Banking, The Real Threat Part IV
Banking, The Real Threat Part IV
The unseen provides the worst horror
Banks thrive and decline based on the value of their risks. Money kept at banks earns interest. This interest is generated from banks making loans and investments. These actions take the form of mortgages, credit cards, loans, bonds, and other services. Banks have an intimate relationship with the financial engineers.
Financial engineers, the mystical artisans of mathematical science whom reside in the lofty citadel of hedge funds. They develop contracts that track the value of assets, like stocks or interest rates, without actually owning the underlying asset itself. These contracts provide the means of transforming assets. Using this technique, two parties can exchange cash flows. Known as derivatives, this technique has been around since the beginning of recorded time.
For example an American has loans which are denominated in the French franks while a French man has loans denominated in the US dollar. Each would like their loans to be in their own currency. Upon examination of exchange rates, interest on the loans, and matching up the life of the loans they decide that they can each make a bundle of loans that shall be equal to each other.
Instead of liquidating or renegotiating the terms of their loans, they decide to write a contract to swap loans with each other. So each man takes the monthly payments from each bundle of loans and transports it to the other mans account. Now the American receives dollars and the French receives franks.
Another form of derivative contracts is stock options. These contracts provide the ability to bet on the price of the stock either appreciating or declining without actually owning the stock. These contracts give the investor the right to buy or sell the stock the option is based upon at a certain price for a finite period of time.
The value of the stock must move above the price of the option for the holder of the option to gain money. If the value of the stock does not exceed the option price the issuer of the option makes money. Options only cost a fraction of what the stock is worth. However, like Cinderella’s pumpkin carriage, when an option time is exceeded, the option expires and is worthless. Investors exponentially increase there leverage of a stock as it moves up or down for the same amount of money as it would have taken to own the stock.
These are two very simple examples of how derivatives work. There are many more complex uses of derivatives. However, these examples give enough definition in order to understand how derivatives and banking is liked together.
Seems innocent, doesn’t it. So did Smurfs and Care Bears. Looks can be deceiving. These helpful little contracts can morph into giants, titans that can unleash unholy retribution upon an unsuspecting country. For no mathematics spell is circumspect enough to encompass human experience.
But how?
Examine the beast; its number is not “666”. The true monster is zombie lending by banks providing for excessive leverage using derivatives. Cloaked in darkness provided by private contracts, the beast has found a way around the fifty percent margin requirement, regulation T. The black death of bankruptcy has unlocked the shackles holding the beast back.
Arbitrage, is the magical ability for financial engineers to find “risk free” investments. Like the Miners 49er, they search for the real gold in the minor price differences in stocks and bonds. The bet they make is that the price shall converge, or the price between the two similar bonds shall contract.
The price differences are very small. Long Term Capital Management called this process “vacuuming up nickels, dimes, and quarters”. Since such a small amount of money is being made in each transaction, the amount of money used in the transaction becomes very important.
In order to increase the money made in arbitrage, hedge funds use borrow money from banks. The banks in return require collateral for the loan called a “haircut”. Since hedge funds are supposed to hedge their assets, the loan is considered safe. Therefore the amount of collateral required by the banks is low.
The horror materializes in the banks lack of prudence. Sins of the banks shall be born upon the populous.
To be continued.
The unseen provides the worst horror
Banks thrive and decline based on the value of their risks. Money kept at banks earns interest. This interest is generated from banks making loans and investments. These actions take the form of mortgages, credit cards, loans, bonds, and other services. Banks have an intimate relationship with the financial engineers.
Financial engineers, the mystical artisans of mathematical science whom reside in the lofty citadel of hedge funds. They develop contracts that track the value of assets, like stocks or interest rates, without actually owning the underlying asset itself. These contracts provide the means of transforming assets. Using this technique, two parties can exchange cash flows. Known as derivatives, this technique has been around since the beginning of recorded time.
For example an American has loans which are denominated in the French franks while a French man has loans denominated in the US dollar. Each would like their loans to be in their own currency. Upon examination of exchange rates, interest on the loans, and matching up the life of the loans they decide that they can each make a bundle of loans that shall be equal to each other.
Instead of liquidating or renegotiating the terms of their loans, they decide to write a contract to swap loans with each other. So each man takes the monthly payments from each bundle of loans and transports it to the other mans account. Now the American receives dollars and the French receives franks.
Another form of derivative contracts is stock options. These contracts provide the ability to bet on the price of the stock either appreciating or declining without actually owning the stock. These contracts give the investor the right to buy or sell the stock the option is based upon at a certain price for a finite period of time.
The value of the stock must move above the price of the option for the holder of the option to gain money. If the value of the stock does not exceed the option price the issuer of the option makes money. Options only cost a fraction of what the stock is worth. However, like Cinderella’s pumpkin carriage, when an option time is exceeded, the option expires and is worthless. Investors exponentially increase there leverage of a stock as it moves up or down for the same amount of money as it would have taken to own the stock.
These are two very simple examples of how derivatives work. There are many more complex uses of derivatives. However, these examples give enough definition in order to understand how derivatives and banking is liked together.
Seems innocent, doesn’t it. So did Smurfs and Care Bears. Looks can be deceiving. These helpful little contracts can morph into giants, titans that can unleash unholy retribution upon an unsuspecting country. For no mathematics spell is circumspect enough to encompass human experience.
But how?
Examine the beast; its number is not “666”. The true monster is zombie lending by banks providing for excessive leverage using derivatives. Cloaked in darkness provided by private contracts, the beast has found a way around the fifty percent margin requirement, regulation T. The black death of bankruptcy has unlocked the shackles holding the beast back.
Arbitrage, is the magical ability for financial engineers to find “risk free” investments. Like the Miners 49er, they search for the real gold in the minor price differences in stocks and bonds. The bet they make is that the price shall converge, or the price between the two similar bonds shall contract.
The price differences are very small. Long Term Capital Management called this process “vacuuming up nickels, dimes, and quarters”. Since such a small amount of money is being made in each transaction, the amount of money used in the transaction becomes very important.
In order to increase the money made in arbitrage, hedge funds use borrow money from banks. The banks in return require collateral for the loan called a “haircut”. Since hedge funds are supposed to hedge their assets, the loan is considered safe. Therefore the amount of collateral required by the banks is low.
The horror materializes in the banks lack of prudence. Sins of the banks shall be born upon the populous.
To be continued.
posted by Chromatic Dispersion at 7/05/2005 04:02:00 PM
0 Comments:
Post a Comment
<< Home