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Peak Credit
1478 αναγνώστες
Πέμπτη, 18 Σεπτεμβρίου 2008
21:06

"Inflation is not a reduction in real wealth for a nation – but a redistribution of the rights to that wealth among its citizens.   Those who lose wealth often pay taxes for the privilege, while the wealth gains can be tax-free."

 

 

 

CREDIT EXPANSION OUT OF CONTROL

  Credit
Growth

GDP Growth

Current
Account Deficit
Personal
Savings Rate
Disposable
Income**
Nom. Real
1997 1,336.1 487.4 374.6 140.4 3.6 3.5
1998 2,045.0 442.7 363.4 213.5 4.3 5.8
1999 2,044.7 521.4 403.4 299.8 2.4 3.0
2000 1,605.6 548.6 346.7 415.1 2.3 4.8
2001 2,034.2 311.0 73.7 388.9 1.8 1.9
2002 2,171.1 341.6 158.1 472.4 2.4 3.1
2003 2,668.2 491.2 252.2 527.5 2.1 2.2
2004 2,800.8 751.7 402.5 665.2 2.0 3.6
2005 3,335.9 743.3 345.1 791.5 -0.4 1.2
2006 4,392.8*     834.8* -1.0 1.7

* annualized, ** growth in chained dollars |  Source: Bureau of Economic Analysis
Table courtesy of  The Richebächer Letter, Sept. 2006


CREDIT DERIVATIVES

Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. The chart below shows the relative size of the credit derivatives and subprime mortgage markets.

1

 

Let's consider the simple heart of what credit derivatives are all about. A major investor has the opportunity to make an attractive-looking investment that involves taking a risk. For instance, a bank or insurance company sees an opportunity in lending to a corporation, but they are concerned about the financial safety of the corporation. They would prefer to keep most of the positive returns from the investment, but not take the risk of the company defaulting. So, as the employee of a company that creates financial derivatives (a credit swap in this case), what you do is promise – for a fee – to take the risk for them. Your company makes assumptions about how bad the risk will be, and based on those assumptions, you determine that this trade is profitable for your employer. You then personally take a nice chunk of those profits in your next bonus as a reward for having been smart enough to get your company into this lucrative transaction. And because this upfront booking of expected profits from these transactions is so lucrative, not only do you get an enhanced bonus -- but so do the other members of your group, your supervisor, their supervisor, and the president and other senior officers of the firm.

Now, this is not to say that you and the other members of your group have entirely assumed the risk away. You make some allowance for the possibility that out of all these contracts that you're entering into, you may have to actually make some payments. To cover the possibility of losses, you set aside a reserve, or buy a credit derivative from another company to cover, or both. The key to your bonus this year is the particulars of the assumptions that your group makes about what those expected losses will be in the future. The lower the assumption for expected losses, then either the greater your profits in a given transaction, or the more competitive your bid, and the greater your chances of beating out competitors who are seeking the same “lucrative" business.

For example, if your firm is being paid $12 million to guarantee payment of a $500 million loan for ten years, and your group assumes there is a 4% chance of having to pay out $250 million on that guarantee, then your expected losses are $10 million – and your firm’s expected profit is $2 million.

This is shown in the top chart below, “Making Money With Credit Derivatives”.

2

However, let’s say that your group comes back and re-examines those assumptions. You find that if you make fairly minor and quite reasonable appearing changes to two of your assumptions, the potential loss on the derivative drops from an expected $250 million down to $225 million. Make two other minor changes in other assumptions that are also each individually reasonable, and the chances of that loss occurring drop from 4% down to 3.5%. As shown above in “Making A FORTUNE With Credit Derivatives”, rerun the numbers with a 3.5% chance of losing $225 million – and your expected losses drop to $7.9 million, while your profits just doubled, going from $2 million to $4.1 million!

Now, it quickly becomes clear to any reasonable person that if you can double the profits your firm recognizes on a transaction by keying in four small assumptions changes on a computer model, each of which sounds individually reasonable, and the end result of those changes is to double the bonus you get paid this year – then the key to making some serious personal money is making the right assumptions! Something that is equally plain to your peers at competitive firms....

Ah, competition! Competition is where the process starts to get interesting over time. Competition for credit derivatives business, for these easy profits, means that you and others in your company have powerful personal incentives to make aggressive assumptions about how low credit losses will be, and to validate your co-workers assumptions as well. If your assumptions are not aggressive enough, you don't win any business, you don't earn bonuses, your bosses don't earn bonuses, and you are quickly out of a job.

The institutional culture then very quickly becomes that if you want to keep your job – you and the other members of your group make aggressive assumptions. If you want to make big bonuses – you make very aggressive assumptions about how low the losses will be on the credit derivatives, which then translates into increased business for you...

To understand this process – you have to understand just how much money there is to be made by playing the game by its own rules, which may have very little to do with maximizing long-term shareholder value. Personal bonuses can be millions per year (with far higher payouts for hedge fund managers). As an individual who is in the right place at the right time – you can make more money in one good year than a doctor or airline pilot will make in a career. Except there is none of this medical school, or being on call, or flying over the Pacific Ocean business involved, there’s just sitting at a desk and manipulating some numbers while working the phone. As a corporation you can mint profits by the billions and tens of billions, without going through that messy business of actually building things, or selling toilet paper, or drilling for oil in two miles of ocean or such...                 D. A. AMERMAN

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