Derivitives melt down explained by leading derivitives guru.. his web site is also mentioned.



The credit bubble is just starting to unwind, a credit-derivative
insider says. And while U.S. borrowers are being blamed for the mess,
they were really just pawns in a global game.

By Jon Markman


Satyajit Das is laughing. It appears I have said something very funny,
but I have no idea what it was. My only clue is that the laugh sounds
somewhat pitying.


One of the world's leading experts on credit derivatives, Das is the
author of a 4,200-page reference work on the subject, among a half-
dozen other tomes.

As a developer and marketer of the exotic instruments himself over the
past 30 years, he seemed like the ideal industry insider to help us
get to the bottom of the recent debt crunch -- and I expected him to
defend and explain the practice.


I started by asking the Calcutta-born Australian whether the credit
crisis was in what Americans would call the "third inning." This was
pretty amusing, it seemed, judging from the laughter.

So I tried again. "Second inning?" More laughter. "First?"


Still too optimistic. Das, who knows as much about global money flows
as anyone in the world, stopped chuckling long enough to suggest that
we're actually still in the middle of the national anthem before a
game destined to go into extra innings. And it won't end well for the
global economy.
An epic bear market

Das is pretty droll for a math whiz, but his message is dead serious.
He thinks we're on the verge of a bear market of epic proportions.

The cause: Massive levels of debt underlying the world economy system
are about to unwind in a profound and persistent way.


* Talk back: Do you think a bear market is just around the corner?

He's not sure if it will play out like the 13-year decline of 90% in
Japan from 1990 to 2003 that followed the bursting of a credit bubble
there, or like the 15-year flat spot in the U.S. market from 1960 to
1975. But either way, he foresees hard times as an optimistic era of
too much liquidity, too much leverage and too much financial
engineering slowly and inevitably deflates.


Like an ex-mobster turning state's witness, Das has turned his back on
his old pals in the derivatives biz to warn anyone who will listen --
mostly banks and hedge funds that pay him consulting fees -- that the
jig is up.

Rather than joining the crowd that blames the mess on American slobs
who took on more mortgage debt than they could afford and have
endangered the world by stiffing lenders, he points a finger at three
parties: regulators who stood by as U.S. banks developed ingenious but
dangerous ways of shifting trillions of dollars of credit risk off
their balance sheets and into the hands of unsophisticated foreign
investors; hedge and pension fund managers who gorged on high-yield
debt instruments they didn't understand; and financial engineers who
built towers of "securitized" debt with math models that were
fundamentally flawed.


Investors are abuzz over the Fed's interest-rate decision, but the
Federal Reserve can't fix everything, cautions MSN Money's Jim Jubak.
Lower interest rates alone won't boost confidence in the debt market.

"Defaulting middle-class U.S. homeowners are blamed, but they are
merely a pawn in the game," he says. "Those loans were invented so
that hedge funds would have high-yield debt to buy."
The liquidity factory

Das' view sounds cynical, but it makes sense if you stop thinking
about mortgages as a way for people to finance houses and think about
them instead as a way for lenders to generate cash flow and create
collateral during an era of a flat interest-rate curve.Although
subprime U.S. loans seem like small change in the context of the
multitrillion-dollar debt market, it turns out these high-yield
instruments were an important part of the machine that Das calls the
global "liquidity factory."

*****Just like a small amount of gasoline can power an entire truck
given the right combination of spark plugs, pistons and transmission,
subprime loans became the fuel that underlays derivative securities
many, many times their size.


Here's how it worked: In olden days, like 10 years ago, banks wrote
and funded their own loans. In the new game, Das points out, banks
"originate" loans, "warehouse" them on their balance *** for a brief
time, then "distribute" them to investors by packaging them into
derivatives called collateralized debt obligations, or CDOs, and
similar instruments. In this scheme, banks don't need to tie up as
much capital, so they can put more money out on loan.


The more loans that were sold, the more they could use as collateral
for more loans, so credit standards were lowered to get more paper out
the door -- a task that was accelerated in recent years via fly-by-
night brokers now accused of predatory lending practices.

Buyers of these credit risks in CDO form were insurance companies,
pension funds and hedge-fund managers from Bonn to Beijing. Because
money was readily available at low interest rates in Japan and the
United States, these managers leveraged up their bets by buying the
CDOs with borrowed funds.

* Talk back: Do you think a bear market is just around the corner?

