geopolitical ideology, 79–82; Germany, 75; Marshall Plan, 74; origins, 67–71; real GDP per capita, 87; unravelling of, 90–4; US domestic policies, 82–5 global surplus recycing mechanism see GSRM global warming, 163 globalization, 12, 28, 125 GM (General Motors), 131–2, 157–8, 160 gold: prices, 96; rushes, 40; US reserves, 92–3 Gold Exchange Standard, collapse, 43–5 Goodwin, Richard, 34 Great Depression, 55, 58, 59, 80 Greece: currency, 205; debt crisis, 206–8 greed, Crash of 2008, 9–12 Greek Civil War, 71, 72, 79 Greenspan, Alan, 3, 10–11 Greenwald, Robert, 125–6 Gross Domestic Product see GDP GSRM (global surplus recycling mechanism), 62, 66, 85, 90, 109–10, 222, 223, 224, 248, 252–6 HBOS, 153, 156 Heath, Edward, 94 hedge funds, 147, 204; LTCM, 2, 13; toxic theory, 15 hedging, 120–1 history: consent as driving force, 29; Marx on, 178; as undemocratic, 28 Ho Chi Minh, 92 Holland, 79, 120, 155, 196, 204 home ownership, 12, 127–8; reposessions, 161 Homeownership Preservation Foundation, 161 Hoover, Herbert, 42–3, 44–5, 230 House Committee on Un-American Activities, 73 house prices, 12, 128–9, 129, 138; falling, 151, 152 human nature, 10, 11–12 humanity, in the workforce, 50–2, 54 Hypo Real Estate, 155 Ibn Khaldun, 33 IBRD (International Bank for Reconstruction and Development) see World Bank Iceland, 154, 155, 156, 203 ICU (International Currency Union) proposal, 60–1, 66, 90, 251 IMF (International Monetary Fund): burst bubbles, 190; cost of the credit crunch, 151; Crash of 2008, 155–6, 156, 159; demise of social services, 163; on economic growth, 159; European banking crisis, 208; G20 support for, 163–4; Greek crisis, 207; origins, 59; South East Asia, 192, 193; Third World debt crisis, 108; as a transnational institution, 253, 254 income: distribution, 64; national, 42; US national, 43 India: Britain’s stance criticized, 79; Crash of 2008, 163; suicides of farmers, 163 Indochina, and colonization, 79 Indonesia, 79, 191 industrialization: Britain, 5; Germany, 74–5; Japan, 89, 185–6; roots of, 27–8; South East Asia, 86 infinite regress, 47 interest rates: CDOs, 7; post-Global Plan, 99; prophecy paradox, 48; rises in, 107 International Bank for Reconstruction and Development (IBRD) see World Bank International Currency Union (ICU) proposal, 60–1, 66, 90, 253 International Labour Organisation, 159 International Monetary Fund see IMF Iran, Shah of, 97 Ireland: bankruptcy, 154, 156; EFSF, 175; nationalization of Anglo Irish Bank, 158 Irwin, John, 97 Japan: aftermath of the Second World War, 68–9; competition with the US, 98, 103; in decline, 186–91; end of Bretton Woods system, 95; financial support for the US, 216; global capital, 115–16; Global Plan, 69, 70, 76–8, 85–6; house prices, 129; labour costs, 105; new Marshall Plan, 77; Plaza Accord, 188; post-war, 185–91; post-war growth, 185–6; relations with the US, 187–8, 189; South East Asia, 91, 191–2; trade surpluses, 158 joblessness see unemployment Johnson, Lyndon B.: Great Society programmes, 83, 84, 92; Vietnam War, 92 JPMorgan Chase, 151, 153 keiretsu system, Japan, 186, 187, 188, 189, 191 Kennan, George, 68, 71 Kennedy, John F., New Frontier social programmes, 83, 84 Keynes, John Maynard: Bretton Woods conference, 59, 60, 62, 109; General Theory, 37; ICU proposal, 60, 66, 90, 109, 254, 255; influence on New Dealers, 81; on investment decisions, 48; on liquidity, 160–1; trade imbalances, 62–6 Keynsianism, 157 Kim Il Sung, 77 Kissinger, Henry, 94, 98, 106 Kohl, Helmut, 201 Korea, 91, 191, 192 Korean War, 77, 86 labour: as a commodity, 28; costs, 104–5, 104, 105, 106, 137; hired, 31, 45, 46, 53, 64; scarcity of, 34–5; value of, 50–2 labour markets, 12, 202 Labour Party (British), 69 labourers, 32 land: as a commodity, 28; enclosure, 64 Landesbanken, 203 Latin America: effect of China on, 215, 218; European banks’ exposure to, 203; financial crisis, 190 see also specific countries lead, prices, 96 Lebensraum, 67 Left-Right divide, 167 Lehman Brothers, 150, 152–3 leverage, 121–2 leveraging, 37 Liberal Democratic Party (Japan), 187 liberation movements, 79, 107 LIBOR (London Interbank Offered Rate), 148 liquidity traps, 157, 190 Lloyds TSB, 153, 156 loans: and CDOs, 7–8, 129–31; defaults on, 37 London School of Economics, 4, 66 Long-Term Capital Management (LTCM) hedge fund collapse, 13 LTCM (Long-Term Capital Management) hedge fund collapse, 2, 13 Luxembourg, support for Dexia, 154 Maastricht Treaty, 199–200, 202 MacArthur, Douglas, 70–1, 76, 77 machines, and humans, 50–2 Malaysia, 91, 191 Mao, Chairman, 76, 86, 91 Maresca, John, 106–7 Marjolin, Robert, 73 Marshall, George, 72 Marshall Plan, 71–4 Marx, Karl: and capitalism, 17–18, 19, 34; Das Kapital, 49; on history, 178 Marxism, 181, 182 Matrix, The (film), 50–2 MBIA, 149, 150 McCarthy, Senator Joseph, 73 mercantilism, in Germany, 251 merchant class, 27–8 Merkel, Angela, 158, 206 Merrill Lynch, 149, 153, 157 Merton, Robert, 13 Mexico: effect of China on, 214; peso crisis, 190 Middle East, oil, 69 MIE (military-industrial establishment), 82–3 migration, Crash of 2008, 3 military-industrial complex mechanism, 65, 81, 182 Ministry for International Trade and Industry (Japan), 78 Ministry of Finance (Japan), 187 Minotaur legend, 24–5, 25 Minsky, Hyman, 37 money markets, 45–6, 53, 153 moneylenders, 31, 32 mortgage backed securities (MBS) 232, 233, 234 NAFTA (North American Free Trade Agreement), 214 National Bureau of Economic Research (US), 157 National Economic Council (US), 3 national income see GDP National Security Council (US), 94 National Security Study Memorandum 200 (US), 106 nationalization: Anglo Irish Bank, 158; Bradford and Bingley, 154; Fortis, 153; Geithner–Summers Plan, 179; General Motors, 160; Icelandic banks, 154, 155; Northern Rock, 151 NATO (North Atlantic Treaty Organization), 76, 253 negative engineering, 110 negative equity 234 neoliberalism, 139, 142; and greed, 10 New Century Financial, 147 New Deal: beginnings, 45; Bretton Woods conference, 57–9; China, 76; Global Plan, 67–71, 68; Japan, 77; President Kennedy, 84; support for the Deutschmark, 74; transfer union, 65 New Dealers: corporate power, 81; criticism of European colonizers, 79 ‘new economy’, 5–6 New York stock exchange, 40, 158 Nietzsche, Friedrich, 19 Nixon, Richard, 94, 95–6 Nobel Prize for Economics, 13 North American Free Trade Agreement (NAFTA), 214 North Atlantic Treaty Organization (NATO), 76 North Korea see Korea Northern Rock, 148, 151 Obama administration, 164, 178 Obama, Barack, 158, 159, 169, 180, 230, 231 OECD (Organisation for Economic Co-operation and Development), 73 OEEC (Organisation for European Economic Co-operation), 73, 74 oil: global consumption, 160; imports, 102–3; prices, 96, 97–9 OPEC (Organization of the Petroleum Exporting Countries), 96, 97 paradox of success, 249 parallax challenge, 20–1 Paulson, Henry, 152, 154, 170 Paulson Plan, 154, 173 Penn Bank, 40 Pentagon, the, 73 Plaza Accord (1985), 188, 192, 213 Pompidou, Georges, 94, 95–6 pound sterling, devaluing, 93 poverty: capitalism as a supposed cure for, 41–2; in China, 162; reduction in the US, 84; reports on global, 125 predatory governance, 181 prey–predator dynamic, 33–5 prices, flexible, 40–1 private money, 147, 177; Geithner–Summers Plan, 178; toxic, 132–3, 136, 179 privatization, of surpluses, 29 probability, estimating, 13–14 production: cars, 70, 103, 116, 157–8; coal, 73, 75; costs, 96, 104; cuts in, 41; in Japan, 185–6; processes, 30, 31, 64; steel, 70, 75 production–distribution cycle, 54 property see real estate prophecy paradox, 46, 47, 53 psychology, mass, 14 public debt crisis, 205 quantitative easing, 164, 231–6 railway bubbles, 40 Rational Expectations Hypothesis (REH), 15–16 RBS (Royal Bank of Scotland), 6, 151, 156; takeover of ABN-Amro, 119–20 Reagan, Ronald, 10, 99, 133–5, 182–3 Real Business Cycle Theory (RBCT), 15, 16–17 real estate, bubbles, 8–9, 188, 190, 192–3 reason, deferring to expectation, 47 recession predictions, 152 recessions, US, 40, 157 recycling mechanisms, 200 regulation, of banking system, 10, 122 relabelling, 14 religion, organized, 27 renminbi (RMB), 213, 214, 217, 218, 253 rentiers, 165, 187, 188 representative agents, 140 Reserve Bank of Australia, 148 reserve currency status, 101–2 risk: capitalists and, 31; riskless, 5, 6–9, 14 Roach, Stephen, 145 Robbins, Lionel, 66 Roosevelt, Franklin D., 165; attitude towards Britain, 69; and bank regulation, 10; New Deal, 45, 58–9 Roosevelt, Theodore (‘Teddy’), 180 Royal Bank of Scotland (RBS), 6, 151, 156; takeover of ABN-Amro, 119–20 Rudd, Kevin, 212 Russia, financial crisis, 190 Saudi Arabia, oil prices, 98 Scandinavia, Gold Standard, 44 Scholes, Myron, 13 Schopenhauer, Arthur, 19 Schuman, Robert, 75 Schumpter, Joseph, 34 Second World War, 45, 55–6; aftermath, 87–8; effect on the US, 57–8 seeds, commodification of, 163 shares, in privatized companies, 137, 138 silver, prices, 96 simulated markets, 170 simulated prices, 170 Singapore, 91 single currencies, ICU, 60–1 slave trade, 28 SMEs (small and medium-sized enterprises), 186 social welfare, 12 solidarity (asabiyyah), 33–4 South East Asia, 91; financial crisis, 190, 191–5, 213; industrialization, 86, 87 South Korea see Korea sovereign debt crisis, 205 Soviet Union: Africa, 79; disintegration, 201; Marshall Plan, 72–3; Marxism, 181, 182; relations with the US, 71 SPV (Special Purpose Vehicle), 174 see also EFSF stagflation, 97 stagnation, 37 Stalin, Joseph, 72–3 steel production, in Germany, 70 Strauss-Kahn, Dominique, 60, 254, 255 Summers, Larry, 230 strikes, 40 sub-prime mortgages, 2, 5, 6, 130–1, 147, 149, 151, 166 success, paradox of, 33–5, 53 Suez Canal trauma, 69 Suharto, President of Indonesia, 97 Summers, Larry, 3, 132, 170, 173, 180 see also Geithner–Summers Plan supply and demand, 11 surpluses: under capitalism, 31–2; currency unions, 61; under feudalism, 30; generation in the EU, 196; manufacturing, 30; origin of, 26–7; privatization of, 29; recycling mechanisms, 64–5, 109–10 Sweden, Crash of 2008, 155 Sweezy, Paul, 73 Switzerland: Crash of 2008, 155; UBS, 148–9, 151 systemic failure, Crash of 2008, 17–19 Taiwan, 191, 192 Tea Party (US), 162, 230, 231, 281 technology, and globalization, 28 Thailand, 91 Thatcher, Margaret, 117–18, 136–7 Third World: Crash of 2008, 162; debt crisis, 108, 219; interest rate rises, 108; mineral wealth, 106; production of goods for Walmart, 125 tiger economies, 87 see also South East Asia Tillman Act (1907), 180 time, and economic models, 139–40 Time Warner, 117 tin, prices, 96 toxic theory, 13–17, 115, 133–9, 139–42 trade: balance of, 61, 62, 64–5; deficits (US), 111, 243; global, 27, 90; surpluses, 158 trades unions, 124, 137, 202 transfer unions, New Deal, 65 Treasury Bills (US), 7 Treaty of Rome, 237 Treaty of Versailles, 237 Treaty of Westphalia, 237 trickle-down, 115, 135 trickle-up, 135 Truman Doctrine, 71, 71–2, 77 Truman, Harry, 73 tsunami, effects of, 194 UBS, 148–9, 151 Ukraine, and the Crash of 2008, 156 UN Security Council, 253 unemployment: Britain, 160; Global Plan, 96–7; rate of, 14; US, 152, 158, 164 United States see US Unocal, 106 US economy, twin deficits, 22–3, 25 US government, and South East Asia, 192 US Mortgage Bankers Association, 161 US Supreme Court, 180 US Treasury, 153–4, 156, 157, 159; aftermath of the Crash of 2008, 160; Geithner–Summers Plan, 171–2, 173; bonds, 227 US Treasury Bills, 109 US (United States): aftermath of the Crash of 2008, 161–2; assets owned by foreign state institutions, 216; attitude towards oil price rises, 97–8; China, 213–14; corporate bond purchases, 228; as a creditor nation, 57; domestic policies during the Global Plan, 82–5; economy at present, 184; economy praised, 113–14; effects of the Crash of 2008, 2, 183; foreign-owned assets, 225; Greek Civil War, 71; labour costs, 105; Plaza Accord, 188; profit rates, 106; proposed invasion of Afghanistan, 106–7; role in the ECSC, 75; South East Asia, 192 value, costing, 50–1 VAT, reduced, 156 Venezuela, oil prices, 97 Vietnamese War, 86, 91–2 vital spaces, 192, 195, 196 Volcker, Paul: 2009 address to Wall Street, 122; demand for dollars, 102; and gold convertibility, 94; interest rate rises, 99; replaced by Greenspan, 10; warning of the Crash of 2008, 144–5; on the world economy, 22, 100–1, 139 Volcker Rule, 180–1 Wachowski, Larry and Andy, 50 wage share, 34–5 wages: British workers, 137; Japanese workers, 185; productivity, 104; prophecy paradox, 48; US workers, 124, 161 Wal-Mart: The High Cost of Low Price (documentary, Greenwald), 125–6 Wall Street: Anglo-Celtic model, 12; Crash of 2008, 11–12, 152; current importance, 251; Geithner–Summers Plan, 178; global profits, 23; misplaced confidence in, 41; private money, 136; profiting from sub-prime mortgages, 131; takeovers and mergers, 115–17, 115, 118–19; toxic theory, 15 Wallace, Harry, 72–3 Walmart, 115, 123–7, 126; current importance, 251 War of the Currents, 39 Washington Mutual, 153 weapons of mass destruction, 27 West Germany: labour costs, 105; Plaza Accord, 188 Westinghouse, George, 39 White, Harry Dexter, 59, 70, 109 Wikileaks, 212 wool, as a global commodity, 28 working class: in Britain, 136; development of, 28 working conditions, at Walmart, 124–5 World Bank, 253; origins, 59; recession prediction, 149; and South East Asia, 192 World Trade Organization, 78, 215 written word, 27 yen, value against dollar, 96, 188, 193–4 Yom Kippur War, 96 zombie banks, 190–1

