Derivatives and You

Again and again, the media keeps stating that nobody understands derivatives, that it is too complex for most people to understand, as if as a kind of apology for the market meltdown.

But, derivatives aren't actually that hard to understand.

Which begs the question – why is nobody explaining it? Do they really actually not understand themselves? Do they just accept that they won't understand, and so don't even try? Or are they merely pretending not to understand?

Or maybe no one wants the public to look to closely, because looking closely requires take a look at the structure of loans, and the finance system does NOT want that.

So, everybody kinda knows what loans are to them – you, the lendee receive a bundle of money which you have to pay back, with interest. Or, more basically, a person who earns $1000 a month who takes out a $1000 loan in January (that must be paid back in November) suddenly has $2000 to spend in January, making that person much more wealthy that month. Yet along comes November, and the bill for the $1000 loan, and then that month this person has no income. But that's not all – then the interest bill comes due, so in December this person pays out another $500, leaving them with only half their income.

So, what is a load, really? It's a way of giving banks your money.

Now, the counterargument to that has always been: with that loan money in January, you will buy things (like a TV), and the enjoyment that you receive for having that TV for all those extra months (instead of saving up for it and buying it with your own money) makes up for the extra money that gets paid out in interest – or, in other words, makes up for those later months of being poor while you pay back the loan bills.

Of course, the counter-counterargument to that is: if you'd saved the money, you could buy a TV and Blu-ray player with the money you would have otherwise paid out in interest, and the enjoyment you would receive for BOTH objects over the coming years, as well as the enjoyment of not being in debt, far outweighs the enjoyment for having the TV right NOW.

But, really, that is kind of an aside, because that is what a loan is to the lendee.

What we need to look at is what a loan is to the lender – ie the bank. The bank lends out a bundle of money, making them poorer now, but with the expectation that they will be getting that money back plus a bundle more in interest.

So, for them, a loan is an investment. An investment with potentially high returns these days, what with the abandonment of usury laws.

And, like any potentially profitable investment, there are other folks out they seeking to cut in on a slice of the action, and the banks are willing to do that. They will sell of a share of the loan, say $100 worth, for say $110 – the bank then loses out on the full interest of that share of the loan, but no longer holds any risk for that share if the loan doesn't get paid back, and can then turn around and loan the $110 they just got to someone else.

That's generally how things were done, until recently – a fairly safe, stable system. It has its quirks, but there were a bunch of financial rules preventing most of those quirks from having any major effect on the overall economy.

Now, banks rate each of those loans on the likelihood of their being repaid, basing that rating on a lot of things, such as assets, income, and the like. Triple-A is the best rating, usually reserved for wealthy, stable countries. Major currencies receive Triple-A ratings, in other words, but people don't.

A certain portion of loans fail. That's a given. Which is problem for investors. Lower ranked loans have a higher risk of default, and investors don't like risk. So, banks are forced to sell shares of the loans at a lower price, thus offering higher potential profits, in order to attract interest from investors.

However…now we come to the gimmick.

Through experience, banks have figured out what percentage of loan failures there will be at any given ranking – that's just a matter of adding up all the loans of a given rank for a year and finding out what percentage of those loans failed, and then keeping track of the failure rate year-to year for each rank.

Nothing special about that.

But, knowing the failure rate of each rating, what if you took a $100 share from 100 different loans and combined them together to form a new $1000 piece of loan property. Sure, a certain percentage of the shares of that loan property will fail, but the bulk of the shares it is made up of wouldn't, so the new loan property would earn.

The earnings wouldn't be as high as a successfully paid-back loan, since a certain portion of those shares would fail, draining the income. On the other hand, there would be a lot less risk in the overall loan investment, since most of those shares would earn.

Then, taking that idea a step further, the bankers theorized that an ideal set of shares could be co-mingled from shares of loans from all of the different ratings to make an loan property (or investment vehicle, to put it their terms) that would be guaranteed to earn a profit.

With that theory centermost in their minds, the banks hired some techs to design a computer program that would plot a formula of loan shares that would do just that – and so prove the theory, while also making them a whole lot of money.

And that's a derivative – a thing whose value is derived from something else (a loan), but whole value is not directly affected by that something.

And so, the program got made, and they stared earning money with their loan properties. And almost immediately, trouble crept into the system.

Much has been made of the fact the formula thus crafted was a "lab formula," and so could only survive in a completely controlled lab environment, as it took so few real-world factors into account, and that's true.

But that's not where trouble crept in first.

First was how these loan properties got rated. Due to financial deregulation and the usual theories of benefits of lax oversight, these loan vehicles got rated Triple-A, since they "could not fail," making them as good as money. Money being an asset.

And banks loaning their assets to other people for a profit.

