|Individual Investors Duped by Derivatives
|"Leona Miller, an 84-year-old retired beautician, says she was seeking safe and steady income from bonds two years ago when she bought securities recommended by her Wachovia (WFC) broker, Robert Baldacci, paying 9 percent interest. Within six months, Miller lost about 30 percent of her 20,000 investment, and the bonds were converted into shares of Merck (MRK) in a falling stock market."
|The city that got swapped
|"A decade ago, the mayor of Saint-Etienne, France, hit on a novel way to help pay for urban renewal: currency and interest rate swaps. He was a hero for a while. Then came the crash. Now he's the ex-mayor of a town facing financial disaster "
|Derivatives should be banished
|"The only firms that will be able to sell the insurance will be firms deemed too big to fail. That is, you wouldn't buy this kind of insurance from a firm you believed might also face a liquidity risk. You would only buy it from a firm you thought was protected from liquidity risk, and that kind of protection ultimately must come from the US government. So, ultimately, the sellers would be making private profits from the existence of public guarantees. They get all the upside, while the taxpayer gets all the risk."
|""We didn't truly know the dangers of the market, because it was a dark market," says Brooksley Born, the head of an obscure federal regulatory agency -- the Commodity Futures Trading Commission [CFTC] -- who not only warned of the potential for economic meltdown in the late 1990s, but also tried to convince the country's key economic powerbrokers to take actions that could have helped avert the crisis. "They were totally opposed to it," Born says. "That puzzled me. What was it that was in this market that had to be hidden?""
|The model made me do it
|"At the bottom of every financial model there is in fact a stubborn lie - the pretense that financial markets operate in the manner of a physical process, subject to the iron laws of statistics, like atoms bouncing around in a thermodynamic equilibrium. This beguiling analogy makes it too easy for geeks like me to lose sight of a timeless truth: If atoms could talk to one another, then the laws of thermodynamics would get broken every day by clouds of stampeding gases."
|'Tax event' may be next for bruised PPNs
|"For a supposedly safe investment, there sure are a lot of risks associated with principal-protected notes. Tax changes being considered by the Canada Revenue Agency could, in the words of one issuer of principal-protected notes (PPNs), "have a material adverse effect" on these investments. And then there's the experience of the U.S. investors who hold PPNs issued by the once illustrious but now bankrupt Lehman Brothers. They're waiting in line to get paid along with other creditors."
|Dig a grave for those wretched PPNs
|"I've called them the worst of both worlds - bad for equity investors and inappropriate for those seeking a predictable flow of income. And professional money managers would never buy one; the odds are stacked against them. I'm talking about principal-protected notes, or PPNs."
|Evil Wall Street exports boomed
|"While the collapse was most visible in the stock markets, the cause was the loss of confidence in the world's biggest bond market, structured finance. So far, it has led to the worst financial crisis since the Great Depression, the disappearance or takeover of more than a dozen banks, including three storied Wall Street firms, and almost $3 trillion in government expenditures and guarantees to contain the contagion."
|Realm of fantasy in credit insurance
|"If you had a 100,000 car, what kind of world would it be where you'd consider paying 50 grand over five years to insure it? You'd either have to be such an appalling driver that you ought not to be on the road, or the world would be such a lawless and dangerous place that your 100,000 car should be among the least of your worries. We do not need the details of mathematical probabilities to see there is little sense in the idea of paying out insurance costs that are a huge chunk of the value of the thing to be insured. But that is exactly what participants in credit markets are being asked to do."
|Traders' worst fears realised at Lehmans auction
|"Analysts say the amount of money that has to change hands could be more than $200bn. Some estimates put the value of outstanding credit default swaps on Lehman Brothers debt at $400bn, although some of these trades have already been netted out because some investors both sold and bought CDS contracts. Exact figures are not available because a CDS is a private contract and is not traded on an exchange, but the payout will certainly be the biggest in the 10-year history of the market."
