Tuesday, October 14, 2008

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.


  1. Anonymous4:59 PM

    Ah, yes, but there is one more detail. You (the bookie) can't pay me (the gambler) and a thousand other folks the $500K you promised. You are finished... unless, of course, you are the largest bookie in the world, in which case, the government will step in and pay your gambling debts for you.

    Who wins? I do. I made a long-odds bet and it paid off big time, heavily subsidized by the American taxpayer.

  2. Of course I can't pay off all of those derivatives I sold. I never had the faintest intention of paying them off. I'm walking away with all of the money people paid me for them. You would be the winner if I paid you off, but this is a Ponzi scheme, and I'm at the receiving level, not the paying out level.

  3. Anonymous10:50 PM

    just freaking great... I suppose there is no regulation, no fact checking to see if there is any actual interest in the property being badied about? if I don't have any interest /equity /etc in a property, I should not be able to perform any financial instrument on it. Another version of "I have a bridge to sell you..."

  4. Would there not be an interest to see that the neighbour defaults on his repayments, therefore entitling me to collect the 500k wager?

  5. Anonymous2:01 PM

    There's a sucker born every minute. The analogy I liked of a Ponzi scheme was: A hotel manager finds $100 dollars on the reception desk, so he decides to pay the butcher to whom he just happens to owe $100 for pork. The butcher pays of the hog supplier the $100 he owes him, the hog supplier pays the feed merchant the $100 he owes him. The seed merchant pays off the local tart who let him have credit for her 'services', the local tart goes to the hotel to pay the hotel manager the $100 she owes him for room rental. The guest in Room 100 looks over his room and decides against staying, he goes back to reception and gets back his $100 from the manager.
    That my friends is a Ponzi scheme.

  6. Anonymous6:39 AM

    Man this post is old but thanks so much, I understand what's going on now that understand this Derivatives nonsense. The writings on the wall.

  7. Anonymous7:57 AM

    Fab explanation for derivatives but it is not Government that is more corrupt than the financial world but that it is currently controlled by finance. The people have become convinced they don't have to take part in Govt but just chase the buck for SUV's and a mythical American Dream

  8. Anonymous5:41 AM

    I have a masters degree in math and looked at what is called a derivative .. it is total nonsense.. what a bunch of lies.. and
    rip offs of the taxpers.. gee !!

  9. Hi Billy, Better late than never! I am so glad I googled derivatives and found your little schemata. Better late than never! It's a good way to get the financial black magic across to people groomed by the financial pedaphiles.
    Personally I think it's a hella lot more fun to go to Vegas. I understand that among our non-renewable resources, fresh water is coming up on the dirivatives discussion table. What do you think?

    PS I was in the North of England on the morning of 9/28/2008 watching all hell break loose on TV, knowing that everyone in New York and places West were still sleeping sweetly, dreaming of derivitive sugarplums.

  10. Anonymous4:33 AM

    Hi! I have been trying to understand Derivative securities since last 3 hours and all definitions across internet and my book did not make sense. Now it does! But I am still wondering what I write in exams...??

  11. how does it work between a bank and a country,(Greece) and /or a County ,as one in Alabama?

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  13. Surely the real elephant in the room, one any one with eyes can see - or not see - is the fact that we in Europe, with the exception of Germany, and to a lesser extent you in America, don't make anything any more. We can trade pieces of paper with each other all day long, but if all the stuff we are using is made in S. E. Asia, regardless of fancy names such as derivatives, you don't need to be a financial expert to realise it's all going to come tumbling down. At the moment all we seem to be doing here in Britain is relying on retail to boost our economy (selling each other things none of us have made), speculating on shares (another bubble ready to burst) and in the last week, re-inflating the property bubble. It's so ludicrous that if it weren't so serious I'd laugh

  14. Anonymous6:39 AM

    This is awesome, explained so concisely in terms that a layman could understand.