Every time I think I know a little bit about economics, I read articles like this and realise I'm playing with wooden blocks while the big boys are playing with space shuttles. ...except they made the space shuttle out of wooden blocks, and they're just pretending really hard that it's going to work.
I'm playing "with the big boys" i.e. 500 million market cap enterprise financial. I'm not sure why I do this other than it's easy to disappear into the noise occasionally and put my feet up. In fact if we disappeared tomorrow there would be a chorus of "meh".
The space shuttle we have is, to paraphrase [1], made from piss-soaked snowflakes and we are crossing fingers that it isn't all going to melt in our hands overnight.
Sometimes it does dissolve in our hands and at that point, that's when the extensive hordes of ancillary staff roll out to lick butt.
So when you think that you're playing with wooden blocks, you're right, but you're probably doing it a bit better than piling them up randomly for the highest margin to support a massive hierarchy of unnecessary staff. And you're right, it is pretending. But it makes money, and that's all they care about at the end of the day.
Good luck for you still have hope of doing an honest job.
This is not economics. Its "finance", well really just a bunch of very long contracts that people pretend to "value", by making up numbers as you see from this article, in order to make money from people.
If you have a small group of brilliant computer scientists, they can create world changing software. How many folks were required to get Snapchat or Youtube off the ground?
What happens when this level of genius in small groups is cut loose on financial markets where "Make money is the only goal"? You get these space shuttles. They are so complex because that's all these people ever think about.
Imagine an empty company loans 100 companies $1 each.
To get the $100 to loan, that company sells bonds to 2 investors for $50 each.
One investor is senior and one is junior.
What this means is that if any of those 100 companies default and don't pay back their loan, then the junior investor loses money.
The junior investor loses money until their entire $50 is lost, and only then does the senior investor have to suffer loses.
The senior investor therefore only has losses if more than $50 of the total $100 loans is lost.
This is basic credit tranching in funded format.
Unfortunately things get a lot more complicated when instead of $1 loans, we have $1 credit default swaps, which instead of loaning someone $1, you promise to pay them if a 3rd party company defaults.
This trade is DB buying protection from a company on a very senior tranche of this type of trade, but they are buying it leveraged, so for example they buy $100 of protection from a company that has $10 of cash inside (provided by the third-party investors), with a promise to pay more if the tranche deteriorates.
As far as rationale, the primary purpose of these trades is to offload super senior risk from DB's balance sheet, which they accrued through doing a different type of trade.
The insurance in question would only pay off under some very improbable and dire circumstances. And under these circumstances the chances of getting a payoff are rather slim because, you know, the world is crashing and burning. Some time during the crisis the risk became very real which was reflected in the market prices of credit protections. But DB and "investors" continued to act as if the risk was small.
What I don't get is who paid for that risk in the end. I suspect it was the government which bailed everyone out with public money so that the doomsday scenario was never realized.
The money moves around and around and around (notionally) a dizzyingly large number of times because the more opaque the process and end product, the less immediate introspection it receives, the less well the average Joe can understand it, and the firm can continue 'alchemy'.
Kudos to the regulators for the arduous task of unravelling the large ball of string and following it to the conclusion!
It reminds me a lot of large code bases. At some point people face a choice between a) forcing sufficient simplicity and clarity that one has a chance of understanding what's going on, and b) saying "fuck it" and letting complexity metastasize to the point nobody really understands what's going on.
The difference, of course, is that with software the opaqueness is pure cost. Whereas in the financial markets the opaqueness is often a profitable resource from somebody.
Long time back i was studying Asset Backed Commercial Papers (ABCP) as a special purpose vehicle conduit and its effects on market runs during the financial crisis.
For those who want to understand it , these might possibly help(These are only personal notes.):
Deutsche Bank is hardly a bank in the traditional sense considering their balance sheet. With $72.8 trillion euro in derivative exposure (the largest in the world, 21x the GDP of Germany) this will have to blow up in a spectacular fashion once one of these counterparties fail:
The notional amount doesn't tell you anything meaningful in term of risk. Say I am Deutsche, you are Citi. I trade a €1bn 10 year interest rate swap with you and then another €1bn 10 year interest rate swap with you in the opposite direction. The risk is exactly zero (the two transactions will be netted to zero in case of an insolvency) and the cash flows will perfectly offset each others. We each have €2bn of notional of derivatives outstanding.
Banks like Deutsche aren't in the business of taking large directional derivative bets. They are market makers so the quasi totality of these 72 trillions are offsetting positions, which are mostly collateralised, i.e. each counterparty has to post assets to match the evolution of the value of the derivative in order to keep the credit exposure minimal.
With such a massive book, there will be residual risks all over the place but 72 trillion is a meaningless number for assessing them.
Off topic but this reminded me of a movie i saw last year, "Blackbox BRD" (http://en.m.wikipedia.org/wiki/Black_Box_BRD) which relates to Deutsche Bank past and has an interesting interview with a high level staff (Bank president?) and found it curious to glimpse on how they think (or thought).
I love Matt Levine's articles. He's good at simply explaining the arcana of Wall Street.
