Ok. Here is a really simple take on these derivatives.
No one, absolutely no one, that I know of or have spoken to have any idea what these things are all about. Bill, do you know?
In addition, no firm involved in these instruments have ever explained, or even tried to explain what they are and how they help or hurt us. And, incidently, they can't even explain how these instruments are going to help them!!. This is terrifying.
Oakam's razor would suggest that these trades are simply too complicated for even those who are making them, to comprehend. I am in a mood to believe that we are at another one of those times when the so-called smart $ is actually being very dumb.
Too clever by half is my take.
Maybe I'm just too stupid to understand these things, but I can't afford to invest in things I can't understand. BTW

Rigdon,
These swaps are basically puts being bought and sold on companies debt. What makes them especially dangerous is leverage, counterparty risk and the dominoe effect it could cause. Also there is not a central clearing agency. I agree it is a mess. Warren Buffet I believe called them "financial weapons of mass destruction."
Kevin

Bill and others...I consider myself a reasonably intelligent person--on odd numbered days at leas. And it was thrilling to see "oddlots" post a provocative article regarding such and more importantly inviting discussion. But this "stuff" makes my head hurt. It's difficult to understand (okay, I'm projecting). Furthermore, to just vault it out there without providing some proposed solution is almost a worst sin than the existence of the issue. In our professional lives, who among us poses a problem without a solution? If I do, I always footnote it--but it's not good practice. And while I passionately agree [maybe it is the 2004 Spier Pinotage (Stellenbosch, SA) with RIPE BANANA flavors, you must try it] that regulation is welcomed, indeed required, these derivatives are akin to string theory--arcane, head-busting items that are difficult to tackle.

The biggest problem with these and all types of derivative products is that the paper profits fron the derivative contract are allowed to show up on the books of, say, a major corporation years ahead of whenever the actual monetary profits appear in the coffers. Therefore, a sick company today can look downright rosy to ordinary shareholders. The ability to abuse the system in this way is left entirely up to the discretion of the corporate officers of the company with no SEC oversight. Enron was guilty of this technique among other things.

So funny, Leisa, thanks.
I think string theory may prove to be more accessible, possibly accretive to our understanding of the world, certainly, than so called "derivatives".
As obtuse and difficult as apllied physics has become, the practicioners discuss, argue, attempt to explian, and generously share their research and theories. A far cry from the lack of transperancy that exists in the world of money.

I'll look for that Pinotage.

Sorry KC, I meant to respond to you first.

Bets on non-performance, particularly with leverage brings visions of waterfalls, to me, once the first default aapears.

Two words from the Simpleton-

"Got Gold?"

Ridgon, thank you for your post. To all...as I reread my post, it does sound that I'm being critical of the original post. I'm merely critical of the complexity of the issue and how difficult it is to develop practicable solutions.

g034
Well of course I do... nice day today, n'est pas.
Have also enjoyed your posts, over time, thanks, hardly simplistic and please carry on, mate.
fr3597
Is that really still true? After Enron, has there been no remedial legislation to prevent another occurance?
Who are these guys?

Re: attacks are growing five times faster than my readership, so I must be doing something right.

I guess to these attackers the 'truth must hurt'

"Truth is generally the best vindication against slander." Abraham Lincoln

Aren't these the basics we the people need to think about re CDS (credit-default swaps)?

* Those who buy the CDS pay a premium to receive 100% of the principal in case of default by the subject.

* Premiums rise when the subject of the CDS becomes less credit-worthy (i.e. takes on more debt for an LBO) and MORE credit-worthy if the LBO falls through, etc.

* HB&B's are the biggest buyers and sellers of CDS'es (per the Bloomberg article bill referenced).

* when the game explodes, you want to be short one or more HB&B's (after all, you can't short a hedge or private equity fund).

* the 2nd tier HB&B's are the best shorts, since they are probably stupider, and more desperate for business than the top tier. (They've probably gotten the diciest deals and have the worst risk profile).

* charts of 2nd tier HB&B's stock price will probably start to show weakness before any crash.

* monitor these charts, and get short (or buy puts) when they roll over.

Does that make sense? What more can we do?

I can't add much, other than to point readers to two sites.

One I've already mentioned:

http://www.ft.com/markets/wizardry

The other is the Bank for International Settlements:

http://www.bis.org/

They have quarterly and annual reports that track the total notional value of derivatives. From their September quarterly report (http://www.bis.org/publ/qtrpdf/r_qt0609.htm):

"Combined turnover measured in notional amounts of interest rate, equity index and currency contracts increased by 13% to $484 trillion between April and June 2006, following a 24% rise in the previous quarter."

According to the latest "Regular OTC Derivatives Market Statistics", interest rate swaps made up by far the largest portion of derivatives contracts in 2005 ($215 trillion out of $284 trillion). Equity-linked contracts (forwards, swaps, options) only made up $5 trillion.

http://www.bis.org/publ/otc_hy0605.htm

Regarding CDS's, from the June 2006 quarterly report on derivatives:

"The notional amount of CDSs increased by one third to $14 trillion at the end of 2005, after a 60% rise in the previous period."

"The data confirm the impression that the CDS market, like most other over-the-counter markets, is largely an interbank market. At end-2005, two thirds of all outstanding positions were between reporting dealers, and a further quarter were between reporting dealers and other banks or securities firms. By contrast, only 3% of the transactions were with non-financial institutions."

As for what to do, that's an "unknown unknown". ;-) If the SEC hadn't stepped in and knocked some banking heads together in 1998 with LTCM, we may have found out.

