Another day another lethal financial derivative

Collateralised Debt Obligation (CDOs) and Credit Default Swap (CDS) are old hat. Say hello to the Exchange Traded Fund (ETF).

The EFT  is a fund which supposedly concentrates on a discrete area of economic activity such as a the trading of a commodity, a  particular  area of business, for example, banks, or a  particular country’s stock exchange index, for example, the FT 100.  Nothing wrong with that you might say.  Let me introduce you to its cousin the Synthetic ETF (SEFT). Suppose it is ostensibly an ETF concentrating on Japan ,  but contains  no Japanese shares. Instead it invests in  shares in Chile. That is an SEFT.

This sounds like an arrangement more suited to Alice in Wonderland than rational investment. The natural response would be to ask why on earth would  anyone set up such a fantastic investment vehicle? Well, it could entice the unwary and inexperienced investor into investing in funds they imagined were much sounder than they actually are. It also allows those holding unattractive hard-to-sell shares  to bundle them up in an SEFT and so disguised  shift them off the books.

The EFT fun does not end there. Holdings  in ETFs are  being shorted in massive numbers .  Short selling is the borrowing of shares for a fee for a period, say six months, selling them immediately  in the hope that their price will fall by the end of the borrowing period at which point they can be bought for less than they were sold for,  returned to the person or organisation from which the shares were borrowed with the difference between the selling and buying price representing the profit for those shorting. If the price rises they make a loss not a profit.  Just describing it makes it sound like a spiv’s delight. In fact it is worse than that because a share may be shorted by any number of people,  so at any one time short positions exceeding the total shares in existence  for a particular business or investment fund.  This means multiple people have a claim to the same share.  This could produce a situation where something akin to a bank to a run on a bank is possible.

The SEFT may be a new boy on the dodgy investment block, but  the CDO and CDS have not become extinct.  CDOs began in a quiet way  with those holding debt  bundling together a  few mortgages  or other debts such as those arising from credit cards, calling them a CDO and selling them to a third party.  Nothing too alarming at first, but the business rapidly ballooned so that vast amounts of debt of greatly varying quality were  bundled together  and traded freely so that the process became ever more complex and opaque the further the debt moved from the initial lender and borrower and the individual CDOs were divided into various layers  (tranches) of risk so that if the cash from the assets covered by a CDO were insufficient to pay all the investors those in the higher risk tranches suffered losses before those i9n the lower rick tranches.  Much more dangerous.

Much more dangerous became an open invitation to disaster when the rating agencies such as Moody’s and Standard and Poor  gave CDOs sparkling credit ratings, quite often AAA marks, almost regardless of the quality of the debt they contained.   Both the CDO issuers and the rating agencies had a vested interest in keeping the CDO balls in the air. The issuer of the CDO, typically an investment bank, earns a commission at time of issue and earns management fees during the life of the CDO;  credit rating agencies  receives fees from CDO issuers  for their service in providing a rating for  CDOs.

To put the cherry on the investment disaster, along came the CDS. This was in its original form simply an insurance against the repayment of the debt held by owners of a CDO not being met.  No harm so far. Then came Naked  Credit Default Swaps  (NCDS)  where the thing insured by the CDS is not held by the owner of the thing insured. This gives the  holder of the NCDS incentive to cause the default of that which is insured by the NCDS because they do not own the thing which is insured but can still get the insurance if, for example, a mortgage fails to be paid.   It is akin to the situation of someone being able to insure a house they did not own and then burning it down and being able to collect the insurance.

The fact that banks and their ilk are still behaving in this reckless fashion shows that either politicians have learnt nothing since the  economic crisis began or are too scared of  or too complicit with bankers to put a stop to their criminally reckless behaviour.