…

A catalogue record for this book is available from the British Library Library of Congress Cataloging in Publication Data available ISBN 978 1 78032 646 7 Contents ABBREVIATIONS PREFACE TO THE NEW EDITION ACKNOWLEDGEMENTS 1 Introduction 2 Laboratories of the future 3 The Global Plan 4 The Global Minotaur 5 The beast’s handmaidens 6 Crash 7 The handmaidens strike back 8 The Minotaur’s global legacy: the dimming sun, the wounded tigers, a flighty Europa and an anxious dragon 9 A world without the Minotaur? POSTCRIPT TO THE NEW EDITION NOTES RECOMMENDED READING SELECT BIBLIOGRAPHY INDEX Abbreviations AC alternating current ACE aeronautic–computer–electronics complex AIG American Insurance Group ATM automated telling machine CDO collateralized debt obligation CDS credit default swap CEO chief executive officer DC direct current ECB European Central Bank ECSC European Coal and Steel Community EFSF European Financial Stability Facility EIB European Investment Bank EMH Efficient Market Hypothesis ERAB Economic Recovery Advisory Board EU European Union FDIC Federal Deposit Insurance Corporation GDP gross domestic product GM General Motors GSRM global surplus recycling mechanism IBRD International Bank for Reconstruction and Development ICU International Currency Union IMF International Monetary Fund LTCM Long-Term Capital Management (hedge fund) MIE military–industrial establishment NAFTA North American Free Trade Agreement NATO North Atlantic Treaty Organization OECD Organisation for Economic Co-operation and Development OEEC Organisation for European Economic Co-operation OMT outright monetary operations OPEC Organization of the Petroleum Exporting Countries RBCT Real Business Cycle Theory RBS Royal Bank of Scotland REH Rational Expectations Hypothesis RMB renminbi – Chinese currency SME small and medium-sized enterprise SPV Special Purpose Vehicle TARP Troubled Asset Relief Program For Danae Stratou, my global partner Preface to the new edition This book originally aimed at pressing a useful metaphor into the service of elucidating a troubled world; a world that could no longer be understood properly by means of the paradigms that dominated our thinking before the Crash of 2008.

