T Nation

Simple Explanation of Derivative Markets

My Uncle sent me this.

Heidi is the proprietor of a bar in Detroit . She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later.

Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers’ loans). Word gets around about Heidi’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Heidi’s bar. Soon she has the largest sales volume for any bar in Detroit .

By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi’s gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi’s borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets.

Naive investors don’t really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various BOND securities.

They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from their cronies in Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi’s bar.
Now do you understand?

V

That was the best explanation of the credit crash I have ever heard.

See I believe in simple solutions to simple problems. Rather than all this annoying governement oversight and revamping bank and lending rules. I would just make selling debt or bundling debt in to other assets for the purpose of selling it, illegal. Enforce the law and the problem is solved for the future.

[quote]pat wrote:
That was the best explanation of the credit crash I have ever heard.

See I believe in simple solutions to simple problems. Rather than all this annoying governement oversight and revamping bank and lending rules. I would just make selling debt or bundling debt in to other assets for the purpose of selling it, illegal. Enforce the law and the problem is solved for the future. [/quote]

If you make bundling debt in to other assets then Fannie Mae and Freddie Mac go under. This would make getting a home loan much more difficult and the Federal Government does not want that. The Federal Government wants everyone to buy a house. Notice how I used the word house and not home.

HOME is where the family lives to together, and a HOUSE is an inanimate object that you live in. I am tired of people using these words incorrectly. “The bank is stealing my HOME.” No actually the bank owns your HOUSE and allows you to live there if you continue to make the payments. Once the loan is paid in full then you own the HOUSE.

[quote]dmaddox wrote:

[quote]pat wrote:
That was the best explanation of the credit crash I have ever heard.

See I believe in simple solutions to simple problems. Rather than all this annoying governement oversight and revamping bank and lending rules. I would just make selling debt or bundling debt in to other assets for the purpose of selling it, illegal. Enforce the law and the problem is solved for the future. [/quote]

If you make bundling debt in to other assets then Fannie Mae and Freddie Mac go under. This would make getting a home loan much more difficult and the Federal Government does not want that. The Federal Government wants everyone to buy a house. Notice how I used the word house and not home.

HOME is where the family lives to together, and a HOUSE is an inanimate object that you live in. I am tired of people using these words incorrectly. “The bank is stealing my HOME.” No actually the bank owns your HOUSE and allows you to live there if you continue to make the payments. Once the loan is paid in full then you own the HOUSE.[/quote]

I think making it harder to get a house would be a good thing. If the norm goes back to, 20% down, then people who want to own a home, will live within thier means to SAVE 20,000 cash (average for a 100,000 home). I think having a family or couple go through an excercise where it takes them a year or two of frugal living to achieve a goal, can only help the country as a whole.

I know I’m digging out of debt myself right now. If all goes well and my wife and I do not lose out jobs we are looking at 2 to 2.5 years to be debt free except the house. This will be huge as over the past year we have been essentially living paycheck to paycheck. Being irresponsible, living above our means.

When we get debt free, we will have approx $1800 per month in disposable income that right now is going almost entirely to debt servicing. Doing things like saving for kids colledge, planning retirement, going on vacation. Those are all pipe dreams right now, but after budgeting and living below our income level, we have planned out our future and it looks bright.

V

you should definately save for your kids “colledge” V :wink:

I think I might post your OP on Facebook

[quote]polo77j wrote:
you should definately save for your kids “colledge” V :wink:

I think I might post your OP on Facebook[/quote]

Yes, hopefully them can be more smarter than me is. :wink:

kthxbye

V

[quote]dmaddox wrote:

[quote]pat wrote:
That was the best explanation of the credit crash I have ever heard.

See I believe in simple solutions to simple problems. Rather than all this annoying governement oversight and revamping bank and lending rules. I would just make selling debt or bundling debt in to other assets for the purpose of selling it, illegal. Enforce the law and the problem is solved for the future. [/quote]

If you make bundling debt in to other assets then Fannie Mae and Freddie Mac go under. This would make getting a home loan much more difficult and the Federal Government does not want that. The Federal Government wants everyone to buy a house. Notice how I used the word house and not home.

