Naked Economics by Wheelan, Charles (spanish books to read .txt) 📕

nothing about parenthood; it did convince me forever that carrying eggs is a risky proposition.

The financial markets make it cheap and easy to put our eggs into many different baskets. With a $1,000 investment in a mutual fund, you can invest in five hundred or more companies. If you were forced to buy individual stocks from a broker, you could never afford so much diversity with a mere $1,000. For $10,000, you can diversify across a wide range of assets: big stocks, small stocks, international stocks, long-term bonds, short-term bonds, junk bonds, real estate. Some of those assets will perform well at the same time others are doing poorly, protecting you from Wall Street’s equivalent of bullies hurling eggs against the wall. One attraction of catastrophe bonds for investors is that their payout is determined by the frequency of natural disasters, which is not correlated with the performance of stocks, bonds, real estate, or other traditional investments.

Even the much-maligned credit default swaps have a legitimate investment purpose. A credit default swap is really just an insurance policy on whether or not some third party will pay back its debts. Suppose your husband pressures you to loan $25,000 to your ne’er-do-well brother-in-law so that he can finally complete his court-man-dated anger management program and turn his life around. You have grave concerns about whether you will ever see any of this money again. What you need is a credit default swap. You can pay some other party (presumably with a more favorable view of your brother-in-law’s creditworthiness) to enter into a contract with you that promises to pay you $25,000 in the event that your brother-in-law does not pay back the cash. The contract functions as insurance against default. Like any other kind of insurance, you pay for this protection. If your brother-in-law gets his act together and pays back the loan, you will have purchased the credit default swap for nothing (which is how the other party to the transaction, or the counterparty, makes its money). How could something so simple and seemingly useful contribute to the near collapse of the global financial system? Read on.

Speculation. Of course, once any financial product is created, it fulfills another basic human need: the urge to speculate, or bet on short-term price movements. One can use the futures market to mitigate risk—or one can use the futures market to bet on the price of soybeans next year. One can use the bond market to raise capital—or one can use it to bet on whether or not Ben Bernanke will cut interest rates next month. One can use the stock market to invest in companies and share their future profits—or one can buy a stock at 10:00 a.m. in hopes of making a few bucks by noon. Financial products are to speculation what sporting events are to gambling. They facilitate it, even if that is not their primary purpose.

This is what went wrong with credit default swaps. The curious thing about these contracts is that anyone can get into the action, regardless of whether or not they are a party to the debt that is being guaranteed. Let’s stick with the example of your loser brother-in-law. It makes sense for you to use a credit default swap to protect yourself against loss. However, that same market also allows the rest of us to bet on whether or not your brother-in-law will pay back the loan. That’s not hedging a bet; that’s speculation. So for any single debt, there may be hundreds or thousands of contracts tied to whether or not it gets repaid. Think about what that means if your brother-in-law starts skipping his anger management classes and defaults. At that point, a $25,000 loss gets magnified thousands of times over.

If the parties guaranteeing that debt haven’t done their homework (so they don’t truly understand what a loser your brother-in-law is), or if they don’t care (because they earn big bonuses for making dubious bets with the firm’s capital), then an otherwise small set of economic setbacks can explode into something bigger. That’s what happened when the American economy hit a real-estate-related speed bump in 2007. AIG was the firm at the heart of the credit default debacle because it guaranteed a lot of debt that went bad. In his excellent 2009 assessment of the financial crisis, former chief economist for the International Monetary Fund Simon Johnson writes:

Regulators, legislators, and academics almost all assumed that the managers of these banks knew what they were doing. In retrospect, they didn’t. AIG’s Financial Products division, for instance, made $2.5 million in pretax profits in 2005, largely by selling underpriced insurance on complex, poorly understood securities. Often described as “picking up nickels in front of a steamroller,” this strategy is profitable in ordinary years, and catastrophic in bad ones. As of last fall, AIG had outstanding insurance on more than $400 billion in securities. To date, the U.S. government, in an effort to rescue the company, has committed to about $180 billion in investments and loans to cover losses that AIG’s sophisticated risk modeling had said were virtually impossible.6

Raising capital. Protecting capital. Hedging risk. Speculating. That’s it. All the frantic activity on Wall Street or LaSalle Street (home of the futures exchanges in Chicago) fits into one or more of those buckets. The world of high finance is often described as a rich man’s version of Las Vegas—risk, glamour, interesting personalities, and lots of money changing hands. Yet the analogy is terribly inappropriate. Everything that happens in Las Vegas is a zero-sum game. If the house wins a hand of blackjack, you lose. And the odds are stacked heavily in favor of the house. If you play blackjack long enough—at least without counting cards—it is a mathematical certainty that you will go broke. Las Vegas provides entertainment, but it does not serve any broader social purpose. Wall Street does. Most of what happens is a positive-sum game. Things get built; companies are launched; individuals