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Derivatives for Dummies

(Oh, and Journalists)

3rd Edition v3b (May 2018)


Or, How to Loose 5 Trillion Tax Payer Dollars

And Keep It A Secret


How The Fed and QE's May Crush Us All



Available at the ARTShop

(263 colour pages,)


TG2RM1st Front Cover PI and PII.jpg (39857 bytes)

   click to enlarge

If you are an ART client, or own a previous Edition, this is free for you, here.

This monographs targets layman and journalists, to provide a clear down-to-earth explanation of the workings of the derivatives markets.  In addition to trading and industry practices, the purpose and essence of IR Swaps, Mortgage Backed Securities, Credit Default Swaps, Collateral Debt Obligations, etc are explained in simple terms understandable by anyone, and especially if you have ever had a loan or a mortgage.

There is not a single mathematical equation in sight, except for some very simple ones in the Appendix.

The motivation for this document was the considerable nonsense in the main-stream media regarding bankers and derivatives.  In many cases, the rhetoric is not only fallacious, but also manipulation in attempts to promote political ideology, and to deceive the public of the true culprits/causes.

The document provides an account of the financial markets "melt-down" of 2008 with hard data that shows the primary cause of the melt-down was the US Government and its agents (the GSE's Fannie, Freddie, et al).  While bankers have a share of the blame, their contribution is seen as primarily that of "speed" of collapse.  The primary issues is the US Government's 5 Trillion dollar "shadow bail-out" of the GSE's and the effective cover-up of the US Government's culpability in the melt-down due their 9.4 Trillion dollar over-supply of the sub-prime mortgage markets, and the repeal of the Glass-Steagall Act. 

The politicians' trick of "Wall Street bashing", who by early 2010 had paid-back 100% of the value of TARP, cleverly diverts the public's attention away from discovering the 5 Trillion used to "bail-out the Government" by "quietly" printing money (and a lot of it).

For "market professional" level products, see also the TG2 Series

This Edition's Update

The essence of this Edition and updates from earlier Editions are provided in the Preface, which is available as an independent document as one of the Extracts.

This monograph was produced using easily available public domain data so that non-market specialists would be able to verify easily and independently the facts and conclusions herein.  Unfortunately, the US Government is rather uncooperative and "sneaky" regarding the financial data for many of its operations/agents.  Moreover, they "morph" the various departments and agencies, thus creating much discontinuity, and the opportunity to "hide" crucial information. 

As such, the data in the earlier editions of this monograph was restricted to the easily available free data, which implies a very much lower US Government created mortgage market (public sector portion of the mortgage market).  For example, just the three agencies Fannie, Freddie, and Ginnie together are reported by the Federal Reserve to have on the order of 7 Trillion (with a T) of the 14.6 Trillion US retail mortgage market as of 2008.  However, it is well known that other agencies have also created or induced huge mortgage pools, such as the Federal Home Loan Banks, the FHA etc.  Indeed, as noted in the document, activities by the FHA and other GSE's are particularly misleading.  For instance a mortgage issued by a bank to somebody who would not receive a mortgage if it was not for FHA insurance generally shows up in the Government data as a private sector mortgage.  Clearly, such Government induced mortgages correctly belong in the realm of public sector mortgages.

The earlier editions of this document put this "hidden" portion of the public sector mortgage pool at 1 - 2 Trillion, as the data that is easily available to non-specialists was not freely available to confirm these "hidden" numbers.  Thus, the earlier editions quoted "verified" portion at around 7 Trillion, but expect a total of about 9 Trillion.  That is, of the 14.6 Trillion of the total market at the end of 2008, the US Gov accounts for 9 Trillion, or approximately twice the size as the entire rest of the market put together.


SOME PUBLIC DOMAIN INFORMATION:  late 2010 (just after the release of our 2nd Edition), the FHFA (who are the new Government controllers of the GSE's, replacing OFHEO and other previous government controlling entities), released freely available public information that the 14 GSE's that they now control have a total mortgage and debt obligation of 9.4 Trillion.  Crucially, the total retail mortgage market at the end of 2010 is quoted by the Fed at 13.8 Trillion.  Therefore, the government's mortgage and related portfolio is 68% of the total market, leaving the entire private sector with about 32%.  Thus, the US Government's "creation" is indeed more than twice as big as the entire rest of the mortgage market put together.