How to Speak Money: What the Money People Say--And What It Really Means by John Lanchester

"Friedman doctrine" OR "shareholder theory", "World Economic Forum" Davos, asset allocation, Basel III, behavioural economics, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, blood diamond, Bretton Woods, BRICs, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collective bargaining, commoditize, creative destruction, credit crunch, Credit Default Swap, crony capitalism, Dava Sobel, David Graeber, disintermediation, double entry bookkeeping, en.wikipedia.org, estate planning, fear index, financial engineering, financial innovation, Flash crash, forward guidance, Garrett Hardin, Gini coefficient, Glass-Steagall Act, global reserve currency, high net worth, High speed trading, hindsight bias, hype cycle, income inequality, inflation targeting, interest rate swap, inverted yield curve, Isaac Newton, Jaron Lanier, John Perry Barlow, joint-stock company, joint-stock limited liability company, junk bonds, Kodak vs Instagram, Kondratiev cycle, Large Hadron Collider, liquidity trap, London Interbank Offered Rate, London Whale, loss aversion, low interest rates, margin call, McJob, means of production, microcredit, money: store of value / unit of account / medium of exchange, moral hazard, Myron Scholes, negative equity, neoliberal agenda, New Urbanism, Nick Leeson, Nikolai Kondratiev, Nixon shock, Nixon triggered the end of the Bretton Woods system, Northern Rock, offshore financial centre, oil shock, open economy, paradox of thrift, plutocrats, Ponzi scheme, precautionary principle, proprietary trading, purchasing power parity, pushing on a string, quantitative easing, random walk, rent-seeking, reserve currency, Richard Feynman, Right to Buy, road to serfdom, Ronald Reagan, Satoshi Nakamoto, security theater, shareholder value, Silicon Valley, six sigma, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, sovereign wealth fund, Steve Jobs, survivorship bias, The Chicago School, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tragedy of the Commons, trickle-down economics, two and twenty, Two Sigma, Tyler Cowen, Washington Consensus, wealth creators, working poor, yield curve

Third, and finally, one of the most brilliant things the financial services industry ever did was to take the word “debt,” which people were brought up to consider a bad thing that you want to avoid, and to rename it as “credit,” which sounds like a good thing that you want more of. This is a major example of reversification at work. credit default swap (CDS) A financial instrument arising from interest rate swaps. The simplest way of looking at a CDS is as a form of insurance. If you are receiving interest from someone to whom you’ve lent money, you may start to wonder what happens if she starts to have trouble paying you. If you get worried, you might want to insure the interest you’re getting, so that in the event of a default by your borrower, you still get your money. That’s a credit default swap: you pay someone a fee to take on the risk of default, and in return, in the event of a default, she pays you the money you are owed.

…

That’s a credit default swap: you pay someone a fee to take on the risk of default, and in return, in the event of a default, she pays you the money you are owed. This might sound straightforward, but the picture is complicated by the fact that you can take out a credit default swap against loans you haven’t actually made. That’s right: you can insure against the risk of a default not of your own loan, but of somebody else’s loan. That’s less like insurance and more like a form of gambling, since you’re basically betting on someone else’s debts. Credit default swaps of this sort played a big role in the credit crunch. currency wars Conflicts that happen when countries adopt “beggar thy neighbor” policies: they make their own currency cheap to bolster their own exports.

…

The British bank C. Hoare and Co. is unusual in being an unlimited liability bank, wholly owned by one family. London Whale The nickname of Bruno Iksil, the trader at J. P. Morgan’s London branch who was paid $7.32 million in 2010 and $6.76 million in 2011, and then in 2012 lost $6.2 billion betting on credit default swaps. The first response of Jamie Dimon, chairman and CEO of J. P. Morgan, was to describe the affair as “a tempest in a teacup,” until the scale of the losses became apparent. The thing that’s interesting about his nickname is that “whale” is a term from gambling: a whale is a punter who gets free hospitality from casinos because he (usually a he) bets such huge sums.

In FED We Trust: Ben Bernanke's War on the Great Panic by David Wessel

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, banks create money, Bear Stearns, Berlin Wall, Black Swan, break the buck, business cycle, central bank independence, credit crunch, Credit Default Swap, crony capitalism, debt deflation, Fall of the Berlin Wall, financial engineering, financial innovation, financial intermediation, fixed income, full employment, George Akerlof, Glass-Steagall Act, Greenspan put, housing crisis, inflation targeting, information asymmetry, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, Michael Milken, money market fund, moral hazard, mortgage debt, new economy, Northern Rock, price stability, quantitative easing, Robert Shiller, Ronald Reagan, Saturday Night Live, Savings and loan crisis, savings glut, Socratic dialogue, too big to fail

“In the case of Lehman Brothers,” he said, reading from prepared testimony, “the Federal Reserve and the Treasury declined to commit public funds to support the institution. The failure of Lehman posed risks. But the troubles at Lehman had been well known for some time, and investors clearly recognized — as evidenced, for example, by the high cost of insuring Lehman’s debt in the market for credit default swaps — that the failure of the firm was a significant possibility. Thus, we judged that investors and counterparties had had time to take precautionary measures.” Paulson and Bernanke’s statements were more than after-the-fact window dressing. Although Lehman was already dead, the cause of death wasn’t a secondary issue.

…

Geithner did muse, occasionally, that the evolution of financial markets might produce fewer crises, but bigger ones. (The “bigger” so far has proven dead-on. “Fewer” remains an open question.) And he did help clean up one mess: an alarming backlog of paperwork in a rapidly growing corner of the markets, the securities called credit default swaps, which allow banks and other lenders to buy insurance against borrowers going bust. The buyers and sellers used sophisticated twenty-first-century finance; but the back office was more circa the late nineteenth century. One firm confessed in June 2006 that it had 18,000 undocumented trades, several thousand of which had been languishing in the back office for more than ninety days.

…

With the help of his predecessor, Gerald Corrigan, then at Goldman Sachs, Geithner summoned representatives of fourteen big Wall Street firms — “the Fourteen Families,” they called themselves — and prodded them to automate the process before a crisis hit. It worked. On September 30, 2006, the firms counted 97,000 unconfirmed trades outstanding for more than thirty days. By October 2008, the backlog had been reduced by 75 percent. And in all the turmoil of the Great Panic, the failure to process credit default swaps was one problem that didn’t occur. Big players on Wall Street knew who their counterparties were — even if they didn’t completely trust them. No one at the Fed, however, rang the gong and warned investors, lenders, business executives, and consumers that years of easy credit even for risky borrowers, placid markets, and shared optimism were unsustainable.

Market Sense and Nonsense by Jack D. Schwager

3Com Palm IPO, asset allocation, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Brownian motion, buy and hold, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, global macro, high net worth, implied volatility, index arbitrage, index fund, Jim Simons, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, managed futures, margin call, market bubble, market fundamentalism, Market Wizards by Jack D. Schwager, merger arbitrage, negative equity, pattern recognition, performance metric, pets.com, Ponzi scheme, proprietary trading, quantitative trading / quantitative finance, random walk, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, subprime mortgage crisis, survivorship bias, tail risk, transaction costs, two-sided market, value at risk, yield curve

.), these securities were extraordinarily vulnerable to any downturn in the housing market. So surely at the first sign of trouble in the housing market subprime bond prices should have fallen sharply below par. Figure 2.9 shows the prices of the ABX-HE-AAA index, an index of credit default swaps tied to 20 subprime-loan bonds rated AAA. (Credit default swaps are derivatives that mirror the risk premiums of the reference bonds.) Note that prices remained near par until early July 2007 when they went over a cliff. Figure 2.9 ABX-HE-AAA 07-1 Index, January to August 2007 Source: Markit.com. Did the real estate market suddenly worsen in early summer 2007, as one might infer from this price chart?

…

*Some of the text in the first two paragraphs has been adapted from Jack D. Schwager, Managed Trading: Myths & Truths (New York: John Wiley & Sons, 1996). 1Commodity trading advisor (CTA) is the official designation of regulated managers who trade the futures markets. 2Although the most widely used model to price mortgage-backed securitizations used credit default swaps (CDSs) rather than default rates as a proxy for default risk, CDS prices would have been heavily influenced by historical default rates that were based on irrelevant mortgage default data. PART ONE MARKETS, RETURN, AND RISK Chapter 1 Expert Advice Comedy Central versus CNBC On March 4, 2009, Jon Stewart, the host of The Daily Show, a satirical news program, lambasted CNBC for a string of poor prognostications.

…

This section has been excerpted from Jack Schwager, Hedge Fund Market Wizards (Hoboken, NJ: John Wiley & Sons, 2012). 2CDOs were a general type of securitization that were also built from many other types of instruments besides mortgage bonds, but these other constructions are not germane to this discussion. 3Although correlations for individual mortgages could also be significant during severe economic downturns, the degree of correlation would still not be nearly as extreme as the correlations between different BBB tranches. 4To be precise, the Gaussian copula formula, which was widely used to price CDOs, used credit default swaps (CDSs) on mortgage-backed securitizations (MBSs) as a proxy for default risk. However, CDS prices would have been heavily influenced by historical default rates that were based on irrelevant data. Moreover, the historical period for which CDS data existed was characterized by steadily rising housing prices and low default rates, thereby implying misleadingly low correlation among defaults in different securitizations and grossly understating the risk in CDOs, which were constructed by combining MBSs. 5Source for this section: see chapter, “The Curious Case of Palm and 3Com,” in Mastering Investment by James Pickford (Upper Saddle River, NJ: Financial Times Prentice Hall, 2002). 6The data on historical S&P daily percentage declines comes from Stock Market Volatility: Ten Years after the Crash, a 1997 study by G.

Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

Alan Greenspan, Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, bitcoin, Bob Litterman, Bonfire of the Vanities, bonus culture, break the buck, Brexit referendum, Brownian motion, business cycle, business process, butterfly effect, buy and hold, capital asset pricing model, Captain Sullenberger Hudson, carbon tax, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, confounding variable, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, democratizing finance, Diane Coyle, diversification, diversified portfolio, do well by doing good, double helix, easy for humans, difficult for computers, equity risk premium, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial engineering, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Glass-Steagall Act, global macro, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, information security, interest rate derivative, invention of the telegraph, Isaac Newton, it's over 9,000, James Watt: steam engine, Jeff Hawkins, Jim Simons, job satisfaction, John Bogle, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, language acquisition, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, megaproject, merger arbitrage, meta-analysis, Milgram experiment, mirror neurons, money market fund, moral hazard, Myron Scholes, Neil Armstrong, Nick Leeson, old-boy network, One Laptop per Child (OLPC), out of africa, p-value, PalmPilot, paper trading, passive investing, Paul Lévy, Paul Samuelson, Paul Volcker talking about ATMs, Phillips curve, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, proprietary trading, public intellectual, quantitative hedge fund, quantitative trading / quantitative finance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Solow, Sam Peltzman, Savings and loan crisis, seminal paper, Shai Danziger, short selling, sovereign wealth fund, Stanford marshmallow experiment, Stanford prison experiment, statistical arbitrage, Steven Pinker, stochastic process, stocks for the long run, subprime mortgage crisis, survivorship bias, systematic bias, Thales and the olive presses, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, uptick rule, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

Not only did they lose their value, they became very difficult to sell, and their illiquidity made it hard to value them. Securities that were once considered darlings of the fixed-income industry were now called “toxic assets.” The companies that insured these securities through credit default swaps now found themselves obliged to pay out. But because credit default swaps weren’t regulated like insurance contracts, insurers like Ambac, MBIA, and AIG weren’t required to maintain sufficient capital to cover potential claims. Those insurers began to fail. Without the protection of insurance, the large investment banks that had bought these securities at already high debt-to-assets ratios now saw their leverage ratios rising toward infinity.

…

There was an adaptive radiation of new mortgage types: adjustable-rate mortgages, “pick-a-payment” mortgages, and even the infamous NINJA loan (“No Income, No Job, no Assets”), evaluated and approved by automated loan-review programs. At the same time, investment banks issued collateralized debt obligations, which enabled large pools of mortgages to be packaged and chopped up into a variety of new securities, and sold with the blessings of the rating agencies. Ultimately, the credit default swap market emerged, in order to provide insurance on some of those new debt issues, which encouraged even more investors to participate in the markets. This process expanded the mortgage ecosystem’s size and reach. In 1996, $480 billion in mortgage-related securities were issued in the United States, including mortgage‐backed securities and collateralized mortgage obligations.

…

But that piece of knowledge is hardly worth keeping a secret, and the fact that you don’t have that knowledge isn’t going to get you too upset. But suppose I know how to cure diabetes and you don’t. Or I know how to prevent cancer by avoiding certain common foods and you don’t. Or I know how to price mortgage-backed securities and credit default swaps and you don’t. In these cases, the knowledge I possess confers a certain power and status to me. Complexity creates the need for better narratives and those who have those narratives will become the high priests of complex systems, the gatekeepers of critical, life-altering knowledge. And the difficulty in joining the priesthood—earning an MD/Ph.D. in molecular biology and having twenty years of work experience at biotech and pharmaceutical companies, in the case of curing diabetes—coupled with the societal value of the special knowledge will determine the divisiveness of this elitism.

Expected Returns: An Investor's Guide to Harvesting Market Rewards by Antti Ilmanen

Alan Greenspan, Andrei Shleifer, asset allocation, asset-backed security, availability heuristic, backtesting, balance sheet recession, bank run, banking crisis, barriers to entry, behavioural economics, Bernie Madoff, Black Swan, Bob Litterman, bond market vigilante , book value, Bretton Woods, business cycle, buy and hold, buy low sell high, capital asset pricing model, capital controls, carbon credits, Carmen Reinhart, central bank independence, classic study, collateralized debt obligation, commoditize, commodity trading advisor, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, deal flow, debt deflation, deglobalization, delta neutral, demand response, discounted cash flows, disintermediation, diversification, diversified portfolio, dividend-yielding stocks, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, fiat currency, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, framing effect, frictionless, frictionless market, G4S, George Akerlof, global macro, global reserve currency, Google Earth, high net worth, hindsight bias, Hyman Minsky, implied volatility, income inequality, incomplete markets, index fund, inflation targeting, information asymmetry, interest rate swap, inverted yield curve, invisible hand, John Bogle, junk bonds, Kenneth Rogoff, laissez-faire capitalism, law of one price, London Interbank Offered Rate, Long Term Capital Management, loss aversion, low interest rates, managed futures, margin call, market bubble, market clearing, market friction, market fundamentalism, market microstructure, mental accounting, merger arbitrage, mittelstand, moral hazard, Myron Scholes, negative equity, New Journalism, oil shock, p-value, passive investing, Paul Samuelson, pension time bomb, performance metric, Phillips curve, Ponzi scheme, prediction markets, price anchoring, price stability, principal–agent problem, private sector deleveraging, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, reserve currency, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, riskless arbitrage, Robert Shiller, savings glut, search costs, selection bias, seminal paper, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stochastic volatility, stock buybacks, stocks for the long run, survivorship bias, systematic trading, tail risk, The Great Moderation, The Myth of the Rational Market, too big to fail, transaction costs, tulip mania, value at risk, volatility arbitrage, volatility smile, working-age population, Y2K, yield curve, zero-coupon bond, zero-sum game

Evolving perceptions of the credit risk of swaps and government bonds over time have also played a role. Recently some observers have emphasized swaps’ off-balance-sheet nature, a factor that could justify swaps’ richness against government bonds that require capital outlays. Credit default swaps (CDS) Compared with buying a corporate bond, a credit default swap offers a purer and more efficient way of gaining exposure to the default risk of the bond’s issuer. In a CDS, the seller provides default protection in exchange for receiving a fee—in default the seller must pay the difference between the bond’s par value and, typically, its market value after the default event.

