I have a question on the financial meltdown

[ljm2002]

I've read different articles, as well as posts here at DU, saying things like "there are $700 trillion in derivatives in the global market". I don't know if I have the right kind of financial instrument named, but I do know I've seen the $700 trillion number. Some analysts have said that is more money than we all (world economies) really have.

I know we've been off the gold standard, and what is supposedly backing up our currency is the actual value of goods and services. What I think is really happening here, is that the financial instruments got so out of control they took on a life of their own, and they no longer reflect any real value; rather they reflect the gigantic inflationary bubble of greed that has taken over the financial markets over the last several years, spurred on by a lack of regulation and oversight. And I'm thinking that no amount of bailouts can save it. It just does not make sense to have trillions of dollars (or, name your currency) out there that are not backed by anything real, and that keep growing. It's a chimera. I think we are seeing it collapse under its own weight for that reason.

So can someone with more financial sophistication than me, please tell me why I'm wrong? Or not?

Thanks.

[NMDemDist2]

1. yup. pretty much. the video "Money as Debt" explains it very well

http://video.google.com/videoplay?docid=-9050474362583451279

[ljm2002]

3. Thanks, I'll take a look at that video... n/t

[Warpy]

2. Bailouts can't, won't and shouldn't save the derivatives trade

The quickie explanation for a derivative is this: Joe Sixpack buys a remote shack with a 30 year fixed mortgage. A hedge fund manager looked at all the financial disclosure numbers on that loan and realized that over a period of 30 years, Joe was going to pay 300% of that loan. That $30,000 shack he bought was going to cost him $90,000 when all the interest was added up, in other words.

The hedge fund guy thought the mortgage was a great moneymaker, so he grabbed it before it got offered to Fannie Mae or Freddie Mac and cut it into 3 pieces he said were worth $30,000 apiece and offered the piece of paper representing a piece of Joe's mortgage along with a lot of other mortgages to banks, pension funds, and other institutions for the bargain price of $20,000. The hedge fund made $60,000 immediately and the institutions held a piece of paper that would give them a 33% return spread over 30 years, ordinarily a great return.

This is the most basic derivative, something sold on the basis of its future return, not its present worth.

Fast forward to California, 2008. Joe finds out the $30,000 shack he bought way up in the hills for a vacation house is now worth only $20,000. Since he bought at the top of the market, he's out $10,000 up front, plus all the interest he's still got to pay on that loan. Since he's working two jobs now and vacations are spent catching up on home chores he can't ordinarily do, he no longer needs a vacation home 200 miles from the nearest town and at the end of a 20 mile logging road, so he mails the keys to the bank.

Everybody who bought a derivative based on the repayment of his and thousand of other loans are now left holding the bag. The derivative is now worthless because nobody else is going to be dumb enough to buy that falling down shack.

This is basically where the astonishing wealth of the plutocrat came from.

[readmoreoften]

4. Great analysis. I'm going to memorize it for when someone asks.

[Warpy]

6. Just bookmark it

and thanks!

It was tough to sift through all the dense verbiage to come out with a common sense explanation. They tried to disguise the whole business with obfuscation and succeeded for a long time.

[ljm2002]

5. Thank you for explaining...

...what derivatives are.

What it looks like, then, is that the so-called "value" being traded out there is really a bet on future value. And we all know, in the financial world as well as elsewhere, that what goes up must come down. Well, that would be true if there were some sort of realistic standard against which the actual money supply could be measured. Seems to me it has all become untethered.

This bailout is pure b.s. I know that we're all supposed to think "Oh, no, if they don't do it then we'll have catastrophe". Well guess what, we already have catastrophe. And I say that knowing full well that you should never say, or think, that it can't get worse. Of course it can. But here's the thing: it is not the financial markets that enable human productivity and human creativity. And we as a nation and as a world are in dire need of both right now. From where I sit, we're seeing the a-holes who gamed the system get their bailouts, while the little guys who got stepped on, it's "Oh well, shoulda thoughta that before youse bought yourse house, suckahs!"

The people need a voice in what will be done to correct this situation. If they can come up with trillions out of the back pocket with the wave of a hand like this, then we can demand that the same sleight of hand be employed to shore up Social Security instead of calling it "threatened" all the time, to give us free education for all, through University and trade schools, and to provide universal single payer health care.

