JohnG@lt wrote:
Taking my $5 a day example, it comes out to $1825 a year. The odds of getting struck by lightning are 1:500,000 so if I as a company were selling a derivative based on getting struck by lightning, I could feel confident peddling this insurance to 500,000 people. I would make $92.5M a year selling this insurance with the odds of a payout only occurring once, lowering my overall profit to $82.5M.
This is all a derivative is. Now, derivatives get a bad rap because it supposedly encourages idiots who have bought my insurance to feel more confident playing golf in a thunderstorm. Still not my fault as the salesman.
You know you're full of $hit right?
I know what a derivative is. its a way to spread risk. They call it insurance but in the gambling arena its called hedging to limit exposure. in other words to bet against your own bet. But it works the same way. Its not a complicated concept to understand at all, but the agreements are made in black boxes between private parties, using complicated models that make assumptions, and the risk is spread out so no one really knows how widespread the exposure is in the market place and that's the real danger. So you can go on and explain all you want about what it is, but no one, no even you, knows the potential harm to the economy if the model assumptions in the risks change.
Take your example where the odds are 1:500,000... now supposing the odds drop ro 1:1,000,000, the odds just changed in your favor, so you can they lay off the bet or hedge and lock in some profit. But if for some unforseen circumstances the year becomes very stormy and you are assuming a risk of 1:500,000 and instead 1:500 people or 10:500 people are struck by lightening that year, well your model just failed and you are probably now bankrupt right? So the health of the derivatives is directly related to the accuracy of your modeling? If you take the AIG example, its was assuming that there would be no deflation so the risk odds actually inverted. In betting its like assuming that only one team can win and you are only assessing risk on the margin of victory. What that does is set the risk of the other team winning to such a low threshold that the bet against the model is really cheap... that's why the hedge fund guy paulson made around $900 million while only risking an exposure of only $20 million. Smart for him, pure idiocy for the people who created the models.
Now in the real economy we've got two problems
First, first you can't assume away deflation. the economy is going through a deflationary period because of irrational greed and economic bubbles that are popping. As in the mortgage market with AIG, the assumption was that housing would never deflate. That upset the risk assumption, the value of the assets underlying the original instrument proved to be less valuable and so the risk on the derivative instrument proved to be much greater and AIG lost out.
Second, it would have been fine for AIG to go down the toilet except they hedge their risks and tied lots of other companies together, ie pension funds, financial institutions who thought these instruments were good investments. We couldn't let AIG go because AIG hedge bets were spread throughout the economy. If AIG went down numerous other companies would have gone down too, but those company names have never been disclosed. But we do know that Goldman Sachs was a market maker on those instruments. And we do know that because these instruments are tradeable, they are counted in the money supply as M3 and any devaluation of that paper would have resulted in capital loss for the financial instiutions, possible leaving them insolvent and bankrupt. That's why the credit markets froze, because the banks would't lend to each other because they didn't know if the other bank was in fact insolvent.
The real problem with the derivative market is that its enormous and it ties companies and fincncial institutions around the globe together. And if their assumptions prove to be incorrect, as there is no such thing as economic bubbles and that deflation is not possible, well I think you can see crash coming if the govts can't keep the economies inflated. And by the looks of things its taking about a $1 trillion a year to keep the whole thing on life support. $1 Trillion last year from the US, $1 Trillion this year from the EU. May be China will kick in $1 trillion next year. and you know if the reflation works, everything will be fine, until the next model assumption fails. If you stand back and look at the derivative market as a companies around the globe tieing their fates to one another so that if one fails they all fail, then the cries for corporate bailouts start to look more like blackmail from a global corporate union.
And that is why derivatives are getting a bad rap.
IMO the differnce between me a you is that I think we are in a deflationary trend, that we experience economic bubbles, and the reason for that is that people are irration whenit comes to handling investments because they get greedy, get careless and to them investment money becomes intangible and loses meaning because it no longer is connected to some item for consumption. And i think that you subscribe to the Chicago school and think people are always rational, and that economic bubbles don't occur... is that correct?
And there are a lot of people complaining about walls of text lately, is that because you guys are using iPhones and have small screens. Man I sure hope the web isn't going to get dumbed down to the level of twittering because peoples screens are too small.
