He called them “the financial weapons of mass destruction”. ‘He’ was ‘Warren Buffet’ and ‘them’ was ‘Derivatives’.
Boy, the world’s smartest investor could not have been more right.

For proof, look no further. First, the world’s fourth largest investment bank, Lehman Brothers, went belly up and then the world’s largest insurance company, AIG, needed a bailout in the land of market economy. A principal reason: Losses due to extensive exposure to Credit Default Swaps (CDS).

What is a CDS?


We explain with a simple example.

Stripped of jargon, a CDS is an insurance contract. Okay, the high priests of finance would call it a derivative but that is a piece of minor detail. Now, suppose, Bank X has lent money to various entities which are non-A grade (read sub-prime) accounts.

To cover the risk that these accounts may default, the Bank sells the risk to someone willing to buy the risk. Suppose this buyer is AIG. In effect, the bank is swapping the risk of default (hence the word credit swap) for cash. If the borrowers fail to pay, AIG settles. Of course, for buying the risk (a k a swap), AIG takes a fee.

Some numbers will help us understand this better. Suppose Bank X wanted to de-risk loans aggregating Rs 200 crore. Suppose AIG charges Bank X Rs 5 crore to guarantee the Rs 200 crore exposures. Suppose AIG assumes that there is a 3 per cent probability that Rs 100 crore of the Rs 200 crore would devolve, that is, go bad — it provides 3 per cent of Rs 100 crore, namely Rs 3 crore in its books for estimated liabilities. That leaves it with a profit of Rs 2 crore on the transaction.

So far, so good. But competition does strange things to organisations. Someone like Lehman to out gun AIG may assume a 2 per cent risk of default and, hence, it may do the deal with Bank X for a lower price of, say, Rs 4 crore. At 2 per cent risk, it would provide Rs 2 crore (Rs 100 cr x 2 per cent) only and, hence, report a profit of Rs 2 crore. As undercutting turns rampant, assumptions relating to the underlying credit going bad becomes more aggressive, at some point becoming zero!

Now, if in the end, 7 per cent of the debt goes bad it would lead to a liability of Rs 14 crore (Rs 200 cr x 8 per cent) on Lehman who sold the CDS, whereas Lehman would have provided only Rs 2 crore in the books. Phew.

The growing chain


The story doesn’t end there. It is quite possible that Lehman Brothers to de-risk itself may buy a swap from someone else on the same loans.

This someone is willing to guarantee it for an even lesser fee because he makes more aggressive assumptions as to the outstanding going bad.

The result: a growing chain of CDSs on the same asset, with each one guaranteeing the previous one. And when the debt goes bad, the firm that holds the parcel pays through the nose.

AIG reportedly sold around $440 billion worth of CDS, which ended up in losses far greater than it had assumed. The ease with which banks could sell the risk clearly fuelled lending to bad accounts.

After all, you could do a crazy loan and the cover it with a CDS so long as there would be a greater fool to sell the cover. What got missed out in the race was that the CDS seller itself could, under the weight of CDSs, go turtle. And that was exactly what happened in the US.

A useful tool, through its blatant misuse, has shaken our confidence in the global financial architecture. Imagine what would have happened if these instruments had been further parcelled and sold to retail investors. Small mercies.
Curtsey: Hindu Business Line...

Dear Mr. Sen,
Your investment in Tiger and Opportunity are high risk investment and sould have been avoided in the first place as you are a senior citizen. Just hold on to it for the time being as there is no point in redeeming at this juncture incurring loss. If you compare the returns of all the 3 funds of DSPML with other similar funds, I think they are in line or even better than all other funds. If you feel that you can not take the loss, you can maybe switch tiger and oppornuity to top 100. DSPML Top 100 has done exeedingly well in this market termoil beating the benchmark in year to date, 1 month, 3 month, 1 year, 3 and 5 year period.
Please visit value research online and check out how your funds have performed and have patience. This downturn shall also pass.
Regards,
Wadia...

Dear Adi,
You are absolutely right about investing in FDs choosing monthly interest option but when this article was initialy published sometime last year, year and a half, the FD interest rate scenario was different and the old article is just repeated word to word here. If I remember correctly, even Mutual Fund Insight magazine too published the same idea 2 years back.
regards,
Wadia
...

These are the investors who have no future goals or plans that they have invested their money in MF for. The most probable reason would be to earn some quick money thinking everybody is making money in this market so why not me. We all keep repeating that equity is for long term and SIP is the best way to invest systematicaly and regularly but at the first sign of a down turn, they want to run away and hide.
Dear Scary investors, remember that one buys low and sells high to make money and not the other way around whch is the sure way of loosing money and allowing others to make money at your cost,
Regards,
Wadia ...

Dear Raj,
Sorry I am based in Dubai and hence have no idea about brokerage houses in US.
Wadia...

Dear Guest,
If downside risk is limited from here on, (which I dont agree because no one can really predict whats going to happen next.) The same goes for even the reputed funds with good track record. Investing in NFOs is like betting on an unknown horse. It may just win the race for you by sheer luck.
Regards,
Wadia...

Dear Guest,
You still have over six months to go for these bonds to mature. However once matured you can invest all at once (not necessarily in UTI) in any 5 or 4 star liquid fund and initiate a Systematic Transfer Plan (STP) in to diversified equity fund of the same fund house having a good track record and again 5* or 4* as per your risk taking ability. Please note that investment in to equity has to be for long term preferably for 3 to 5 years, longer the better. STP or SIP works better when planned for longer durations.
Regards,
Wadia ...

Hi Bank FDs are not so safe nowadays considering the crisis in the credit market. The PSU Banks are not offering the highest interest rates for the FDs, only the newgen banks like ICICI are offering 10+% but its not safe to be with them. Considering the 0% risk on capital, POIMS comes as the 1st Option - irrespective of the tardy service in the post offices. Happy Investing Sodium...

Dear Wadia, Thanks for your reply. So one needs to go through a broker initially. Do you happen to know if there any brokerage houses like ShareKhan which operate from the US? -Raj...

Dear Wadia, Welcome back. Something was missing from this board due to ur absence. I hope everything is fit n fine on ur side. I'm eager to read ur posts. Thanks Ashal...

Dear Wadia, Hope you had a pleasant holiday. When you get a chance, can you please enlighten us on the procedure for NRI's to invest in Indian mutual funds either from Dubai or the US. Thanks, Raj...

Dear Wadia, Welcome back Wadiaji, We were all missing your expert advise. Hope you start posting right away!!! Srikanth...