…

Index AAA/AA/A-rated bonds absolute valuation academic investors active investing active risk puzzle (Litterman) active strategies adaptive markets hypothesis (Lo) advisors, CTAs agriculture alpha—beta barbell alpha—beta separation alphas CAPM currency carry hedge funds long horizon investors portable alpha alternative assets assets list commodities hedge funds liquidity momentum strategies PE funds premia real estate risk factors alternative betas AM see arithmetic mean ambiguity aversion Amihud, Yakov announcement days arbitrage behavioral finance CRP front-end trading equity value strategies term structure models Argentina arithmetic mean (AM) art investing asset classes 1990—2009 alternative assets “bad times” performance currency carry derivatives foreign exchange forward-looking indicators growth sensitivities historical returns inflation long history momentum strategies performance 1990—2009 profitable strategies risk factors style diversification traditional trend following understanding returns value strategies volatility selling world wealth assets 1968—2007 asset richening AUM Berk—Green management model cyclical variation empirical “horse races” ERPC feedback loops forward-looking measures growth illiquidity liquidity long-horizon investors market relations multiple asset classes prices/pricing privately held real assets risky assets seasonal regularities survey-based returns tactical forecasting tail risks time-varying illiquidity premia volatility see also asset classes assets under management (AUM) asymmetric information asymmetric returns asymmetric risk at-the-money (ATM) options seasonal regularities tail risks volatility selling attention bias AUM see assets under management BAB see betting against beta backfill bias backwardation “bad times” carry strategies catastrophes crashes crises inflation rare disasters bank credibility Bank of England Barcap Index BBB-rated bonds behavioral finance applications arbitrage biases cross-sectional trading heuristics historical aspects macro-inefficiencies micro-inefficiencies momentum over/underreaction preferences prospect theory psychology rational learning reversal effects speculative bubbles value stocks BEI see break-even inflation benchmarks, view-based expected returns Berk—Green asset management model Bernstein, Peter betas alpha—beta barbell BAB currency carry equity hedge funds long-horizon investors risk time-varying betting against beta (BAB) biases attention behavioral finance confirmation conservatism currency carry downgrading extrapolation forward rate hedge funds heuristic simplifications high equity premium hindsight historical returns learning limits memory momentum overconfidence overfitting overoptimism reporting representativeness reversal tendencies self-attribution self-deception survey data terminology volatility selling binary timing model Black—Litterman optimizers Black—Scholes (BS) option-pricing formula Black—Scholes—Merton (BSM) world blind men and elephant poem (Saxe) bond risk premium (BRP) approximate identities bond yield business cycles covariance risk cyclical factors decomposed-year Treasury yield drivers ex ante measures historical returns inflation interpreting BRP IRP macro-finance models nominal bonds realized/excess return safe haven premium supply—demand survey-based returns tactical forecasting targets terminology theories YC bonds AAA/AA/A-rated balanced portfolios BBB-rated credit spreads ERPB government historical records HY bonds IG bonds inflation-linked long-term nominal non-government relative valuation stock—bond correlation top-rated yields see also bond risk premium; corporate bonds booms break-even inflation (BEI) Bretton Woods system BRIC countries BRP see bond risk premium BSM see Black—Scholes—Merton bubbles absolute valuation memory bias money illusion real estate Shiller’s four elements speculative Buffet, Warren building block approach business cycles asset returns economic regime analysis ex ante indicators realized returns buybacks B-S see Black—Scholes option-pricing formula C-P BRP see Cochrane—Piazzesi BRP forward rate curve calls seasonal regularities tail risks volatility selling Campbell, John Campbell—Cochrane habit formation model Capital Asset Pricing Model (CAPM) alphas carry strategies Consumption CAPM covariance with “bad times” disagreement models ERP Intertemporal CAPM liquidity-adjusted market frictions market price equation multiple risk factors risk factors risk-adjusted returns risk-based models skewness stock—bond correlation supply—demand volatility Capital Ideas (Bernstein) capitalism capitalization (cap) rate CAPM see Capital Asset Pricing Model carry strategies 1990—2009 active investing asset classes business cycles credit carry currency ERP financing rates foreign exchange forward-looking indicators forward-looking measures generic proxy role historical returns long-horizon investors non-zero yield spreads real asset investing roll Sharpe ratios 2008 slide tactical forecasting cash, ERPC cash flow catastrophes see also “bad times” CAY see consumption/wealth ratio CCW see covered call writing CDOs see collateralized debt obligations CDSs see credit default swaps central banks Chen three-factor stock returns model China Citi (Il—)Liquidity indices Cochrane—Piazzesi BRP (C-P BRP) forward rate curve see also Campbell—Cochrane collateral return collateralized debt obligations (CDOs) comfortable approaches commodities characteristics equity value strategies excess returns expected returns expected risk premia futures historical returns inflation momentum return decomposition returns 1984—2009 supply—demand seasonals term structure trading advisors value indicators commodity momentum performance rational stories simple strategies trend following tweaks when it works well why it works see also momentum strategies commodity trading advisors (CTAs) composite ranking cross-asset selection models compound returns conditioners confirmation bias conservatism constant expected returns constant relative risk aversion (CRRA) Consumption CAPM consumption/wealth ratio (CAY) contemporaneous correlation contrarian strategies blunders feedback loops forward indication approach see also reversal convenience yield corporate bonds credit spreads CRP forward-looking indicators front-end trading IG bonds liquidity sample-specific valuation tactical forecasting correlation asset returns correlation premium correlation risk default correlations equities implied risk factors tail risks costs control currency carry enhancing returns taxes trading costs country-specific vulnerability indices covariance with “bad times” covariance risk risk factors covered call writing (CCW) crashes markets see also “bad times” credit default swaps (CDSs) credit-pricing models credit risk credit risk premium (CRP) analytical models attractive opportunities business cycles credit default swaps credit spreads decomposing credit spread default correlations emerging markets debt front-end trading historical excess returns IG bonds low ex post premia mortgage-backed securities non-government debt portfolio risk reduced-form credit-pricing models reward—risk single-name risk swap—Treasury spreads tactical forecasting terminology theory credit spreads AAA/AA/A-rated bonds BBB-rated bonds business cycles CRP cyclical effects decomposition empirical “horse races” forward-looking indicators high-yield bonds rolling yield top-rated bonds volatility yield-level dependence credit and tactical forecasting creditworthiness crises 2007—2008 crisis currency carry liquidity money markets see also “bad times” cross-asset selection forecasting models cross-sectional market relations cross-sectional trading CRP see credit risk premium CRRA see constant relative risk aversion CTAs see commodity trading advisors currency base of returns carry empirical “horse races” equity value strategies inflation see also foreign exchange currency carry baseline variants combining carry conditioners costs diversification emerging markets ex ante opportunity financial crashes foreign exchange historical returns hyperinflation indicators interpreting evidence maturities pairwise carry trading portfolio construction ranking models regime indicators seasonals selection biases strategy improvements “timing” the strategy trading horizons unwind episodes why strategies work cyclical effects credit spreads growth seasonal regularities see also business cycles D/P see dividend yield data mining see also overfitting; selection bias data sources of time series data series construction day-of-the-week effect DDM see dividend discount model debt supercycle default correlations, CDOs default rates, HY bonds deflation delta hedging demand see supply—demand demographics derivatives Dimson, Elroy direct hedge funds disagreement models discount rates discounted cash flows discretionary managers disinflation disposition effect distress diversification currency carry drawdown control long-horizon investors return risk factors style diversification return (DR) dividend discount model (DDM) equities ERP forward-looking indicators growth rate debates dividend growth dividend yield (D/P) DJCS HF index dollars base of returns cost averaging currency carry foreign exchange downgrading bias downside beta DR see diversification return drawdown control duration risk duration timing dynamic strategies equity value strategies portfolio construction risk factors E/P see earnings/price ratio earnings E/P ratio EPS equity returns forecasts growth rates yield see also earnings/price ratio earnings-per-share (EPS) earnings/price (E/P) ratio absolute valuation drivers forward-looking indicators measures choices relative valuation value measures economic growth see also growth efficiency behavioral finance macro-inefficiencies market inefficiency micro-inefficiencies efficient markets hypothesis (EMH) elephant and blind men poem (Saxe) EMBI indices emerging markets carry strategies currency carry debt equity returns future trends growth EMH see efficient markets hypothesis empirical multi-factor finance models endogenous return and risk feedback loops market timing research endowments energy sector commodity momentum trend following volatility selling enhancing returns costs horizon investors risk management skill EPS see earnings per share equilibrium accounting equilibrium model equities 1990—2009 business cycles carry strategies correlation premium empirical “horse races” forward-looking indicators inflation long history momentum sample-specific valuation tactical forecasting ten-year rolling averages value strategies see also stock . . .

…

Antti Ilmanen Bad Homburg, November 2010 Abbreviations and acronyms AM Arithmetic Mean ATM At The Money (option) AUM Assets Under Management BEI Break-Even Inflation BF Behavioral Finance B/P Book/Price, book-to-market ratio BRP Bond Risk Premium, term premium B-S Black–Scholes C-P BRP Cochrane–Piazzesi Bond Risk Premium CAPM Capital Asset Pricing Model CAY Consumption wealth ratio CB Central Bank CCW Covered Call Writing CDO Collateralized Debt Obligation CDS Credit Default Swap CF Cash Flow CFNAI Chicago Fed National Activity Index CFO Chief Financial Officer CMD Commodity (futures) CPIyoy Consumer Price Inflation year on year CRB Commodity Research Bureau CRP Credit Risk Premium (over Treasury bond) CRRA Constant Relative Risk Aversion CTA Commodity Trading Advisor DDM Dividend Discount Model DJ CS Dow Jones Credit Suisse DMS Dimson–Marsh–Staunton D/P Dividend/Price (ratio), dividend yield DR Diversification Return E( ) Expected (conditional expectation) EMH Efficient Markets Hypothesis E/P Earnings/Price ratio, earnings yield EPS Earnings Per Share ERP Equity Risk Premium ERPB Equity Risk Premium over Bond (Treasury) ERPC Equity Risk Premium over Cash (Treasury bill) F Forward price or futures price FF Fama–French FI Fixed Income FoF Fund of Funds FX Foreign eXchange G Growth rate GARCH Generalized AutoRegressive Conditional Heteroskedasticity GC General Collateral repo rate (money market interest rate) GDP Gross Domestic Product GM Geometric Mean, also compound annual return GP General Partner GSCI Goldman Sachs Commodity Index H Holding-period return HF Hedge Fund HFR Hedge Fund Research HML High Minus Low, a value measure, also VMG HNWI High Net Worth Individual HPA House Price Appreciation (rate) HY High Yield, speculative-rated debt IG Investment Grade (rated debt) ILLIQ Measure of a stock’s illiquidity: average absolute daily return over a month divided by dollar volume IPO Initial Public Offering IR Information Ratio IRP Inflation Risk Premium ISM Business confidence index ITM In The Money (option) JGB Japanese Government Bond K-W BRP Kim–Wright Bond Risk Premium LIBOR London InterBank Offered Rate, a popular bank deposit rate LP Limited Partner LSV Lakonishok–Shleifer–Vishny LtA Limits to Arbitrage LTCM Long-Term Capital Management MA Moving Average MBS (fixed rate, residential) Mortgage-Backed Securities MIT-CRE MIT Center for Real Estate MOM Equity MOMentum proxy MSCI Morgan Stanley Capital International MU Marginal Utility NBER National Bureau of Economic Research NCREIF National Council of Real Estate Investment Fiduciaries OAS Option-Adjusted (credit) Spread OTM Out of The Money (option) P Price P/B Price/Book (valuation ratio) P/E Price/Earnings (valuation ratio) PE Private Equity PEH Pure Expectations Hypothesis PT Prospect Theory r Excess return R Real (rate) RE Real Estate REITs Real Estate Investment Trusts RWH Random Walk Hypothesis S Spot price, spot rate SBRP Survey-based Bond Risk Premium SDF Stochastic Discount Factor SMB Small Minus Big, size premium proxy SR Sharpe Ratio SWF Sovereign Wealth Fund TED Treasury–Eurodollar (deposit) rate spread in money markets TIPS Treasury Inflation-Protected Securities, real bonds UIP Uncovered Interest Parity (hypothesis) VaR Value at Risk VC Venture Capital VIX A popular measure of the implied volatility of S&P 500 index options VMG Value Minus Growth, equity value premium proxy WDRA Wealth-Dependent Risk Aversion X Cash flow Y Yield YC Yield Curve (steepness), term spread YTM Yield To Maturity YTW Yield To Worst Disclaimer Antti Ilmanen is a Senior Portfolio Manager at Brevan Howard, one of Europe’s largest hedge fund managers.

