Saturday, February 25, 2012

Now I Understand . . .

A Primer: Understanding Derivatives

Heidi is the proprietor of a bar.

She realizes that a good deal of her customers are unemployed alcoholics and, as such, cannot afford to have all the drinks they would like to have at her bar.

To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later. She requires them to pay on each visit only for their first drink, but not for any drinks thereafter.

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 town.

By providing her customers the freedom to have as many as they can consume after paying for just one drink, 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, as does her book of customer loans.

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 because he has had Heidi sign over the debts of the unemployed alcoholics as collateral for the bank's loans to her.

But at the bank's corporate headquarters, expert traders figure a way to make huge commissions on top of the value of Heidi's ever-increasing loans, and transform these "collateralized debt obligations" into securitized packages called DRINKBONDS.

With Heidi's help, they are divided into "tranches", or "layers", according to the time when Heidi knows the customer in question first comes into her bar.

Those who come in the evening are figured to furnish the best collateral, because they are presumed to be able to earn money during the day. (In fact, they are mostly sleeping off their hangovers until three o'clock, and then standing in line to get their welfare checks, but never mind.) The debts secured by their obligations receive an AAA grade.

Those who start their binges early in the morning are graded the lowest, but because of the higher risk, they pay a higher return. (They drink more, and so borrow more, and so Heidi charges them a higher book rate of interest.) And the others fall in between.

(The third-party firms who are paid to provide the ratings have no idea of the quality or value of the collateral securing each tranche, because the packages are too complex for them to say just which loans secure which bundle of securities. But the brokers tell them that if they will just give the top tranche an AAA rating, and grade the rest accordingly, they will be given lots and lots more securities to rate, and make lots and lots more fees for doing so.)

These "securities", as rated by independent and trusted rating agencies, then are bundled and traded on international securities markets.

Naive investors don't really understand that the securities being sold to them as "AAA Secured Bonds" really are secured largely by the obligations of unemployed alcoholics who sleep during most of the day. Nevertheless, because of their novelty, they are pitched as the newest type of investment vehicle with a great potential for appreciation, and demand is created.

As a result, the bond prices continuously climb, justifying the sales pitch for them - and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

The smart folk at the brokerage houses realize that they can sell even more DRINKBONDS to more cautious investors, and make even more commissions, by arranging for insurance on them in case they drop in value. A giant international insurance company agrees to underwrite the value of each new series of bonds, in exchange for annual premiums.

The premiums are included in the price of the repackaged securities. With this added layer of protection, now international banks and investment houses feel secure in acquiring DRINKBONDS backed by the giant insurance company. Other insurers soon get in on the act, and rake in the premiums. (Heidi's prices for her drinks are continually rising, so what can go wrong?)

One evening, one of Heidi's customers, driving home intoxicated from her bar, crosses over the center line and collides with another vehicle. Luckily, the driver of that vehicle is not injured. But he works as a risk manager at the local bank that is managing Heidi's loans.

When he finds out that the other driver had just come from drinking at Heidi's bar, and carried no insurance because "he couldn't afford it, being out of work", he begins to look more closely into Heidi's debtors.

Even though the DRINKBOND prices still are climbing, he  decides that the time has come to call in the collateral on Heidi's loans, to provide the bank with more cushion against default. He so informs Heidi, tells her to collect her customers' debts, and put the cash into CD's at the bank.

Heidi then demands payment from her patrons. But most of them, being unemployed alcoholics, cannot pay back their drinking debts. The bank then calls all of Heidi's loans.

Since Heidi cannot repay her loan obligations, she is forced into bankruptcy. The bar closes and Heidi's 32 employees lose their jobs.

The income stream from DRINKBONDS dries up. Overnight, DRINKBOND prices drop by 90%.

The now worthless asset value of its loans to Heidi destroys the bank's liquidity and prevents it from issuing new loans, thus freezing most 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 DRINKBOND 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 in their pension funds.

Her wine supplier cannot make up the loss and 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.

The giant insurance company is suddenly on the hook for more losses than it has reserves, because it had reinsured its risks with other insurers who had sold their own policies on the DRINKBONDS to make more money, and who now face losses themselves.

