Yesterday, Marketplace had a store about a complex financial instrument called a “default credit swap“.
They try to explain what it is, and the best they can do is say is that it is some sort of complex financial transaction that serves as a sort of insurance against companies defaulting on their loans.
But that’s not what they are, that is their intended purpose.
This excerpt of the exchange may clarify a bit:
MOON: Well, this is where it gets tough, Kai, because a lot of people on Wall Street, even some of the leading economists in the academic world, don’t really understand exactly how these things work. A lot of them are whipped up with some computer wizardry, some advanced math — think of those fancy Greek letters turned on their sides. And there’s a lot of guesswork to this, too, about how much they’re really worth.
Boy…That makes it a lot clearer, doesn’t it?
So we have another derivative like instrument where there is no value that can be understood. In fact, most of the people who trade this stuff not only don’t know the value, they don’t know what it is.
It could be bellybutton lint futures for all we know, and for all Wall Street knows.
RYSSDAL: All right, so what’s the problem, though, if everybody agrees that they don’t know what they’re worth?
MOON: Well, the critics I’ve spoken to complain that they’re really nothing more than gaming instruments — gambling. Turns out that the big hedge funds that attract so much money from rich investors and big institutions, well, they’re playing the market on their own, and they don’t even need to have a stake in a particular company to do that.
RYSSDAL: I’m going to make the analogy here to a March Madness office pool, right? I go in, I pick a basketball team, and if they do great, that’s great, but I’m not vested.
It is. Except instead of wagering on UCLA and Auburn, these big bankers and brokers and hedge fund managers pick up the phone and they negotiate these wagers privately. Nobody really regulates this. They’ve created this incredibly enormous shadow financial system, if you will, that’s virtually hidden from investors and analysts and regulators.
You know when those high energy physicists do that complex stuff that explains how to smash two pieces of metal together to wipe out Hiroshima, I feel a bit more secure about this.
RYSSDAL: How big would “incredibly enormous” be?
Good question. I’d like to know how many billions of dollars are nothing more than fairy dust.
MOON: OK, I’m about to unload some numbers on you here, so I’ll speak slowly so you can follow this.
The value of the entire U.S. Treasuries market: $4.5 trillion.
The value of the entire mortgage market: $7 trillion.
The size of the U.S. stock market: $22 trillion.
OK, you ready?
The size of the credit default swap market last year: $45 trillion.
RYSSDAL: That’s a lot of money, Bob.
Ummm…why yes, it is. Doing math in my head 4.5×1013/3×108=1.5×105, or in normal notation, about $150,000.00 for every man, woman, and child in the United States of America.
MOON: It is, and the great unknown here is that these things get traded, or swapped, between the banks and hedge funds and other investors, and there’s really no one who oversees or regulates these trades to guarantee that the buyer actually is going to be able to make good on these if they have to. And these things end up being so interconnected that it’s not just like single line of dominoes falling, if one fails. Imagine one falling domino taking down two more, and those taking down four more, and eight, and so on.
I don’t know about you, but I’m spending this evening gibbering inconsolably.
Here is the full audio, including some comments from an expert on this that is even less reassuring, and the tid-bit that Alan “Bubbles” Greenspan loved these.