

Ask HN: What are those "other complex financial derivatives?" - tstegart

So tons of news articles these days talk about mortgage backed securities and usually mention "other complex derivatives" when talking about the latest struggles on Wall Street. So what are these derivatives, and how exactly are they causing all these troubles? I understand the mortgage mess fine, but I'm not sure what a "complex derivative" is, and more importantly, I can't find an article explaining exactly how they cause a firm to lose money. Anyone got any links to something that describes the mess in detail?
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tstegart
Can anyone explain this: "The market for credit derivatives is now so large,
in many instances the amount of credit derivatives outstanding for an
individual name are vastly greater than the bonds outstanding. For instance,
company X may have $1 billion of outstanding debt and $10 billion of CDS
contracts outstanding. If such a company were to default, and recovery is 40
cents on the dollar, then the loss to investors holding the bonds would be
$600 million. However the loss to credit default swap sellers would be $6
billion."

My understanding was, if you have $1 billion in outstanding debt, and that
defaults, then the people providing the credit default swap would have to pony
up $1 billion. So who are they giving the other $5 Billion to?

~~~
lacker
A CDS doesn't necessarily have to be tied to debt, it's basically just a bet
whether a third party will or will not go bankrupt. It is commonly used to
hedge debt, but it doesn't have to be.

See: <http://en.wikipedia.org/wiki/Credit_default_swap>

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rms
Does anyone trade in second and third derivatives?

For example, the value of the risk of a credit derivative. Or the risk of the
risk of a credit derivative.

~~~
jwilliams
In essence - yes.

Firms will hedge and hedge and hedge (and hedge) internally and between each
other. These are essentially derivations.

Also, a complex instrument might require multiple hedges. These hedge
positions might be confounded in themselves - so you might put together a
strategy between your hedges.

It's becomes a bit of a financial Jenga - which is why one or two key failures
is getting people very nervous.

~~~
tstegart
I'm beginning to suspect that many problems are a result of people not being
able to keep track of what does what for who's benefit. Seriously, it sounds
like a bankruptcy seminar I went to. Banks trying to foreclose were getting
upset when judges started to tell them to produce the title to the loan. It
turns out they had repacked and sold them and never actually delivered the
titles. The excuse was "its on someone's desk somewhere." But the laws in some
states require you to bring it to court to prove you own the loan. And they
couldn't, even though everyone knew who owned the loan, nobody had the piece
of paper.

Once the Jenga pile collapses, I highly doubt people will be able to figure
out who owes what to who, even though they claim to have hedges against this,
that and the other.

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noodle
<http://en.wikipedia.org/wiki/Collateralized_debt_obligations>

~~~
tstegart
Credit default swaps were also interesting:
<http://en.wikipedia.org/wiki/Credit_default_swap>

