It’s all over the news, the internet and talk in the street - we are in the midst of a full blown recession the likes that have not been experienced since the Great Depression. Yet some people are steadily building their fortunes as we witness long standing financial giants topple. Having had first hand experience with big movers and shakers in the real estate and business world (and insight from political powerhouses) I have a unique perspective on this mess that few others have had the privilege to bear witness to. I am dedicated to revealing to you the little known facts about how to develop wealth and be successful in any economy based upon my unique experience. In order to fully understand how to make money in any economy, it is important to understand the mindset of the players (buyers and sellers) in the “market,” and how it led to the situation we find ourselves in.
It is critical to realize that it is the emotional state of the players in the market that create bubbles and their inevitable bursts. How did we get into such a quagmire with the economy? The simple answer is pure greed, but that wouldn’t adequately sum it up. You see the market is driven by two emotions fear and greed. During a recession fear is the prevailing emotion and buying, selling, lending and investing grind to a halt. However, during boom times greed or the prospect of making outrageous sums of money at little risk drives investors to invest, lenders to lend, business owners to expand and consumers to spend recklessly. Unfortunately, it also lures the unskilled and unknowledgeable into the game as well. The prospect of easy money makes people and institutions take chances on things they clearly don’t understand.
Our economic disaster started out fifteen years ago like a scene from a stereotypical Hollywood movie about greedy bankers. In 1994, a team of JP Morgan bankers was having what they call one of their “Off-Site Weekends." Typically these are yacht parties, with bikini models, and $1,000 bottles of Cristal; and this trip wasn’t much different at the Boca Raton Resort & Club in Florida. The difference was, as they were holed up for most of the weekend in a conference room at the pink, Spanish-style resort, these JPMorgan bankers were brainstorming how to free up their capital reserves and still be able to lend tens of billions of dollars skirting the current banking regulations (By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad). They pondered how they could create a device that would protect them if those loans defaulted, and free up that capital at the same time so they could lend even more (Greed).
What those hard partying bankers came up with was a sort of insurance policy where a third party would assume the risk of the debt going bad, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices.
The difference is JPMorgan hired young math and science grads from schools like MIT and Cambridge to create a new market for these complex instruments. In 1997, the credit default swap (CDS) was launched and quickly became the hot financial instrument, and the “safest” way to mitigate risk while maintaining a steady return. There are very few people on the planet that can tell you exactly how a CDS works, yet they were being gobbled up like hot cakes by foreign nations, major US corporations, hedge funds, pension funds and anyone with big money looking for an easy return. By 2007 it is estimated that the CDS market grew to more than $45 trillion (Greed).
When the economy turned and many of the loans that the CDS’s were created to cover went bad, the banks didn’t have the cash reserves to cover them and it started the domino effect of failing financial institutions. AIG became the best known casualty to CDS’s having to be bailed out by US tax dollars after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and dozens of other entities.
In the next segment of this article, I will reveal the truth about how the real estate bubble was created and what really caused the bubble to burst. As usual, I welcome your questions, comments and insight and look forward to sharing more insider wealth tips with you.
It is critical to realize that it is the emotional state of the players in the market that create bubbles and their inevitable bursts. How did we get into such a quagmire with the economy? The simple answer is pure greed, but that wouldn’t adequately sum it up. You see the market is driven by two emotions fear and greed. During a recession fear is the prevailing emotion and buying, selling, lending and investing grind to a halt. However, during boom times greed or the prospect of making outrageous sums of money at little risk drives investors to invest, lenders to lend, business owners to expand and consumers to spend recklessly. Unfortunately, it also lures the unskilled and unknowledgeable into the game as well. The prospect of easy money makes people and institutions take chances on things they clearly don’t understand.
