Traders, Guns & Money

Traders, Guns & Money: Knowns and unknowns in the dazzling world of derivatives, by Satyajit Das

Written in 2006, just before the current credit collapse, Traders Guns and Money details how the bizarre world of financial derivatives works – and helps explain previous collapses, like the spectacular implosion of LTCM in 1998 which almost tanked the international banking system.

The author, a savvy insider with decades of experience, shows how over reliance on mathematical models, insane amounts of leverage, and most of all, underestimating risk leads to the collapses – and there’s been plenty of them.

A key insight. Money is never made in financial markets, it is merely transferred. Banks, hedge funds, insurance companies and even governments all chase maximum return, and since there’s so much competition, increasingly weird financial derivatives keep being developed, then marketed and exploited until everyone copies them or something blows up. Then a new one gets developed.

Need to borrow in euros and pay back in dollars? No problem. Ditto for debt packaged from 100 companies at $10 million each where you sell bits of it to CDOs of CDOs. How about an inverse floater? You make more money as interest rates drop – and it pays a better rate than elsewhere. What could go wrong? You might want to ask Orange County that, they lost $1.5 billion on them in 1994. Ouch. But it was a safe investment. The banks told them so.

The key problem for all the blowups was underestimating risk. They package up thousands of mortgages into CDOs and SIVs, slice and dice them every which way and their models show that no more than 4.0% of the subprimes will default. Oh, the default rate is 6.0% now? But the higher rated mortgages are ok because they have a minuscule default rate. What’s that you say, a 2.6% default rate for them now? Impossible. Just mathematically impossible. Can’t be happening. The models don’t predict it.

The traders long ago made their bonuses on such trades, the carnage is not their problem. Everyone made lots of money on mortgage derivatives until.. they didn’t. Those who bought Credit Default Swaps thinking them to be a swell investment now may have to make good on defaulted mortgages. They, in effect, sold insurance they never expected to have a claim against and thus could lose much more than their original investment. Double ouch. And if and when they can’t pay, the banks that issued the CDS will take huge financial hits.

Warren Buffett has said derivatives are “financial weapons of mass destruction.” The detonations we’ve seen in the past may well be dwarfed by the credit crisis unfolding now.

The insane part is, it’s all just air. Nothing of substance is created by derivatives. Nothing new gets built. Just money changing hands. Much of what we see is sleight of hand. Ever wonder why companies are so happy to buy back stock? Let’s say a company has one million shares on the market and made $5 million last quarter or $5 a share. It buys back 500,000 shares and, wow, suddenly it’s making $10 a share! Analysts upgrade the company, and management gets a big bonus because the stock price has zoomed upwards. But nothing in the company changed. Just a financial trick or two, that’s all.

As the mortgage crisis plays out, we’re learning the hard way that this is no way to run an economy. The author was recently asked, where are we now in this crisis, maybe the third inning? He laughed and said no, we’re still listening to the pledge of allegiance.