tag:blogger.com,1999:blog-678695784698978970.post2154726927147709824..comments2024-03-24T07:05:18.668-04:00Comments on Commercial Law: Explaining the Financial Crisis to StudentsJim Chenhttp://www.blogger.com/profile/13981455878475838042noreply@blogger.comBlogger1125tag:blogger.com,1999:blog-678695784698978970.post-31461916230721999772008-10-15T18:09:00.000-04:002008-10-15T18:09:00.000-04:00This is a good summary, but a few more points ough...This is a good summary, but a few more points ought to be added for a full picture. I write from in house at a hedge fund so I deal with this regularly.<BR/><BR/>First, swaps are often entered into purely for speculation, not as insurance (in the hedge fund world, it is mostly for speculation). And you can pretty much swap anything as long as you find a counterparty. Often they are done to avoid regulations such as FIRPTA so that a Cayman fund can buy companies connected to US real estate, for example, or for tax reasons. Thus, e.g., I can swap Libor+3% against the upside in an oil company stock (That is, I pay Libor plus 3% and I get back the rise in value of a stock price, but I have to pay if the stock goes down). Many swaps are just bets on interest rate movements. And some are insurance style swaps that you describe. They are basically anything you can get the other side to agree on. You pretty much agree when you will compare sides of the swap (say quarterly) to see who is ahead and whether one side needs to add collateral. There is a master agreement and a form swap confirmation, but the details are pretty negotiable. <BR/><BR/>Second, the swap market is otc (over the counter between parties in private agreement), which means it is not reported anywhere, and unregulated, there is no established dispute resolution system, no clearinghouse like an exchange to monitor collateral, etc. There is virtually no law in the area, so it is not even clear when, for example, an event constitutes a 'default' that would trigger payment under the swap contract. The whole area is a morass, and collection from a counterparty is difficult. <BR/><BR/>Third, swaps have massive hidden leverage. Most investors are stuck at 50% margin under RegT, hedge funds are offshore and outside RegT, but in a swap you can create as much leveage as you like by changing the notional amount. So in the 'real' world if I have $100 I can only bet $200 but in the swap world I can place a bet on the notional amount of 1MM, or 10MM, or 100MM, or whatever the other side agrees. Many swap counterparties have written swaps that aggregate many dozens of times their own equity. In other words, in most cases swaps will amplify leverage but are not shown on balance sheets as a potential loss.<BR/><BR/>Fourth, many swaps are keyed to downgrades or defaults by referenced companies, so if, for example, Ford files bankruptcy then all the swaps where they were a counterparty are in default and there has also been a massive change in swaps that used Ford as a reference, which means that some counterparties will have to make massive payments, which can affect their swaps, and so on ad infinitum in an endless chain. When these parties are broker dealers (e.g. Lehman) the collateral that they are holding is rehypothecated already and is now lost to senior creditors, so hedge funds with assets parket there go out of business, etc etc. <BR/><BR/>Lastly, many of the swaps were tied to CLOs and other structured products which have become toxic, so no one has any idea the vastness and interconnectedness of the toxicity. Much of this is held by banks who have no idea the value of what they are holding or the value of swaps that reference it. And some of these structures do not even have 'real' mortgages in them, they are purely synthetic structures that replicate or imitate the real structures. Thus people made bets on swaps against the performance of synthetic tranches of mortgage backed securities. The complexities are mind-boggling, and were created by PhDs in mathematics and physics, believe it or not. It is an unreal world. <BR/><BR/>The problem, then, is not just bad mortgages but a completely interconnected web of unregulated products among a handful of companies that are so big that the failure of any one could take down the whole market. Mortgages are just a reference point, the problem is the fantastical structures built that use mortgages as a reference point. <BR/><BR/>Some day, swaps will be traded on an exchange with clear collateral requirements (in the way that futures are traded, for example).<BR/><BR/>Eventualy, reality will assert its head and we will have to return to regulated markets, real assets, and fundamental accounting principles.Anonymousnoreply@blogger.com