David's Macro Blog

Someone wrote a good summary of credit derivatives.
(Hat tip Eric Overfield for pointing this out)

At last, what we’ve all been waiting for, an understandable explanation of derivative markets.

Heidi is the proprietor of a bar in Detroit. 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 Heidi’s drink now pay later marketing strategy and as a result, increasing numbers of customers flood into Heidi’s brand soon she has the largest sale volume for any bar in Detroit. By providing her customers’ freedom from immediate payment demands, Heidi gets no resistance when she substantially increases her prices for wine and beer, the most consumed beverages. Her sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes these customer debts as valuable future assets and increases Heidi’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, 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 who collect enormous fees on their sales, pay extravagant bonuses to their sales force, and who in turn purchase exotic sports cars and multimillion dollar condominiums.

One day, although the bond prices are still climbing, a risk manager at the bank (subsequently fired due his negativity), decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar.

Heidi demands payment from her alcoholic patrons, but being unemployed they cannot pay back their drinking debts. Therefore, Heidi 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 Heidi’s bar, 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 wine supplier claims bankruptcy, her beer 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.

Finally an explanation I understand.

The following is from Mike Morgan’s blog (12/09/2008). I agree with many of his points.

If you still believe we are at or near the bottom, please consider a few of my Key Points to support the coming Depression:

1 – Housing prices are still falling.

2 – We are nowhere close to resolving the mortgage crisis, and millions of foreclosures are coming. In turn, this means lower housing prices and, in turn, more foreclosures.

3 – Wall Street and the Banking System has still not accepted the consequences of the toxic assets they built, sold, profited from . . . and now they are stuck with. All they have done is covered them up with a thin layer of Magic Dust (taxpayer bailout money).

4 – The housing ATM is closed. And with the closing of the housing ATM, consumers have less money to spend . . . and less money to pay their mortgages with, so there will be more foreclosures.

5 -If you map out the consequences for 1, 2, 3 and 4 you quickly see that less FFM “free-funny money” means less to spend and this means more job losses throughout the system, and this means much more pain to come.

6 – Worldwide we are seeing government responses with nonsensical bailouts and “spending” programs. The sad thing is, the spending programs are not directed at making us better, but just at how we can buy more toys and treats. In fact, governments are repeating the very same mistakes made in the 1930′s. By the way, these are only the big picture issues. I could give you a hundred reasons we are headed to very dark times, but all of it stems from the housing bubble that created the toxic asset crisis, and until we detox, the pain will get worse. This is no different than a drug addict. All we are doing now is feeding the drug addict and making matters worse . . . just like we did in the 1930′s. And just like a drug addict must go through a horrible physical detox, so must the world.

Here’s a blog post by Reggie Middleton (one of my favorite bloggers) on BoomBustBlog:
http://boombustblog.com/20090301853/Banking-out-of-Control.html

It is a bit dense but contains a clear description of the problem of an economy that is based on debt, fractional reserve banking, and fiat currency.

Here are my observations:

• The current financial crisis is NOT a liquidity crisis but a solvency crisis.
• The crisis is built into the system; i.e. it was bound to happen at some point due to escalating debt relative to savings.
• The current political leaders are NOT solving the root problems but bailing out their Wall Street friends and donors.

In summary, the system will collapse due to debt that cannot be repaid.

My hope is for serious monetary reform in the U.S. starting with an END to:

• Debt-based money
• The Federal Reserve
• The bubble economy
• “Financial engineering” (as opposed to real productivity) consuming the “best and brightest” minds

Unfortunately, we have just the opposite system. Until the system changes we are slaves to our monetary masters.

President Abraham Lincoln said it best over 200 years ago:

“The Government should create, issue, and circulate all the currency and credit needed to satisfy the spending power of the Government and the buying power of consumers.”

“The privilege of creating and issuing money is not only the supreme prerogative of Government, but it is the Government’s greatest creative opportunity.”

“By the adoption of these principles, the taxpayers will be saved immense sums of interest. Money will cease to be master and become the servant of humanity.”

I recently read some good comments on one of the blogs I follow, which explained why Wall Street investment banks’ financial systems were doomed to collapse. Unfortunately I do not remember the source’s name. The following is me paraphrasing what I read:

Investment banks used a daily financing method that was doomed to failure at some point. A secured repurchase agreement (repo) occurs when a borrower temporarily sells a security for cash to a lender with an agreement to purchase the security back, often the next day.

Secured repos are crucial for investment banks, which borrow and lend billions to fund their daily business. Think of it this way: Wall Street firms have an inventory of hundreds of billions of dollars of securities that have been built up over the years (in the case of Bear Stearns, it was about $350 billion of assets). Like Macy’s, the firms try to move this inventory as rapidly as possible, hoping to sell it for more than they paid. In the meantime, like Macy’s, they use those assets as collateral to obtain financing to run their business. While Macy’s uses its inventory and receivables to secure a revolving line of credit with a maturity of around four years, Bear and other Wall Street firms finance part of their inventories in the repo market. They sell their securities to investors at one price and agree to buy them back the next day for a slightly higher price. The difference is the investors’ compensation for providing the financing (the repo rate). It is called “overnight repo” and for years it worked mostly without incident.

If Macy’s creditors had the ability to decide every night whether to finance its inventory, they could pull the plug on the company – especially if they felt Macy’s had loaded the stockroom with questionable merchandise. Macy’s would never do such a crazy thing, but this is exactly how Wall Street operates. Bear’s reliance on overnight repo effectively gave the overnight lenders – such as Fidelity and Federated Investors – a vote on the firm’s viability every night. And during that fateful week in mid-March, those overnight lenders voted a collective no. The result? Bear Stearns did not have enough cash on hand to meet customers’ demands during the run on the bank.

Once overnight lenders lost faith in a firm’s collateral, the firm would have no cash available to run their business. Thus their collapse was inevitable.