You might already see where this is going. Banks make money by making loans with the money that public stores in them in the savings accounts. And one of the causes of the Great Depression was systemic bank failure caused by banks having loaned so much of that money out that they couldn't make pay-outs when the public started demanding their savings, and the banks went belly-up, and everyone who banked there lost everything.

That wasn't exactly an uncommon occurrence before the Great Depression, either – the Great Depression's bank failure was just so much more widespread. And because of it, the government instituted two rules – government-insurance on money that the public placed into a bank, up to a certain point, and a requirement that banks keep a certain percentage of their assets in reserve on their premises, so that they will always have enough money on hand to pay out to people who want their savings back.

The key here is – assets. These new loan properties were considered Triple-A, making them assets, which the banks could then keep instead of real assets, like money, or they could even make new loans based on their new loan properties.

Or, in other words, they started making loans on the promise of earnings from loans that they had made earlier.

Then, on top of that, since the banks were keeping less real assets on hand, in order to cover emergencies, and so that any bank could show real assets when they had to, such as for government inspections, a shadow banking system developed. Again, only because of financial deregulation. The shadow banking system would make overnight loans to any bank that was strapped for cash, and so propped up the thin reserves of the banks.

But, this shadows banking system really only exacerbated the problem, since the shadow banks weren't covered by reserve requirements either, and so they loaned out their assets to a far more extensive degree than even the regular banks were on their new loan properties system.

With everyone that over-extended, no one could survive even the slightest tremor to the system. One hint of trouble, and the over-extended system would collapse. However, the new loan properties were guaranteed to earn, and everyone was making hordes of money, so no one looked too closely at the over-extensions.

But, that's not even all. With so much money being made, crime started to leak into the system, inevitably. And with deregulation, there was no one keeping a close look-out for it. Fraud, among other things, became rampant.

The loan companies needed fresh loans to plug into their loan formula, so they could make new loan properties, but they needed a certain ratio of loans from the different loan ratings in order to obey the formula. After a while, though, they ran out of new loans in certain ratings, even with the newly lax lending laws, and so some people (many people) started fudging their loan packages. Whether out of belief that the system was so perfect it wouldn't matter if a few loans were set into the formula improperly, or more direct fraud, load officers began inflating lendee assets (sometimes conspiring with the lendee, often not) in order to give them a higher rating, and so gather more loans of the right kind in order to make more loan properties.

But if you mess with the formula like that, then more of the shares that make up that loan property are going to fail, which will cause the earnings of the loan property to be weakened, and eventually even to the point that will cause it to go bust.

But, even that is not all. All of these new loans are based on a product, in this case mostly real estate. Which caused a building boom. And people were taking out loans to build vast tracks of property in anticipation of other people taking out loans to invest in the property in anticipation of some future people wanting to purchase that property to live in.

And, well, that ain't gonna work.

Some of those buildings loans are going to go bad. Whether because they were built in the wrong place, or without amenities, or the market changed, or any number of problems, some are going down. Which is going to bring not only the building loan down, but all of the investment loans as well. Which is going to make some of those loan properties go bust. Which, since those loan properties are supposed to be Triple-A, guaranteed, is going to shake the foundations of the system.

And that's still not all. With so many loans being made with so little oversight, and since the loans properties were guaranteed, nobody paid much attention what loans were cut into which properties and where those properties were then sold. It was just cut and sell, as fast as you can. And that means, if any – that's ANY – loan ending up having a problem at some point, nobody could track down who carried the note, who was now responsible for it, who made the error, how to correct the error, or even, sometimes, who was now lawfully in control of the loan.

Instead, third-party institutions were put into place to administer the loan properties that they weren't in any other way responsible for. Which just added another layer of chaos to an already unmanageably hard to administer system, which should never have been allowed to even have arisen in the first place.

And all of that is on top of the structural problems of the loan formula itself. Not only did the formula not take into account systemic failures, such as downturns in the economy, it didn't even take into account local and quite visible downturns in real estate, in places such as Detroit, where real estate was going for 1/100th of its original sales value. Nor did it take into account the actual effect of averages – that formula did make a much safer loan property, but ALL loans have the potential to go bad, and it was just going to happen – even in an ideal non-fraud-based situation – that one loan property was going to have enough shares go bad that it was going to go bust. The only reason that this hadn't happened yet was the fact that the loan properties were such a hot commodity that they were inflating the appearance-value of even horrid-looking loans and not quite enough time had passed yet for the first un-refinanceable loan to come due. But it was coming.

With all that over-extension, fraud, and lab-only-formulas, it isn't actually a question of whether or not the derivatives market was going to collapse, it was a question of which part of the whole house-of-cards was going to fall first.

And that's what the derivatives-market was: a weak, overloaded, logically-bankrupt, and sometimes even fraudulent idea destined to fall apart in the first slight wind of trouble.