Financial toxic waste removal 101
Derivatives as carnival house of mirrors
By Jon Fernquest 
Financial
engineering and the complicated financial instruments
called derivatives
may only be the last step in a long series of steps that led to the
current global economic crisis.Economist Joseph Stiglitz traces these steps back to the late 1980s.
First, Alan Greenspan replaced Fed Chairman Paul Volker and regulation of financial markets began to disappear.
New and ever more complicated derivatives, also known as financial engineering, started to appear. Leverage ratios as high as 30-to-1 allowed high returns for many years.
Financial "wizards" began to believe in their own immortality.
financial engineering - a
phrase used for "finance" to make it sound like regular engineering
such building buildings, designing cars, etc. ระบบการเงิน
financial instruments - any investment that can be sold for cash such as stock shares, bonds, or futures การลงทุนทางการเงิน เช่นการซื้อหุ้น พันธบัตร
derivatives - complicated assets that derive their value from other assets (See Wikipedia article and list)
Joseph Stiglitz - Nobel prize winning economist and critique of IMF policy during the 1997 Asian financial crisis (See Wikipedia) นักเศรษฐศาสตร์รางวัลโนเบล
Alan Greenspan - served as Chairman of the US central bank (The Fed) from 1987 to 2006 (See Wikipedia) ประธานธนาคารกลางประเทศสหรัฐอเมริกา
Paul Volker - served as Chairman of the US central bank (The Fed) from from 1979 to 1987 (See Wikipedia) ประธานธนาคารกลางประเทศสหรัฐอเมริกา
leverage ratios - how much the purchase of an asset was funded by loans rather than your own funds (equity) อำนาจเพิ่มผลทางการเงิน
wizards - male witches, masters of the supernatural พ่อมด
immortality - live forever, never die อมตะ
financial instruments - any investment that can be sold for cash such as stock shares, bonds, or futures การลงทุนทางการเงิน เช่นการซื้อหุ้น พันธบัตร
derivatives - complicated assets that derive their value from other assets (See Wikipedia article and list)
Joseph Stiglitz - Nobel prize winning economist and critique of IMF policy during the 1997 Asian financial crisis (See Wikipedia) นักเศรษฐศาสตร์รางวัลโนเบล
Alan Greenspan - served as Chairman of the US central bank (The Fed) from 1987 to 2006 (See Wikipedia) ประธานธนาคารกลางประเทศสหรัฐอเมริกา
Paul Volker - served as Chairman of the US central bank (The Fed) from from 1979 to 1987 (See Wikipedia) ประธานธนาคารกลางประเทศสหรัฐอเมริกา
leverage ratios - how much the purchase of an asset was funded by loans rather than your own funds (equity) อำนาจเพิ่มผลทางการเงิน
wizards - male witches, masters of the supernatural พ่อมด
immortality - live forever, never die อมตะ
Then came the belief under President Bush that tax cuts could cure every economic ill: "The cut in the tax rate on capital gains contributed to the crisis in another way... [T]he decision encouraged leveraging, because interest was tax-deductible. ... The Bush administration was providing an open invitation to excessive borrowing and lending..."
Next came stock options and the incentive it provided upper management to distort financial information to pump up stock prices. Credit ratings agencies were paid by the very people they evaluated. The Fed flooded the economy with liquidity and...BOOM...this dangerous mixture blew up in everyone's face and here we are today. (Read Stiglitz's Capitalist Fools cited in Economist's View and review by James Kwak).
leveraging -
borrowing a lot to buy assets
interest was tax-deductible - the interest paid on a loan can reduce the taxes you pay ดอกเบี้ยสามารถนำไปหักภาษีได้
stock options, employee stock options - rights to buy stocks in the future (See Wikipedia) มีสิทธิในกการซื้อหุ้น
incentive - a reward that encourages certain types of behaviour ผลตอบแทน
distort financial information - not report money information accurately ไม่แจงสถานะหรือข้อมูลทางการเงิน
credit ratings agencies - companies that try to measure how likely companies are to pay back their loans
interest was tax-deductible - the interest paid on a loan can reduce the taxes you pay ดอกเบี้ยสามารถนำไปหักภาษีได้
stock options, employee stock options - rights to buy stocks in the future (See Wikipedia) มีสิทธิในกการซื้อหุ้น
incentive - a reward that encourages certain types of behaviour ผลตอบแทน
distort financial information - not report money information accurately ไม่แจงสถานะหรือข้อมูลทางการเงิน
credit ratings agencies - companies that try to measure how likely companies are to pay back their loans
Derivatives as house of mirrors
Gao Xiping
is the western-educated head of China
Investment Corporation, one of China's largest sovereign wealth
funds One day he was called upon to explain derivatives to China's State Council, the main ruling body of China, the largest country on earth.
How did he explain how these complicated beasties work?
He used the analogy of a house of mirrors.
A house of mirrors is the part of a carnival funhouse with mirrors that distort your image, often grotesquely (See photos on the right from carnivalmirror.com).
Here is how he explained derivatives to some very important people who had little background in finance (Also check out recent critical articles that describe financial engineering educational scams and financial engineering as a crime or grotesquely high incentives):
If you look at every one
of these [derivative] products, they make
sense. But in aggregate,
they are bullshit. They are crap. They serve
to cheat people...
