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FINANCIAL MISCONDUCT: Derivative Market Logic

By Steve Lombardi

My good friend Marion Brown, (we were undergrads together at the University of Iowa) passed this analogy on to me. I was impressed with it's simplicity. To understand it let's first review derivatives.

What are derivatives?

They are investments that depend on insuring the value of other assets; like sub prime loans packaged together as mortgage backed securities. The value of the derivative depends on what happens to some other investment value.

What risks do derivatives pose for investors who own derivatives?

You need to watch the movement of value of the underlying asset. Also you have to know how much of the underlying investment the owner of the asset is self insuring.

What is the purpose of a derivative?

Derivatives allow lousy loans to be sold as if they were AAA prime loans. Derivatives are complex mathematical calculations that allow a buyer of financial instruments to have confidence in the amount of risk involved with certain financial assets going into default. By using derivatives the asset can be more easily bought and sold (liquidity) allowing assets that used to be bought and held for long periods to be bought and more easily resold. A basket of mortgages isn't easy to assess how risky one or more borrowers are; a pension fund in Europe doesn't have the ability to meet, interview and get to know a homeowner who lives in Iowa. The easier it is to sell the mortgages the more liquid the market is said to be.

Here is the analogy of the derivative markets and the sequence of transactions and thinking that got us into so much trouble in the financial markets.

Barbara is the proprietor of an Irish pub in West Des Moines, Iowa. In order to increase sales, she decides to allow her loyal customers - most of whom are unemployed alcoholics - to drink now but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Barbara's drink-now-pay-later marketing strategy and as a result, increasing numbers of customers flood into Barbara's Irish Pub and soon she has the largest sale volume for any bar in West Des Moines.

By providing her customers freedom from immediate payment demands, Barbara gets no resistance when she substantially increases her prices for wine and Guinness, the most consumed beverages. Her sales volume increases massively.

A young and dynamic vice-president (Paul Pickaloan) at the local bank (Normalwest) recognizes these customer debts as valuable future assets and increases Barbara's borrowing limit.

He sees no reason for undue concern since he has the debts of the alcoholics as collateral. At the bank's corporate headquarters, (in Spencerville, Iowa) expert traders transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then traded on security markets worldwide. Naive investors don't really understand the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, their prices continuously climb, and the securities become the top-selling items for some of the nation's leading brokerage houses. (Paul Pickaloan is awarded a $10m bonus for that year.)

One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due to his negativity - We'll call him Negative Ed.), decides that the time has come to demand payment on the debts incurred by the drinkers at Barbara's Irish Pub.

Barbara demands payment from her alcoholic patrons, but being unemployed they cannot pay back their drinking debts. Therefore, Barbara cannot fulfill her loan obligations and claims bankruptcy.

DRINKBOND and ALKIBOND drop in price by 90 %. PUKEBOND performs better, stabilizing in price after dropping by 80 %. The decreased bond asset value destroys the banks liquidity and prevents it from issuing new loans.

The suppliers of Barbara's Irish Pub, having granted her generous payment extensions and having invested in the securities are faced with writing off her debt and losing over 80% on her bonds. Her Guinness supplier claims bankruptcy, her other ale supplier is taken over by a competitor, who immediately closes the local plant and lays-off 50 workers.

The bank and brokerage houses are saved by the Government following dramatic round-the-clock negotiations by leaders from both political parties. The funds required for this bailout are obtained by a tax levied on employed middle-class non-drinkers.

The derivative investors are sitting back waiting to see how many investment funds have bought the DRINKBONDS, ALKIBONDS and PUKEBONDS and how much they will have to pay to those who paid them for the derivative insurance premium.

The real scary part is the crisis doesn't have much to do with sub prime liar's loans but with the $180 trillion dollars of outstanding derivatives that banks hold. Sub prime mortgages do have a value; but derivatives may have no value. To put this in perspective the entire GDP of the world is $60 trillion. If the derivatives don't go the right way there is no way to bail it out.

http://www.youtube.com/watch?v=3sqqVENwkS0

http://www.youtube.com/watch?v=0YNyn1XGyWg

Originally posted at InjuryBoard by Steve Lombardi

Full post as published by Des Moines Personal Injury Lawyer on April 02, 2009 (boomark / email).