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My Colleagues Like Gambling Metaphors

This comes courtesy of Postie Neil Irwin:

To suggest a mildly more degenerate metaphor for your post on securities vs. derivatives:

Buying a security is like buying a racehorse. If it does well, you will make money, if it does poorly, you could lose some or all of your money.

Buying a derivative is placing a wager on a given racehorse.

Metaphor accepted. Meanwhile, exactly as I was writing this post, Frank Ahrens -- author of Economy Watch -- wandered by my desk with another metaphor.

"I've come to describe naked credit default swaps like this," he said. "Imagine a poker game. Then imagine a ring of guys standing around the poker game, betting on who will fold and who will win. They've got no skin in the actual game, they're just betting on outcomes. That's a credit default swap."

By Ezra Klein  |  June 2, 2009; 3:00 PM ET
Categories:  Financial Crisis  
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At the track the betting odds reflect prior betting patterns -- is that also true of what a newly written derivative will bring in?

Posted by: bdballard | June 2, 2009 3:32 PM | Report abuse

IMO it is a fundamental problem with banking and BTW with the FDIC.

Would you invest in a mutual fund that did not tell you what it was investing in? Would you invest in a mutual fund that bought derivatives described above? Would you invest in a bond mutual fund that if the value of bonds went down would pay the first people to redeem the full amount that they deposited and the last to redeem nothing?

If you say no, would you deposit money at a bank? If so ask yourself why?

Gambling usually does not cause systemic economic problems because for every winner there is a loser but when banks fail money is destroyed, people who did not know that they were gambling get wiped out. The FDIC encourages the use of banks. Bad!

Posted by: jwogdn | June 2, 2009 3:35 PM | Report abuse

An entrepreneur owes the racehorse.
An "investor" bets on the outcome of the race.
A seller of derivatives offers a side bet to someone else as to the chances that the investor will win his bet.
A seller of CDO's offers a side bet as to whether the derivative seller will honor his bet if he loses.

Question: who is the real person making money in all this?

Answer: the track, they don't care whether the horse wins or loses, they gets their commission either way. The only way they can lose is if they accepts unbalanced bets. Pari-mutual odds are designed so that this can't happen.

In my analogy the track owner's and bookies' roles used to be taken by brokers and investment bankers, but they got greedy and started to take bets themselves instead of just collecting transaction fees (of which there are now many).

Even with subprime mortgages they wouldn't have been in much trouble since they packaged up the loans and sold them to others, thus reducing the risk. It was the CDO's and other financially purposeless transactions that brought the system down.

If you want to point the final finger at blame, then ask who was demanding that banks and other financial firms keep generating ever higher returns? The answer is us. As mutual fund holders and investors in IRA's and the like we kept demanding 8-15% return per year. Any fund that didn't meet this level quickly found its investors going elsewhere. The result was everyone got trapped in a cycle of increasing risk.

As Pogo said: "We have met the enemy and he is us."

Posted by: robertfeinman | June 2, 2009 3:46 PM | Report abuse

I think the poker example is missing a layer or two. The poker players were buying the default swaps from the people in the ring around the table as insurance against the other players, so that if those other players lost, there would be insurance on their ability to deliver cash for the chips they had in the pot. And the chips were tiny houses that the greedy home speculators had overvalued.

Posted by: staticvars | June 2, 2009 5:01 PM | Report abuse

the "invisible hand of the market" is a familiar metaphor that is used frequently in free market debates but i haven't seen it used very much in the context of the credit default debacle

you might use it to say: the "invisible hand" of the market" took a pin and burst the credit default balloon

Posted by: jamesoneill | June 2, 2009 7:26 PM | Report abuse

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