Derivatives: The Devil Is In The Details

Two years ago,  a relative handful of economists and bankers understood what a financial derivative was. At that time, the rest of the public might have had a vague understanding based on their high school calculus class, and understanding that would have been wrong. Today, two years later, most of the public has heard the term “derivative”, and the majority still don’t know what it means. To listen to the news, one might think that a derivative is a gift from Satan; our modern world’s version of the apple from the tree of knowledge.

As much of the language in the soon to be signed financial reform bill is directed at derivatives, I think it is time for the public to learn the nature of the fruit. In our great financial conflagration, derivatives weren’t the the campfire or the careless campers; some of them were, in fact, the hot and dry wind that whipped up the blaze into the forest fire. Federal financial policy, as executed by three Republican presidents, one Democratic president, and two chairman of the Federal Reserve Board set the board up. Our consumer appetite, helped along by opportunistic realtors and mortgage lenders, put the board in motion. Some classes of derivatives served to take the crisis from economic catastrophe to potential worldwide economic failure.

So what is a derivative? Simply put, a derivative is a financial instrument (product) based on another, “underlying” asset. Most of the public has heard of derivatives, albeit in typically negative terms. When a CEO is paid in stock options and lays off a boatload of employees, it becomes easy to report that stock options are the bad guys. When a company’s stock falls dramatically because it is being “shorted”, the reporting of short-selling of stock has similar negative connotations. When a major firm like AIG writes several trillion dollars worth of credit swaps on less than several trillion in underlying assets, the negative aspects are again, easy to report. So why have them at all? Is it just an instrument created by the greedy, for the greedy? Shouldn’t these things have been outlawed outright, or strictly regulated in the new law?

The Rational Middle will say no. The finance law is not as strong as it should be in many areas, and is overly burdensome in others. But it is the result of legislative give and take; a result, by the way, that will limit some of the systemic risk in our system, while adding some consumer protections. Much like health care reform and the stimulus before it, financial reform represents steps taking the right direction, and done so against and despite heavy and intractable opposition. There is room in this law to deal with some of the problems with derivatives, but I believe it is important to keep some flexibility for some of these instruments. Much will depend upon the rules written by the President’s team. (Remember, laws are not enforced directly from the document, but rather through the rules written pursuant to the law by executive agencies. Such is the prescription of the Founders in our Constitution.)

To explain flexibility, lets look at derivatives in the housing market first. It was the more exotic derivatives at the end of this chain that served as the primer cord to the financial bomb. Most of us understand the idea of diversity in our financial environment. We know that we don’t want all of our eggs in one basket. Thirty years ago, however, community banks had all of their eggs in the same basket. Honest banks make their living investing your deposits; when they earn more off of your deposits than they pay you, they can pay their bills and salt away some profit. The problem for banks was that their investments were always the same; thirty year mortgages in the communities they served. It is easy to see problems with this scenario; sudden changes in market interest rates or a sudden collapse in the housing market could destroy  good banks in a hurry.

The secondary market, established by the federal government through Fannie Mae and Freddie Mac, provided an answer to those risks. Although there are several classes of derivatives, we will focus on one for simplicity. In order to increase the amount of money that local banks could responsibly lend, the secondary market created collateralized mortgage obligations. I know, big obnoxious word alert right?  CMO’s are good, sound, safe derivatives that lower systemic risk and helped folks get into homes. So here is what it is (its not bad friends, really):

  • The CMO is a little like a mutual fund made from mortgages
  • It is made up from the cash flows of many mortgages (tens of thousands)
  • The cash flows are the principal payments and interest payments from the mortgages in the mix
  • The mortgages come from different cities, are written at different times, and have different interest rates
  • The CMO is split into graded classes from A (close to zero risk with small return) to residual (very risky, big return)
  • Banks sell the cash flows to the secondary market, who creates and sells the CMO’s to investors
  • Banks will often buy CMO’s in virtual exchange for their mortgages

The instruments allow the banks more money to lend to communities at a lower level of risk. The risk to investors is well defined and well compensated. Only two things could sink the system, and of course, both happened. Non-depository (they aren’t banks but they write mortgages) firms like Countrywide, Argent, and Ditech flooded the secondary market with low documentation, sub-prime mortgages. While the new law does not prohibit these transactions, it does limit the ability of institutions to issue such loan in the first place. The second problem lay with the ratings agencies that graded the derivatives. Financial geniuses (when you hear that term friends, run the other way), kept on creating new derivatives. These D squared and D cubed instruments were built on the cash flows of the first derivatives, which made them far more risky. But the ratings agencies continued to grade them as if they were first level instruments.

The new law provides for oversight and increased liabilities for the ratings agencies. These steps should help to prevent the addition of extra risk into the system via improperly rated instruments. The law also provides extensive remedies to problems with appraisers, predatory lending, and mortgage servicing. While it doesn’t “crack down” on derivatives in the sense that it outlaws them, it does provide for oversight and enforcement that is largely at the discretion of whoever is in Congress and the White House at the time. This provides a check on the oversight by the Fed, which is done by individuals who do not serve at the pleasure of the voting public. I can take some comfort in that.

Derivatives and swaps serve a reasonable and reputable place in our economy. They provide the market with needed liquidity by allowing risk to be spread out over a larger footprint. They contributed to our financial calamity only because several firms used them to create false wealth; a process that created real additional risk. The new financial reform law walks several steps in the direction of reducing that potential. We the people can walk the remainder of the steps ourselves. Credit unions and real community banks (Wells Fargo calling themselves a community bank does not make it so) deserve our business. They are local and will listen when you ask them to be prudent in their investments. Just as important are the  interactions we have with our pension funds and financial advisers. A loud and consistent consumer expression of displeasure over swaps and exotic derivatives will be heard by customer-driven firms. Vote with your investment money friends…I promise they will hear that noise.

The Rational Middle is listening…

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