VIDEO: Derivatives Are Sort Of Like A Pre-Ordered Turkey

The business and financial news are full of something called “derivatives.” But, okay, what is that? You’re not the only one who’s wondering. That’s why Paddy Hirsch from the public radio program Marketplace put together a whiteboard, some stick figures, and a bunch of metaphorical turkeys to explain it all to us.

Derivatives from Marketplace on Vimeo.

Derivatives [Marketplace]

(Photo: Seansie)

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  1. andre060 says:

    Excellent video!! Would love to see more like these on the site.

  2. Powerlurker says:

    He missed the one final step that made the CDS crash as devistating as it was, which is you had large chains of people trading these things so that if one person in the chain defaulted, everyone else would because people down the line were banking on payments from one side paying off losses on the other side of their hedges. Imagine that instead of Jones being another poultry farmer, he is instead a poultry broker. And imagine that instead of actually owning turkeys, he sources his turkeys through other brokers and exchanges in such a manner that the turkeys that he’d be selling ultimately end up coming from Bailey’s farm in the first place, so when the farm goes under, not only can’t Terry get his turkey’s from Mr. Bailey, but he may not be able to get them from Mr. Jones either because Mr. Jones’ traders can’t get the turkeys they promised him, resulting in Mr. Jones losing his shirt because he can’t fulfill his contract with Terry.

    • Trai_Dep says:

      @Powerlurker: Adding to the party, say Mr McDonald (a beef broker) wants to bet that Mr Jones will have a bad year. He gets to place an unlimited bet without providing any collateral, public notification or ability to pay.
      Further, say Mr McDonald has it in for Mr Jones (2 farmers, 1 wife, you do the math). Say he wants to destroy Mr Jones. He and his friends can buy up scores of these bets against Mr Jones (little money down, no collateral, notification or bank balance needed). They then leverage these speculative bets 20 to 1 for close-to-free.
      Then, armed with these bets, they go drinking with a braying financial news network TV host, Mr Cramer. They let slip the “unfortunate fact” that the markets hate Mr Jones, then watch with grim satisfaction as Mr Jones becomes Topic A on that network. With his network happy at the increased ratings, Mr Cramer soon becomes a captive of Mr McDonald and his friends.
      Since they also short-sold Mr Jones’ company’s stock, when the banks financing Mr Jones’ business freeze him out, Mr Jones becomes bankrupt, his chickens are slaughtered, and his wife divorces him. Even though Mr Jones’ fundamentals are unchanged.

      Mr McDonald and his beefy friends make so much money off this, they can then do the same thing across a whole sector, picking off the chicken farmers until everyone’s buying more beef at higher prices.

      Of course, all of this is too complicated to regulate. So let’s trust Mr McDonald and Mr Cramer to do the right thing. Since eventually, we – and Mr Jones – will all work for them anyway, what’s good for them is good for us!

  3. Skipweasel says:

    Much better with calm speech and a whiteboard than with flashy distacting graphics and shouty presenter.

    • Trai_Dep says:

      @Skipweasel: All of the flash and distraction is within the presenter.
      Paddy’s only calm and collected whilst in front of the whiteboard and camera because underneath, he’s wearing a spangled, Union Jack man-thong.

  4. MooseOfReason says:

    Alan Greenspan was on the Daily Show about two years ago, and admitted that because we have a Federal Reserve, we don’t have a free market.
    [www.thedailyshow.com]

    Stewart: “So, we’re not a free market then. There is an invisible–there is a benevolent hand that touches us.”
    Greenspan: “Absolutely, you are quite correct, to the extent that there is a central bank governing the amount of money in the system — that is not a free market, and most people call it regulation.”

    • Trai_Dep says:

      @MooseOfReason: There has never, ever, ever been a Free Market.
      Get over it: the question is never will we regulate markets, it’s how will we regulate them?
      Clearly the “Laissez-Faire” model promoted by Libertarian types was a fiasco of historic proportions costing trillions and benefiting but a handful of swarmy insiders.
      So let’s be sensible and do it right from now on.

