I believe people are already changing their mindsets. The changes are slow in Australia so far. But they are noticeable all the same.

Some examples of change, are people talking about saving more, spending less and finding a cheaper way.

As people’s losses intensify they will become even more risk averse. That will mean less investment. This flows from a change in psychology. People will become more conservative and less ostentatious. This will happen as people’s mouths will match their changing actions. Or the other way round.

Remember reading about the changes that occurred from the 1920s to the 1930s. People changed from being risk taking show offs to conservative homely types. This change was slow but very long lasting. Some of the depression generation are still very conservative and risk averse today.

Some economies are soon ready to raise interest rates ,like Greece, Ireland, UK ,Portugal, Spain, Italy, so on, as their 10 year notes are showing signs of blowing up, especially Greece. If this disaster spread to Spain that would really deflate the Spanish property bubble. My guess is that Spain rather would rather buy their own debt than raise interest rates. That would bring hyperinflation to Spain. A very likely scenario in my opinion.

It will be interesting to see if these countries choose 10-20 % short term interest rates, or monetizing debt.

The upside will be that our kids will be able to buy (and actually pay off) a house. We will rebuild a genuine savings base that can support production. This will create satisfying jobs for Gen Y and their kids. Our kids will be able to start businesses without masses of debt and risk.

I don’t subscribe to the view that the world is over and it will never be good again.

For the next 10 years though many people will do it very tough. All power to human nature and good old Aussie ingineuity. People will re-find joy in relationships and forget their love of money and things.

Great discussion. I’ve been out of the office all day and missed it.

Derivatives (as per their name) are an asset or liability (a piece of paper) with has its value derived from an underlying “real” asset. Eg, a call option is a derivative. It is a piece of paper that gives the holder the right to buy say a share or a property at a predetermined price within a fixed time. The leverage (or multiple exposure) is usually 100 times. Therefore, a small rise in the price (or value) of the asset leads to a very large rise in the value of the option. The option goes up in value because the holder agreed to pay X for the share, but now the share is worth X+10. Therefore the option can be sold for more than it cost. They go down in value too.

Now CDS (Credit default swaps) are also a derivative. Their value is derived from bonds sold by companies. The insurance description (agreed there is no reserves like insurance companies have) is a good way to describe them, because it helps one understand.

Think of CDS this way. Assume you are a Japanese bank and you want to buy a Macquarie Bank bond for $100M. A bond is a fancy way to say a loan to Maquarie Bank. An American Bank then comes along and agrees to sell you a CDS. The CDS will insure you so that if MacBank defaults, you will recover all your principal. The numbers worked something like this. The interest you would earn on the bond would be say 6% but the CDS would cost 1%. Therefore netting you 5%. Rates for you to borrow in Japan are only about 2.5%. Once you hedge the currency (some extra cost), you are “guaranteed” to make a net 2% “risk free”!!! The American Bank makes 1% with no capital cost. “free money”.

The American bank loved this business, because they got money for nothing. The thought was that MacBank would never default. If
macbank got into trouble they could just raise more equity in the market and pay out the bond. Easy money for all. So the Japanese banks started selling CDS as well. In fact many banks and insurance companies did.

By the way. CDOs (collateralised Debt Obligations) are just a fancy name for securitised loans. A bundle of loans. Say home loans or commercial property loans bundled up and sold off as a “diversified” low risk bond. Banks wrote CDS against these as well.

Now the rub. When MacBank was never going to default that was fine. But now that raising fresh capital is getting harder and nobody knows the true exposures of banks, the risk of default is much higher. So what the American bank earned $1M (1%) a year from, might now cost them $30M, $50M or even $100M, depending on what can be recovered if MacBank defaulted.

The word around when AIG (American International Group) was nationalised. Was that their CDS exposure was so big it would cause a domino effect and bring down all the other players with them. So they said.

Furthermore it’s hard to on-sell the CDS because the contingent liability has skyrocketed. Also the cost of writing new CDS has skyrocketed and so banks are very reluctant to buy bonds (without cover) so the bond market has frozen solid also.