Instead, the great advantage of being a U.S. citizen seems to be, we can honestly say we have the world's most powerful military (well, mostly if you count hardware and nukes at our disposal), and we are fed the world's bestest, most effective jingoistic propaganda.

Sorry, had to rant.

(on edit: "universal single payer health insurance" ==> "universal single payer health care"

[Beetwasher]

7. Thx Warpy

Very cogent, as usual. :thumbsup:

[SmileyRose]

11. Oh Warpy - THANK YOU SO MUCH!!

Your simple example made it all click in my head. -- I'm assuming they do this with credit cards, car loans and everything else on credit?

[prayin4rain]

12. thank you for the explanation!!! so what are WE buying in the bailout?

the shack? the original loan for $30,000? hopefully not the $90,000!!!

(thanks again for explaining.... i so rely on you guys at DU) :)

on edit: and also every time you reduce your interest rate.. remortgage... does that hurt the derivatives ?

[Warpy]

17. Time, basically.

If the Democrats take over and start to address the demand side of the equation, the time we're buying right now might mean this is a big, nasty recession and not another depression.

If the GOP gets in, forget it. Their ideological rigidity will prevent any solution to this mess from being passed and put into action. We will have a Depression and it will be a long one.

[cui bono]

25. On Thom Hartmann this morning, Ravi Batra said they bought 3 weeks with

what they've done this week.

Wonder what will happen after that. I had to go out and didn't get to listen to the rest of the interview.

[A HERETIC I AM]

16. So out of curiosity, how many 30 year loans were written at 9.4% interest...

on $30,000 shacks?

Because that's what the interest rate would be for a 30 year, thirty grand loan that added up to $90,000 if every payment was made.

Here's a mortgage calculator page. 30 years is 360 months. For a $30,000 mortgage to equal $90,000, the interest rate would have to be 9.4%. That's 360 payments of $250.00.

I realize that you were perhaps being extreme in order to make a point, but your point has a serious flaw.

Warpy, I have noticed you have stated and implied in various posts, several times in the past that Hedge Funds create and/or issue bonds.

Poppycock. I don't buy it.

The hedge fund guy thought the mortgage was a great moneymaker, so he grabbed it before it got offered to Fannie Mae or Freddie Mac

HOW? How does a Hedge Fund Manager "grab" a mortgage loan? It does not happen.

and cut it into 3 pieces he said were worth $30,000 apiece and offered the piece of paper representing a piece of Joe's mortgage along with a lot of other mortgages to banks, pension funds, and other institutions for the bargain price of $20,000.

Based on what? If he said they were worth $30,000 a piece, why would he sell them for $20,000? Even if this scenario were even a remotely reasonable hypothetical situation, (and it isn't, not by a long shot), bonds and other debt instruments are not priced at the whim of some guy sitting in a corner office overlooking the East River. It's a shitload more complex than that.

The hedge fund made $60,000 immediately and the institutions held a piece of paper that would give them a 33% return spread over 30 years, ordinarily a great return.

Claptrap. What you are trying to describe has a kernel of truth to it in that packaged mortgages are sometimes split into "Tranches" but all of them do NOT have a maturity of 30 years and the bonds sold within each tranch are not arbitrarily priced. They are priced based on any number of variables, including but not limited to credit quality, average duration, coupon rate, call provisions, put provisions (if any), NONE OF WHICH have anything to do with the aforementioned corner office dweller.

This is the most basic derivative, something sold on the basis of its future return, not its present worth.

No, it's not. What you have described is not a derivative at all. You've described a Mortgage Backed Security.

Puts and Calls are derivatives. Options are priced on their present value and change as the perceived future value of the underlying security changes. There are many others but those are the most basic. An MBS is not. It's a Bond. If the Hedge Fund manager were to hold some of these bonds in his account and used their value as collateral to purchase further securities, then you are getting closer to a derivative. That's a margin loan. In fact, that is basically what blew up that Carlyle fund a few months back. They had taken margin loans on their accounts to purchase further securities and the collateral in the accounts were mortgage backed bonds, (If I remember correctly, Fannies and Freddies). The bonds were falling in value when marked to market and they got margin calls they could not keep up with.

Where do you get this notion that Hedge Funds issue debt paper? Do you have any proof at all that ANY of the 9000 Hedge Funds out there are actually issuing debt securities?

