Reply #2: Bailouts can't, won't and shouldn't save the derivatives trade

[Warpy]

The quickie explanation for a derivative is this: Joe Sixpack buys a remote shack with a 30 year fixed mortgage. A hedge fund manager looked at all the financial disclosure numbers on that loan and realized that over a period of 30 years, Joe was going to pay 300% of that loan. That $30,000 shack he bought was going to cost him $90,000 when all the interest was added up, in other words.

The hedge fund guy thought the mortgage was a great moneymaker, so he grabbed it before it got offered to Fannie Mae or Freddie Mac and cut it into 3 pieces he said were worth $30,000 apiece and offered the piece of paper representing a piece of Joe's mortgage along with a lot of other mortgages to banks, pension funds, and other institutions for the bargain price of $20,000. The hedge fund made $60,000 immediately and the institutions held a piece of paper that would give them a 33% return spread over 30 years, ordinarily a great return.

This is the most basic derivative, something sold on the basis of its future return, not its present worth.

Fast forward to California, 2008. Joe finds out the $30,000 shack he bought way up in the hills for a vacation house is now worth only $20,000. Since he bought at the top of the market, he's out $10,000 up front, plus all the interest he's still got to pay on that loan. Since he's working two jobs now and vacations are spent catching up on home chores he can't ordinarily do, he no longer needs a vacation home 200 miles from the nearest town and at the end of a 20 mile logging road, so he mails the keys to the bank.

Everybody who bought a derivative based on the repayment of his and thousand of other loans are now left holding the bag. The derivative is now worthless because nobody else is going to be dumb enough to buy that falling down shack.

This is basically where the astonishing wealth of the plutocrat came from.