One of the main reasons for the financial meltdown was when it was realized that many financial instruments weren't worth anywhere near what they were being bought and sold for, and one of the main culprits was derivatives -- especially derivatives in the mortgage industry ( mortgages were bundled together in large groups called derivatives and traded by the financial giants, until it was learned that many of the mortgages, and therefore the derivatives, were worthless).
Now this angered many people on Main Street, as it should have, because many held mortgages that had been bundled with worthless mortgages and they found their own mortgages affected by the failure of the derivatives, and it angered them even more because they had no idea their mortgages were being traded this was, or even what a derivative even was (in fact most Americans still don't really understand what a derivative really is). What they do understand is that these mysterious "derivatives" wound up costing them a lot more that the Wall Street greedmongers who invented and traded them.
And checking for a definition of a financial derivative doesn't help very much. Consider this definition from Wikipedia -- "In finance, a derivative is a financial instrument that has a value, based on the expected future price movements of the asset to which it is linked -- called the underlying asset -- such as a share or a currency." Now that's about as clear as mud to most of us.
But one of my blogging friends has posted an excellent analogy that makes it very clear just what a derivative is (and why the smart small investor would do good to stay away from them). Adam Cohen over at Zero Energy Construction gives us the following explanation:
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. These securities then are bundled and traded on international securities markets.
The President and his financial advisors become concerned about the massive expansion of the Drinkbond market and ask the Congressional oversight committees to rein in the process and investigate the GSE's that are underwriting the Bonds. The President is not aware that Heidi has given unlimited free drinking rights in perpetuity to the ranking members of the oversight committees, BF & CD.
These oversight committee members state that all is well both in the Drinkbond market and the GSE's and in fact more unemployed drinkers should be given access to free whiskey.
Naive investors don't really understand that the securities being sold to them as AAA secured bonds really are 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 still are 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 Heidi's 11 employees lose their jobs.
Overnight, DRINKBOND prices drop by 90%. The collapsed bond asset value destroys the bank's 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 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 multibillion 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.
The recently passed Wall Street regulation law was originally meant to establish rules that would prevent the trading of really speculative things like derivatives, and return Wall Street to what it used to be -- an investment in the long term growth of a company (with the speculation left to such things as the commodities market, where investors have always know they were taking a substantial risk). Unfortunately the law was so watered down by the time it was passed, that it didn't change a whole lot.
The Wall Street greedmongers are back to business as usual, earning huge bonuses for trading derivatives and other financial instruments of doubtful value. And the new law did not put sufficient regulations in place to prevent another financial meltdown in the future (especially with the vast wealth and income gap still growing even larger).
Wall Street and the stock markets are booming again for the financial giants and insiders, but the small investor would be well-advised to stay as far away from it as possible. That's my opinion, anyway.
Ted, thanks for the cross post!
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