Hedge Funds are complicit to a degree in the current difficulties because they were a source of capital with which purchases of risky debt securities were made. Since they are open only to "accredited" investors, they by their very nature tend to have a limited number of participants (clients) but large amounts of dollars to be invested. Managers of such funds have many different strategies, some of which are designed to provide high yield on an investment, some seek stable returns regardless of market direction and others seek total return, but I find absolutely ZERO evidence that any Hedge Fund is the actual issuer of any paper.

It's like suggesting a Mutual Fund issues bonds.

It does not happen.

[Common Sense Party]

20. I'm no expert on Hedge Funds, but I've NEVER heard of one

acting as the ISSUER of a debt instrument. The very nature of being an underwriter or issuer is contrary to the goal of a hedge fund--namely, being quick, nimble and able to leverage assets. A bond issuer can't do that; by definition it's a lengthy, low-margin process.

I agree with you, Heretic. A hedge fund is basically a mutual fund with almost no rules. Mutual funds BUY securities, but they do not CREATE the securities.

[Warpy]

22. I think that if you do a little more reading

you'll find that they bought debt and laundered it into securities.

[Common Sense Party]

26. What do you mean by "laundered"?

And point me to something you've read that shows Hedge Funds bundling together debt into securities. They purchase those derivatives all the time, I know, but I wasn't aware that they were issuing those securities to other investors. Thanks.

[SmokingJacket]

18. That really is a good explanation.

Warpy, I think you rock.

[unblock]

28. you're describing only one particular type of derivative (cmo pac tranches) and overstating things

if there's $30,000 of principal over the life of the mortgage, this way of carving it up provides that the first $10,000 of principal goes to the owner of the first tranche; the second $10,000 of principal goes to the owner of the second tranche, and the last $10,000 of principal goes to the owner of the third tranche.

it's true that investment banks do this carve-up thing because the sum of the parts is worth more than the entire mortgage. the reason for this is not (necessarily) anything underhanded, misrepresented, or otherwise evil. it's simply that the risks and rewards are more tailored to the customers' needs.

however, it's not remotely true that there's $90,000 of net present value or price available. the investment bank that carved up the mortage makes no where near $60,000 of profit. in fact, the profit comes from subtle adjustments in the interest rates for the entire deal. in this case, say joe is paying 8% interest. the first tranche is very safe, so it might pay only 5%, the second is riskier and so might pay 7%, and the last tranche might pay 9%.

how much are these tranches worth? the math is remarkably complicated because you have to make assumptions about the likelihood of prepayments, but it should be intuitively clear that the investment bank can expect to earn more interst (8% on $30,000 from joe) than they might have to pay out to the tranche holders. that's where the profit comes in. it's quite small on a $30,000 mortage, which is why they only do this sort of thing on (multi-)billion dollar pools of mortages. then that fraction of a percent of interest really adds up to something meaningful.


the hedge funds would actually be the owners of the verious tranches, not the creators of them; that's the job of the investment bank. of course, part of the problem is that the investment banks also played owners as well.



in any event, the are vastly more complicated forms of derivatives. basically, anytime a big company wants to get protection from some circumstance, they can see if someone will insure them against it. for instance, a company might be planning to embark on some major business in a certain part of the world, and that venture would be a disaster if the weather were not accomodating. so they can create a derivative (with the help of an investment bank) that compensates them for every day that temperature is below the threshold at which they can't run their plant equipment or whatever.

that's obviously a tough thing to value because you have to guess about the weather. but the key point is that someone's going to win and someone's going to lose. so when you see a figure like $700 trillion in derivatives, that doesn't mean that's the amount at risk in total. that's closer to the amount that might be transfered from the loser to the winner. someone's losing money, but someone else is gaining money.

unless the loser goes bankrupt....

[A HERETIC I AM]

29. Thank you.

I'm glad to see that Commonsenseparty and I aren't the only ones who noticed the flaws in that analogy. And they're huge flaws.

so when you see a figure like $700 trillion in derivatives, that doesn't mean that's the amount at risk in total. that's closer to the amount that might be transfered from the loser to the winner. someone's losing money, but someone else is gaining money.

Absolutely spot-on. The key word in that statement is might. Not all derivatives settle either. Many, many billions of dollars of them expire worthless, as in the case of an expiring out-the-money option.

