US Financial Crisis Explained

Derivatives, Collateralized Debt Obligations and Credit Default Swaps Explained in One Video
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Derivatives Are Easy to Understand

Derivatives were created to help banks, investors and corporations, to manage risk. Derivatives are: Financial arrangements between two groups You buy a derivative so you can buy an investment at a set price in the future. These items can include: Commodities, Corporate Bonds, Currency, Government Debt, Interest Rates, Mortgages, Stocks, etc.

The Cup of Coffee Example

I Forgot my Wallet Can you Buy? Ill Pay for yours Next Time.

COFFEE $1.00

A Future Cup of Coffee was Bought Today for $1

Sure Just Sign this Contract Stating I Get my Coffee No Matter the Price!

Another Example Using Airlines

Oil is $100 a Barrel. I Want to Pay you for the Option to Buy it at $100 in 6 Months Sure Even if it Costs Me $150 a Barrel you Get it For $100. Just Buy this Derivative

Airline

The Bank

There are 2 Types of Derivatives the 1st is an Option

I Bought the Coffee but I Might Not Want it in the Future

Sounds Good

The 2nd Type of Derivative is Called a Future or Swap

I Demand a Coffee in the Future. I Wont Except No! Youve Got my Word. My Word isnt Worth Much in an Unregulated Market Though

Collateralized Debt Obligations Explained

CDO is a pool of assets. To own a mortgage CDO, you pay a fixed amount of money and then collect from the CDO based on the amount received when people make their mortgage payments.

Investor

Simple Collateralized Debt Obligation

Home Owner

The Bank

Bank Sells the Mortgage Contract to an Investor

The Bank

The Investor

Now the Home Owner Pays the Investor Instead of the Bank

Home Owner

The Investor

To Protect Himself the Investor Buys a Credit Default Swap

Stock Broker

The Investor

A Credit Default Swap is Kind of Like Life Insurance

$
Insurance Buyer Insurance Agent Cash Reserves

If Insurance Wasnt Regulated

Sure Ill Pay $100,000 to Your Beneficiary Upon your Death Wink, Wink
$

Insurance Buyer

Insurance Agent

Since I Dont Have Cash to Pay Out Upon a Death I Buy a CDS
I Need to Buy a CDS That Pays Out $100,000 if Mr. Smith Dies

CDS
The Bank Stock Broker

Credit Default Swaps Can Be Sold to Uninterested Parties

We Want a CDS That Pays Out $100,000 if Mr. Smith Dies Sure I Like Money. Pay no Attention to the Fact that I Cant Pay Out When He Dies

CDS
Uninterested Parties Stock Broker

Banks Find it Hard to Sell Low Rated Mortgages

AAA
Credit Rating Agency

So Begins a Vicious Cycle

BBB

The Bank

Credit Rating Agency

AAA

This Situation Quickly Got Out of Hand

The Credit Rating Agency Rates this

AAA
$

CCC

The Bank

The Investor

When the Defaults Occurred Nobody Had Reserves to Cover the CDS
What Do You Mean You Cant Pay us for the Credit Default? We Want Our Money

Foreclosure

The Amount of Money Owed through CDSs Ballooned & Busted

CDS 2007 CDS 2008 Global GDP 2010

70 52.5 35 17.5 0 Total CDS Payout 2007 vs. 2008 and Global GDP 2010

Trillions

The Values of Collateralized Debt Obligations Collapsed

CDO 2007 CDO 2008

200 150

Billions

100 50 0 Total Value of CDOs

Banks Decide to Create CDOs Destined to Fail & Sell Them to their Clients
Yes Mr. Client. This a Good Investment

Bad CDOs

The Bank

Bank Client

Then They Buy Credit Default Swaps on These Bad CDOs

Who Wants to Sell me a Swap on These Bad CDOs I Sold My Client?
We Dont Have the Money to Pay you When the Default Happens but Our Uncle Does

CDS
Bad CDOs The Bank Other Banks

What Has Changed?

Federal Reserve spent $2.74 Trillion buying toxic assets & funding banks Credit Default Swaps are still not regulated Over 75% of all trades are unregulated
$

Nobody has been punished for this When will it happen again?
The Fed The Banks

Massive Fed Spending in Perspective

Trillions of Dollars
40 30 20 10 0 Region 1

Fed Spending:

$2.76

Net Worth 80%: $4.54 Net Worth 19%: $32.67 Net Worth 1%: $27.74

Net Worth of Citizens & Fed Spending