...First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror — I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.
When I told the State Council about the mirrors, they all started laughing. “How can you sell a mirror image! Won’t there be distortion?” But this is what happened with the American economy, and it will be a long and painful process to come down.
I think we
should do an overhaul
and say, “Let’s get rid of 90 percent of the
derivatives.” Of course, that’s going to be very unpopular, because
many people will lose jobs... (Source:
Atlantic Monthly, "Be Nice to the Countries that Lend You Money," James
Fallows, link)
...First of all, you have this book to sell. [He picks up a leather-bound book.] This is worth something, because of all the labor and so on you put in it. But then someone says, “I don’t have to sell the book itself! I have a mirror, and I can sell the mirror image of the book!” Okay. That’s a stock certificate. And then someone else says, “I have another mirror — I can sell a mirror image of that mirror.” Derivatives. That’s fine too, for a while. Then you have 10,000 mirrors, and the image is almost perfect. People start to believe that these mirrors are almost the real thing. But at some point, the image is interrupted. And all the rest will go.
When I told the State Council about the mirrors, they all started laughing. “How can you sell a mirror image! Won’t there be distortion?” But this is what happened with the American economy, and it will be a long and painful process to come down.
I think we
should do an overhaul
and say, “Let’s get rid of 90 percent of the
derivatives.” Of course, that’s going to be very unpopular, because
many people will lose jobs... (Source:
Atlantic Monthly, "Be Nice to the Countries that Lend You Money," James
Fallows, link)China Investment Corporation
(CIC) - a Chinese sovereign wealth fund managing $200
billion in assets that began operations in 2007 (See Wikipedia)
sovereign wealth fund - an investment fund owned by the government of a country that uses currencies from other countries it has gained and accumulated from exports to fund purchases of stocks, bonds, and real estate (See Wikipedia) กองทุนรัฐบาล
derivatives - complicated assets that derive their value from other assets (See Wikipedia article and list)
beasties, wild beasts - dangerous animals that live in the jungle สัตว์ป่า สัตว์ดุร้าย
an analogy - explaining one by comparing it with another การอุปมา
a carnival - a traveling show that has rides, games, shows and other entertainments (See Wikipedia) งานแห่ งานฉลอง
a carnival funhouse - an amusement at a carnival with unusual and amusing experiences such as image distorting mirrors or a freakshow (See Wikipedia) เครื่องเล่นในงานฉลอง หรืองานวัด
a carnival funhouse mirror - image distorting mirrors, see photos to right (See carnivalmirror.com) กระจกที่แสดงภาพหลอน
an image - a picture of something, the appearance of something, the way it really looks ภาพลักษณ์
distortion (noun) - appearance changed so that it looks bad, not the way it really looks การทำให้ผิดรูปผิดร่าง
distort an image (verb) - changing appearance changed so that it looks bad, not the way it really looks การทำให้ผิดรูปผิดร่าง
a house of mirrors - the part of a carnival funhouse with image distorting mirrors
grotesquely - shocking because it is exaggerated, unnatural, and extremely unpleasant พิสดาร ประหลาด
in aggregate - many things taken together and treated as one thing ผลรวม
the mirror image of Y - a reflection in a mirror of something, looks exactly the same or reversed (See Wikipedia) ภาพสะท้อนของ
an overhaul - completing repairing and changing something so that it is like new ยกเครื่อง การปรับปรุง แต่งแต้มใหม่ทั้งหมด
sovereign wealth fund - an investment fund owned by the government of a country that uses currencies from other countries it has gained and accumulated from exports to fund purchases of stocks, bonds, and real estate (See Wikipedia) กองทุนรัฐบาล
derivatives - complicated assets that derive their value from other assets (See Wikipedia article and list)
beasties, wild beasts - dangerous animals that live in the jungle สัตว์ป่า สัตว์ดุร้าย
an analogy - explaining one by comparing it with another การอุปมา
a carnival - a traveling show that has rides, games, shows and other entertainments (See Wikipedia) งานแห่ งานฉลอง
a carnival funhouse - an amusement at a carnival with unusual and amusing experiences such as image distorting mirrors or a freakshow (See Wikipedia) เครื่องเล่นในงานฉลอง หรืองานวัด
a carnival funhouse mirror - image distorting mirrors, see photos to right (See carnivalmirror.com) กระจกที่แสดงภาพหลอน
an image - a picture of something, the appearance of something, the way it really looks ภาพลักษณ์
distortion (noun) - appearance changed so that it looks bad, not the way it really looks การทำให้ผิดรูปผิดร่าง
distort an image (verb) - changing appearance changed so that it looks bad, not the way it really looks การทำให้ผิดรูปผิดร่าง
a house of mirrors - the part of a carnival funhouse with image distorting mirrors
grotesquely - shocking because it is exaggerated, unnatural, and extremely unpleasant พิสดาร ประหลาด
in aggregate - many things taken together and treated as one thing ผลรวม
the mirror image of Y - a reflection in a mirror of something, looks exactly the same or reversed (See Wikipedia) ภาพสะท้อนของ
an overhaul - completing repairing and changing something so that it is like new ยกเครื่อง การปรับปรุง แต่งแต้มใหม่ทั้งหมด