As I asked in my post above, I am curious where Warpy gets the notion that Hedge Funds are actually issuers of debt paper. They don't do it any more than PIMCO or Vanguard or Fidelity or American Funds does through a bond Mutual Fund.

6 replies of "What a great explanation!" No, it sounds great, but it is inaccurate.

These issues are complex enough without misinformation being spread around using language that sounds good but is completely wrong.

[Odin2005]

8. It's funny money. That said, I don't think gold is workable as a standard anymore.

The gold-bugs are Libertarian morons or people that fell for those morons' BS. There is simply not enough gold in the world for a gold standard to work. A gold standard also leads to periods of economy-crushing deflation, in where it is better to hoard one's wealth then invest it. Such deflation was the ultimate cause of the Populist movement in the late 1800s and that movement's desire to take the US off a pure gold standard, the demand to go off a gold standard died when a series of gold rushes ended the deflation. A better option in my opinion, is a currency that is backed in some way by energy, since energy use and the size of the economy would be proportional I would think.

[ljm2002]

9. Yes, I think you're right about the gold standard...

...I wasn't implying we should do that, as you say it just encourages hoarding and what is the "real" value of gold anyway?

I don't think energy is the right answer either, especially since in the current scheme of things, that means that oil and nuclear become the big financial powerhouses and have a stranglehold on the value of everything. I want to see energy decentralized, and I certainly don't want our financial systems pinned to the current big-energy powers that be.

I think we need a new model. The only reason the wealthy are wealthy, is that we have all agreed to live by the illusion that money -- the medium of exchange -- is wealth. Yet real wealth is the resources, including the people, of a nation. It is the water, the land, the gold, the oil, the water, the trees, the crops -- and the human creativity and work that enriches our lives out of our use and stewardship of these things.

This giant whirligig that the financial geniuses have built for their own self-aggrandizement is a juggernaut, so big it crushes all in its path. Yet stupidly, we continue to believe that it is the whirligig that is the creator of wealth. It is not.

[Odin2005]

10. Good point. n/t.

[KakistocracyHater]

13. punishing the wrong people

it sounds like the Hedge Fund Managers made the money immediately off of mortgage profiteering & it is there that the blame should settle not on the homeowners. The Hedge Funders also were recently balking at paying more realistic taxes & if they had been-as they still should be-maybe this mess would have been smaller. Also the Money Market going below a $1 per share is an emtional assessment not a realistic 1, since you could confiscate their assets which would be more than $1 in value.

[lelgt60]

14. the institutions that bought the paper were pretty stupid/greedy, as well..

If something looks too good to be true, it probably is.

Also, the original loan was only worth that much because of the extra high interest rate that Joe paid for a "sub-prime" mortgage.

Finally - aren't some of the "assets" backing up many money market funds actualy bonds - iou's - from corporations? If those become worthless because the corporations can't pay them back, then there wouldn't be anything of value to seize, right?

When an economic system collapses it really is not pretty...

[Warpy]

15. Part of the problem was that derivatives/ structured investment vehicles

were cloaked in such obfuscatory language that nobody in big institutions knew exactly what the hell they really were. All they saw was a security from a hedge fund that offered them a guaranteed return of over 3% year after year and they jumped at it.

I'm barely a big enough fish to have been offered some of this stuff, which is why I started to do all the reading on it.

Fortunately, I have a built in mistrust of anyone incorporated in the Caymans, and that bought me enough time to kick and claw my way through the language to discover that these miraculous investments were bets on commodities, stocks, and bad loans in California and Florida. They represented nothing but a BET and weren't really worth the paper they were printed on (or the bandwidth on the net) and people who are holding the phony "wealth" they represent should not get a bailout.

Some institutions, however, are worth saving, like Fannie and Freddie.

[Common Sense Party]

21. Which hedge funds sold these derivatives to thepublic?

Are there some hedge funds you know of that *create* derivatives? I've only heard of hedge funds that *invest* in securities.

[Motown_Johnny]

19. I'm no expert... but here is my take on it

First, when Nixon took us off the gold standard he did something brilliant (in the short term). He used his influence with OPEC and arranged that all oil is bought/sold with American dollars. So there is a demand for our currency. It helps keep our dollar artificially higher than it would be other wise. When/If the world switches off the American dollar for oil transactions then our dollar collapses. There is already talk of switching to the Euro.