So if you follow the bouncing ball, borrowed money bought borrowed
money. And then because they had the blessing of credit-ratings
agencies relying on mathematical models suggesting that they would
rarely default, these CDOs were in turn used as collateral to do more
borrowing.
In this way, Das points out, credit risk moved from banks, where it
was regulated and observable, to places where it was less regulated
and difficult to identify.


Turning $1 into $20

The liquidity factory was self-perpetuating and seemingly unstoppable.
As assets bought with borrowed money rose in value, players could
borrow more money against them, and it thus seemed logical to borrow
even more to increase returns. Bankers figured out how to strip money
out of existing assets to do so, much as a homeowner might strip
equity from his house to buy another house.


These triple-borrowed assets were then in turn increasingly used as
collateral for commercial paper -- the short-term borrowings of banks
and corporations -- which was purchased by supposedly low-risk money
market funds.


According to Das' figures, up to 53% of the $2.2 trillion commercial
paper in the U.S. market is now asset-backed, with about 50% of that
in mortgages.

****When you add it all up, according to Das' research, a single
dollar of "real" capital supports $20 to $30 of loans. This spiral of
borrowing on an increasingly thin base of real assets, writ large and
in nearly infinite variety, ultimately created a world in which
derivatives outstanding earlier this year stood at $485 trillion -- or
eight times total global gross domestic product of $60 trillion. ****



Without a central governmental authority keeping tabs on these cross-
border flows and ensuring a standard of record-keeping and quality,
investors increasingly didn't know what they were buying or what any
given security was really worth.


A painful unwinding

Now here is where the U.S. mortgage holder shows up again. As subprime
loan default rates doubled, in contravention of what the models
forecast, the CDOs those mortgages backed began to collapse. Because
they were so hard to value, banks and funds started looking at all
CDOs and other paper backed by mortgages with suspicion, and refused
to accept them as collateral for the sort of short-term borrowing that
underpins today's money markets.

Through late last month, according to Das, as much as $300 billion in
leveraged finance loans had been "orphaned," which means that they
can't be sold off or used as collateral.

Investors are abuzz over the Fed's interest-rate decision, but the
Federal Reserve can't fix everything, cautions MSN Money's Jim Jubak.
Lower interest rates alone won't boost confidence in the debt market.

One of the wonders of leverage is that it amplifies losses on the way
down just as it amplifies gains on the way up. The more an asset that
is bought with borrowed money falls in value, the more you have to
sell other stuff to fulfill the loan-to-value covenants. It's a
vicious cycle. In this context, banks' objective was to prevent
customers from selling their derivates at a discount because they
would then have to mark down the value of all the other assets in the
debt chain, an event that would lead to the need to make margin calls
on customers already thin on cash.

Now it may seem hard to believe, but much of the past few years'
advance in the stock market was underwritten by CDO-type instruments
which go under the heading of "structured finance." I'm talking about
private-equity takeovers, leveraged buyouts and corporate stock
buybacks -- the works.


* Talk back: Do you think a bear market is just around the corner?

So to the extent that the structured finance market is coming undone,
not only will those pillars of strength for equities be knocked away,
but many recent deals that were predicated on the easy availability of
money will likely also go bust, Das says.
That is why he considers the current market volatility much more
profound than a simple "correction" in prices. He sees it as a
gigantic liquidity bubble unwinding -- a process that can take a long,
long time.



While you might think that the U.S. Federal Reserve can help prevent
disaster by lowering interest rates dramatically, as they did
Wednesday, the evidence is not at all clear.
The problem, after all, is not the amount of money in the system but
the fact that buyers are in the process of rejecting the entire new
risk-transfer model and its associated leverage and counterparty
risks.

Lower rates will not help that. "At best," Das says, "they help smooth
the transition."
More from MSN Money


The fine print

Das notes that Japan in the 1990s lowered interest rates to zero and
the country still suffered through a prolonged recession. His
timetable for the start of the next serious phase of the unwinding is
later this year or early 2008. . . . Das' most readable book for
laypeople is "Traders, Guns & Money," an amusing exposé of high
finance, published last year. Das occasionally writes a blog at his
publisher's Web site. Also available are a boxed set of his reference
books on derivatives and his book specifically on CDOs. . .
.
Perhaps the oddest line on the subject by a world leader was uttered
by Luiz Inacio Lula da Silva, the president of Brazil. Asked if he was
worried about the effects of the credit crunch in his country, he
dismissively called it "an eminently American crisis" caused by people
trying to make a lot of "third-class money." . . . CDOs were first
widely used back in the late 1980s by Drexel Burnham Lambert junk-bond
king Michael Milken to sell off damaged and previously unsellable debt
in a way that was more palatable to customers.





Phil scott






.