  5. RandomHookup says:

    There’s something strangely sexual about that turkey. And, no, I no longer harbor a duck fetish.

  6. Trai_Dep says:

    They need to reform the derivatives system, which perform a vital and needed function. I’d suggest these, although maybe I’m missing some?

    * All derivatives have to be published.
    * Participants need to prove – with a great deal more effort – why their contracts can’t fit a standard format to ease comparisons by the public.
    * No leveraging of derivatives.
    * No third-party derivatives: too speculative, little public good.
    * Escrow accounts for [x] amount of the contracts.
    * Reserves for n[x] of the contracts, based on worse-case scenarios for both parties.
    ** Part of a derivative contact must have an Unwinding Clause stating who will pay what when, in the event that the contract goes crazy. The above n[x] figure has to exceed this worst-case scenario figure.
    * No bundling of derivatives, no tranches, no baroque shufflings.
    * Some Federal authority has to have responsibility and authority to apply the Ban Hammer quickly and completely.

    • Trai_Dep says:

      @Trai_Dep: OK, upon second reading, the above would be a starting point for negotiation. But reserves, worst-case contingencies, no third-party Ks and a public clearinghouse are the ones I’d fight for.

  7. Neurotic1 says:

    I love NPR, especially marketplace. Comes on at 2pm daily on KCRW 89.9 here in Los Angeles.

  8. JimmyJimmington says:

    Not bad, but I’m afraid viewers might get confused when trying to translate this to the real world. Stock options, for instance, act more like bets on stock price movements and the ability leverage a stock purchase.

  9. JennyDreadful says:

    I’m sorry if I sound like a dumbass because I don’t know much about this shit… but from what he’s explained here, especially the first type of derivative sounds a lot to me like the speculative stocks during the depression.
    At it’s very core, you’re speculating that the farmer will have 20 turkeys and paying him in advance for those turkeys. If the farmer doesn’t get the turkeys in time, then he can just go bankrupt and Mr Stickfigure dude is screwed and won’t have enough turkeys for his thanksgiving feast, regardless of paying upfront.

    Also, a somewhat different but related topic: could someone explain to me how this is different than Madoff not actually owning the stocks he was selling? The farmers do not have the turkeys they are selling. They are not just counting the eggs before they hatch, but counting the eggs before they are laid.

    If this is the case, and the majority of trading is happening on projecting how stocks will preform, then we’re pretty screwed, aren’t we?

    • Powerlurker says:

      @JennyDreadful:

      Futures contracts and options are very common and largely innocuous. They’re what are sold in mercantile exchanges around the world and what allowed Southwest Airlines to get such cheap fuel during times of high oil prices. The big problems were in credit default swaps, which are a member of the third type that he mentioned. When you sell a credit default swap, you accept a payment in exchange for paying the seller off in case a “credit event” occurs. Now, this may sound a lot like insurance where, for example, I may have a bond that I think might default, so I pay you money in exchange for your paying me back if my bond does default.

      However, in the case of a credit default swap, I don’t actually need to own the underlying debt instrument. I can also purchase them from anyone who will sell them. Because of this, you end up with situations where a bond may be issued for $1 million, but there may be $20 million in outstanding CDSes in circulation. Imagine if your whole neighborhood were able to take out fire insurance on your house for more than it’s worth and think about how long it would take for it to burn down. Imagine if on top of this, you could also get in on the same scam and maybe forget to turn off your gas oven one day…

      Combine this with heavy leverage and when something bad happens, lots of people owe lots of other people lots of money that no one has.

  10. dmuth says:

    PROTIP for those with older/slower machines (like me) and can’t watch the video without it skipping/stopping: install the Download Helper extension for FireFox.

    Then, download the video and fire up VLC to watch it.

  11. hi says:

    What is Glass-Steagall for 200, Alex.

  12. FrankenPC says:

    Interesting presentation.

    It’s my understanding that the fundamental financial failure wasn’t necessarily tier 1 derivatives, but the insurance taken out ON the derivatives. Thereby creating a second derivative tier that, in itself, could also be traded (a meta-derivative). Or am I confused (most likely)?