Derivatives: Q & A

by Tex Norman⁽⁷⁸⁾

Q: Why is it important to understand derivatives? A: If news and pundit comment on the current economic downturn, this Great Recession, then you have heard the terms derivatives. For many of us, these terms are just words, not all that different from a burp sound. We hear it, we think we know what the sound means, sort of, but if asked to define derivatives or hedging, we would be, well, at a loss for words. We hear the terms, and we know this has something to do with financial matters, probably stock trading or investment banking, but what these terms really mean, well, most of us havent a clue.

Since the economy is flailing away at my life, and yours, and the thing that shoved us off the ledge is called derivatives, then shouldnt we know what everything we can about our attacker? Life as we had known it, has changed, become more fear filled, we are, mostly, more cautious, we think just a little more before we spend, and more often than that, we dont spend because we dont have enough left over after essentials to spend on anything extra. So what are derivatives, and what do that do that hurts our economy, and our daily lives?

Q: What is a derivative?

A: Let me get all Webster on your ass: a derivative is a financial instrument, and this financial instrument is worth money because of the characteristics and the value of the underlier.

It is a little like paper money. Actually, paper money is just printed paper, but we endow this paper with value because it is backed up by the full faith and worth of the United States government, and most Americans, and much of the world, trusts the underlier of our paper money. Like money, derivatives are just stacks of paper and those stacks of paper are called financial instruments. Derivative has value to others because those that trust derivatives also trust that the backers of that stack of paper. If people who once trusted the underliers of derivative paper, stop trusting the underliers, this stack of paper that had value has less value. To some people derivatives have no value, and instead seem to be deals you should run from, deals that are not made of values they are made of debt. If youre a bank and you have invested your money in derivatives, and if the world stops trusting the underliers, then what you have invested in is not a money maker, it is a money vacuum and it is cleaning you out.

Q: What is in this pile of paper we call a derivative?

A: Usually within the derivative, if you looked at the papers one at a time, you would find commodities 1 , bonds 2 , equity 3 , futures 4 , options 5 , currency 6 , commercial & home real estate 7 .

Q: What is it used for?

A: The motivation for creating these derivatives was to spread your risk out over a package of financial products with the hope that if one or two go down in value the other parts of your derivative package will hold or even gain value and that would off-set any losses on one or two products. This is hedging your bets. If you are in finance and you anticipate an adverse movement in the price of some category of assets you can use derivatives as a hedge against the fall in value you fear. In a derivative package as the price moves, loss is made on some products and is made on other products making the profits and the losses cancel each other out. Cash and the derivatives markets are suppose to move together like goose stepping Nazis, but from time to time, they get catastrophically out of step with one another. Adjustments can sometimes bring everything back into step, keeping the beat, but there are other times when no amount of tweaking is going to help.

Q: Isnt our Great Recession caused by High Finance Greed?

A: Sort of. The problems facing the economy in 2009 was caused by Wall street greed, the sub prime loans and derivatives. Our problem is not caused by sub prime loans, and it is not caused by derivatives, it is caused by both. Our problem is caused by derivatives that consisted of too many sub prime loans.

The problem started like this:

First the lenders (a mortgage company or bank) made an offer for a home loan to a sub prime customer. A sub prime customer is some dude or dudette with a poor credit rating (that's why they are called sub-prime). The lenders knew they were going to package these crappy loans as part of derivative packages, so not only did the home buyers have a bad credit rating, but often the lender didnt even check to see how much money they made, they had no clue as to their income and outgo to bills. The lenders didnt care that the loans they were making were risky and there was a good chance that they would default because as soon as the deal is signed, before the ink is dried, the lender has packaged those shaky loans into several classes of Mortgage Backed Securities and sold the loans off to some other financial institution. It is a little like the used car salesman that puts a can of Engine honey into a car so that the tapping and squeaking from a the rough running engine are muted. The fix wont last, but by the time the engine starts making alarming noises and the head cracks, well, that car is someone elses problem.

