Understanding the Bailout

sponger

n2integrity wrote:

My question is why would investors purchase derivatives? If they are high risk loans bundled up in a bunch - what is the attraction for an investor? I can understand the banks figuring out a way to sell off their risk - but who would want to buy them? What was the payout to them?

I'm trying to put this in a way so not to sound elitist, but derivatives are by nature extremely "complicated."

I remember my derivatives professor in college telling the class one day, "No one has really truly figured out derivatives yet."

Think of derivatives as being like the physical embodiment of the controlled chaos that is the stock market.

At any rate, high risk is not without the occasional high return.

If you would like an idea of the nature of the derivatives that were used, here's wikipedia to the rescue.

OutOfBreath

Thank you, sponger. This was really informative, and increased also my understanding of the situation.

Peace
Dan

sponger

OutOfBreath wrote:

Thank you, sponger. This was really informative, and increased also my understanding of the situation.

Peace
Dan

Again...I'm feeling the love here.

Also, I want to take a moment to note that I have noticed in the past several days other members providing excellent "low-downs" on the events at hand. Namely JOEJOEJOE comes to mind, but that is not to exclude others.

I think the difference is that this thread provided an opportunity to lay down a somewhat definitive account, but not one that should be regarded as authoritative by any means.

screamingPJ

sponger wrote:

Well, the thing to keep in mind is that in the last, say, 4-5 years, housing values literally increased 200%-300%. That is, a house that once sold for $250,000 in 2002 would've sold for $625,000 in 2005-2006.

A natural rate of inflation would be 3%-5% at the most. Instead, we saw rates of inflation hovering at 30%-40% each year.

I find this aspect interesting...that people are selling their houses for much less than what they paid for them. I don't think the market has bottomed out because, as you said, there were 30-40% increases each year, but people aren't marking down their houses that much. I recently talked with my real estate broker who wanted to show me a house - and I told her that I already knew what the person bought it for in 2005, and they think they are still going to make a profit on that inflated price now...no way. It wasn't worth the asking price when the bought it, and it certainly isn't worth that same amount now. Simply because someone paid $500k for a house doesn't mean that it's actually worth that much - that was just how much it was worth to THEM.

NMyTree

Nice job, sponger.

Thanks for taking the time to explain this situation, in terms I could understand:D

You and Drifting have been very helpful and informative.

NMyTree

Sponger and Drifting,

So is it true that this $700 Billion Bail Out Bill contains/contained stipulations that would give Treasury Secretary Henry Paulson full and complete control of the $700 Billion, as well as complete immunity from legal and criminal charges/ramifications for his utilization of the $700 billion and whatever deals/transactions he makes?

Seems like there's a few people claiming this and I'm seeking clarification and confirmation.

polaris

i would just like to say as a "socialist" that i am offended at the use of the word to describe the actions of the gov't ...

no modern day socialist gov't would allow this to happen ...

thank you and have a nice day

NMyTree

polaris wrote:

i would just like to say as a "socialist" that i am offended at the use of the word to describe the actions of the gov't ...

no modern day socialist gov't would allow this to happen ...

thank you and have a nice day

That's because America is closer to Facism, than it could ever be to 'Socialism".

DriftingByTheStorm

NMyTree wrote:

Sponger and Drifting,

So is it true that this $700 Billion Bail Out Bill contains/contained stipulations that would give Treasury Secretary Henry Paulson full and complete control of the $700 Billion, as well as complete immunity from legal and criminal charges/ramifications for his utilization of the $700 billion and whatever deals/transactions he makes?

Seems like there's a few people claiming this and I'm seeking clarification and confirmation.

I believe that is one of the first stipulations that got thrown out the window.
Thankfully Congress is seemingly the last functioning vestige of our constitutional government, and they actually answer to the will of their constituency.

I have not read the bill (that has now failed), but from everything i was hearing, this provision was removed, along with several other tax payer unfriendly clauses.

