It would not be a big deal….if it did not effect your paycheck, mortgage, college loan

October 14, 2008 · Posted in Big Business Ripoffs, Financial Crisis, Politics, Social Issues, Things to think about, Thoughts on the economy 

OK, probably not something you hear discussed in a bar everyday.  But I think this is one of the most important stories of the financial crisis that has slipped between the cracks (or the headlines).

It is perfectly easy to understand how this has gone unreported (except by a very few, namely Jim Cramer on his CNBC show Mad Money has touched on this topic).  What has taken place seems to me as if it should clearly be against the law.  And if it is not now, it should be in the future.  This is somewhat complex and thus escapes the easy and simple cause and effect that the popular press likes to report.

Finally, with banks collapsing and the economy in crises there are many other more dramatic stories.

I write this so that regular people will understand a trading strategy employed by hedge funds that has contributed to this crisis.  I want this understood, so that when Congress starts re-thinking the regulation of the financial industry it addresses this – and protects you.

Why should you care?

You should care because hedge funds have engaged in a strategy to manipulate the price of credit default swaps to destroy the price of major companies and banks.

Because these companies and banks depend on short term financing markets for capital the strategy had the odd effect of creating a perception of failure in the debt markets which caused certain companies to get locked out of the short term financing markets, it caused rating agencies to make knee-jerk actions, it causes banks to rein in credit.  By creating this perception, the hedge funds created a reality.

The reality impacts your ability to buy a house, stay in a house you are currently in, finance your child’s college education, quite possibly it impacts the ability of your employer to keep you on the payroll.

Now, I am not blaming everything on the hedge funds.  Many of the assets of these companies were and are of questionable value, the dependence of these companies on short term debt was foolish to begin with (in many undergraduate finance textbooks the concept of matching the term of your assets with appropriate financing is a basic concept that one is required to understand.  Apparently you do not have to understand the concept to run a major corporation.)

All that said, here is the basic play:

1) Buy credit default swaps (basically insurance on the value of the bonds of a particular company)

2) Drive down the stock price by shorting shares

3) Spread rumours to other hedge funds to bring them on the trade

4) Buy more CDS at higher prices because as the price goes up the perception in the market will be that the company is increasing its chances of default

5) Short more stock

6) Repeat steps 1 – 5 until:

a) The rating agencies, fearing that they are “missing” something put the debt on negative watch or downgrade the credit rating

b) Lenders, fearing that the market “must” know something they do not start to make calls for more collateral, call in loans, stop buying commercial paper

c) The investors owning the stock in their 401-K assume there is something awful they do not know and in a panic they sell out at the bottom to the short selling hedge funds so that they can cover their positions and make millions, even billions.

Pretty soon you have an all out panic.  Now the rich guys that are invested in those hedge funds make money.  The hedge fund managers make an insane amount of money (you may get to see a few of them on next year’s Forbes 400).

I have no problem with these people making insane amounts of money, except when they do it in a way that creates the destruction required to make their positions profitable.

I have no problem with these people making insane amounts of money, except when it destroys the finances of millions of average Americans.

I have no problem with these people making insane amounts of money, except when it contributes to requiring our tax dollars be put at risk to fix some of the damage done to the system – the very system that has given them this opportunity to become fabulously wealthy.

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Comments

5 Responses to “It would not be a big deal….if it did not effect your paycheck, mortgage, college loan”

  1. Chris Moran on October 14th, 2008 5:56 pm

    Nice writing style. Looking forward to reading more from you.

    Chris Moran

  2. Susan Kishner on October 14th, 2008 5:57 pm

    You know, I have to tell you, I really enjoy this blog and the insight from everyone who participates. I find it to be refreshing and very informative. I wish there were more blogs like it. Anyway, I felt it was about time I posted, I

  3. they on October 15th, 2008 10:00 am

    It is about time someone explained the process in a way the common man can understand. Great job We. I knew it was coming for some time, but I am glad it is finally out there for people to discuss.

  4. they on October 15th, 2008 11:59 am

    Check out this post on another blog. The comments are interesting. http://www.reason.com/blog/show/129272.html

  5. The $58 Trillion elephant in the room has just taken a dump | Heard it in a bar on October 21st, 2008 11:25 pm

    [...] that in the interest of time I will not be able to explain, so I encourage you to view this post http://www.hearditinabar.com/2008/10/14/it-would-not-be-a-big-dealif-it-did-not-effect-your-paycheck... for more information on the subject, and for everyone in eye sight of this article I encourage you [...]

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