Our economic disaster started out fifteen years ago like a scene from a stereotypical Hollywood movie about greedy bankers. In 1994, a team of JP Morgan bankers was having what they call one of their “Off-Site Weekends." Typically these are yacht parties, with bikini models, and $1,000 bottles of Cristal; and this trip wasn’t much different at the Boca Raton Resort & Club in Florida. The difference was, as they were holed up for most of the weekend in a conference room at the pink, Spanish-style resort, these JPMorgan bankers were brainstorming how to free up their capital reserves and still be able to lend tens of billions of dollars skirting the current banking regulations (By the mid-'90s, JPMorgan's books were loaded with tens of billions of dollars in loans to corporations and foreign governments, and by federal law it had to keep huge amounts of capital in reserve in case any of them went bad). They pondered how they could create a device that would protect them if those loans defaulted, and free up that capital at the same time so they could lend even more (Greed).
What those hard partying bankers came up with was a sort of insurance policy where a third party would assume the risk of the debt going bad, and in exchange would receive regular payments from the bank, similar to insurance premiums. JPMorgan would then get to remove the risk from its books and free up the reserves. The scheme was called a "credit default swap," and it was a twist on something bankers had been doing for a while to hedge against fluctuations in interest rates and commodity prices.
The difference is JPMorgan hired young math and science grads from schools like MIT and Cambridge to create a new market for these complex instruments. In 1997, the credit default swap (CDS) was launched and quickly became the hot financial instrument, and the “safest” way to mitigate risk while maintaining a steady return. There are very few people on the planet that can tell you exactly how a CDS works, yet they were being gobbled up like hot cakes by foreign nations, major US corporations, hedge funds, pension funds and anyone with big money looking for an easy return. By 2007 it is estimated that the CDS market grew to more than $45 trillion (Greed).
When the economy turned and many of the loans that the CDS’s were created to cover went bad, the banks didn’t have the cash reserves to cover them and it started the domino effect of failing financial institutions. AIG became the best known casualty to CDS’s having to be bailed out by US tax dollars after it defaulted on $14 billion worth of credit default swaps it had made to investment banks, insurance companies and dozens of other entities.
In the next segment of this article, I will reveal the truth about how the real estate bubble was created and what really caused the bubble to burst. As usual, I welcome your questions, comments and insight and look forward to sharing more insider wealth tips with you.
Heru,
ReplyDeleteThanks for part 1 of how we got here? Exactly what is a hedge fund and how does it differ from a mutual fund? Secondly how do insurance companies as AIG function? Do they keep money on hand to cover the amounts of various premiums or do they also invest to maintain their reserves in case they have to pay out a premium? In other words how do insurance companies make money? And finally are credit default swaps a mechanism for making money available only to banks or was this mechanism also available to individuals?
Docgloria
I second the thanks for this post Heru Nekhet. I look forward to your answers to Docgloria's questions.
ReplyDeletebometernally
Thanks for the positive comments and questions. Please keep them coming.
ReplyDeleteHedge funds and mutual funds are alike only in two ways: They are pooled investment vehicles - meaning that multiple investors entrust their money to a manager; and they invest in publicly traded securities. However, there are important differences between a hedge fund and a mutual fund. A hedge fund engages in more aggressive strategies and positions, such as short selling, trading in derivative instruments like options and using leverage (Borrowing) to enhance the risk/reward profile of their bets. Hedge funds tend only to be open to very wealthy investors which often allow them an exemption in many jurisdictions from regulations governing short selling, derivative contracts, leverage, fee structures and the liquidity of interests in the fund.
The way insurance companies make money is by investing the monthly premiums that their clients pay. They hedge their losses by calculating that a certain amount of payouts will occur that is equal to less than the amount they make from their investments. Insurance companies on traditional insurance are required to keep a certain amount of liquidity to cover a percentage of their potential payouts. In the case of CDS this rule was able to be skirted because it was not in the technical sense insurance, it was a security.
CDS were so large that very few individuals could afford to invest in them. Most investors were large financial institutions, huge corporations and governments.