Derivatives Explained

Suppose your neighbor’s house is worth $500K, and he has a $400K mortgage held by a bank. He doesn’t owe you any money, and you are no more than nodding acquaintances. I sell you a piece of paper for $5000 that says I will pay you the value of your next door neighbor’s house if he defaults on his mortgage. Congratulations, you just bought a derivative.

Why do you care if he defaults? You don’t.
What do you lose if he defaults? Nothing.
What do you gain by him not defaulting? Nothing.
So who gains by this silly ass derivative? Aha, we both do.

I gain $5000 by selling it to you, and all it cost me was a few dollars to have a lawyer draw it up and create some legalese. You gain because you now have a “secured debt obligation.” It is “secured” because it is tied to the value of your neighbor’s house, which you do not own and upon which you do not now and will never have any real financial claim.

The face value of your “secured debt obligation” is $500K, so you can show it to a banker and borrow cash using this piece of paper as collateral. The bank now has what it considers to be a “secured loan” for however much it loaned to you.

So we now have the $400K mortgage, the $500K derivative, and a bank loan all secured by this one $500K house. Something more than two times the value of the house is riding on the homeowner paying the mortgage.

And I’ve only sold one derivative against it. There is no limit on the number of derivatives I can sell against that house. That’s why the derivatives market is estimated to be in excess of fifty trillion dollars. And all of it is play money.

Derivatives are financial instruments created for the sole purpose of making money selling the instruments to people who are stupid enough or crooked enough to buy them.

So your neighbor defaulting on his mortgage is not the real problem in today’s crisis. Forget all this talk about how the government can pay off his mortgage and everything will be fine, because his mortgage is not the problem. The problem is your derivative and the loan that you obtained based on it. I have to pay you that $500K (along with all the others I sold), and I can’t do it. Since the derivative is now worthless, your loan has become an “unsecured loan” and your bank is freaking out about that. It can’t afford to have all this “unsecured debt” on its books and, as a result of that imbalance, the bank must obey bank laws and stop lending.

Your neighbor triggered the problem, but your derivative and your bank loan actually caused the problem. Nobody looked at your finances until your neighbor defaulted; that was the trigger. Then they looked at your books and mine (in this little blog drama) as a result of his default and saw that those finances were rotten and corrupt to the core, and the grits hit the fan.

And yet politicians of both parties keep yammering about the “housing crisis” and about getting those mortgages paid. Both talk about lack of regulation permitting the issuance of bad mortgages as having caused the present crisis, and promote paying off those mortgages as a solution. The Bush Administration is still, even now, pressing to buy up as much bad debt as possible to hold until it “regains its value” as if there is any hope that it ever will.

Review our blog drama again. Is your derivative and your bank loan ever going to have any value? Did they ever have any real value to begin with?

Government is even more corrupt than our financial world.