Back in my single days, I worked out. A lot. But now happily enjoined in domestic bliss, I’m getting fatter every year. So my friend Pam and I made a bet in July. For every pound I lose between now and the end of the year, she’ll pay me ten bucks. But for every pound I gain in the same period I’ll pay her. We drew the bet up in a nice legal looking piece of paper, a contract each of us holds, and either one of us can sell our respective end of the bet to someone else, provided of course we find someone interested. Now it’s October, and I’ve lost over 10 pounds. Whose end of the bet is worth more?
I’d say mine! Sure, the holidays lay ahead. And my loss is theoretically unlimited; I could hypothetically gain an infinite number of pounds. But for now I’m 'in the money' by ten pounds or a 100 bucks.
The value of the bet is derived from my current weight in relation to my initial weight and the amount of time remaining. It's a derivative of those constantly changing numbers. Now, replace, my weight on any given day with the fluctuating price of a stock, my initial weight with the initial stock strike price, the end of the year with the exercise date, and that bet is an imperfect but fairly decent analogy to a type of derivative called a stock option.
In a wider context, a derivative is simply a bet where the value at any given time is in part derived from the price of an underlying item, like a stock, bond, currency exchange rate, even a bushel of wheat or a mortgage. You can bet on it going up, down, or staying the same. There’s usually a time limit of some kind and the bets can be placed through a broker-dealer by anyone interested in getting a piece of the action. They can be pure Vegas style speculation, or used as a hedge: if I own a stock at a huge profit and want to wait and sell it next year for tax reasons, it would be prudent to bet that it will go down between now and then as a form of insurance.
Thousands and thousands of stock option contracts are traded every day. But stock options are just a tiny piece of the global derivatives market. These markets include items far more complex than a stock option and they are huge, with daily volumes that run into the many trillions of dollars. Just as with any bet, there are winners and losers. So, what if someone loses and doesn’t have the money to pay off?
Brokers handle that dilemma by requiring the players to have enough money in their account to cover losses. For bets where the risk is theoretically unlimited, they require the players to keep a hefty cushion on hand. In the rare event the underlying item, stock or pork belly or whatever, moves so fast the loser still doesn't have enough on deposit to cover it, the brokerage company holding the bet is responsible for honoring it. Since the brokerage company itself might be tempted to make some wagers of their own -- while holding millions of bets for clients adding up to billions of dollars -- the ability of the broker-dealer to pay off and the amount of exposure they're allowed to have are overseen by exchanges and regulatory agencies, basically financial market cops, that require the broker-dealers to have a cushion, too.
That’s all well and good, until some enterprising financial engineer cooks up new ways of betting that aren’t overseen and regulated, and/or manages to lobby Congress to ease existing oversight and regulations. And that they did. Lobbyists managed to get rules put in place after the 1929 fiasco and Great Depression relaxed or removed. This paved the way for banks, brokers and insurance companies to consolidate into financial Goliaths. These shiny new giants developed a new kind of bet, a derivative, called a Credit Default Swap (CDS). In a CDS, one party agrees to cover the mortgage payments to another party if the borrower defaults. In return the guarantor gets a premium representing a sliver of the monthly mortgage payments.
Now, this next part is key to understand: originally a CDS was simply a way for a lender to safely loan money to a borrower with non-existing or less than stellar credit, a so-called Subprime loan. But banks, brokers, and insurance companies, no longer encumbered by Depression Era restrictions and rules, figured out lickety-split they could print up as many CDS's as they wanted on the same mortgage. They could sell them on a burgeoning unregulated shadow market, package them into bundles and sell them to retail investors, or just hold them and collect the juicy monthly premium. All without the homeowner or lender knowing anything about it or having anything to do with it. No regulation, no rules, no requirements to keep a cushion or limit exposure.
To go back to my bet with Pam on my weight, imagine that I just up and printed off a hundred thousand copies of the bet and sold them without bothering to tell her -- or maybe did tell her and cut her in, both of us knowing full well she wouldn't be able to pay off. This is downright dreamy for a company, it's about as close to printing money as it gets. And brother, they all jumped in and printed it as fast as they could.
When the mortgage market inevitably went through a rough patch, and some subprime borrowers defaulted, each one of those mortgages could represent dozens, hundreds, even thousands of CDS bets. The companies on the loosing end of the bet, who had up until then been receiving a nice check every month, suddenly found themselves obligated to pay out trillions of dollars to the folks on the other side of the wager. Which, thanks to no requirements to have a cushion and limit exposure, they could not even begin to cover without going bankrupt ten times over. At the same time, if the folks on the winning side of the bet couldn't collect, they might go down in flames. The fear was this chain of falling dominoes could take out every major bank, brokerage, and insurance company. Overnight, your checking account, IRA, insurance coverage, brokerage deposits, etc., would Cease to Exist. Or so the sociopaths running the losing companies said anyway, as they begged to be bailed out from the result of their unregulated, endless greed.
In the heat of the moment, with the 2008 Presidential election looming, the Bush admin actually let these assholes have truckloads of money, no questions asked. And so far Obama seems fine with letting that shitty deal stand. About 700 billion dollars to start with. The corporate robbers walked away from their catastrophic gambling spree, Scott-free, with hundreds of billions of our dollars, no doubt laughing their asses off all the way to their own banks. On top of that the bankstas were given trillion dollar lines of credit at basically zero interest courtesy of the US taxpayer. And before anyone pipes up that saving the economy was necessary and therefore forgivable, let's keep in mind there are two separate issues here: 1) Stopping a train wreck, and 2) Letting the same dipshits that pointed the train at an earth shattering wreck remain behind the wheel. One is at least defensible, the other is asinine beyond words to anyone with a shred of common sense, and yet inexplicably popular with both the Bush and Obama administrations.
The bailout, the free loans, and allowing these crooks to stay at the helm after they ran the ship hard aground causing more damage than a hundred drunken oil-tanker captains, have collectively 1) allowed the robbers to pay themselves more huge bonuses, 2) treat themselves to swank vacations and other perks that cost more than most families make in a year, and 3) start juicing up the cops: Key members of Congress and the WH who are supposed to be drafting new regulations to prevent this crap from ever happening again.
The rest is gut renching, wretched history. Those losing bets were labeled 'toxic assets' and you and I, being the responsible, hardworking middle class taxpayers we are, bought them by government decree and honored them. Let that fucking outrage sink in for a moment: as long as the bets paid off, the super wealthy multinational corporations and their insatiably greedy senior execs pocketed billions. Much of it sheltered in offshore accounts and every other tax dodge under the sun. While bitching and moaning for years on end like Randian pixies about how terribly unjust it was that they actually had to pay taxes on any of it. But when the bets lost in a big way, We the Middle Class Taxpayers not only covered it, we were forced by our so-called representatives to keep those same sons of bitches employed at the same job they so spectacularly failed at. Still collecting their incredibly bloated salaries and decadent bonuses.
Our reward package included millions of middle class taxpayers losing our jobs, homes, and healthcare as a direct result of the bankstas willful malfeasance. Just a few weeks later, Congress and the Very Serious Media had a rootin-tootin good time debating if those of us lucky enough to be officially laid off -- as opposed to fired for some contrived cause -- deserved a small extension on our pitiful unemployment benefits, or 25 bucks of additional food stamps each month.
This stinking scam is sometimes referred to as privatizing profits and socializing losses. Whatever the euphemism, unless a bunch of people responsible lose every ill-gotten gain and go to jail for a very long time, it will go down as the largest heist in history. One aided and abetted every step of the way by both political parties and all three branches of the US government.