It annoys me when people try to blame the problem on a single thing, banks, the government, deregulation, etc. The situation is so much more complex than can be explained by any one reason and most people that are trying to blame a particular factor have an agenda they are trying to promote. Greed and cognitive dissonance should be high in the list of causes though.

The Mark Cuban article Todd talked about in #415 offers quite a good high level analysis of what has been going on and some reasonable solutions to the problem. I thought at least some of the GNC readers would like some deeper insight into some of the factors that tend to get glossed over in the media coverage. When Mark talks about Investment vs Financial Engineering, he is touching on a very profound difference between two sources of wealth creation in modern capital markets. One method is to create something that has value and sell it to someone. People with money can invest in these type of companies and share in the returns. The other method is to move money around and take a cut for doing so. While this second method can help money get to where it is needed, it can also be used for personal gain without any real benefit to the economy. This is what Mark means by financial engineering.

You have probably heard ‘derivatives’ mentioned occasionally, most likely in relation to the sub-prime mortgage market. These financial tools, and their misuse are at the heart of the financial crisis. The derivatives market is so complex that Nobel prize winning economists struggle to understand the complete details of them. The basics are quite simple though, and probably the simplest derivative to understand is an option. As a reward for good service, your company may give you an option to buy shares. The price of the share is the current buy price, but you will not pay for it until some point in the future. The option itself has no value unless the share price moves. If it goes up the option has a positive value, if it goes down it has a negative value. The value of the option depend on, or ‘derives’ from the value of something else, in this case a stock.

In the case of a company giving you stock options there is no downside to you, if the stock price goes down you just ignore them and they eventually expired. Lets say though, that the rules of the option you have allowed you to sell it (which some do). Another person to offer to buy them from you. If you are not confident the stock price will go up you might sell them to get some cash for something that is essentially worthless to you. The person gives you cash now and if the stock goes up in the future they get the benefit then, what they have actually bought off you is a potential reward and the risk that goes along with that. This illustrates the key reason for the existence of derivatives which is to transfer risk.

Currency hedge positions protect companies from movements in exchange rates, credit default swaps transfer the risk of bankruptcy, CDO’s spread the risk of mortgage defaults, short selling buffers against stock price falls. There are hundreds of different types of derivatives and none of them have any intrinsic value. What they do is transfer both the positive and negative aspects of risk. When used in the right way they lower the risk of an investors portfolio. The way they have increasingly been used in recent years (since about 2001) is essentially gambling.

The consequence of the over 5 fold increase in derivatives trading since 2001 was to release lots of extra money into the market. This money was essentially created out of thin air and represented the possible future value of a range of base assets. This money was essentially a loan that could only be repaid if those assets legitimately increased in value in the future. You can probably see what a house of cards this was. This is why so many commentators talk about trust when talking about the problem. As long as everyone believed that they would get paid in the future they were happy to go along with what was going on. As soon as that trust was gone the whole house of cards falls down. Like when the housing market, artificially inflated by the easy availability of credit, finally snaps back to reality.

As I said earlier, there are so many reasons why this got out of hand. Government removed regulations that limited the use of derivatives; aggressive fund managers pushed products that became more and more risky; lenders were more concerned with getting customers than evaluating their ability to pay; ratings agencies like Moody’s and S&P gave AAA ratings to investments that were by definition risky; analysts and the press didn’t bother to understand what the realities of the situation were; many people chose to believe that asset prices would continue to rise, despite a history of this being wrong. Many people let their greed get the better of them.

While this description only scratches the surface I hope it has helped you understand what is going on a bit better.