A Fun Way to Learn the Dangers of Derivatives
Happily, the plot of Michael Lewis's new book, "The Big Short," about a handful of characters who foresaw the crisis and profited from it, centers on derivatives and elucidates the problem better than anything I've seen. Lewis is a gifted storyteller and explainer, and also a very funny guy. The heroes in his book place bets against the housing market by purchasing derivatives contracts that are supposed to pay off if the market collapses (actually, if the market dips only slightly, but that's another story). The challenges that confronted one of Lewis's main characters, an obscure hedge fund manager named Mike Burry, derive largely from the murkiness of the dervatives market, which is controlled mainly by large Wall Street institutions.
When Burry decides to bet against subprime mortgages, he has to call around to individual Wall Street institutions to find one that will sell him derivatives contracts, since they're not traded openly. He can't know if the prices he's quoted are competitive, because banks don't reveal them. When subprime mortgages start going bad, giving Burry the right to collect collateral from the banks, he discovers that he cannot because the banks refuse. Since there's no agreed upon trading price, the banks can rely (dishonestly) on their own models. Burry is helpless to challenge them and rightly suspects fraud--Lewis milks this for some hilarious scenes. Even so, the banks clearly didn't understand the risks on their balance sheet. They might have had there been more transparency.
It's clear from Lewis's book that banks favor this status quo, because the opacity usually benefits them: they can charge higher prices, avoid booking losses, and take on insane levels of risk, all of which yields huge profits--along with the occasional systemic crisis.