10/6/08

Mo' money

This American Life has produced "Another Frightening Show About the Economy." That's the show's title, not my assessment.

Like TAL's hour on the mortgage crisis, the program features sources intimately familiar with the issues and conveys their insights in an accessible way. The highlight for me was the description of credit default swaps @ the 20:20 mark.

"Swaps" are like insurance for financial products, such as bonds. If you buy a $100 bond from Company X and want to make sure that investment is safe, you might by a CDS for, say, $2 per year, from Company Y, who promises to pay you $100 if Company X defaults on their bond. OK, now change $100 to $1 billion and and $2 to $20 million and you'll have a sense of the deals that were being made.

Why the funny name? If swaps are like insurance, why not call them insurance?

By using the term "swap" buyers and sellers of these products were able to side-step insurance regulations, allowing some creative, if not logic-defying, practices to flourish. For instance, it's possible to buy a swap that insures you against the default of bonds you don't own. In other words, it's like buying insurance on someone else's house. You're not protecting your investment at that point; you're betting your neighbor's house will burn down. The only limit on how many swaps could be sold was the willingness of buyers and sellers to take risk.

In the TAL program Andrew Ang from the Columbia Business School points out that the corporate bond cash market totals $5 trillion. The value of all the swaps insuring those bonds: around $60 trillion. As it turns out, the vast majority of swaps weren't insuring anything, they were more like bets.

These days it's not hard to loose track of how much money we're talking about. How much is $60 trillion? Two points of comparison: the annual U.S. Gross Domestic Product is $13.7 trillion, and the Gross World Product is about $65 trillion per year (2007 estimates).

Sure, not every company would default on their bonds. The amount owed would never approach the world's GWP, but the absurdity of such a system and the trouble it's causing was foreseeable and preventable. In 2003 Warren Buffett referred to these products as "financial weapons of mass destruction." Here's hoping the new, soon-to-be established systems that will define our future economy are built on a foundation of common sense.

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I'm not sure what benefit there is for a guy who has never balanced his checkbook to attempt to understand money and the mess we've made with it. I guess there's a comfort to be had in insight, even if it doesn't give me any more control over what's happening.

When my apartment half-collapsed during the '94 Northridge earthquake I spent the next few nights sleeping on the floor under my couch which was turned face down so its back created a roof of sorts. This 'protected' me from falling plaster jarred loose by after shocks.

I put my TV on the floor, too, positioned at one end of the couch and tuned it to a local news station. This kept the tv from taking another tumble off its stand and it provided me with an industrial strength night-light. Following each late-night aftershock I would squint at the screen which quickly cut to the then-ubiquitous Richter-scale shot. Once the mini-quake's magnitude was reveled, I would doze off again.

Understanding (or thinking I understand) what's happening, taking it's measure, placing it in context, somehow makes a situation less frightening, even though the danger remains exactly the same. In other words, being well informed doesn't automatically make us less adverse to risk. There's a lesson there.

I can see now that my personal tendencies were as irrational as the practices of our largest financial institutions... The key difference, I suppose, is that any ill effects from my decision to remain in my apartment would have been limited to me, while the actions of a handful for corporations pulled the entire free market down around them.

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NPR’s new Planet Money podcast produces regular updates on the financial world on par with TAL’s longer pieces, and contributors to the The Baseline Scenario blog are taking steps to make the events understandable to lay reader.

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