Friday, May 24, 2013

2008 Meltdown Cause: Derivatives — Here We Go Again

Banks Made the Mess and Now They Get Their Way With New Policy ??? WTF...

A look back to the 2008 mess from here (*update follows) - highlights:

Introduction and Simple Definition for derivatives (more at this site: There are a financial instrument used in hedging (the topic of update that follows). Derivatives are basically contracts or agreements between two parties to buy or sell a certain asset. The certain asset can be decided to be bought and/or sold in the future with pre-determined specifications.

This update (May 25, 2013) starts with this headlines: "How Did Major Hedge Fund Earn 30% Returns for 20 Years Straight? Lots of Cheating"  — the sub-heading is: There are 8,000 hedge funds, and they are up to their eyeballs in unethical behavior.

Heart of this story: How would you like to invest $10,000 and watch it grow over 20 years into $1,461,920? Well that's what happened at the giant hedge fund, SAC Capital Advisers, which made a 30% return for 20 years in a row. How is it possible to make such profitable investments again and again and again? The U.S. Attorney for Manhattan, Preet Bharara, believes he has the answer: SAC is cheating ... again and again and again. In fact, Bharara suggests that hedge funds that engage in insider trading may be rotten to the core (more at the link).
Original Post Starts Now: Derivatives are complicated financial products that derive their value by reference to an underlying asset or index. A good example of a derivative is a mortgage-backed security. Here's how it works (try not to fall asleep):

•  A bank makes an interest-only loan to a homeowner.

•  The bank then sells the mortgage to Fannie Mae. This gives the bank more funds to make new loans.

•  Fannie Mae resells the mortgage in a package of other interest-only mortgages on the secondary market. This is a mortgage-backed security (MBS), which has a value that is derived by value of the mortgages in the bundle.

•  Often the MBS is bought by a hedge fund, which then slices out portion of the MBS, let's say the second and third years of the interest-only loans, which is riskier since it is farther out, but also provides a higher interest payment. It uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.

•  All goes well until housing prices decline or interest rates reset and the mortgages start to default.

It went down hill from there. Now here we are again in 2013 and the banks seen to have gotten their way with Congress on a new law that, now wait, helps them do it all over again.  A good rundown here (about 7 minutes) from MSNBC and guest who knows this stuff. Enjoy. Then contact your member of the House thank them for standing up for, now wait again, the banks.

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