Bank got into the routine of passing off these risky loans (that never should have been made) to another investor. For awhile this was no problem. Most people were happy because they fooled themselves into believing they could afford to buy houses that the really could not afford to buy, and yet they did. How? Those easy loans remember? Developers were also happy because suddenly they could build and sell more house at a higher profits. For awhile it looked like a win win. HGTV started running shows about house flippers who would buy these Junker-homes, fix them up, and sell them within 30 to 60 days doubling their investment. Money was coming in fast because there were few regulations or safeguards in place, and on the books it looked like everyone was making money. Banks got in trouble only after the defaults for these sub prime loans, these toxic assets started coming in so fast that the income was not keeping up, and now, even reselling these foreclosed on homes was impossible because the inventory of homes on the market was enormous. These crazy practices caused a housing bubble with builders and developers building more and more homes anticipating a roaring demand that turned out to be a whimper of buyers remorse. In late 2006 the defaults begin.

But the banks were making loans and selling derivatives filled with packages of these weak home loans, and the derivatives were being bought and sold and moved, as if we were playing a game of musical chairs and when the music stopped there were too many people holding loans and not enough places to seat them.

The image of a house of cards became the perfect way to describe these toxic loans. Any jiggle in the economy, any shift in the wind and the whole thing collapses. cards, and This is not the whole picture. Derivatives and the sub prime loans are not totally responsible for our current economic woes, but it certainly played its part and played it well.

------------------------

1 commodities: A commodity is something for which there is demand, but which is supplied without qualitative differntiation across a market. It is a product that is the same no matter who produces it, such as petroleum, notebook paper, or milk. In other words, copper is copper. Rice is rice. Stereos, on the other hand, have many levels of quality. And, the better a stereo is, the more it will cost. The price of copper is universal, and fluctuates daily based on global supply and demand.

2 bonds: A debt security in which the authorized issuer of the bond owes the holders a bond (debt) and, depending on the terms of the bond, is issuer of the bond is obliged to pay the holders of the bond interest for a set period of time, and eventually, once the time has run out (the bond matures) the authorized issuer of the bond also repays the holder of the bond his or her principal. A bond is a formal contract to repay borrowed money with interest at fixed intervals. This means that a bond is a loan. Typical authorized bond issuers are cities, states, the nation, and on a smaller scale you may also see church bonds, school bonds, and so on and so forth. Bonds are loan deals. The authorized issuer of the bond is the borrower. The bond holders are in the position typically occupied by the banks, and other lending institutions.

3 equity: a share of ownership in a corporation, known as stock holders and what they hold is stock, tiny little shares of the company that issued the stock. Equity is stock, and stock is tiny little shares of ownership in companies like Apple, AT & T, GM, GE, and so on and so forth. If the company is making money, then the stock holders are making money. If the companies are going bankrupt, then so are the stock holders. Thus the value of equity has its ups and downs, its pros and cons.

4 futures: a futures contract is a standardized contract that is traded on a futures exchange. The purpose of future contracts is to buy or sell a specified commodity of standardized quality at a price (the futures price) which is determined by the tugs and pulling of supply and demand. Futures contracts are typically made up of foreign currencies (both commercial and government bonds), or with " baskets " of corporate equity (stock).

5 options: an option is a contract between a buyer and a seller that gives the buyer the rightbut not the obligationto buy or to sell a particular asset at a later day at an agreed price. The buyer is interested in having this option if he or she believes the asset is going to go up in price and demand in the future. If the buyer believes this upturn in value and price is pretty sure, the buyer will pay a set fee to the seller (a premium) immediately and then, when the time is right, sell that asset and keep the profit.

6 currency: this is buying and selling foreign currencies on the foreign exchange market. It is where banks and other official institutions facilitate the buying and selling of foreign currencies. The purpose of the foreign exchange (FX) market is to facilitate trade and investment. The need for a foreign exchange market arises because of the presence of different international currencies such as US Dollar, Pound Sterling, etc., and the need for trading in such currencies.

7 commercial and private real estate: real property, shopping malls, condos, single family homes.

Article submitted Tuesday, March 31, 2009 & read 2800 times.

Tex Norman is a social worker, currently working at the Oklahoma DHS Abuse and Neglect hotline. He interviews people reporting abuse and/or neglect of children and vulnerable adults and writes a narrative. The narratives (and demographics) are used to initiate investigations of the allegations. He says it is like writing 8 to 10 stories a day. In August 2012, he will have been married to Kathie for 40 years. He has a son Ryan who earned a PhD from Princeton and he is now a scientist doing research in molecular biology. Tex spends his free time working as an artist and writer. He has one art site, and a blog that might be of interest: http://tex-norman.artistwebsites.com/ and http://collagepoetrybytex.blogspot.com/

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