But when I read this article, I can only say one thing: Why?
Why is Wall Street spending all this time and energy in creating all these different securities? I suspect that any excess "profits" or "returns" to be had from them accrue 90% to the bankers and 10% to the muppets funding them. So why do the muppets keep playing this game?
To expand on the other replies, and based on experience:
1) The way you get to sell products to investors is by promising some sort of alpha: "My fund is less risky, my derivative pays more for the same risk, etc."
2) But magic does not happen in the financial markets (and when it does is through the old stories.. diversification, transferring the risk to those of broader shoulders, etc.)
3) So what you do is HIDE THE RISK. There are many ways to do that, and they usually involve COMPLEXITY. Complexity and opacity are your friends, as they confuse investors who don't realize there is a hidden risk somewhere there, or a scenario you haven't told them (but put on page 350) where if A B and C happen, then he will lose a lot of money.
I'm not joking here.. sometimes complexity is good as it allows you to e.g. reduce mismatches in your risks (your income is in USD and expenses in EUR, your debts are long term and assets short term, etc.). However, the ultimate purpose of most complex products is that they allow you to sell stuff that appears better than it really is. And IT WORKS. Everytime. Against millionaires and against folks buying silly combos of insurances plus deposits (forgot their names).
It's a regulatory arbitrage. Everyone knows that the risk on those super-senior tranches is basically zero (it would take something like 60% of the world's investment-grade companies going bankrupt for them to actually pay off), but the regulations say that Deutsche would have to hold assets to cover it. So they find some investors who declare that they'll cover it instead, in exchange for a few percentage points, and everybody wins: the investors get (a small amount of) free money, Deutsche can hold fewer assets and use its balance sheet for more profitable things. Even the regulators probably don't mind so much - the regulations are overly simplistic (dare I say populist?) in circumstances like this, and everyone knows that.
The "muppets" are multi-billionaire asset holders. That money has to go somewhere and they want a return on it, or at least the promise of a return.
Quite a lot of financial strangeness can be answered with "where else are you going to put your money?" Western treasury bonds are the safe option, but they're close to negative yields. Spending $1.01 at auction to buy a bond which nominally costs 95c and pays back $1 in five years doesn't look great. So there is a huge demand for "riskless" positive-yielding investments.
That's why London (and elsewhere) property continues to shoot upwards in value way beyond the ability of the inhabitants to afford it. That's why Switzerland has negative interest rates. And so on.
>Why is Wall Street spending all this time and energy in creating all these different securities?
The primary purpose of these trades is to offload super senior risk from DB's balance sheet.
Super senior risk is the risk that DB retained when it (very profitably) sold various other tranches on a group of assets (typically CDS on a bunch of corporate and sovereign credits).
This type of risk is very difficult to sell as the return is very low and most entities they might buy unfunded protection from are likely to not be able to pay in the event that the swap pays out.
Offloading that risk through a swap to a conduit like this allows DB to release (expensive) capital/reserves that would otherwise need to hold.
In this case, the sucker would actually have been DB's investors if the worst case ever did happen. (They would have gone under like many other banks - the bailout saved them.)
In this case the investors they sold protection to (hedge funds) got better prices than they ordinarily would have, because of the risk hidden in the conduit.
[+] [-] Daneel_|11 years ago|reply
[+] [-] kropotkinlives|11 years ago|reply
The space shuttle we have is, to paraphrase [1], made from piss-soaked snowflakes and we are crossing fingers that it isn't all going to melt in our hands overnight.
Sometimes it does dissolve in our hands and at that point, that's when the extensive hordes of ancillary staff roll out to lick butt.
So when you think that you're playing with wooden blocks, you're right, but you're probably doing it a bit better than piling them up randomly for the highest margin to support a massive hierarchy of unnecessary staff. And you're right, it is pretending. But it makes money, and that's all they care about at the end of the day.
Good luck for you still have hope of doing an honest job.
[1] http://www.stilldrinking.org/programming-sucks
[+] [-] justincormack|11 years ago|reply
[+] [-] mathattack|11 years ago|reply
What happens when this level of genius in small groups is cut loose on financial markets where "Make money is the only goal"? You get these space shuttles. They are so complex because that's all these people ever think about.
[+] [-] tormeh|11 years ago|reply
[+] [-] Aloha|11 years ago|reply
I got lost somewhere around the first appearance of the word tranch,
[+] [-] ddeck|11 years ago|reply
Imagine an empty company loans 100 companies $1 each.
To get the $100 to loan, that company sells bonds to 2 investors for $50 each.
One investor is senior and one is junior.
What this means is that if any of those 100 companies default and don't pay back their loan, then the junior investor loses money.
The junior investor loses money until their entire $50 is lost, and only then does the senior investor have to suffer loses.
The senior investor therefore only has losses if more than $50 of the total $100 loans is lost.
This is basic credit tranching in funded format.
Unfortunately things get a lot more complicated when instead of $1 loans, we have $1 credit default swaps, which instead of loaning someone $1, you promise to pay them if a 3rd party company defaults.
