01 July 2010

If Financiers Taught Second Grade

I often hear bandied about the "fact" that there are $600-700 trillion dollars in derivative contracts that are supposedly going to make the whole economy go boom and have us all selling pencils to each other for a nickel apiece like the stories my grandfather told me about the Great Depression (q.v. last month's history paper.)  What's interesting is how they arrive at this figure; whenever an asset is packaged into a derivative, it is booked at its full value each time it is divided.  One begins to see where this can be a problem.

Consider an asset worth $1 million (a mortgage on a San Francisco house, let's say.)  Now for a rather extreme example, we're going to chop it into a million pieces and package it into as many derivative contracts.  What's the book value of the asset in total?

If you guessed "$1 on each contract for a total of a million bucks", you're good at math and bad at investment banking.  The correct answer is $1 trillion.  The original million dollars times a million contracts into which it has been stuffed.  Now here's the fun part.  Do this enough times with enough assets and you quickly begin to see where $14 trillion (the US gross domestic product) or even better, $60 trillion (the GDP of the entire world) can be inflated into $700 trillion and used by journalists to scare the holy hell out of people.  You also begin to see where it is not possible to have real assets valued at $700 trillion to the point where they can somehow crash and require the world to boil stones for soup for half a century to get even.

This in turn provides an interesting thought experiment.  If in fact this is the "new math", then how do we teach our children to be prepared for careers in the seven-figure-salary world of finance?  We want them to be successful, right?  So here's how I propose we rewrite second-grade math textbooks to prepare American schoolchildren to be successful in the new global market.  I'll provide the first problem for our hypothetical seven-year-old's homework assignment.

"Johnny has six apples.  His teacher told him that he has to share them equally between all of his friends.  Kamryn, Kaylynn, DaMarcus, Madysyn, and Emyly all want an apple.  How many apples must Johnny give to each of his friends and still have a share for himself?"

Wrong answer: One apple.
Correct answer:  1,296 apples.  See, Johnny went to the Chicago Mercantile Exchange and created six derivatives, each with an apple from his original stash.  The book value of the original asset on each derivative was six apples and there were six derivatives (6x6=36).  Then those derivatives were themselves packaged into equal-sized chunks in secondary-market derivatives trading in New York, and since Johnny was able to find 36 buyers less amount paid to lobbyists so the government would be snowed into thinking this was kosher, he got 36:1 leverage, which is still a safer deal than anything Lehman Brothers had on the market before September 15, 2008.  And since the five oddly-named children listed above can't possibly eat that many apples, there's no reason for Johnny to try and cash out those derivatives; after all, the apple market can't possibly go down, can it?

And this, friends, is why you should never, EVER trust a business major.  Myself included.