Second, we all trade dollars for other forms of currency. It fluctuates but it does give us an idea of the actual value.

Third, The Federal Reserve tries to control the value of the American dollar by controlling interest rates as well as the amount of currency that is printed. This is part of our current problem. Interest rates were kept far to low for far to long just to make Shrub look like he was doing a good job with the economy, while he was actually fucking it all up.

[inna]

23. great thread, i had the same question actually... n/t

[inna]

24. a little primer on a related issue....

http://docs.google.com/TeamPresent?docid=ddp4zq7n_0cdjsr4fn&skipauth=true&pli=1

[On the Road]

27. Here are a Couple of Questions to Think About:

1) What were the reasons that moving OFF the gold standard and into fiat currency was a core progressive issue a hundred years ago?

2) What was the economic performance of the US like during that period, and how did the rich do compared to the poor?

As uncomfortable as it may seem, the idea of money backed by something of tangible value is a fiction. The gyrations of gold should indicate that. Without the ability to manipulate the money supply, the federal reserve would be pretty much helpless in the face of any economic crisis like this. What actions would they take to reliquify the markets and restore confidence without fiat money?

The system does have to be handled responsibly, and it has not been. Returning to a preindustrial monetary system would make it far, far worse.

[ljm2002]

30. So you must have missed the posts...

...where two of us, at least, said that going back to the gold standard would be a bad idea?

The value of money does need to be tethered to something real. The ability of the Fed to print new money (or, in this day and age, to release vast new amounts of money electronically) is exactly the problem. Once people figure out that the stuff they put such value on, can just be printed as necessary, whenever the financial geniuses need a bailout (but never, ever for mere citi... er, consumers) -- that is when the money loses its value altogether.

Supposedly money represents the value of goods and services. Unfortunately, a lot of the "services" that our money represents right now are the "services" that laundered bad loans into Class A Securities and sold it to unsuspecting institutions around the world. Crash, our name is mud and our financial system -- once the envy of the world -- is lost in a sea of red ink and finger pointing, the result of unbridled greed without regulation.

So do you have an idea what the value of money should be tied to? Because what we have now ain't working, in case you haven't noticed.

[On the Road]

31. No, I Didn't See Those Posts

Sorry to attribute beliefs to you that you do not hold.

Personally, I am more concerned about results than about theory. As a result, I think that tying money to the value of any tangible resource is a bad idea. Your concern about people find out that money can be printed as necessary is basically a concern about confidence.

Confidence is definitely an issue, but it can be created by sound economic management and responsible control of the money supply. Ultimately, steady economic growth and limited inflation are the greatest sources of confidence in the currency.

First, fractional reserve banking pretty much means that money is never fully backed by any commodity. The negative impact of going to full reserve banking is infinitely greater than any benefits to be derived from making currency exchangeable for some underlying commodity.

Tying money to tangible assets (even a basket of all goods and services in the economy) not only limits the money supply, but has the effect of exacerbating rather than moderating economic swings. During times of deflation, the money supply shrinks by definition, when what is needed is an infusion of money to restart the supply. During overheated periods with rising commodity prices, the money supply rises when it needs to be controlled.

Having a small constant growth in the money supply achieves some of the goals of tying money to a commodity. That was Milton Friedman's idea. It has the advantage of being simple, conservative, and not susceptible to abuse, but it still leaves the Treasury and Fed without important tools to moderate growth or lift the country out of a recession.

While the Fed has made mistakes, it has gotten progressively better over the decades. It probably made the Great Depression more serious, but has resulted in progressively less serious recessions since then. Before the Fed, there were frequent sharp crashes and contractions which not only limited growth and increased suffering, but made the rich richer and the poor poorer.

As far as the current crisis goes, I don't think fiat money is the issue. The fact that the debt ceiling has to be raised tells me that the money will be borrowed rather than created.

[A HERETIC I AM]

32. Several excellent points.

While the Fed has made mistakes, it has gotten progressively better over the decades. It probably made the Great Depression more serious, but has resulted in progressively less serious recessions since then. Before the Fed, there were frequent sharp crashes and contractions which not only limited growth and increased suffering, but made the rich richer and the poor poorer.

Nicely stated.

I think many DU'rs are of the opinion that the people at the Federal Reserve and the Treasury are idiots.

Nothing could be further from the truth.