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Derivatives and human hubris.

Learning of the kinds of exotic instruments used by Wall Street in the years before the crash can be a mind-boggling experience. First, of course, because of the complexity of these things; but also because of the staggering sums of “paper wealth” they produced. AIG and other firms sold credit default swaps in such massive numbers that there was at one point insurance on over $60 trillion in credit. In other words, they wrote so many CDS contracts that on paper they were insuring a credit market that exceeded, several times over, the GDP of the whole country. Try to wrap your mind around that.

Now they did this because each one of those swaps generated a steady revenue stream. Let’s say I hold a mass of Lehman Brothers corporate bonds, and I start to get wind the Lehman Brothers may not be in the best shape. So I call the AIG Financial Products office in London and place an order for swaps protecting $10 million in Lehman debt. For this I agree to pay AIG, say, 150 grand in premiums every year for five years. I feel good because my Lehman debt is now insured. AIG feels good because they have another revenue stream — my yearly premiums. Of course, I don’t even have to actually hold any Lehman debt to buy the swaps. Maybe I just think Lehman’s in deep trouble, and suspect that there could be a nice profit to turn if the poor company defaults. The CDS become a speculative instrument for me.

Nor is that all. Turns out you can purchase swaps on almost anything. Not just on companies, but on countries’ sovereign debt (CDS on Icelandic debt soared in the days before its banks failed), on municipal bonds (CDS for cities and states is soaring right now, making their budgetary issues even more severe), on basically any kind of debt instrument imaginable.

Today Bloomberg is reporting on various American local and state governments battered by their exposure to interest-rate swaps. The article contains an amusingly deadpan judgment on the matter: these governments, we read, “failed to comprehend the extent of the risks involved.”

You might think only local government bureaucrats could be so short-sighted. Hardly. The New York Times reported in its useful if flawed “Reckoning” series that Citibank had a mass of subprime mortgages bundled into CDOs. According to the Times, Citibank’s risk assessment on these CDOs “never accounted for the possibility of a national housing downturn.” Ponder that for a moment.

Nor is that all. Remember that credit default swaps are desirable because they generate steady revenue streams. And one thing we have learned in all this mess is that where there’s a revenue stream, Wall Street will devise a security. Sure enough, some hotshot operators were busy converting revenue from credit default swaps into CDOs. They securitized the revenue streams on derivatives.

Yesterday the Wall Street Journal ran a really extraordinary report on how a little town in Australia, by investing in pools of corporate CDS, is coming to grief as the recession triggers the obligations in the event of default. In this case the instrument is the synthetic collateralized debt obligations (as if there were some tangible or “organic” version out there), which is an outlandish security composed of the payments from hundreds of CDS contracts.

Nor is that all. I have even heard (but not properly confirmed) that AIG was selling CDS on its own debt instruments, on the CDOs it created. In short, it was selling contracts to insure counterparties in the event of a default on its own obligations. The only thing stupider in than that is the idea that someone out there actually purchased this paper.

So the smart people knew there were technical obligations out there of unimaginable size, all interlocking in a web of abstract engineering, but they just pretended that the kind of default events that would trigger these obligations were essentially impossible. And then they went out and marketed it to local officials and bureaucrats.

Months ago when some neophyte would point out that $60 trillion market in credit derivatives may not be the healthiest way to hedge default risk, he’d get some remark about “mere paper wealth.” Not to worry. Lehman Brothers will never fail. They’ve been on Wall Street since before the Civil War for Pete’s sake!

Except Lehman did fail, and the combustion of all this notional paper threatened spectacular detonations all over the world, of sufficient magnitude to bring down the whole financial system. I have it on good authority that when Paulson and Bernanke got a good look inside AIG in mid-September they literally turned white. That 300-man Financial Products office in London, once astoundingly profitable with its business in exotic derivatives, eventually racked up losses roughly equivalent to the entire 2009 budget of the state of Georgia.

And now, thanks in part to all this high finance engineering, every time I pull out my Citibank credit card to buy my morning coffee and egg sandwich, I get to be reminded that this lovely institution is now for all intents and purposes a nationalized bank, and that all the staggering myopia of these hotshots, combined with the Too Big to Fail doctrine, means that my country has been forced to embrace more ruinous socialism in the last three months than in the previous half century.

[NB: Undoubtedly my description of these instruments lacks precision, and it very likely that I have some of the technical details quite wrong. Perhaps Blackhedd will politely correct me. But I do believe I’ve conveyed the general concepts accurately. Let me also note my indebtedness to Blackhedd on all these matters. Without his patience with my questions, I would be lost.]

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