My biggest problem with a bailout is not the provisions of it, it is the fundamental concept.

Lesbelges

n2integrity wrote:

Sponger - thanks for putting it in layman's terms. It all gets so confusing trying to figure out.

My question is why would investors purchase derivatives? If they are high risk loans bundled up in a bunch - what is the attraction for an investor? I can understand the banks figuring out a way to sell off their risk - but who would want to buy them? What was the payout to them?

I may be completely off-base in what I'm about to say, so Sponger or other knowledgeable people correct me if I am wrong.

To me the reasons these derivatives had appeal was due to the spreading of risk. Lending to someone who will have a hard time repaying will require a high interest rate to cover the risk. However, if you take 1,000 such loans, you figure that some people will be able to pay the loan back, and some won't therefore making it less risky than the single loan and in turn requiring a lower interest premium. Apparently, investors thought that this risk spreading was so efficient that these derivatives were at a bargain price.

Investors had not valued in the risk of a housing market bubble burst. Now that this has occured, the values of these derivatives have to be written down which is how all these banks are losing value.

NMyTree

Thank you, Drifting.

n2integrity

Lesbelges wrote:

I may be completely off-base in what I'm about to say, so Sponger or other knowledgeable people correct me if I am wrong.

To me the reasons these derivatives had appeal was due to the spreading of risk. Lending to someone who will have a hard time repaying will require a high interest rate to cover the risk. However, if you take 1,000 such loans, you figure that some people will be able to pay the loan back, and some won't therefore making it less risky than the single loan and in turn requiring a lower interest premium. Apparently, investors thought that this risk spreading was so efficient that these derivatives were at a bargain price.

Investors had not valued in the risk of a housing market bubble burst. Now that this has occured, the values of these derivatives have to be written down which is how all these banks are losing value.

Thanks sponger, drifting and lesbelges for answering my question. I don't feel bad for not completely understanding it now if a derivative professor has trouble doing it, but I do have a clearer understanding.

Note to self: make sure any investments in the future don't include derivatives.

What a mess we are in.

DriftingByTheStorm

n2integrity wrote:

Thanks sponger, drifting and lesbelges for answering my question. I don't feel bad for not completely understanding it now if a derivative professor has trouble doing it, but I do have a clearer understanding.

Note to self: make sure any investments in the future don't include derivatives.

What a mess we are in.

Note to n2integrity:
just to clarify, derivatives is somewhat of a generic term.
What sponger meant when he said, these loans were packaged into something called "derivatives" was probably to say "derivative mortgage backed securities", which itself is a general category of investments.

Further,
derivatives CAN be a GOOD thing.
"Futures" and "Options" are both common derivatives, and along with mortgage derivatives even, are very often used by institutions to HEDGE their portfolios.

In other words, if i am betting the market will go up, and have large sums of money on that bet, i would find comfort in having an OPTION placed AGAINST the direction of my major trade (in this case, down), so that if the market does ruin the equity in my main position, i have the OPTION -- which i only paid a fractional price for -- of claiming a gain in the counter-move.

Any how,
i just wanted to illustrate that, less we muddy the water and have lots of folks on here now thinking that derivatives in general are the devil. Certainly they are "misused" quite a bit for rampant speculative profit (and losses!), but they have a valuable purpose as well.

vduboise

DriftingByTheStorm wrote:

Note to n2integrity:
just to clarify, derivatives is somewhat of a generic term.
What sponger meant when he said, these loans were packaged into something called "derivatives" was probably to say "derivative mortgage backed securities", which itself is a general category of investments.

Further,
derivatives CAN be a GOOD thing.
"Futures" and "Options" are both common derivatives, and along with mortgage derivatives even, are very often used by institutions to HEDGE their portfolios.

In other words, if i am betting the market will go up, and have large sums of money on that bet, i would find comfort in having an OPTION placed AGAINST the direction of my major trade (in this case, down), so that if the market does ruin the equity in my main position, i have the OPTION -- which i only paid a fractional price for -- of claiming a gain in the counter-move.

