A reader asks:
I have been reading that the reason for our economic downturn is the proliferation of "Derivatives" in the last decade. Can you explain to me exactly what is a derivative and how it works?
Here's how it works:
- A bank makes an interest-only loan to a homeowner.
- The bank then sells the mortgage to Fannie Mae. This gives the bank more funds to make new loans.
- Fannie Mae resells the mortgage in a package of other interest-only mortgages on the secondary market. This is a mortgage-backed security (MBS), which has a value that is derived by value of the mortgages in the bundle.
- Often the MBS is bought by a hedge fund, which then slices out portion of the MBS, let's say the second and third years of the interest-only loans, which is riskier since it is farther out, but also provides a higher interest payment. It uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.
- All goes well until housing prices decline or interest rates reset and the mortgages start to default.
Since no one really understood what was in the MBS, no one knew what the true value of the MBS actually was. This uncertainty led to a shut-down of the secondary market, which now meant that the banks and hedge funds had lots of derivatives that were both declining in value and that they couldn't sell. When this happened, they stopped making new loans, which meant houses didn't sell, which only put more downward pressure on housing prices, which then caused more loans to default.
Soon, banks stopped lending to each other altogether, because they were afraid of receiving more defaulting derivatives as collateral. When this happened, they started hoarding cash to pay for their operations. Then they stopped lending to other businesses. That is what prompted the Bailout Bill, which is really the only solution to get these derivatives off of the books of banks so they can start making loans again.
It is not just mortgages that provide the underlying value for derivatives. Other types of loans and assets can, too. For example, if the underlying value is corporate debt, credit card debt or auto loans, then the derivative is called a Collateralized Debt Obligations. A type of CDO is Asset-backed Commercial Paper, which is debt that is due within a year. If it is insurance for debt, the derivative is called a Credit Default Swap.
Not only is this market extremely complicated and difficult to value, it is unregulated by the SEC. That means that there are no rules or oversights to help instill trust in the market participants. When one went bankrupt, like Lehman Brothers did, it started a panic among hedge funds and banks that the world's governments are still trying to fully resolve.
- What Are Securities?
- Did Hedge Fund Housing Losses Cause Economic Slump?
- How Hedge Funds Affect the U.S. Economy