Unhappy Union: How the Euro Crisis - and Europe - Can Be Fixed by John Peet, Anton La Guardia, The Economist

"World Economic Forum" Davos, bank run, banking crisis, Berlin Wall, Bretton Woods, business cycle, capital controls, Celtic Tiger, central bank independence, centre right, collapse of Lehman Brothers, credit crunch, Credit Default Swap, debt deflation, Doha Development Round, electricity market, eurozone crisis, Fall of the Berlin Wall, financial engineering, fixed income, Flash crash, illegal immigration, labour market flexibility, labour mobility, light touch regulation, low interest rates, market fundamentalism, Money creation, moral hazard, Northern Rock, oil shock, open economy, pension reform, price stability, quantitative easing, special drawing rights, supply-chain management, The Great Moderation, too big to fail, transaction costs, éminence grise

It was also allowed to lend money to governments to recapitalise banks and extend precautionary loans. The deal would prompt ratings agencies to declare a temporary “selective default” (the EFSF would have to offer the ECB alternative collateral), but its voluntary nature ensured it would not count as a “credit event” that triggered payments of credit-default swaps, a form of insurance against sovereign defaults. However, the deal proved to be the worst of both worlds: the haircut was too small to turn around Greece’s public finances, but big enough to spread fear that other bonds were at risk. Markets had other reasons to worry. The original banking crisis had never been satisfactorily resolved; it had only been masked by the Greek turmoil and, to a great extent, worsened by the sovereign-debt crisis.

…

They first chose a complete bail-out; then at Deauville suddenly flirted with the idea of across-the-board bail-in of creditors; and then backed away from the idea more or less entirely. By July, when they got around to cutting Greece’s debt, the haircut was too modest and came too late. Months were wasted seeking a “voluntary” contribution from private creditors that would not trigger credit-default swaps (CDS); in the end CDS contracts were paid out anyway. The same uncertainty affected their judgment about the pace of fiscal consolidation. To make the numbers fit within the money made available by the euro zone and the IMF, Greece was forced into excessively harsh deficit-cutting (and at first had to pay high rates of interest).

…

Bond yields for Italy and Spain dropped markedly, by about 250 and 90 basis points respectively between January and March. The long-drawn-out second Greek bailout, with its large haircut on privately held government bonds, was concluded in February and markets seemed unconcerned by the triggering of credit-default swaps that had once been so feared. Draghi quietly retired Trichet’s official bond-buying operation in February. Yet no sooner had he told Bild in March 2012 that “the worst is over” than the crisis entered another, more perilous phase. The LTRO drug was wearing off, and the euro zone had entered a double-dip recession at the end of 2011, caused in part by the previous year’s turmoil.

Weapons of Math Destruction: How Big Data Increases Inequality and Threatens Democracy by Cathy O'Neil

Affordable Care Act / Obamacare, Alan Greenspan, algorithmic bias, Bernie Madoff, big data - Walmart - Pop Tarts, call centre, Cambridge Analytica, carried interest, cloud computing, collateralized debt obligation, correlation does not imply causation, Credit Default Swap, credit default swaps / collateralized debt obligations, crowdsourcing, data science, disinformation, electronic logging device, Emanuel Derman, financial engineering, Financial Modelers Manifesto, Glass-Steagall Act, housing crisis, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, Ida Tarbell, illegal immigration, Internet of things, late fees, low interest rates, machine readable, mass incarceration, medical bankruptcy, Moneyball by Michael Lewis explains big data, new economy, obamacare, Occupy movement, offshore financial centre, payday loans, peer-to-peer lending, Peter Thiel, Ponzi scheme, prediction markets, price discrimination, quantitative hedge fund, Ralph Nader, RAND corporation, real-name policy, recommendation engine, Rubik’s Cube, Salesforce, Sharpe ratio, statistical model, tech worker, Tim Cook: Apple, too big to fail, Unsafe at Any Speed, Upton Sinclair, Watson beat the top human players on Jeopardy!, working poor

The damage was compounded by other vast markets that had grown up around the mortgage-backed securities: credit default swaps and synthetic collateralized debt obligations, or CDOs. Credit default swaps were small insurance policies that transferred the risk on a bond. The swaps gave banks and hedge funds alike a sense of security, since they could supposedly use them to balance risk. But if the entities holding these insurance policies go belly up, as many did, the chain reaction blows holes through the global economy. Synthetic CDOs went one step further: they were contracts whose value depended on the performance of credit default swaps and mortgage-backed securities.

…

Synthetic CDOs went one step further: they were contracts whose value depended on the performance of credit default swaps and mortgage-backed securities. They allowed financial engineers to leverage up their bets even more. The overheated (and then collapsing) market featured $3 trillion of subprime mortgages by 2007, and the market around it—including the credit default swaps and synthetic CDOs, which magnified the risks—was twenty times as big. No national economy could compare. Paradoxically, the supposedly powerful algorithms that created the market, the ones that analyzed the risk in tranches of debt and sorted them into securities, turned out to be useless when it came time to clean up the mess and calculate what all the paper was actually worth.

…

This ratio is crucial to a trader’s career, his annual bonus, his very sense of being. If you disembody those traders and consider them as a set of algorithms, those algorithms are relentlessly focused on optimizing the Sharpe ratio. Ideally, it will climb, or at least never fall too low. So if one of the risk reports on credit default swaps bumped up the risk calculation on one of a trader’s key holdings, his Sharpe ratio would tumble. This could cost him hundreds of thousands of dollars when it came time to calculate his year-end bonus. I soon realized that I was in the rubber-stamp business. In 2011 it was time to move again, and I saw a huge growth market for mathematicians like me.

Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street by Kate Kelly

Alan Greenspan, bank run, Bear Stearns, book value, buy and hold, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Donald Trump, eat what you kill, fixed income, housing crisis, index arbitrage, Long Term Capital Management, margin call, moral hazard, proprietary trading, quantitative hedge fund, Renaissance Technologies, risk-adjusted returns, shareholder value, technology bubble, too big to fail, traveling salesman

Unsurprisingly, Bear’s credit analysts remained upbeat on the housing sector, even as doubts about the health of subprime loans crept in. That spring, Bear had an embarrassing tussle with one of its big clients. A prominent hedge fund manager, John Paulson, accused the firm of double-dealing in its handling of certain securities. Paulson was bearish on the subprime market and was buying credit-default swaps, or insurance policies, that would compensate him if subprime securities lost value. Bear sold the swaps, and had sold some to Paulson. But since the firm also packaged and serviced some of the very subprime securities that Paulson was betting would fall, he worried Bear might try to prop up those securities by renegotiating the home loans they contained to prevent them from going into default—a situation that would otherwise cause the securities to drop in value.

…

In their discussion with aides and with each other, he and Geithner began using a dramatic analogy: They couldn’t “spray enough foam on the runway” to prevent this jetliner from crashing. Bear’s collapse wouldn’t be limited to the financial services firms, either. A bankrupt firm would dump a plethora of troubled securities into the market. These included mortgage-backed securities, corporate loans, and a large swath of derivatives, like credit-default swaps. Amid the mortgage downturn and lending dry-up, bids for many such securities were already low, but adding thousands of bits of new inventory to a market with few sellers would only depress the prices further, harming other banks and funds that were already struggling to sell the same sorts of items.

…

Derivative is a general word that applies to everything from stock options to commodities, like gold and pork bellies; it consists simply of a bilateral, or two-party, contract. But the last several years had brought a slew of innovations to the market—perhaps most notably, the $46 trillion market for credit-default swaps, the insurance policies that paid the buyer money if the entity he or she was insuring failed to pay back its debt. Swaps covered a variety of default risks, from large companies like Bear and Morgan Stanley to obscure pieces of mortgage-backed securities tied to home loans generated by specific mortgage lenders.

Financial Market Meltdown: Everything You Need to Know to Understand and Survive the Global Credit Crisis by Kevin Mellyn

Alan Greenspan, asset-backed security, bank run, banking crisis, Bernie Madoff, bond market vigilante , bonus culture, Bretton Woods, business cycle, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, deal flow, disintermediation, diversification, fiat currency, financial deregulation, financial engineering, financial innovation, financial intermediation, fixed income, foreign exchange controls, Francis Fukuyama: the end of history, George Santayana, global reserve currency, Greenspan put, Home mortgage interest deduction, inverted yield curve, Isaac Newton, joint-stock company, junk bonds, Kickstarter, liquidity trap, London Interbank Offered Rate, long peace, low interest rates, margin call, market clearing, mass immigration, Money creation, money market fund, moral hazard, mortgage tax deduction, Nixon triggered the end of the Bretton Woods system, Northern Rock, offshore financial centre, paradox of thrift, pattern recognition, pension reform, pets.com, Phillips curve, plutocrats, Ponzi scheme, profit maximization, proprietary trading, pushing on a string, reserve currency, risk tolerance, risk-adjusted returns, road to serfdom, Ronald Reagan, shareholder value, Silicon Valley, South Sea Bubble, statistical model, Suez canal 1869, systems thinking, tail risk, The Great Moderation, the long tail, the new new thing, the payments system, too big to fail, value at risk, very high income, War on Poverty, We are all Keynesians now, Y2K, yield curve

Banks used derivatives to hedge their bets on many of these structured credit deals. At the extreme end of this complexity within complexity were so-called synthetic CDOs. These structures did not even own a pool of real assets like bonds or loans. Instead, they used something called a credit default swap or CDS to gain ‘‘credit exposure’’ to pools of assets. ‘‘Credit exposure’’ is finance-speak for getting paid to take risk. Without going into detail, a credit default swap is a derivative in which the seller of protection on a loan or bond gets paid a fee and ongoing premium by the owner of the instrument. If a pre-defined event of default happens, the swap is triggered. The seller takes the bond, and the buyer gets paid its full value.