It is unfortunate that Felix Salmon, the author of the "Idiotic chart of the week" post, missed the essence of my graph, and in doing so, revealed his ignorance.

In any case, here is what I posted in response to his remarks:

"The point of the chart was to give a sense of scale. Even if, as you argue, the growth in open interest outstanding stems partly from the fact that old contracts can only be offset with new ones, the parabolic rise nonetheless implies an unhealthy exuberance.

Regardless, your assertion that net exposure, rather than gross exposure, is all that matters seems to reflect a lack of understanding about counterparty risk, as well as the inherent problems associated with netting arrangements that are based on nonstandardized, ambiguous, or otherwise flawed legal agreements."

Aside from that, if anyone is interested in knowing a bit more about the dangers of derivatives, here is an article I wrote back in November:
http://www.financialsense.com/editorials/2005/1109_b.html

It seems inherently untidy to continue to show contracts as "open" when they've been swapped out. Why wouldn't they treat those contracts like options contracts? (Rhetorical question). If my poor memory serves me correctly, wasn't there some issue in recent memory where there was some theoretical (or pricing gap) that caused a ripple in this underlying market. It was not on my radar screen to understand at the time, but given this discussion and given that circumstance, it might be worth visiting if any can remember the episode from my oblique reference.

CDS are a different beast entirely from interest rate swaps. In theory they are similar to mortgage insurance; the creditor defaults and the CDS pays out.

The enormous problem, in my eyes, is that the notional value of the CDS insurance in many cases (e.g. General Motors) dwarfs the size of the underlying debt. That creates not only conflicts of interest, but moral hazards. For example, why wouldn't a distressed debt player buy up a large chunk of the debt of an issuer (but silently even more CDS), and use the debt position to force a bankruptcy?

CDS are a different beast entirely from interest rate swaps. In theory they are similar to mortgage insurance; the creditor defaults and the CDS pays out. In practice, though, they are vehicles of speculation.

The enormous problem, in my eyes, is that the notional value of the CDS in many cases (e.g. General Motors) dwarfs the size of the underlying debt. That creates not only conflicts of interest, but moral hazards. For example, why wouldn't a distressed debt player buy up a large chunk of the debt of an issuer (but silently even more CDS), and use the debt position to force a bankruptcy?

Leisa,

Perhaps you are referring to the Delphi bankruptcy fiasco, where the face amount of credit-default swaps outstanding was 10 times as large as the amount of bonds being "insured"? If so, here is an article about it (from Bloomberg):
http://www.bloomberg.com/apps/news?pid=10000103&sid=aJ7hmKuEPFOM&refer=us

More grist...Meant to post this yesterday, but I see the thread is still active. I remember that David Merkel on RM had expressed his opinion (always worth hearing) on CDSs a few times. Here is what he said most recently,

By Default, No Credit Where It Is Not Due
David Merkel
7/26/06 2:23 PM EDT
"....if someone makes the argument that the rates on corporate bonds 10 years and longer haven't increased significantly over the past 27 months, I would agree with that, but that has little to do with credit default swaps, which are a short maturity phenomenon for the most part.
I thought of writing a note on the article cited in Bernstein's piece, but ran out of time yesterday. It is a horrendously optimistic article, and too short-sighted. Credit derivatives, as I have noted before, have induced two anomalies into the credit markets. First, they make spreads artificially tight on the short end. Second, they create demand for bonds after they default.
Both of these are "tail wagging the dog" phenomena. When the market for making side bets gets bigger than the main business of financing corporate credit, something weird is going on. The real test will come when we get the next spike in investment grade defaults. When we had the last spike, the credit default swap market had notional amounts smaller than the corporate bond market. Now the credit default swap market is more than four times the size of the corporate bond market in nominal terms. When it happens, all of the negative effect of too much insurance chasing too few bonds to be insured will be revealed.
One more aside, the idea that the low default rates since 2003 is unusual is wrong. We had a longer period in the mid-90s. The effect of credit default swaps and collateralized debt obligations on default in the short run is modest at best (even the article says CDOs lower borrowing costs by 3-5 basis points).
In the long run, it may make the default problem worse. Whenever you lend a debtor money, he immediately looks more creditworthy because of the liquidity. When the liquidity goes away, as it always does for some minority of corporate borrowers, the debt problem is worse not better.
Position: none, but my bet is that Buffett is right on credit derivatives, and Greenspan wrong (why does that seem like an easy bet?)

oops...the article David is citing above is here:

http://www.bloomberg.com/apps/news?pid=20601103&sid=a1byM.IyLrFU&refer=us

Many large investors (i.e. hedge funds) make large, risky bets (for example on junk bonds) and then buy this 'insurance' to control the risk.

For me, the question is 'counter-party' risk. If you have massive leverage as the risk issuer (recipient of the insurance premium), what happens if the fat tail hits you, and as HB&B YOU default.

Can anybody predict or project the outcome? I think not. But don't worry, because we have the Tout TV Cheerleading Squad and their allies out there reminding us every day that we've got a soft landing, and minimal inflation.

I'm still trying to understand how the money supply (M3) grows 9% and inflation 2-3%. I guess I'll never understand that one, except for the price increases I pay (tuition, employee salary and benefits, insurance of every kind) which are far above the 'core rate'.

When I first read this there were no comments. I am glad people explained this.

I guess this market is highly leveraged as well –buy futures on debt and possibly own the debt from a leveraged account.

I guess there is money in money shuffling.