In the past 10 years or longer we have seen growth in a special type of derivative that strips the credit rating of one asset so that it can be attached to another.
For many many years credit rating agencies such as Standard and Poors and Moodies have done a good job of fairly assessing banks and companies, their business plans and strategies and their debt burden. Culminating in a rating from AAA the best possible to non rateable junk bond status. As the result the cost of borrowing for the companies is cheapest for a triple A rated company and most expensive for a low on non rated company. Basic banking 101.
With a credit derivative product it is possible in theory to take a junk bond, mix it with some medium quality bonds and put a triple A label on it. Effectively circumventing the credit rating agencies. Selling mutton as lamb. Although just tongue in cheek scenarios the following explains the reason for their creation and the stupidity of the product.
1. A bunch of old money guys are holding some bonds they bought at the recommendation of their broker or investment bank. The company suffers a downgrade due to bad management or missed contracts or any number of business reasons. Therefore the assets the old money guys had purchased is no longer worth anywhere near what they paid for it and will never yield the amount that they expected to receive. Therefore these old money guys (From very famous and powerful families), go back to their investment bank and tell them to fix the problem and get their money back. The investment bank calls on its financial engineering team to skew the payoff from the bonds. So.. The investment bank buys back the bonds at face value, puts a few other high quality bonds in a so called basket. Estimates the payoff, sets a new coupon rate and either gives its own credit rating or issues credit default swaps based on a 3rd party to improve the default characteristics of the basket.
Then the investment bank lets call them Weidman, issues this new basket of bonds and attaches their own credit rating lets say single A to the issue. That way they can sell junk to the market at the price of gold because it has this "Credit derivative" attached. The financial engineers however miscalculated the VAR or value at risk of these products thinking that diluting the risk in this way for a fixed fee would be fine.
No, just step outside the box and think about it. A piece of shit is still a piece of shit even with a new coat of paint. The device seemed to become so popular that everyone wanted in on the game to improve the notional value of their holdings.
2. In layman terms.
Joe owns a one pump garage on a dusty lonely stretch of route 66. He has worked there and lived there alone since his mother and father passed away. He gets a few customers a week, just enough to keep his head above water and not much else.
Then one day the suits from Weidman pull up in their limo at Joe's garage. They fill their tank and start up a conversation with him. They ask Joe how long he has been there. What a fine and prosperous garage he owns. This country needs more businessmen like you Joe. They ask Joe how long it has been since he has taken a holiday. Joe says he has not had the chance as there is no one to run the business.
So they ask him if he has a destination in mind, somewhere he would really like to visit. Yes, he answers my daddy always used to say Vegas was like paradise on earth So i think I would like to go there.
The suits convince Joe that his garage is worth at least 1 mio dollars and that they can borrow $2mio against it and future profits and sell bonds protected by a credit default swap by a big company and everything would be fine. Joe would be able to take a holiday and maybe even make some improvements to the business. Of course the cost of this financial engineering would be $1mio which Joe would have to pay Weidburg from the $2mio he is going to borrow. After agreeing, the suits get back in their car and tell Joe they will be back in a month. Sure enough they come back with a contract and documents that are an inch thick. Joe signs in all the places they circle. They guys from Weidman get back in the car and tell joe the issue should be made in a few weeks time and he should have his $1mio net in about 6 weeks. Sure enough, 6 weeks later Joe gets a cheque from Weidman for $1mio. Joe packs his bag gets in his truck and sets off for Vegas.
When he gets there he finds a hotel checks into a nice room and goes downstairs to buy some chips with his Weidman draft. Joe didn't know much about casinos but he had seen them on TV. So he took his $1mio worth of chips and put it all on black on the roulette table. Well of course it came up red. Joe looses everything including his garage and truck, the bonds (not just Joe's part but another 1,000 people like him) default. The buyers of the repackaged bonds try to cash in on the default with the credit derivative event attached to the basket. However, the amount of default swap payout is not enough to cover the loss of the investment, just the difference in bond value between one credit level and another (typically a downgrade by one step).
So Joe looses everything. New investors loose almost everything. Weidman get rich.
Weidman salesmen get multi-million dollar bonuses and go on to prove to the world that black is red and whats more red is more valuable than black.
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