What the Heck is a Derivative?

April - 28 - 2010 Author: Samantha Davis Respond

Despite all the news these days on derivatives, most people don’t know much about them. It could be that they are called a “complex” investment product by the media. The average person knows a derivative is somehow associated with the stock market and investments, but not much more. We will unravel the mystery.

After the dot.com bubble burst in March 2000, investors were scrambling for a new place to put their money. The mini-recession which happened around 2000 (or so it seems as compared today’s problems) was only worsened by 9/11. Interest rates were lowered to historical figures, but the economy was slow to take off. So Wall Street decided to promote another kind of investment vehicle in order to have a salable product. The product was the derivative.

In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, banks “originate” loans, “warehouse” them on their balance sheets for a brief time, then “distribute” them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don’t need to tie up as much capital, so they can put more money out on loan to consumers.

Let’s examine how your mortgage might be packaged up and used in a derivative.

The bank makes a loan to you for the purchase or refinance of your home. This would be the original mortgage loan.
The bank packages up your loan along with other mortgages and uses them for securities to borrow more money
Banks would in turn lend out the money they just borrowed in the form of new mortgages.
Banks would package the new mortgages into more securities to borrow even more money.
Rinse and repeat.

CDOs (derivatives) were often referred to as “triple-borrowed funds”, but this is a nickname – the funds loaned out could be leveraged as much as 20-1.

Credit-ratings agencies, relying on assumption-based mathematical models (and not real data), suggested that underlying mortgages on which the securities were derived would rarely default, therefore the securities were rated as “Triple A”. No one took a look at WHY these securities were “Triple A Rated”. No one questioned the amazing assumptions behind the “sophisticated” math models = such as housing prices would not decline and borrowers would not default. These assumptions are obviously crazy and irrational – not just in hindsight.

Before the crisis, such “triple-borrowed assets” (securities) were increasingly used as collateral for commercial paper – the short-term borrowings of banks and corporations – who thought they were being purchased by the equivalent of low-risk moneymarket funds.

Satyajit Das, one of the world’s derivative authorities, predicted the magnitude of the current derivative bust in 2007. According to Das’ figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market was asset-backed (derivative-backed) in 2007, with about 50% of that in mortgages. This staggering statistic is what led to the house-of-cards like failure in the credit markets and bank failures in 2008.

“Defaulting middle-class U.S. homeowners are blamed, but they were merely a pawn in the game,” he says. “Those easy to get mortgage loans were invented so that hedge funds would have high-yield debt to buy.” The more loans that were sold, the more they could use as collateral for more loans. Credit standards were lowered to get more paper out the door.

Part of the fighting going on in Congress right now is whether or not derivatives should have a cash backup fund to support them should they fail again, instead of being backed by nothing but crazy assumptions. Well, duh.

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