Did one disaster lead to another?

[angledge]

I've been reading up on the Exxon Valdez oil spill, trying to get a feel for what the Gulf Coast might be in for in the wake of the Deepwater Horizon disaster. This morning I found this interesting little tidbit on Wikipedia:

"In the case of Baker v. Exxon, an Anchorage jury awarded $287 million for actual damages and $5 billion for punitive damages. The punitive damages amount was equal to a single year's profit by Exxon at that time. To protect itself in case the judgment was affirmed, Exxon obtained a $4.8 billion credit line from J.P. Morgan & Co. This in turn gave J.P. Morgan the opportunity to create the first modern credit default swap in 1994, so that J.P. Morgan would not have to hold so much money in reserve (8% of the loan under Basel I) against the risk of Exxon's default."

Comments

Issue of timing

[vulgarbarbarian.livejournal.com]

Banks always want to take risk off of their balance sheets so that they can deploy more capital, which is also why securitization is now so common. Remember that they get to charge fees for making these loans, so why charge one fee and then leave the loan sitting on your books where your regulators will require you to allocate capital against it when you can take out an insurance policy that will pay off if the counterparty defaults? This way you can free up money to make more loans, for which you can charge more fees. Securitization is even better: you package up the debt into bonds, which you can sell to investors for a markup. You make money going in and getting out. Any of the bonds that you can't sell, you just insure.

Pension and mutual funds make money by holding securities on their books long term for investors, banks make money by charging fees to originate loans because the carry trade (borrowing money at a lower interest rate from depositors and lending it at a higher one) is much riskier even though that's what people generally think of banks as doing.

Financialese -> English translation plzthx.

[angledge.livejournal.com]

Hey buddy, could you re-post your comment in standard English? I understood about half of this version...

Re: Financialese -> English translation plzthx.

[vulgarbarbarian.livejournal.com]

How about some definitions to start:

1. Balance sheet: a statement of a company's assets and liabilities. Making a loan to a company produces an asset, taking deposits (basically many small loans from individual customers) or issuing bonds produces a liability.

2. Equity: the amount of money that has been invested in a company's equity.

3. Regulatory requirements: banks are partially in the leverage business, they borrow money from depositors at low rates and loan money to individuals and businesses at higher rates and keep the difference as profit (what I called the "carry trade" before). This is well known to be a dangerous business because if the creditors can't pay their loans, then the depositors may not get their money back. Any money that is owed to depositors (and other creditors) must either be paid back from the proceeds of the loans or come out of the bank's equity, and if the bank's equity goes to zero before creditors are paid off, then they have a serious problem. To mitigate this risk, regulators impose requirements on how much equity a bank must have relative to its outstanding loans and if they hit that limit, they can't make any more loans (and thus earn juicy fees) until they get more equity capital from investors. Naturally, banks look for ways, legitimate and less legitimate, to make their equity ratios look better to regulators so they can continue to carry out fee-generating business. This is called cleaning up the balance sheet.

4. Credit default swap: don't let all the talk about derivatives fool you, this is basically an insurance policy on a bond or loan. If the debtor doesn't pay, the insurer makes up the difference to the creditor. When a bank enters into a credit default swap, if the insurer has a high enough credit rating, then the bank no longer needs to count the amount of the loan against its equity ratio because the regulator basically assumes that the loan can no longer go bad (it's actually more complicated than this, but you get the general idea). If the premium that they need to pay for this insurance is lower than the amount they expect to make in fees for originating new business, then they are happy to pay for it.

5. Securitization: another way for banks to make their equity ratios look better is to package up a bunch of assets (i.e. loans) into a pool. They then create bonds which receive income that is passed through the pool, so now the bondholders basically own the loans (and the risk that they might go bad). When building a pool like this, it is best to package together assets that you don't expect will all go bad at the same time (e.g. put in a loan from one company that will tend to do well when the economy does poorly and another loan from a different company that is relatively unaffected by changes in the economy). With this diversification, the bond is safer and can get a higher credit rating. The bank then sells these bonds for a bit more than they cost to build and it now has another source of income in addition to making room on its balance sheet for more fee-generating activity.

Hope this help.

Re: Financialese -> English translation plzthx.

[angledge.livejournal.com]

I don't know why, but financial information is Teflon-coated for me. Every time you explain it, it makes sense, but it never sticks in my head. So every time I try to understand this stuff I feel like I'm start back at ground zero.

[chaosvizier.livejournal.com]

I think I lost money just reading this conversation.

[phrench-phried.livejournal.com]

Makes you feel kinda puny doesn't it? Imagine how a seagull feels.