HOME is where the family lives to together, and a HOUSE is an inanimate object that you live in. I am tired of people using these words incorrectly. “The bank is stealing my HOME.” No actually the bank owns your HOUSE and allows you to live there if you continue to make the payments. Once the loan is paid in full then you own the HOUSE.[/quote]

No, not make it illegal to bundle debt into assets, make it illegal to bundle them into assets to sell them. In other words, make it illegal to sell debt.

Often times these jerk off’s would bundle the subprimes, in with other profitable assets to hide them and get pawn them off on others. I simply want to make that practice illegal. You aquire debt, you own it.

This is not an exact analogy of a derivative market. These are credit derivatives which are a little bit different from the asset classes that make up futures and options, for example. Exactly like the names of these fictional instruments implies credit can be represented by bonds – it is essentially a contract for a loan payment in full at a certain date. The bond holder is the loan granter; he expects to be paid a certain sum for this bond at some point in the future.

Stock options and commodities futures are derivatives, too, however, they are contracts for goods and services priced now and delivered at a later date which is the exact opposite of a credit derivative. Bonds represent goods that are consumed now and paid for later – for example, homes and other government spending.

With derivatives one can either buy a contract (buy a bond) which gives the buyer the right to either buy or sell certain goods or services at the contracted price; or one can sell a contract which obligates the seller to either buy or sell certain goods or services at that contracted price.

In this example a derivative could also be a futures contract for delivery of booze at a certain price. The holder of the contract profits if the price of drinks rise because he now has the right to buy at the lower contracted price and loses the premium paid for the contract if they go down. Typically, a bar owner would hedge against a sharp rise in alcohol prices by buying a futures contract for booze at a certain price. It is kind of like buying insurance in that the only loss is the price of the premium if prices go down.

The seller of the contract will profit if prices go down because the contract he sells will expire worthless (he collects his money up front) and looses if they go up because we will be forced to deliver booze at the lower contracted price minus what he was paid for the contract.

We should not lump all derivatives into the same risk category. However, all derivatives serve a purpose in that they help regulate supply and demand and keep asset prices stable. The people who take on the risk of these instruments are market makers making sure viable assets find buyers. The higher the risk the more profit one would expect to make.

The funny thing about these credit derivatives is that they were offering returns greater than the rate of the loans being granted by FM/FM. That should have been the first clue not to get involved with these particular instruments.

[quote]pat wrote:
No, not make it illegal to bundle debt into assets, make it illegal to bundle them into assets to sell them. In other words, make it illegal to sell debt.
[/quote]
???

This is a bad idea. Please see my post above.

Buying and selling debt helps interest rates remain stable with respect to supply and demand for credit. Also, in a free and unfettered market (as opposed to one that has money printed at will by the government) loans would be extremely hard to come by without the healthy credit market these instruments allow for.

As with anything the responsibility is with the buyer to understand the product and for the seller not to sell a lemon. Most of the brokers who sold these products could not have known the loans would have fallen through to the extent that they did. Or at least I would be interested to see if any court of law could prove it. If so then yes, it is fraudulent and the guilty should pay.

The government is fully to blame for the failure of the credit and housing market – not credit derivatives in and of themselves.

[quote]Vegita wrote:

[quote]dmaddox wrote:

[quote]pat wrote:
That was the best explanation of the credit crash I have ever heard.

See I believe in simple solutions to simple problems. Rather than all this annoying governement oversight and revamping bank and lending rules. I would just make selling debt or bundling debt in to other assets for the purpose of selling it, illegal. Enforce the law and the problem is solved for the future. [/quote]

If you make bundling debt in to other assets then Fannie Mae and Freddie Mac go under. This would make getting a home loan much more difficult and the Federal Government does not want that. The Federal Government wants everyone to buy a house. Notice how I used the word house and not home.

HOME is where the family lives to together, and a HOUSE is an inanimate object that you live in. I am tired of people using these words incorrectly. “The bank is stealing my HOME.” No actually the bank owns your HOUSE and allows you to live there if you continue to make the payments. Once the loan is paid in full then you own the HOUSE.[/quote]

I think making it harder to get a house would be a good thing. If the norm goes back to, 20% down, then people who want to own a home, will live within thier means to SAVE 20,000 cash (average for a 100,000 home). I think having a family or couple go through an excercise where it takes them a year or two of frugal living to achieve a goal, can only help the country as a whole.

