The Econophysics Blog

This blog is dedicated to exploring the application of quantiative tools from mathematics, physics, and other natural sciences to issues in finance, economics, and the social sciences. The focus of this blog will be on tools, methodology, and logic. This blog will also occasionally delve into philosophical issues surrounding quantitative finance and quantitative social science.

Tuesday, January 01, 2008

Putting a Face on the Victims of Credit Derivatives

I came across an extremely interesting New York Times article this Sunday by Gretchen Morgenson: The Debt Crisis, Where It’s Least Expected (Dec. 30, 2007). One of the things I liked about this article is that it put a very sympathetic face -- the Indiana Children's Wish Fund -- to a very abstract and complex problem -- credit derivatives and the monsterous affect it has had on fueling the wildfire of the credit crises.

It turns out that this charity, which is dedicated to fulfilling the wishes of extremely ill children (many of them terminally ill), was tricked into investing in complex credit derivatives! It's the same old story: Unwitting small time investors lured into investments that promise higher yields at supposedly low risk; unbeknownst to them, they are writing options (i.e., could lose their shirts) in exchange for that slightly higher yield. But this time, the victims are truly sympathetic ... the director of the Wish Fund went out of her way to make sure the investments were as safe as CDs and money market funds. The (unscrupulous) broker -- no doubt selling her some propaganda about AAA rated mortgage-backed securities (we know what those ratings are worth ... zilch) -- bamboozled the fund into buying into credit derivatives as all hell was about to break lose.

This is one of the -- if not THE -- best articles I have read on the credit crises. There are many interesting aspects to this article. The one I found darkly humorous was mortgage-backed securities hedge fund 'hotshot,' John Devaney, owning a yacht called "Positive Carry." The name of the yacht is derived from the 'carry trade' ... and as I have written about this in the past (just do a search of the blog) ... this is essentially, as Nassim Nicholas Taleb so aptly puts it, "stepping in front of steamrollers to pick up pennies." Apparently, the steamroller finally caught up with "Positive Carry" ... apologies for a bit of schadenfreude.

As for the Indiana Children's Wish Fund, there is some good news. They were able to get a very quick settlement (thanks, in part, to the exposure by the New York Times) from their brokers. If anyone needed a concrete example of how the shameless marketing of credit derivatives to investors who have NO business getting mixed up with complex financial derivatives, then the Wish Fund serves as Exhibit A. Without the settlement, the credit crises would have meant that nine children's wishes would have gone unfulfilled. When you see a photo of a terminally ill child getting to meet Indiana Colt's quaterback, Peyton Manning ... sadly, the child in the photo died a few weeks after meeting his hero ... one can get a full sense of the gravity of the damage that some hotshot traders and derivatives salesmen have caused in ordinary people's lives on their way to buying yachts, luxury homes, etc.

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