Entries Tagged 'Derivatives' ↓

Of SUVs and SIVs

Sent out by newsletter October 30, 2008

It’s great to see the price of gas at $2.45! When was the last time we saw that? And it looks like we are finally beginning to pull out of the freeze on short term borrowing (short term meaning a day to 3 months) between banks. Ever wonder why bank to bank borrowing froze up in the first place? Why money market funds that traded “commercial paper” became so shaky they had to be bailed out by the government’s guarantee that their holdings of a dollar would return you a dollar?

The fancy term for what happened is “flight to quality.” What that means is smart investors (like money market funds) didn’t want to buy commercial debt because they realized those were risky, bad investments. They fled in droves from the banks and financial institutions who were selling them. Commercial paper became so worthless banks wouldn’t even buy it from each other. How on earth did that happen?

Because banks and financial institutions created trusts called “structured investment vehicles” (SIVs) by tossing together the loans and complex debt of lots of different companies. These “vehicles” then sold “commercial paper” to investors who had little idea what was behind the paper, but trusted their banks.

In addition, SIV investments were highly rated. Standard and Poor’s once said in a remark that’s come back to haunt it, that it would rate a deal “structured by cows.” SIV assets were what backed commercial paper. As subprime borrowers and other borrowers began defaulting, smart investors realized their danger. SIV assets were likely to be far less than they cost.

In the beginning SIVs were a terrific deal for banks because the commercial paper being sold just “passed through” the banks. The banks never owned the SIVs. That means banks didn’t have to report them on their books. SIVs were invisible—until they failed! Continue reading →

What Did Goldman Do Wrong? Betting on ‘Library Binding’

Once upon a time long ago in a land faraway, there was a community of successful business people who wanted more books to read. They decided to pool their resources and create a brand new library.

These people founded a beautiful new library building in the center of their city. They sought the best librarian in the land, so they offered the extra incentive of fees. In addition to a salary and bonuses, their librarian could earn fees for services. They instructed their librarian to uphold two of Mr. S.R. Ranganathan’s “five laws of library science”:

A book for every reader.
A reader for every book.

Our industrious librarian immediately began making deals with both book publishers and library patrons, charging each side a fee. These deals were all based on the value of books. So these kinds of deals quickly become labeled “book derivatives,” or “BODs” for short.
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Financial Derivatives – CDSs & CDOs: How Big Is the Financial Mess?

[NOTE: Today’s news:  bondholders with derivatives force GM towards bankruptcy. How many more companies might this happen to?]

According to Ira Glass’ “This American Life” program on NPR, the scope of the financial problem is as big as that huge 100 foot wave in the movie, “The Perfect Storm.” The title of the NPR show is “Another Frightening Show about the Economy.”  Included is a terrific section on derivatives, specifically the type of derivatives called credit default swaps (CDSs). [minutes 20-40 of Oct. 3-5 episode 365 on http://www.NPR.org]
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