As in the book, keep in mind that the reality is much worse, since the public sector/government position is more than 60% "crap prime" (i.e. the "special sub prime" created by the government for the so-called NINJA etc loans, and which have a default rate of around 30-35%). By comparison, only about 18% of private sector positions are "sub prime" and those are generally composed of "normal sub prime" (which default at around 8-15%).  Put differently, the total write-off of government created mortgages is around 5 Trillion, while the total write-off in the private sector is around 0.6 - 1.1 Trillion ... i.e. the Government's pool of lost money is about 5 - 8 times the size of the entire private sector put together, and about 40% of US GDP.

Keep in mind that the GSE's have already received as much as 400 Billion in direct cash infusions/bail-outs, plus many Trillions in bail-outs by direct purchase of their MBS's or Fed "trickery" to artificially inflate Fannie et al's holdings and profits (see the book and also its Appendix)

As a matter of interest, reports state that 9 of every 10 outstanding mortgages are now controlled by the Government.


A COUPLE OF CHARTS - and the Real Culprits

There are a number of charts detailing all aspects of the "Crash".  A couple are presented here with abridged explanations, to illustrate, with data, a tiny portion of the real cause and culprits.

The image to the right (click to enlarge) shows the data in the current book, and is referred to as "unadjusted" Fed data, since it is taken directly as published by the Fed.  Notice that this image implies that the Gov's share of the total market is about 50 - 60% around 2009.

US housing prices are included to demonstrate the Gov's mortgage funding expansions creating the "bubble" starting around 2002 - 2003.

However, the Fed uses a "special" kind of reporting in which large portions of the Gov's involvement are buried in the private market data.  For example, the FHFA's annual reports show that the FHLB contributed on the order of 1 Trillion, but in the Fed's data this shows up as private market activity.  Similarly, the "insurance" and other "indirect" efforts by the Gov create mortgages that otherwise would not have existed.  These too show up as private market mortgages and induce on the order of another Trillion or so that needs to be moved from the private sector side in the data to the public sector side,  The image to the right shows this "adjustment**", with US GDP overlaid to illustrate the scale of the Gov's "insanity".

Notice that the Gov's hyper-inflation of the mortgage market (which starts around 1998) continues to increase for almost two years after the mortgage market started to collapse in early 2007 (and also well after the private sector has actually started reducing its mortgage exposure in early 2007).  That represents on the order of 1.5 Trillion in "insane" additional fuelling of the mortgage/sub-prime disaster by just Fannie & Freddie.  Crucially, Congress knew of this in 2007 as can be confirmed by creation of the HERA legislation (to bail-out the GSE's) by Nancy Pelosi ... so why did the Gov allow the GSE's to continue past 2007?  Indeed, Congressional and related documents illustrate that Congress should have closed-out the GSE's already in 2005-2006, but certain Representatives (e.g. Barney Frank)  scuttled every effort to stop-out the GSE's.

So who is the "gorilla" in the room, who is trading in massive uncontrolled risk, and who is the real culprit in creating the sub-prime melt-down?

Incidentally, and as explained in the book, the real problem is/was not the "crash" at the end of 2008, but rather the recession that started in 2007 due the Gov using a colossal credit card to underwrite the us economy at rate averaging around 5% of GDP each year from 1998 - 2008, via the "backdoor" we call the mortgage market.

Any financial reform that only restricts Wall St is nonsense, since the Gov's role is 5 - 8 times the size of the entire private sector.  "Goldman bashing" may be good sound bites, but utterly meaningless when their entire operation is the proverbial "pee in the ocean".  Moreover, if we are to send Wall St types to jail for the collapse, then surely you must give even bigger sentences to the politicians et al.



** Some of the "adjustment" follows from various interpolation/extrapolation of known data, since it is particularly difficult to have the Gov release certain data (e.g. the "indirect" effects in the period 2000-2007).  The data for 2008-2011 is more complete, or can be extracted from additional sources.  To be sure, the "uncertainty" or "sparseness" in the data only applies to the "adjustment" or "difference" between the Fed's and actual results.  In the worse case scenario, the few estimated data point would not be more than 15% off, and again, that is only for a small number of inputs to the charts.


See also

Table of Contents


Subject Index



Available at the ARTShop

(263 colour pages,)


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Last modified: July 25, 2011