…

This process, called ‘‘asset securitization,’’ made the reckless expansion of consumer debt not only possible but almost irresistible because of buy-side demand. The investment banking wiz kids even invented whole new classes of securities called ‘‘derivatives.’’ Derivatives have no value in themselves but allow investors to ‘‘bet’’ on the value of an asset or contract linked to them. For example, a credit default swap allows investors to make money if a company or country cannot pay its bond holders. The rapid fire invention and roll out of new, untested securities has been central both to the explosive growth of the global financial markets and the shocking meltdown we are now living through. Hedge Funds New providers—often called ‘‘alternative investment vehicles’’— have also sprung up to meet the ‘‘buy-side’’ demand for higher returns on invested money.

…

The man the press dubbed the ‘‘Sheriff of Wall Street’’ did nothing to head off the excesses behind the bubble in asset-backed securities that brought down Wall Street in 2008. In fact, by vindictively driving the one man from power who really understood AIG and who essentially managed its risk, its founder Hank Greenburg, Spitzer bears at least some responsibility for destabilizing a critical cog in the credit default swap market on the eve of the crisis. AIG’s default book may have proved fatal in any case but Spitzer weakened the company by arbitrarily using an arcane state law to undermine other key parts of its global business model such as finite risk contracts, a key product in the global reinsurance market.

Mathematics of the Financial Markets: Financial Instruments and Derivatives Modelling, Valuation and Risk Issues by Alain Ruttiens

algorithmic trading, asset allocation, asset-backed security, backtesting, banking crisis, Black Swan, Black-Scholes formula, Bob Litterman, book value, Brownian motion, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, delta neutral, discounted cash flows, discrete time, diversification, financial engineering, fixed income, implied volatility, interest rate derivative, interest rate swap, low interest rates, managed futures, margin call, market microstructure, martingale, p-value, passive investing, proprietary trading, quantitative trading / quantitative finance, random walk, risk free rate, risk/return, Satyajit Das, seminal paper, Sharpe ratio, short selling, statistical model, stochastic process, stochastic volatility, time value of money, transaction costs, value at risk, volatility smile, Wiener process, yield curve, zero-coupon bond

If the whole set of exchanged cash flows involves a common single currency, the swap is called an interest rate swap (IRS). If the exchange of cash flows involves two currencies, one talks of currency rate swap (CRS) or cross currency rate swap (CCRS).2 A swap is an unconditional product: the exchange of cash flows cannot depend from any kind of condition. A contrario, credit default swaps and similar derivatives on a default risk are not swaps, strictly speaking, because there are conditional. We will look at these in Chapter 13. The market trades swaps on maturities from 2 to 30 years, 3 the peak of traded volumes being between 5 and 10 years. If one excludes some attempts to trade swaps on a derivative exchange (but up to now, the traded volumes are too tiny), the swap market is an OTC or interbank market, at least one of the counterparts being a bank.

…

The deterministic approach leads to the valuation of products such as vanilla swaps and futures, for which the forward value is obtained independently from the further evolution of their underlying instrument. The non-deterministic approach allows for taking into account a random evolution of the underlying spot instrument, which is necessarily the case for valuing products conditioned by such an evolution, that is, for options or any products presenting a conditional feature (for example, credit default swaps). The evolution of the prices or returns of a financial instrument is to be represented by a mathematical model describing, at best, how prices or returns behave. It is important to distinguish between a forecasting model and an ex post – or explanatory – model. Here, we consider only ex post models.

…

This collateral secures that, in case of default, the protection seller can assume his role vis-à-vis the protection buyer (see product example). 13.1.5 Example of a credit derivative Before looking at credit derivative valuation properly said, let us present the most traded product, the credit default swap (CDS). The CDS is an OTC contract between two parties (at least one is a bank, active in credit derivatives), with a contractual maturity and notional amount, on a specific underlying risky bond (reference obligation): The “protection buyer” can be viewed as a hedger: he holds the bond and pays for being compensated in case of default on this bond; said payment is called “premium”; The “protection seller” receives a premium in exchange of supporting the default risk.

The Butterfly Defect: How Globalization Creates Systemic Risks, and What to Do About It by Ian Goldin, Mike Mariathasan

air freight, air traffic controllers' union, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, barriers to entry, Basel III, Bear Stearns, behavioural economics, Berlin Wall, biodiversity loss, Bretton Woods, BRICs, business cycle, butterfly effect, carbon tax, clean water, collapse of Lehman Brothers, collateralized debt obligation, complexity theory, connected car, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deglobalization, Deng Xiaoping, digital divide, discovery of penicillin, diversification, diversified portfolio, Douglas Engelbart, Douglas Engelbart, Edward Lorenz: Chaos theory, energy security, eurozone crisis, Eyjafjallajökull, failed state, Fairchild Semiconductor, Fellow of the Royal Society, financial deregulation, financial innovation, financial intermediation, fixed income, Gini coefficient, Glass-Steagall Act, global pandemic, global supply chain, global value chain, global village, high-speed rail, income inequality, information asymmetry, Jean Tirole, John Snow's cholera map, Kenneth Rogoff, light touch regulation, Long Term Capital Management, market bubble, mass immigration, megacity, moral hazard, Occupy movement, offshore financial centre, open economy, precautionary principle, profit maximization, purchasing power parity, race to the bottom, RAND corporation, regulatory arbitrage, reshoring, risk free rate, Robert Solow, scientific management, Silicon Valley, six sigma, social contagion, social distancing, Stuxnet, supply-chain management, systems thinking, tail risk, TED Talk, The Great Moderation, too big to fail, Toyota Production System, trade liberalization, Tragedy of the Commons, transaction costs, uranium enrichment, vertical integration

A number of studies show how concentration in commodity networks also enables firms to exert control over suppliers, “making them captives.”21 The increasingly complex financial network expanded not only in terms of size but also in terms of sophistication. Drawing on increased processing power, financial traders have invented new ways to trade and to gain access to credit. Though marginal at the turn of the century, credit default swaps, collateralized debt obligations (see box 2.1 for a nontechnical explanation of these products), and the resale market for capital had all become ubiquitous operations by 2008. In less than a decade the over-the-counter derivative market expanded to 10 times global GDP, or roughly $600,000 billion.

…

Special-purpose vehicle (SPV): A specially created company designed to have limited liability and insulate the ultimate beneficial owners from risks associated with investments and/or to obscure ownership of financial assets and liabilities. Sometimes known as a “special-purpose entity” or a “financial vehicle corporation” instead. Collateralized debt obligation (CDO): An investment security composed of a wide range of assets that is passed on to different classes or tranches of owners who face varying degrees of risk. Credit default swap (CDS): A financial swap agreement that transfers the credit link of a financial product between parties. It usually involves the seller compensating the buyer in return for a payoff in the event of a default. Asset-backed security (ABS): A security collateralized or backed by combining pools of assets (such as car loans, credit card debt, or royalty payments).

…

See management education butterfly defect, xiii–xiv butterfly effect, xiii, 80, 81 California: energy imports of, 140; environmental regulation in, 142 Cameron, Geoffrey, 197 capital flows: cross-border, 12, 19, 21f, 41; liberalization of, 12, 20f carbon dioxide. See greenhouse gas emissions Cash, Richard A., 159, 163–64 CDOs. See collateralized debt obligations CDSs. See credit default swaps central banks: European, 56, 59–60, 63; Icelandic, 37, 38–39; research at, 63; systemic risk measurements by, 59–60 chaos theory, xiii chemical weapons, 194, 254n80 Chen, Lincoln C., 159, 163–64 Chicago, Burnham Plan, 105 China: air pollution in, 137; domestic air travel in, 15–16, 17f; economic reforms in, 74–75; exports of, 16, 73–74, 74f, 75, 234n12; income inequality in, 172, 175f, 250n19; Internet use in, 193; MBA programs in, 87; political liberalization of, 74; rare earth element production in, 71, 71f; relations with Western countries, 11; SARS outbreak in, 144, 154; WTO membership of, 12 cholera, 145, 160–61 Cisco Visual Networking Index, 14 cities.

Why I Left Goldman Sachs: A Wall Street Story by Greg Smith

Alan Greenspan, always be closing, asset allocation, Bear Stearns, Black Swan, bonus culture, break the buck, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, East Village, fear index, financial engineering, fixed income, Flash crash, glass ceiling, Glass-Steagall Act, Goldman Sachs: Vampire Squid, high net worth, information asymmetry, London Interbank Offered Rate, mega-rich, money market fund, new economy, Nick Leeson, proprietary trading, quantitative hedge fund, Renaissance Technologies, short selling, short squeeze, Silicon Valley, Skype, sovereign wealth fund, Stanford marshmallow experiment, statistical model, technology bubble, too big to fail

On Tuesday of that week, the stock of AIG, the world’s biggest insurance company, dropped 60 percent, after already having dropped more than 95 percent from its fifty-two-week high of $70.13. AIG was an insurance institution that affected millions of lives in almost every country in the world, and because of some reckless gambling in credit-default swaps,** it was on the brink of collapse. The Federal Reserve stepped in and gave AIG an initial $85 billion bailout. This would grow. After people saw what was going on with AIG, the reaction was: Holy shit! Wall Street likes predictability, and the way the government was flip-flopping between bailing out companies and letting them fail was not helping the markets.

