I have to preface this by admitting that I don't have intimate knowledge of the derivatives market, but I believe this little allegory is probably pretty accurate:

Derivative Market for dummies - Off the Cuff

That seems pretty clear cut to me. There was huge risk that had to be known to people that extended credit initially.....and then that risk was bundled and sold and resold....at each level, there was probably a decreased awareness of the risk. After the catastrophe, given the nature of the game, it's easy to diffuse the blame...



1) So who is most irresponsible in this scenario (back to the quoted analogy)?


A) Heidi's Customers - They wanted a drink and they were happy to get one even though they knew that they had no means to pay for it

B) Heidi - She certainly had to be conscious of the risk

C) Heidi's Direct Creditor (local bank) - The bank extended credit to her apparently either without doing a good determination of creditworthiness or in spite of knowing the risk. Did they do their homework?

D) The Bank's Creditor (Corporate Investment Bank) - They bundled the expected future returns into derivatives and sold them.



2) If we would want to prevent this kind of scenario from happening, at which level would it make sense to regulate the risk taking?

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The world could use more Stan Ovshinsky's

Every person in this scenerio is responsible. They each played their part.



No reason to. If you let them all crash and burn when the time comes, in the future they will ALL be less likely to be so risky. If the government comes along and bails them all out, none of them learn anything from the experience.

yea, thats about the size of it...

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"The captain has turned off the `No Dubbing' sign. You are free to speak any language you choose."

You would assign the exact same level of responsibility to each?





But if you let the people responsible for the risk taking crash and burn after letting the whole thing get out of hand, there will be collateral damage whether or not the investment bank gets a bailout.

In other words, responsible people will pay for the irresponsible ones whether it's through taxes (bailout) or it's through losing value of personal holdings (macroeconomic consequences - 401K, Home Value, Currency Value).

Wouldn't it be in the interests of responsible people to get involved...rather than taking a hands-off approach and letting the cycle repeat?

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The world could use more Stan Ovshinsky's

Pretty much!


Through taxes--- people who weren't involved in this scenario at all will be on the hook. That is BS.

as far as marcoeconomic concequences--- I would rather be hit once and let the losers that do this fail and let stronger and more ethical ones take their place than to allow those that did this give the government more control over the private market. If this effected your 401k, maybe those invested should pay a bit more attention to what they are investing in. If you invest in something this risky because you are getting a good return, well then.... you will be in the same boat they are.


If the irresponsible fail and are shown that this isn't a good strategy to use, then in the future people will be less likely to make those types of deals.

As far as the cycle repeating, our government is already talking about making even MORE risky loans to people who have no business getting loans for homes. This is what started all this to begin with. So, obviously, bailing them out didn't teach them a God damn thing.

I'm not pro-bailout. I too would have rather accepted the fallout from the credit markets and banks collapsing.

In regard to personal losses of responsible people, I don't care how wise or conservative an investor you are, to not take some hit through this recession would require quite a bit of magic. Even if you came out ahead somehow, your dollars are worth less, your house is worth less, etc.


Nor would letting them fail by itself. We have strict punishment for burglary, for example.....and yet people still break into houses and steal things. It makes sense not only to maintain the threat of punishment, but also to try to take preventative measures......police patrol, alarm systems, lighting, neighborhood watch..etc.

It's a false dilemma to propose that the only choices are to bailout or to let them fail.

As it relates to these financial markets, a third option is to put preventative measures in place.

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The world could use more Stan Ovshinsky's

How about the real story behind derivatives.
A guy named Lewis Ranieri is put in charge of the mortgage division of Salomon Brothers, he apologizes to his bosses and asks for their forgiveness but he doesn't know what he's done wrong. They tell him it's not a punishment, they expect him to do great things.
Mortgages suck if you have to sell the bonds. If interest rates go up, the mortgage bond loses value and your customer loses money, if interest rates go down, the mortgagees refinance, and the customer gets his money back.
Try selling an instrument where there is a possibility of a big loss, a possibility to get your money back, or a stream of income at a fairly low rate of return.
To sell stuff, you need a way for the customer to win big.
So Ranieri turns his mortgage bonds into derivatives. An interest only tranche (IO) and a principal only tranche (PO).
You know when you pay your mortgage, the payment is broken down between interest and principal.
Well if you buy the principal only tranche, you get the principal portion of the payments, if interest rates go down, and everyone refinances you get the full face value of the mortgages.
If interest rates go up and you bought the Interest only you get the interest payments for the full 30 years.
Now in a perfect world, a million dollars worth of mortgage bonds would be split up to make a million dollars worth of IOs and POs, but because there is the possibility of winning big, both tranches sell at a premium, an you get 1,050,000 for a million dollars worth of mortgage bonds.
$50,000 profit for handling a million dollars worth of bonds for less than a day, and they handled hundreds of millions of dollars worth of mortgage bonds a day, by the end of the year the mortgage department at Salomon was not only making more money than all the rest of Salomon, they were making more money than all the other firms on Wall St combined.
Profits went down a bit as other firms got into the party, but the slicing and dicing of financial instruments into new products that people didn't quite understand made Wall ST profits soar.
And all you needed to make this money machine work, was the raw material, a new mortgage.
By 2005, the demand for new mortgages skyrocketed, and Wall St paid a big premium to get a hold of this precious raw material, and they really didn't care about the quality because they were only exposed for less than a day.
And this created all kinds of deals to get homeowners to refinance, because the supply of new mortgages from new homeowners was just to small to meet the demand, and it is that demand and the huge profits that were being made from it that forced the creation of a large number of bad mortgages from the end of 2004 to the beginning of 2006.

