Credit Derivatives: A New Gloss on an Old Game

     Several weeks ago the credit rating agenices downgraded the bonds of both General Motors and Ford Motor Company.  The downgrades had the anticipated effect of dropping the value of the bonds of both companies.  We also learned, however, that hedge funds had taken large losses in the "credit derivatives" market.  Credit derivatives are financial instruments that are linked to and therefore rise or fall on the value of underlying credit obligations.  The credit derivatives most affected by the GM and Ford downgrades were "collaterized-debt" obligations.  Banks pool credit obligations of a company and slice and package the debt for investors.  Some investors buy the "first-loss" piece;  they absorb the full loss on a first debt default.  Other investors buy pieces that are not affected until their are multiple defaults.

   In any event, hedge funds and other investors combine the fancy credit derivatives based on computer models.  And -- surprise-- the computer models did not predict how price would respond in the face of the downgrades.  Hedge funds who thought they had hedged their risk had not and absorbed big, big losses.

    I am convinced that much of the game in the financial community is the constant invention of "new" financial investment vehicles (usually some form of financial derivative) or "new" combinations of old investment vehicles (hedges) to hoodwink investors.  The inventions, complete with complicated computer models, enable snake oil salepeople to use time honored techinques to hoodwink investors.  The salesperson of the derivatives hooks investors with promises of high returns and no risk, snows them with complexity and unverifable detail that leads to false confidence in their expertise, takes their money, and then gets out of town before the losses attach.