This trade is DB buying protection from a company on a very senior tranche of this type of trade, but they are buying it leveraged, so for example they buy $100 of protection from a company that has $10 of cash inside (provided by the third-party investors), with a promise to pay more if the tranche deteriorates.
As far as rationale, the primary purpose of these trades is to offload super senior risk from DB's balance sheet, which they accrued through doing a different type of trade.
[+] [-] ianpurton|11 years ago|reply
Deutsche bank sold lot's of this type of insurance.
If the markets had turned and some large companies had gone bankrupt they would not have had the means to pay the people who bought this insurance.
Basically they took very low quality insurance and re-packaged it as high quality insuarance.
[+] [-] dunkelheit|11 years ago|reply
What I don't get is who paid for that risk in the end. I suspect it was the government which bailed everyone out with public money so that the doomsday scenario was never realized.
[+] [-] webtards|11 years ago|reply
[+] [-] wpietri|11 years ago|reply
The difference, of course, is that with software the opaqueness is pure cost. Whereas in the financial markets the opaqueness is often a profitable resource from somebody.
[+] [-] th3iedkid|11 years ago|reply
For those who want to understand it , these might possibly help(These are only personal notes.):
[part 1]https://medium.com/finance-and-economics-studies/read-note-o...
[part 2]https://medium.com/finance-and-economics-studies/asset-backe...
[+] [-] randomname2|11 years ago|reply
http://imgur.com/MNECKC4.jpg
A former Kansas Fed president called them "horribly undercapitalized", with a leverage ratio of 1.63 percent:
http://www.reuters.com/article/2013/06/14/us-financial-regul...
[+] [-] cm2187|11 years ago|reply
Banks like Deutsche aren't in the business of taking large directional derivative bets. They are market makers so the quasi totality of these 72 trillions are offsetting positions, which are mostly collateralised, i.e. each counterparty has to post assets to match the evolution of the value of the derivative in order to keep the credit exposure minimal.
With such a massive book, there will be residual risks all over the place but 72 trillion is a meaningless number for assessing them.
[+] [-] zemanel|11 years ago|reply
[+] [-] dba7dba|11 years ago|reply
[+] [-] PhantomGremlin|11 years ago|reply
But when I read this article, I can only say one thing: Why?
Why is Wall Street spending all this time and energy in creating all these different securities? I suspect that any excess "profits" or "returns" to be had from them accrue 90% to the bankers and 10% to the muppets funding them. So why do the muppets keep playing this game?
[+] [-] zzleeper|11 years ago|reply
1) The way you get to sell products to investors is by promising some sort of alpha: "My fund is less risky, my derivative pays more for the same risk, etc."
2) But magic does not happen in the financial markets (and when it does is through the old stories.. diversification, transferring the risk to those of broader shoulders, etc.)
3) So what you do is HIDE THE RISK. There are many ways to do that, and they usually involve COMPLEXITY. Complexity and opacity are your friends, as they confuse investors who don't realize there is a hidden risk somewhere there, or a scenario you haven't told them (but put on page 350) where if A B and C happen, then he will lose a lot of money.
I'm not joking here.. sometimes complexity is good as it allows you to e.g. reduce mismatches in your risks (your income is in USD and expenses in EUR, your debts are long term and assets short term, etc.). However, the ultimate purpose of most complex products is that they allow you to sell stuff that appears better than it really is. And IT WORKS. Everytime. Against millionaires and against folks buying silly combos of insurances plus deposits (forgot their names).
[+] [-] lmm|11 years ago|reply
[+] [-] pjc50|11 years ago|reply
Quite a lot of financial strangeness can be answered with "where else are you going to put your money?" Western treasury bonds are the safe option, but they're close to negative yields. Spending $1.01 at auction to buy a bond which nominally costs 95c and pays back $1 in five years doesn't look great. So there is a huge demand for "riskless" positive-yielding investments.
That's why London (and elsewhere) property continues to shoot upwards in value way beyond the ability of the inhabitants to afford it. That's why Switzerland has negative interest rates. And so on.
[+] [-] ddeck|11 years ago|reply
The primary purpose of these trades is to offload super senior risk from DB's balance sheet.
Super senior risk is the risk that DB retained when it (very profitably) sold various other tranches on a group of assets (typically CDS on a bunch of corporate and sovereign credits).
This type of risk is very difficult to sell as the return is very low and most entities they might buy unfunded protection from are likely to not be able to pay in the event that the swap pays out.
Offloading that risk through a swap to a conduit like this allows DB to release (expensive) capital/reserves that would otherwise need to hold.
[+] [-] meric|11 years ago|reply
[+] [-] mathattack|11 years ago|reply
In this case, the sucker would actually have been DB's investors if the worst case ever did happen. (They would have gone under like many other banks - the bailout saved them.)
In this case the investors they sold protection to (hedge funds) got better prices than they ordinarily would have, because of the risk hidden in the conduit.
[+] [-] x3n0ph3n3|11 years ago|reply
[+] [-] unknown|11 years ago|reply
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