This idea of creating new financial instruments produced things like Credit Default Swaps, which were unregulated and not really understood. Huge risks were taken, huge profits made, prompting bigger risks.
Hedge fund managers needed to make 40 or 50% return to be competitive, so they were all forced into making huge risky bets.
But the whole system was based on portfolio theory, that if you were diversified, even if something went bad, you had all the rest of your portfolio that would still be good, the idea that the entire world or even a large portion of the world would go bad at the same time wasn't considered. If GM shit the bed, you still had your Ford and Chrysler, all three wouldn't go bad at the same time, and if the Auto stocks all did underperform, you still your tech stocks, your internet stocks, etc.

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“ The subjects of every state ought to contribute towards the support of the government, as nearly as possible, in proportion to their respective abilities; that is, in proportion to the revenue which they respectively enjoy under the protection of the state.”

Adam Smith , The Wealth of Nations 1776

"We have always known that heedless self-interest was bad morals; we know now that it is bad economics"
FDR's second Inaugural Address

1) So "D"?

2) Would you suggest any intervention at that level?

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The world could use more Stan Ovshinsky's

Other than reaffirming the fact that you hate all things capitalist, do you have a point?

Well, if you have a deeper understanding of derivatives (as they applied to the mortgage crisis) than I have presented, or if you feel that the allegory/analogy is off base, please indulge us.

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The world could use more Stan Ovshinsky's

Of course, risk was assessed by the market. Their risk model was that as derivatives did better in the market, the risk declined. While the model was insane and only leveraged up the very market it was supposed to assess, it was industry standard. S&P's model didn't even allow for the real estate going down yoy.

Goldman Sachs hedged heavily against the model, but still would have eaten a lot of losses if AIG hadn't been bailed out.

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Giving money and power to government is like giving whiskey and car keys to teenage boys. ---P. J. O'Rourke

No, not really except that, all the ballyhoo over what mechanism was created and how we hit the shitter, really forgoes the finer point; since the CRA was created; this was preordained.

The gov. told the banks hence wall st. you’ll give out loans to folks whom cannot afford it or else. (They even commissioned a study that was so far off base it was pathetic, it alleged that race was the primary factor in loans not being prvioced to what became sub prime markets. From there, it was all down hill).

Anyway, they said oh fuck no, you are not going to hang us out to dry for a 7% increase in home ownership to make yourselves look good, so they fought back. They found a way to lay it back on them, which yes means us, but then again we were on the hook from the beginning anyway ( why do you think F&F wound up being the mismanaged and bankrupt inst. It has become? Answer; because there was in the end NO way to make the numbers work). And when I see we I mean anyone who pays net taxes, we were gonna get screwed the day Carter signed that act, one way, or another.

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"The captain has turned off the `No Dubbing' sign. You are free to speak any language you choose."

Sadly, Congress still hasn't wised up. As outfits like Goldman pay back TARP Congress is using the money as it's repaid to shore up bad debt, mandating renegotiations, bailing out GM and Chrysler, etc. TARP is becoming the latest greatest welfare program. 700 billion, essentially off budget with Barney Frank and friends in charge.

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Giving money and power to government is like giving whiskey and car keys to teenage boys. ---P. J. O'Rourke

Yet another item supporting my contention that math in general, and economics in particular, are way too complex for a very large number of liberals to be able to comprehend.

Absolutely, we are supposed to be buying up toxic assets to clear out the trash with TARP money, not staking equity positions in firms……its all bullshit. The Goldman Sachs crew...man in 20 years theres gonna be some book to write.

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"The captain has turned off the `No Dubbing' sign. You are free to speak any language you choose."