A while back me and my buddies were playing poker. I got to the game late so there wasn't a spot for me (the game was capped at eight people). So one of the players was playing absolutely awful and losing a ton of cash. I turn to another guy who wasn't playing and said, I bet he'll be the first out. So we made a bet on it (mostly for sport).So, if poker were finance, here's how it would be: the poker players are investing straightforwardly in stocks and bonds and what have you. They're investing in an asset directly. I'm investing in a derivative: my bet is derived from the standing of someone else. As it happens, poker doesn't really serve a social purpose beyond having fun, whereas derivatives often (but obviously more often don't) serve a legitimate business purpose.My bet was similar to a credit default swap, one of the common derivatives we hear about a lot. That's basically an insurance policy on someone not being able to pay their debt. Let's say you're a bank who's made a loan that it needs to have back--you might take out one of these swaps on that loan, to make sure you always get the money back.There are a few other common derivatives. There's an "option", where you pay a small fee to have the option to buy or sell something at a future date at a predetermined price. Airlines often use an option to hedge against the risk of oil prices going up; you might call up a dealer and say, I want to buy oil at $70/barrel a few months from now and pay a fee for it to happen. What you want there, if you're an airline, is certainty--this is what my fuel costs are going to be.There's an "interest rate swap", where you exchange your floating interest rate for a fixed interest rate. Where it gets confusing is that other derivatives are basically permutations of these (and I'm sure others that I've forgotten) basic derivatives. The thing to keep in mind is that they're always based on these basic concepts and that you can figure them out. They're complicated, but it's not like this is quantum physics.
Love that. Anyway, I was reading this piece from Pro Publica (HT to Ari Berman for the link) and I couldn't help wondering what some of the financial heads over here made of it. Something which caught my attention:
Resolution AuthorityWhat Dodd-Frank does: Gives regulators the power to seize and unwind "too big to fail" financial institutions that are on the brink of failure.Reason for the rule: Regulators hope to avoid another economically disruptive situation like the collapse of Lehman Brothers, where government officials contend their only option was to put the company into bankruptcy.Stumbling blocks: Some wonder if Congress ordered regulators to do more than they could feasibly and legally accomplish. Take Citigroup. It has more than 260,000 employees, operations in 160 countries and jurisdictions, over 200 million clients, and more than 170 subsidiaries worldwide.It's the poster child for the classic "too big to fail" institution. Unwinding a company the size and complexity of Citigroup in a way that preserves value and does not harm the economy may well be impossible. "How do you put together resolution authority for these banks that have $2 trillion in assets? How do you do it across country lines?" Kaufman said. Frank and Treasury Department officials acknowledge the potential difficulty in successfully winding down these huge institutions, but they argue that there is no other alternative. "It's not easy, but it's not optional," Miller said.
After all the talk about the problems of "Too Big Too Fail" and never having that happen again, it is interesting that it might prove prohibitively onerous to see that promise through.
But as I said, I'd like to read your comments on this, more than I'd like to sit with my own thoughts.
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