Oct
15
2008
0

The “Smell Test” – Credit Default Swaps Explained

There are two types of “smell tests.”[1]

Smell test: Good or bad investment?

Smell test: Good or bad investment?

The first type of smell test is a very literal smelling test.  A bachelor smells an article of clothing to determine whether said article of clothing could be worn on that day around the people said bachelor anticipates being near.  Doesn’t smell bad?  Put it on!  Smells bad?  Turn it inside-out and put it on!

The second type of “smell test” is where you evaluate a situation based upon your gut reaction.

Some blame “credit default swaps” for our current financial crisis.  (Disclaimer: I have no special knowledge about finance – I just listen to NPR constantly).  So, here’s what happened:

  1. Investors (Company A) buy up lots of sub-prime mortgages through a trust.
  2. Company A, looking to make money as investors are wont to do, sell pieces of the trust as if they were stocks.
  3. Other people (Company B), having seen these investors buying up risky sub-prime mortgages, have a great idea – “credit default swaps.” (Or, as they are known on NPR, “CDS’s”).
  4. Company B promises Company A that, in exchange for a very reasonable sum, if one of the people living in one of those sub-prime mortgage homes stops paying that mortgage, Company B will be responsible for that lost asset and income.
  5. Company B tells Company A that this wonderful product is called a “credit default swap,” and that it is definitely-not-insurance.  In fact, its significantly cheaper than buying insurance.
  6. Since Company B is not selling insurance they don’t have to be regulated like insurance.  Insurance companies are required to hold “reserves.”  A “reserve” is simply money that can’t be spent in case an insurance company be required to honor some of their insurance policies.
  7. There are so many Company A‘s looking to hedge their bets that all the Company B‘s CDS’s are selling like hotcakes.  The people that own Company B are so pleased with themselves that they don’t really bother with reserves.
  8. In a few years those sub-prime mortgages with adjustable rates were finally out of their introductory rate period – and thousands of people start defaulting on their loans.
  9. Company A‘s portfolio is now worthless, but they are very happy they had so much foresight as to take out not-insurance policies with Company B.
  10. Company B‘s doesn’t pick up the phones.  Their offices are boarded up, the e-mails bounce back, and Company A stops getting Christmas cards from Company B.

The problem is that Company B went out of their way to invent something that was definitely-not-insurance so they wouldn’t be regulated like insurance companies.  Obviously, Company B didn’t use the “smell test” when they designed their product.  If they had, they would have charged more or kept more money in reserve.

Unfortunately, Company A didn’t use the “smell test” either when shopping around for a way to insure their investments.  You don’t insure your home, car, or life with the cheapest or newest insurance company.  You choose a company that has been around a while and charges reasonable rates for reasonable risk.

When people stop performing the “smell test” $62,000,000,000,000.00 evaporates overnight.

  1. Photo courtesy of Charles & Clint.  Photo editing: All me! []
Sep
09
2008
0

End of the World Survival Guide

or…  The Apocalypse Can Be Fun!

Almost Midnight

Almost Midnight

Yesterday I mentioned how the CERN project is going to fire up its Large Hadron Collider on Wednesday September 10, 2008.  Several lawsuits have been filed (most in the US even though the project is located in Switzerland and France) to stop the machine from being turned on.  Here are some of the allegations:

  • It will create “strangelets” that will convert all other matter in the universe into “strangelets.”
  • It will create a black hole that will swallow up the Earth.

And, my PERSONAL favorite:

  • It will create a hole in space where where time becomes stuck in an infinite loop.

However infinitesimal, you have to admit the possibility that one of the above will happen.  Here’s a list of things you can do today to prepare for the world (maybe) ending tomorrow:

  1. Save your breath and don’t work out today.
  2. Eat fatty greasy salty food.  Garlic, onions, beans – go nuts!
  3. Take up smoking, drinking, and a drug of your choice.
  4. Tell your boss what you really think about them.[1]
  5. Leave work early today and don’t show up ever again!  (Or, kill two birds with one stone and do this at the same time as #4).
  6. Shred your will and cancel all insurance policies.
  7. Credit is your friend.  Apply for every line of credit you can.  Call your credit card company and see if you can raise your credit limits.
  8. Things to buy: an air horn, fireworks, a megaphone, a costume (favorite super hero, movie star, pirate, etc), a lot of champagne, and a beer hat.
  9. Book a caterer for tomorrow.  Sure, its last minute, but money is no object, right?
  10. Call your mom – she worries.

Be prepared to stay up late tonight and get up early tomorrow.  You’re not going to want to waste any daylight.  The next blog post will be at 5am. Set your alarm and check back here bright and early for your itinerary.

Get ready to party like its 1999.

  1. Steve, buddy, you gotta work on your golf game. []

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