One of my favorite activities is to talk to strangers at a diner, while doing a crossword puzzle. If you ever find yourself lonely, I suggest you try it.
Well this morning I talked to a guy, who seemed pissed when reading his paper. He brought up that it said someone was betting against Greece. I nodded and said that probably sped up their collapse. He looked at me and asked a fair question.
"How the hell do you bet against a country?"
I'm by no means a financial expert, which might actually make me qualified to answer this question.
I mentioned derivatives, but let me answer the question more simply first.
Short Selling
Everyone here probably understands how the stock market works basically. You can buy or sell stocks. Based on how the market feels about the stock it goes up or down. The basic idea is to buy a stock when the price is low and sell it when it gets high. In that basic understanding, there isn't much room for betting against anything. Here is where you and I get kicked out of the room, and the real dealing starts.
If your some big shot, there will be special rules for you. See brokers are the guys who buy and sell stocks. At anytime they are holding on to tons of stocks for their customers. So let's say you are this big shot, and you are friends with a bunch of brokers. You look at a stock they are holding, and you think it will lose its value soon.
You can borrow the stock from them for a fee. The broker lets you borrow it, because they aren't making any money with it just sitting there. Now you arrange a length of time you are borrowing it for.
After you are lent the stock, you turn around and sell it. You now have the money in hand. You then wait for the stock to go down in price. When it gets as low as you think it will go, you buy the stock again. Now you return the stock to the broker. You keep the difference between the price you sold it at, and the price you repurchased it at.
Now there are a few things to understand:
-If you follow the traditional buy low / sell high model, the most you can lose is the value of the stock.
-Short sellers assume infinite risk, because if the stock goes up they lose the difference.
-Brokers also take on risk in this equation, because they don't actually own the stock they lend out. If that stock goes up and the owner wants to sell, they now have to get the stock back in a hurry.
Because of these issue, there are some protections to deal with short selling. On most stock markets any shares lent out are publicly listed with the stock. This means buyers know, when someone is trying to short the stock. Also there are rules for the broker regarding lending out other people's stocks.
The bad part of short selling is that everyone can't do it. As I said this is a high rollers club only. Often borrowed stocks come out of pension funds, where there are lots of shares to be lent out, and no owner watching over the shares.
Okay, so that is how you would bet against a stock. Let's say you want to bet against something else like chickens, mortgages or Greece. To do this we have to enter the shadows.
Derivatives
A derivative is not a stock or bond. It isn't a barrel of oil or a bushel of corn. There is no market place where derivatives are bought or sold. Welcome to the biggest and yet most intimate casino in the world.
Quite simply a derivative is a contract between two people. Contract may be the wrong word. Think of it more like a bet between two people that is backed up by law suits. The derivative has no value of its own. Instead it is based on the value of something else. Anything else.
Let's say you grow broccoli. When your crop comes in, you will take it down to the broccoli distributor, who will pay you the current market price for your broccoli. Some years you get a really good price, and some years you get a bad price. After a few years, you feel pretty comfortable guessing what the price will be at harvest.
So you make a bet with the distributor a few months in advance. You convince them to buy your broccoli at $10 a bushel. They agree to that price. You have just created a derivative. This kind of derivative is called a future. If come harvest the going price is $8 a bushel, you will come out ahead for making that bet. If the market price is $15 a bushel, the distributor wins. You are both contractually obligated to honor the agreement.
Futures are only one type of derivative. Futures are also critical to many farmers staying in business. Not all derivatives are bad things. For a farmer to properly budget year to year, a guaranteed price is well worth the risk.
Some derivatives can be very bad things though. For instance AIG offered derivatives based on the value of mortgage backed securities. They agreed to pay other people if these securities lost value. If they gained value, the people had to pay them. This kind of derivative is called a swap or credit default swap.
This is a very odd feature about derivatives. Neither of the two parties has to actually own the thing they are betting on. I could actually make a derivative on broccoli without being a farmer or distributor. There is no rule on what a derivative should look like. I also don't have to make the existence of the derivative public in any way.
So when it comes to the bond markets in Greece, I can bet against it using a derivative. Instead of short selling like I showed above, I just need to create or purchase a derivative based on the value of that bond. If I think Greece is going down the tubes, I can purchase a swap against the value of the bond. Like I said, I don't actually need to own a bond. I just find someone willing to bet in the opposite direction as me.
Speculation
This now absurdly long and no doubt ignored diary revolves around the concept of speculation. Speculation is part of doing business, but there is a problem with speculation. With so much of the speculation being done in the shadows we are seeing an amplification of down swings in the economy. Greece did have serious government deficit issues, but speculation more than likely accelerated its demise.
The problem is all this speculation happens without public knowledge. This is where casinos might actually start resenting the comparison to Wall Street. At least in a casino everyone has the same ability to bet, and all the chips are sitting out on the table in plain sight.