|Lehman credit-swap auction sets payout
|"Sellers of credit-default protection on bankrupt Lehman Brothers Holdings Inc. will have to pay 91.375 cents on the dollar to settle the contracts, setting up the biggest-ever payout in the $55 trillion market."
|The monster that ate Wall Street
|"What the bankers hit on was a sort of insurance policy: a third party would assume the risk of the debt going sour, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves."
|The day the ticking time bombs went off
|"The underlying philosophy behind derivatives sounds terrific. The weak can get rid of risks they can't handle and the financial system should be stronger as a result. In the right hands, derivatives can perform this role. But the general practice is very different, as the great investor Warren Buffett worked out years ago. His 2002 letter to his Berkshire Hathaway shareholders made headlines by condemning derivatives as "financial weapons of mass destruction". They were "time bombs, both for the parties that deal in them and the economic system"."
|Counterparty risk and CDSs
|"Given the crisis on Wall Street and the focus on American International Group Inc., one of the world's largest insurers, everybody is suddenly talking about counterparty risk. What is counterparty risk, and why is it now an issue? In the simplest terms, counterparty risk is the chance that the person on the other side of a deal - the counterparty - won't be there when it's time to pay up. Take an example most people can relate to: Selling a home. There's always the chance that when it comes time to close the deal a month or so down the road, the buyer won't show up or won't have the money."
|Moody's ratings error probe
|"Moody's Corp. plunged the most in nine years after the ratings company said it is conducting 'a thorough review' of whether a computer error caused it to assign Aaa rankings to debt securities that later fell in value."
|"Structured finance, of which this deal is typical, is both clever and useful; in the housing industry it has greatly expanded the pool of credit. But in extreme conditions, it can fail. The old-fashioned corner banker used his instincts, as well as his pencil, to apportion credit; modern finance is formulaic. However elegant its models, forecasting the behavior of 2,393 mortgage holders is an uncertain business. 'Everyone assumed the credit agencies knew what they were doing,' says Joseph Mason, a credit expert at Drexel University. 'A structural engineer can predict what load a steel support will bear; in financial engineering we can't predict as well.'"
|"In fact, Black-Scholes may not be used that much in the markets to begin with. New research by veteran traders and best-selling authors Nassim Taleb and Espen Haug points in that direction. Clearly, a formula that isn't used can't have much of an effect on markets, let alone cause the massacre that began last summer."
|Anatomy of a panic
|"For three days in August, an obscure but massive investment class teetered on the brink of a meltdown, rescued only by the ingenuity of a small group of bankers and lawyers. The aftershocks have shaken the markets, destroyed reputations and frayed friendships"
|"With the global numbers and values already enormous, adding U.S. pension funds, more institutions and a retail investment audience to the hundreds of trillions of capital the derivatives market attracts could further shift the scale in favor of them more than any other financial instrument or asset class. Yet, it wouldn't take all that much to create a domino effect of market mishap. And there is no net. The Securities Investor Protection Corporation, which insures brokerage accounts, recently announced its reserves. It has a little more than $1.2 trillion. That may sound like a lot. Compared with half a quadrillion, it's a pittance."
|"Warren Buffett, the American who has been one of the world's most successful investors for the past 40 years, warned shareholders in his Berkshire Hathaway company last year that derivatives were "time-bombs both for the parties that deal in them and for the economic system". "Large amounts of risk, particularly credit risk, have been concentrated in the hands of relatively few derivative dealers who, in addition, trade extensively with one another. The troubles of one could quickly affect the others," he wrote."
|Rogue waves & standard deviations - part 2
|"The companies, funds, investors, and governments best able to withstand a crisis are those who are unleveraged, liquid and have access to cash. Having no debt enables one to ride out a storm. Leverage becomes a ticking time bomb that offers few avenues for escape. In summary, the best protection against adversity is to have minimal debt and plenty of liquidity."
|Rogue waves & standard deviations
|"What we are seeing in the financial system is similar to what we are seeing in the natural world, which is the increasing frequency and magnitude of storms. As seen from the above list and frequency of crises, storms continues to grow and raise the possibility of one too many shocks to the system."