Any how,
i just wanted to illustrate that, less we muddy the water and have lots of folks on here now thinking that derivatives in general are the devil. Certainly they are "misused" quite a bit for rampant speculative profit (and losses!), but they have a valuable purpose as well.

Wow! Thanks drifting, sponger and all- this has been very informative and also to OP for posting the question. I was trying to make sense of it myself- and this helped a lot.

So Thanks

sponger

Yes, mortgage backed securities are in a family of investment instruments known as derivatives.

The word derivative basically implies that an investment is being derived from another investment.

Also, I think Lesbelges offered up an excellent analysis as to why investors so carelessly gobbled up those securities in spite of the inherent risks.

But also worth mentioning is that there was a mistaken belief among many investors that mortgage backed securities purchased from Fannie Mae or Freddie Mac were guaranteed by the government.

Freddie Mac and Fannie Mae used to be actual government programs that at one time were in fact guaranteed by the government. However, they became independent corporations at some point, and for some reason their reputation of being associated with the government still stuck.

So, many investors purchased these risky security instruments from Fannie Mae and Freddie Mac while thinking that they couldn't lose.

But, Fannie Mae and Freddie Mac are, in fact, not guaranteed by the government, and in early September the government took control of both entities as it became evident that insolvency was on the horizon -meaning that they were imploding just like every other bank out there. It's still unknown as to whether or not the government will end up guaranteeing those loans after all.

But, like lesbelges was saying, no one foresaw the coming implosion.

ryan198

DriftingByTheStorm wrote:

Note to n2integrity:
just to clarify, derivatives is somewhat of a generic term.
What sponger meant when he said, these loans were packaged into something called "derivatives" was probably to say "derivative mortgage backed securities", which itself is a general category of investments.

Further,
derivatives CAN be a GOOD thing.
"Futures" and "Options" are both common derivatives, and along with mortgage derivatives even, are very often used by institutions to HEDGE their portfolios.

In other words, if i am betting the market will go up, and have large sums of money on that bet, i would find comfort in having an OPTION placed AGAINST the direction of my major trade (in this case, down), so that if the market does ruin the equity in my main position, i have the OPTION -- which i only paid a fractional price for -- of claiming a gain in the counter-move.

Any how,
i just wanted to illustrate that, less we muddy the water and have lots of folks on here now thinking that derivatives in general are the devil. Certainly they are "misused" quite a bit for rampant speculative profit (and losses!), but they have a valuable purpose as well.

so, in the end, isn't this essentially rich people gambling and losing then asking us to help them out? i know that some of the middle class is getting caught up in this, but, in all reality don't we need to let this crash hit? is fixing it with a "bailout", similar to the gov's response to standard and loans scandal of the 80s (which included all of the Bush's, even one's you didn't know existed, and McCain), going to cause a large amount of inflation, essentially destroying the value of the already plummeting dollar?

just wondering what our 'experts' are thinking on this.

ryan198

sponger wrote:

Yes, mortgage backed securities are in a family of investment instruments known as derivatives.
But, like lesbelges was saying, no one foresaw the coming implosion.

wasn't it more like if you saw the coming implosion and talked about the evils of the free market, and speculative gambling...err investing, then you were referred to as a commy, red, unamerican bastard, who didn't understand the greatness of free market corporate capitalism? I mean people have been writing about this shit for years, Henry Giroux, Lawrence Grossberg, David Harvey, Peter McLaren, and so on, and they've been ridiculed for it.

sponger

ryan198 wrote:

wasn't it more like if you saw the coming implosion and talked about the evils of the free market, and speculative gambling...err investing, then you were referred to as a commy, red, unamerican bastard, who didn't understand the greatness of free market corporate capitalism? I mean people have been writing about this shit for years, Henry Giroux, Lawrence Grossberg, David Harvey, Peter McLaren, and so on, and they've been ridiculed for it.