The conclusion I reach is that when the public get tired of the wasteful bailouts and the Government tap is turned off. The system will melt down. (my guess is Sept/Oct this year) Only to start again from a much lower base.

my suspicion was that they were largely hollow bulldust instruments in the form of a ‘pass the parscle’ and make sure that YOU are not the smuck left holding it AND that you have picked up all the available fees and commissions along the way.

So this is the origin of the 10,000 billion US$ ‘worth’ of “ghost assets”, refered to in the GEAB Report to which I refered in my post of jan 17.

Isn’t it just stunning to realise that probably 97% ( my guess) of the community has no idea of these ‘drivers’/factors in a big part of this finacial economic train wreck.

And that the people who they are relying on to fix it all (and quickly so things can get back to ‘normal’ -doesn’t that concept crack you up) – like ‘super Kev’ and ‘St. Barack’ don’t want them to get an appreciation of what has gone on, in order that they will continue to swallow that they should keep ‘signing up’ for their dream home, aided by their caring gov’t who has increased the subsidy ( read developers extra margin),whilst ALSO continuing to spend spend spend !

And gees if people really knew that the govts effectively sanctioned the creation of these ‘products’/paper through slack regulatory regimes and ratings authorities,
boy they might start causing anar… oops
I mean ‘social unrest’ !

It gives “buggered” an entirely new dimension.

what derivatives are?-Exceedingly complex contracts of insurance between 2 parties that have a life of the underlying security (mortgage)- say 15 years for example. The derivative is a very complex algorithm based insurance type contract- made by usually an investment bank then underwritten by the bank then sold off to a party who wants to mitigate risk (fees fees fees)from that underlying security. That party can then onsell at a small discount or hold to maturity whereby the seller of the derivative in teory collects premiums for holding the risk . The derivative “market” is like a stock market but facilitates the buying and selling of derivatives which essentially discovers its “market value”. The big difference is that the derivatives trade is largely UNREGULATED.

How are they valued? They are valued initially at their selling price (say 100) then thereafter what they are traded at (which as we know fluctuates) until maturity. When nothing trades ie no bidders (no buyers)only offers (sellers) what are they worth? Yesterday say 95, now 5 or 3? ZERO??? Who knows? That is the scope of the massive collapse in this monstrous market.

Who benefits?- Those who collect premiums, until they dont (mom and dad pension funds)because the other party cannot pay. Underwriters who make and then sell these things on to mom and dad penion funds. Traders who profit by commissions and fees in the buy and sell of the derivatives markets (investment banks, brokers etc), those that trade the derivatives betting on a rise or fall in price (hedge funds, SIVS, conduits, BANKS,etc ) This was the biggest gravy train ever known to man. It has now imploded.

You look at a major International Bank and see simply a bank- when inside it is a casino!!!

The best data source on the scale of derivatives and their subsets is maintained by the Bank of International Settlements (BIS).

The BIS is also the only formal body that “got” the financial crisis before it happened.

The essential feature of all these derivatives is that they are a “tails I win, heads you win” bet between two parties. However, what happens if the bloke you bet with is actually bankrupt? Then you can “win” and lose all at once.

My favourite such instruments are Credit Default Swaps (notional value as at June 2008: US$57 trillion out of the US$684 trillion total), where Firm A and Firm B take a bet over the survival of Firm C. If Firm C goes bankrupt, then A “wins”; if it doesn’t, then B “loses”–though B might be a bank charging a fee to A for the fee.

Of course, the CDS contract assumes that both A and B will continue to exist, even though they’re betting over whether C will go bankrupt!

These are spun as a form of insurance, but legitimate insurance companies maintain a reserve to cover them in the event that an insured against event actually happens. No such requirements are placed on derivatives traders, with the result that the bankruptcy of C could actually expose B to a claim from A that will bankrupt B as well.

Suddenly the winner A finds itself as an unsecured creditor in the bankruptcy of B, and therefore has to take a contingency charge against its own assets that might bankrupt it as well.

That’s the fun and games of derivatives, and even today it still has a long way to play out.

The toxic derivatives I refer to I describe in my post above, far far beyond the realm of “sub prime”.

I see the globalization process as the main reason why the manufacturing we did have has been eroded. We embraced globalization warts and all. Well, now we all know the warts.