I know I’m digging out of debt myself right now. If all goes well and my wife and I do not lose out jobs we are looking at 2 to 2.5 years to be debt free except the house. This will be huge as over the past year we have been essentially living paycheck to paycheck. Being irresponsible, living above our means.

When we get debt free, we will have approx $1800 per month in disposable income that right now is going almost entirely to debt servicing. Doing things like saving for kids colledge, planning retirement, going on vacation. Those are all pipe dreams right now, but after budgeting and living below our income level, we have planned out our future and it looks bright.

V [/quote]

you sound like a Dave Ramsey family. If you are good job, because the wife and I finished up 2 years ago and love having the extra money each month to do what we want to with instead of paying the credit card companies. You can do it V.

[quote]dmaddox wrote:

[quote]Vegita wrote:

[quote]dmaddox wrote:

[quote]pat wrote:
That was the best explanation of the credit crash I have ever heard.

See I believe in simple solutions to simple problems. Rather than all this annoying governement oversight and revamping bank and lending rules. I would just make selling debt or bundling debt in to other assets for the purpose of selling it, illegal. Enforce the law and the problem is solved for the future. [/quote]

If you make bundling debt in to other assets then Fannie Mae and Freddie Mac go under. This would make getting a home loan much more difficult and the Federal Government does not want that. The Federal Government wants everyone to buy a house. Notice how I used the word house and not home.

HOME is where the family lives to together, and a HOUSE is an inanimate object that you live in. I am tired of people using these words incorrectly. “The bank is stealing my HOME.” No actually the bank owns your HOUSE and allows you to live there if you continue to make the payments. Once the loan is paid in full then you own the HOUSE.[/quote]

I think making it harder to get a house would be a good thing. If the norm goes back to, 20% down, then people who want to own a home, will live within thier means to SAVE 20,000 cash (average for a 100,000 home). I think having a family or couple go through an excercise where it takes them a year or two of frugal living to achieve a goal, can only help the country as a whole.

I know I’m digging out of debt myself right now. If all goes well and my wife and I do not lose out jobs we are looking at 2 to 2.5 years to be debt free except the house. This will be huge as over the past year we have been essentially living paycheck to paycheck. Being irresponsible, living above our means.

When we get debt free, we will have approx $1800 per month in disposable income that right now is going almost entirely to debt servicing. Doing things like saving for kids colledge, planning retirement, going on vacation. Those are all pipe dreams right now, but after budgeting and living below our income level, we have planned out our future and it looks bright.

V [/quote]

you sound like a Dave Ramsey family. If you are good job, because the wife and I finished up 2 years ago and love having the extra money each month to do what we want to with instead of paying the credit card companies. You can do it V.[/quote]

Yup, Just started beginning of Feb. Already have everything planned out. There is a lot to overcome, but it doesn’t seem so hard when you plan it out to the T. It also makes not spending on bullshit easy, it’s not in the plan so we CANT do it. If we want to do something outside the box, we have to save our monthly “blow” money up and do it off that.

As a matter of fact, I just took $10 of my blow money and turned it into $30 last week at darts playing some money games. If I lost the $10 that would have been it, but luckily my partner and I were on fire.

V

So in this example it’s all the fault of the unemployed alcoholics, right? Same as the sub-prime fallout was all because of lazy stupid home buyers taking out too much mortgage debt.

I mean, how could Heidi, the bank or the traders have ever seen this coming?

[quote]tme wrote:
So in this example it’s all the fault of the unemployed alcoholics, right? Same as the sub-prime fallout was all because of lazy stupid home buyers taking out too much mortgage debt.

I mean, how could Heidi, the bank or the traders have ever seen this coming?

[/quote]

I think at each level the injustice was greater. I mean if a bar owner under normal circumstances, loans out drinks to people who cannot pay, that bar owner is going to go under. The money coming from the top allowed this bad practice to continue far longer than it would have under normal circumstances. Unfortunately, only the top level of idiots got bailed out.

V