October 15th, 2008 08:30 EST
What's Really Wrong with Wall Street?
Nobody talks about it. 99% of consumers have never heard about it. And even the masters on Wall Street are finding out that they don`t really understand it. But the biggest problem underlying our country`s financial woes is a new "bet" that financial institutions are making on each other. The problem with the new bet is that when you win you lose. And when you lose, you get shut down. Let me explain.
I have wanted to share this information for some time now, but it`s so complex and it`s so esoteric, that the mainstream media has shied away from the topic. It`s a topic that even the most sophisticated minds on Wall Street are having a hard time getting their arms around. And the magnitude of the problem, which just began to surface earlier this year, is barely beginning to get acknowledged " although it is hardly understood. Washington knows about it but has been very quiet because the complexity of the issues involved puzzle even our most brilliant economic minds " and because they can`t control it.
What am I talking about? I`m talking about "credit default swaps."
A credit default swap or CDS, is a pseudo-insurance policy that Wall Street cooked up so that as credit risk increased, a side bet would pay off to make sure that one financial institution was able to protect against the risk of another. This is a very common practice in the investment banking business. It`s all about risk management, and risk management is frequently done using hedges. A hedge is protection or a bet that somehow, if things go out of your control, that you`re protected on the downside. That means if something goes wrong, you have a counter bet in place that pays when your bet goes in the wrong direction.
The credit default swaps are similar, but these bets are naked. Naked means that you don`t own the underlying securities, and therefore if something goes wrong, it goes really wrong. Since you don`t own the underlying securities, you`re responsible for all of the financial gain or loss that comes with the bet that you made. There also isn`t much guarantee in place that you will be able to cover the position that you have created when you don`t own the underlying securities. Are you starting to see the problem?
In the credit default swaps, the financial institutions underwrote trillions of dollars of insurance-type bets for very paltry sums of money. For as little as $30,000, one institution could write a swap on another financial institution`s portfolio with a payout of as much as $10 million. Trillions and trillions of dollars of these swaps were created and traded over the last several years, all designed to mitigate the risk on the mortgage securities that were well-known to be a bad bet. That is because they were made to borrowers who had less than perfect credit and less than perfect reason to believe that they would actually make good on their promises.
As one of my Wall Street friends described to me that in the life insurance world, you can`t just buy a policy on anybody you want. You have to have an "insurable interest." And of course, you can`t legally buy life insurance on someone and then go kill them. Firstly, murder is illegal, and secondly, if you get caught, you don`t get the insurance money.
But not with the credit default swaps. Buyers could purchase swaps at will and then many of them shorted (betting that the price would fall) huge volumes of stock in an effort to force stock prices and credit ratings down. This created payoffs on the swaps " but it also forced Bear Stearns out of business when their stock was forced to nearly zero in March 2008.
The most well-known example of a swap flop was AIG. The reason that AIG collapsed is because they`re one of the largest providers of the credit default swap side bets that the financial institutions were making. They were taking in huge amounts of fees for writing the swaps, largely gambling that although significant premiums would come in, hardly any payoff would be required. So they never set aside the appropriate reserves to make pay outs in the event that something went terribly wrong. And Murphy`s law says that something will go terribly wrong. Therefore, since the reserves were never set aside, the ability to pay on the swaps was not in place, causing AIG to collapse when the bets went against them.
The government stepped in, and now has no idea about how many dollars of these swaps are actually in place. The swaps are technically not insurance policies, so there is no reporting and no regulation on them. The trading community was very careful to create a product that would not be regulated by the Department of Insurance in any states or any other agency. But, this "under the radar" product has now put many institutions under water.
The reason that I`m bringing this up now is that for the first time in my experience, the lay media is exposing these credit default swaps. I saw a piece last week on 60 Minutes that I think is worth your time to watch. There are several pieces - credit default swap number one, credit default swap number two, and several others that equate the stock market to gambling on sports in much the same way that I equate raising money for entrepreneurial ventures similar to going to the horse racing track. These pieces are well-done, and because they were putting it out to the common community, I felt it would be worthwhile for me to share this information with my list of loyal readers. See for yourself: http://is.gd/41ob. By the way, Wikipedia also explains something about how the swaps work.
I hope this information is of great value to you. As you are working hard every day to build your company, or as you`re building your career, knowing exactly what`s going on in the marketplace is the only way that you`ll be able to protect yourself going forward. Learn this material, study what`s happening with these credit default swaps, and start finding out why you haven`t been exposed to this information in the past. This is insiders` information about the ways that the trading business actually works. It`s very complex, but it`s worth your time and energy to understand because it`s going to make a lot of what is happening in our economy make some sense.
About Joel G. Block, President of Growth-Logic, Inc.
Often dubbed a "Growth Architect" by his clients, Joel Block advises companies on explosive growth strategies by driving revenue and sales. Well known in the capital markets, Joel is a successful entrepreneur, speaker and advisor. To bring Joel into your company, please visit http://www.joelblock.com or http://www.growth-logic.com. Also, be sure to check out our newest project: a blog to organize the blogs that cover entrepreneurship - http://www.entrepreneur-hub.com. And finally, for film makers: http://www.filmfundingblog.com - our newest project.