August 26, 2009

Dodd, you and Frank allowed this to happen

What caused the housing and economy to tank. Derivative markets. Fannie and Freddie were among the worst offenders of this practice. Here is a succinct description of what happened provided in an email from my brother -- Otter:

AN EASILY UNDERSTANDABLE EXPLANATION OF DERIVATIVE MARKETS


Manny is the proprietor of a bar in Pittsburgh . He realizes that virtually all of his customers are unemployed alcoholics and, as such, can no longer afford to patronize his bar. To solve this problem, he comes up with new marketing plan that allows his customers to drink now, but pay later.

He keeps track of the drinks consumed on a ledger thereby granting the customer’s loans.

Word gets around about Manny's "drink now, pay later" marketing strategy and, as a result, increasing numbers of customers flood into Manny's bar. Soon he has the largest sales volume for any bar in the Burgh.

By providing his customers' freedom from immediate payment demands, Manny gets no resistance when, at regular intervals, he substantially increases his prices for wine and beer, the most consumed beverages. Consequently, Manny'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 Manny'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 transform these customer loans into DRINKBONDS, ALKIBONDS, and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the 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 are still 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 Manny's bar. He so informs Manny.

Manny then demands payment from his alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Manny cannot fulfill his loan obligations he is forced into bankruptcy. The bar closes and the eleven employees lose their jobs. Overnight, DRINKBONDS, ALKIBONDS, and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Manny's bar had granted him generous payment extensions and had invested their firms' pension funds in the various B ND securities. They find they are now faced with having to write off his bad debt and with losing over 90% of the presumed value of the bonds. His wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, his 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 multi-billion dollar no-strings attached cash infusion from the Government. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers.

Now, do you understand?

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