…

But I remember thinking, Welcome to the changing world of Goldman Sachs leadership. Company culture and morale seemed to be bygone values. To paraphrase that great sage Puff Daddy, it was all about the Benjamins now. If you were in the right place at the right time, if you were the trader with the “hot pad” (credit-default swaps, for example), or if you were the salesperson with the clients who were running for the exits, and if you had the instincts to know how to capitalize on this, then—boom!—the firm promoted you and paid you well and you were now a leader of the firm. This was the new model of Goldman Sachs managing directorship from about 2008 onward.

…

I listened in; everybody at Goldman did. It was a masterful performance under extraordinarily difficult circumstances. As the experts peppered Viniar with questions, he succeeded in making a two-pronged, essentially self-contradictory argument: that Goldman Sachs, which was owed billions of dollars related to credit-default swaps with AIG, had hedged itself to such a degree that we would have been just fine if AIG had gone bankrupt—but also that Goldman had been completely justified in accepting $12.9 billion, a hundred cents on the dollar, in AIG’s bailout money. You see, AIG had insured Goldman’s mortgage securities, and when the mortgage market crashed, Goldman wanted to get its insurance money—even though we were shorting the market.

Finding Alphas: A Quantitative Approach to Building Trading Strategies by Igor Tulchinsky

algorithmic trading, asset allocation, automated trading system, backpropagation, backtesting, barriers to entry, behavioural economics, book value, business cycle, buy and hold, capital asset pricing model, constrained optimization, corporate governance, correlation coefficient, credit crunch, Credit Default Swap, currency risk, data science, deep learning, discounted cash flows, discrete time, diversification, diversified portfolio, Eugene Fama: efficient market hypothesis, financial engineering, financial intermediation, Flash crash, Geoffrey Hinton, implied volatility, index arbitrage, index fund, intangible asset, iterative process, Long Term Capital Management, loss aversion, low interest rates, machine readable, market design, market microstructure, merger arbitrage, natural language processing, passive investing, pattern recognition, performance metric, Performance of Mutual Funds in the Period, popular capitalism, prediction markets, price discovery process, profit motive, proprietary trading, quantitative trading / quantitative finance, random walk, Reminiscences of a Stock Operator, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, risk/return, selection bias, sentiment analysis, shareholder value, Sharpe ratio, short selling, Silicon Valley, speech recognition, statistical arbitrage, statistical model, stochastic process, survivorship bias, systematic bias, systematic trading, text mining, transaction costs, Vanguard fund, yield curve

A cigar Event-Driven Investing203 butt found on the street that has only one puff left in it may not offer much of a smoke, but the ‘bargain purchase’ will make that puff all profit.” — Warren Buffett, Berkshire Hathaway 1989 shareholder letter The distressed-asset universe is huge and spans all kinds of below-­ investment-­grade debt securities. These investments may include high-­ yield bonds, below-par distressed bank loans, debtor-in-possession loans, credit default swaps, preferred stock, common stock, warrants, and real estate assets. Distressed-asset investing tends to perform best during bull markets, when investors make money on the turnaround on investments made during the preceding economic downturn. A downturn provides a large number of opportunities for this form of investing.

…

CAPITAL STRUCTURE ARBITRAGE A company’s capital structure comprises the shares, debts, and other financial instruments it uses to finance its operations. In capital structure arbitrage, one security of a company is traded against another security of the same company – for example, buying the company’s bonds and shorting its stock, or trading its credit default swaps (CDSs) against its stock. Another play could be on the arbitrage between listings of the same security on different exchanges; such mispricings may happen because of liquidity or other factors. Another type of capital arbitrage is to trade on changes in the company’s capital structure, such as share buybacks, share issuances, debt issuances, or debt exchanges.

…

Another type of capital arbitrage is to trade on changes in the company’s capital structure, such as share buybacks, share issuances, debt issuances, or debt exchanges. These trades do not express a view on the overall quality of the company but on relative mispricings or shifts in value among different forms of capital. One of the most popular capital structure arbitrage plays is to profit from mispricings between a company’s equity and its bonds or credit default swaps. This strategy has gained a lot of popularity with the growth of the CDS market. Consider, for example, what happens when extremely bad news hits a company. This will cause both its bonds and its stocks to fall, though the stock prices will likely decline further, for several reasons. Stockholders will absorb a greater loss than bondholders Event-Driven Investing205 if the company is liquidated, because bondholders have a priority claim on the assets of the company; the dividend might be reduced or dropped altogether, whereas annual bond payments are fixed, and the stock market is usually more liquid and so reacts to news more dramatically.

Fault Lines: How Hidden Fractures Still Threaten the World Economy by Raghuram Rajan

"World Economic Forum" Davos, accounting loophole / creative accounting, Alan Greenspan, Andrei Shleifer, Asian financial crisis, asset-backed security, assortative mating, bank run, barriers to entry, Bear Stearns, behavioural economics, Bernie Madoff, Bretton Woods, business climate, business cycle, carbon tax, Clayton Christensen, clean water, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency risk, diversification, Edward Glaeser, financial innovation, fixed income, floating exchange rates, full employment, Glass-Steagall Act, global supply chain, Goldman Sachs: Vampire Squid, Greenspan put, illegal immigration, implied volatility, income inequality, index fund, interest rate swap, Joseph Schumpeter, Kaizen: continuous improvement, Kenneth Rogoff, knowledge worker, labor-force participation, Long Term Capital Management, longitudinal study, low interest rates, machine readable, market bubble, Martin Wolf, medical malpractice, microcredit, money market fund, moral hazard, new economy, Northern Rock, offshore financial centre, open economy, Phillips curve, price stability, profit motive, proprietary trading, Real Time Gross Settlement, Richard Florida, Richard Thaler, risk tolerance, Robert Shiller, Ronald Reagan, Savings and loan crisis, school vouchers, seminal paper, short selling, sovereign wealth fund, tail risk, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, Vanguard fund, women in the workforce, World Values Survey

As the Wall Street Journal reported in 2009 in an article on my Jackson Hole presentation: Incentives were horribly skewed in the financial sector, with workers reaping rich rewards for making money but being only lightly penalized for losses, Mr. Rajan argued. That encouraged financial firms to invest in complex products, with potentially big payoffs, which could on occasion fail spectacularly. He pointed to “credit default swaps” which act as insurance against bond defaults. He said insurers and others were generating big returns selling these swaps with the appearance of taking on little risk, even though the pain could be immense if defaults actually occurred. Mr. Rajan also argued that because banks were holding a portion of the credit securities they created on their books, if those securities ran into trouble, the banking system itself would be at risk.

…

Much like a financial Venus flytrap, though, AAA mortgage-backed securities masked their risk with their ratings, and their attractive returns drew in many an investor innocent about finance and many more who should have known better. Among the firms that should have understood the risk better was the American International Group (AIG). Its now-infamous financial products unit (AIGFP) sold insurance through credit-default swaps on billions of dollars of asset-backed securities, including senior (AAA-rated) tranches of the mortgage-backed securities described above. It promised buyers of the swaps that if the insured securities defaulted, AIGFP would make good on them. The unit was thus betting that defaults would be far rarer even than the market anticipated.

…

It started attracting and recruiting the smartest students in class, people who thought they could price CDO squared and CDO cubed (particularly egregious forms of securitization involving collateralized debt obligations) and manage their risks. As Trillin writes: “When the smart guys started this business of securitizing things that didn’t even exist in the first place, who was running the firms they worked for? Our guys! The lower third of the class! Guys who didn’t have the foggiest notion of what a credit default swap was. All our guys knew was that they were getting disgustingly rich, and they had gotten to like that.”11 The suggestion that bosses, recruited in a staid and regulated era, were of lower caliber than the employees they had recruited from the top of the class in a deregulated and high-paying era is not completely without foundation.

Boom and Bust: A Global History of Financial Bubbles by William Quinn, John D. Turner

accounting loophole / creative accounting, Alan Greenspan, algorithmic trading, AOL-Time Warner, bank run, banking crisis, barriers to entry, Bear Stearns, behavioural economics, Big bang: deregulation of the City of London, bitcoin, blockchain, book value, Bretton Woods, business cycle, buy and hold, capital controls, Celtic Tiger, collapse of Lehman Brothers, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, cryptocurrency, debt deflation, deglobalization, Deng Xiaoping, different worldview, discounted cash flows, Donald Trump, equity risk premium, Ethereum, ethereum blockchain, eurozone crisis, fake news, financial deregulation, financial intermediation, Flash crash, Francis Fukuyama: the end of history, George Akerlof, government statistician, Greenspan put, high-speed rail, information asymmetry, initial coin offering, intangible asset, Irish property bubble, Isaac Newton, Japanese asset price bubble, joint-stock company, Joseph Schumpeter, junk bonds, land bank, light touch regulation, low interest rates, margin call, market bubble, market fundamentalism, Martin Wolf, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, negative equity, Network effects, new economy, Northern Rock, oil shock, Ponzi scheme, quantitative easing, quantitative trading / quantitative finance, railway mania, Right to Buy, Robert Shiller, Shenzhen special economic zone , short selling, short squeeze, Silicon Valley, smart contracts, South Sea Bubble, special economic zone, subprime mortgage crisis, technology bubble, the built environment, total factor productivity, transaction costs, tulip mania, urban planning