Moreover, rather than use the premium payments they received to increase reserves, the insurers instead paid them out as big bonuses for their oh-so-clever executives, who had boosted their companies' earnings by arranging for insurance which they told each other would never be called upon, since DRINKBONDS simply could not go down in value. (H/T: NW Bob, below.)

Fortunately, though, the bank, the insurance companies, the brokerage houses and their respective executives are saved and bailed out by a multibillion-dollar, no-strings-attached cash infusion from the government -- to whose politicians they had prudently made large campaign contributions, lest the former forget where lay their true loyalty.

The politicians rush the bailout through Congress as an emergency measure, to prevent what they tell the voters and the compliant media will otherwise be "a system-wide collapse." They also claim that the banks, brokerage houses and insurance companies (their loyal contributors, remember) are all "too big to fail."

The funds required for this bailout are obtained by new taxes levied on employed, middle-class, nondrinkers who have never been in Heidi's bar.

Even those new taxes, however, are not enough to fund the complete bailout. So the government borrows the rest of the money required from China, and reckons that the taxpayers' grandchildren can take care of figuring out later how to pay all the money back.

With the bailout moneys, the banks, brokerage houses and insurance companies pay large bonuses to their clever executives who got them out of their mess, and begin looking for the next scheme by which they can make money.

(H/T: A serendipitous email)


  1. Thinking of our Congress, this puts a whole new perspective on the shout, "The drinks are on the House!"

  2. Excellent explanation! You forgot to mention that the giant insurance company used their credit default premiums to pay big executive bonuses instead of setting them aside as reserves against possible claims. They viewed the chance of default as negligible. When the default claims were filed, they were shocked, I say, shocked that there was gambling going on.

    NW Bob

  3. Of course, given that Fannie Mae and Freddie Mac (not to mention FDIC and and FSLIC) are both creatures of government, we really should not be surprised. What is most commonly referred to as "the free market" only ever truly exists when government (by which I refer to all of its entities and their employees, including the elected ones) restricts itself to the rigorous enforcement of property rights and the Rule of Law. That describes a set of conditions which have not applied in the United States for a century, at the very least (government interference with the market is easily traced back to the Theodore Roosevelt administration.)

    Pax et bonum,
    Keith Töpfer

  4. Keith, your paean to the very forces that helped create this mess is one of the more conspicuous cases of denialism I've seen in, well, OK, the last few hours. A little historical perspective on TR is that we got regulation in the first place to try to suppress the "free" market from cooking up this kind of con job a century ago. It is apparently the tendency for the market to evolve so as to prevent the game from being played fairly, and securitization of mortgages certainly played out that way. That Fannie and Freddie were governmental figured into the fraud aspect by giving the false impression of governmental security and supervision; they can be faulted for not bothering to do the latter, but the more fundamental fault (that risk was being obscured) had little to do with their attachment to the federal government. I would tend to assume that the legislation that created them also took away old regulation that prevented securitization.

    The bottom line, at any rate, is that the government created this market at the behest of the market. If the government has simply allowed the market to come into being, things may have progressed somewhat differently, but I believe the outcome would have been about the same.

  5. Well put, C. Wingate. I would also add, having worked in the "welfare" dept. (aka CalWorks) of Santa Clara Co., the description of the alcoholics as being on welfare is inaccurate- "welfare" was substantially changed in 1996 by the Clinton Administration. No more staying at home indefinitely and having more babies. Nowadays you are either in job training or job hunting all day - in four years, soon to become two years, end of welfare whether you are trained and employed or not. And you have to have kids under 19 to qualify.

    Also it would have been more accurate analogy to say that bartender lied to people at the bar about the true cost of their drinks and led them to believe that it was an affordable health drink, not alcohol.

    Love reading Michael Lewis!

  6. The analogy is based on the subprime program as it was encouraged by enactment of the Housing and Community Development Act of 1992, signed by President Bush. It was James Johnson of Fannie Mae who shortly thereafter began pushing loans for low-income people who could show any kind of income at all -- including welfare income, as it then existed.