I wouldn't call that seeing the coming implosion. I'd call that writing off capitalism in general as being too volatile for a harmonious society.

You could use instances like the current crisis as an argument against capitalism, but that is not how I personally feel about it.

No matter what style of government or society you choose, there are always going to be problems with the individual people who make decisions that affect other people.

This crisis was not unforeseen by everybody. There were politicians like Ron Paul and underpaid financial workers like yours truly who knew something was terribly wrong with the way the housing market was structured.

In fact, when I was flying home from a business trip last winter, I was sitting next to a guy who was in charge of all California sales for the pharmaceutical company he worked for.

We both had the same exact views about where the economy was going. I said, "Right now interest rates.." and he goes, "too low."

But no one listened. This is because everybody was profiting and buying ferraris with all the excess. Seriously...I think the number of ferraris, lambos, and porches in Orange County went up significantly soon after the boom.

Things might look bleak now, but I like to think that we can walk away from this as a lesson learned.

That is to say that capitalism isn't perfect. That's because nothing in life is perfect. But, just as with all things, we can roll with the punches and try to make things better as we go along.

ryan198

sponger wrote:

I wouldn't call that seeing the coming implosion. I'd call that writing off capitalism in general as being too volatile for a harmonious society.

You could use instances like the current crisis as an argument against capitalism, but that is not how I personally feel about it.

No matter what style of government or society you choose, there are always going to be problems with the individual people who make decisions that affect other people.

This crisis was not unforeseen by everybody. There were politicians like Ron Paul and underpaid financial workers like yours truly who knew something was terribly wrong with the way the housing market was structured.

In fact, when I was flying home from a business trip last winter, I was sitting next to a guy who was in charge of all California sales for the pharmaceutical company he worked for.

We both had the same exact views about where the economy was going. I said, "Right now interest rates.." and he goes, "too low."

But no one listened. This is because everybody was profiting and buying ferraris with all the excess. Seriously...I think the number of ferraris, lambos, and porches in Orange County went up significantly soon after the boom.

Things might look bleak now, but I like to think that we can walk away from this as a lesson learned.

That is to say that capitalism isn't perfect. That's because nothing in life is perfect. But, just as with all things, we can roll with the punches and try to make things better as we go along.

i wasn't being smart when i wrote 'experts', and just realized that it may have come across like that. i was actually wondering if those things in the first were actually going to happen? then i was kind of being smart by posting the part that this wasn't a surprise, b/c (edit) they are professors in the "ivory tower" with 'little to no connection with reality'...kind of funny now isn't it?

i teach a lecture called 'capitalism has never worked' and it goes along the lines of what you are saying. no system is ever perfect, and capitalism is part of it (in fact free market capitalism has failed in every case but the united states), but there are better forms of capitalism that can be used. we just aren't doing that, in my opinion, by bailing banks out. BUT i was legitimately wondering if i was wrong with my statements in the first post.

sponger

ryan198 wrote:

i wasn't being smart when i wrote 'experts', and just realized that it may have come across like that. i was actually wondering if those things in the first were actually going to happen? then i was kind of being smart by posting the part that this wasn't a surprise, b/c (edit) they are professors in the "ivory tower" with 'little to no connection with reality'...kind of funny now isn't it?

i teach a lecture called 'capitalism has never worked' and it goes along the lines of what you are saying. no system is ever perfect, and capitalism is part of it (in fact free market capitalism has failed in every case but the united states), but there are better forms of capitalism that can be used. we just aren't doing that, in my opinion, by bailing banks out. BUT i was legitimately wondering if i was wrong with my statements in the first post.

I was not offended. In fact, I'm sort of scratching my head somewhat.

I agree that the bailout plan went against the principles of capitalism as we know it. In fact, I remember reading that just before the house voted, a republican spoke to the house and said something like, "Vote what you know in your heart is right if you believe in capitalism - in small government."