You no doubt have read the word in financial pages or heard it on CNBC, but what are derivatives and what do they have to do with the failure of Lehman Brothers?
From HowStuffWorks.com:
Derivative: A dependent security whose price is derived from one or more underlying assets and whose value is determined by fluctuations in the underlying asset. Futures contracts are a common type of derivative.
Hang with me here.
Click here to understand more about how Lehman and AIG are/were major players in the derivative game.
Here is a tip site for writing about derivatives.
Derivatives, like stock investments, are a sort of bet. What investors are betting on here is whether a creditor is going to go under. It all works sort of like a life insurance policy (except this “insurance policy” has little regulation). A lender loans money to a company. The lender then takes out a sort of insurance policy, a “swap” with a third party. If the borrower defaults, the lender loses the loan repayment, but collects on the insurance, the swap.
The Initiative for Policy Dialogue at Columbia University explained:
Farmers use derivatives to hedge against a fall in the price of their crop before the crop can be harvested and brought to market. Banks use derivatives to reduce the risk that the short-term interest rates they pay to their depositors will rise above the fixed interest rate they earn on their loans and other assets. Utility companies can hedge the (typically very volatile) price at which they purchase gas, oil and other source fuels as well as the (increasingly deregulated and, as such, variable) price at which they sell electrical power. International businesses hedge their (volatile) foreign exchange risk from trade and investment.
Some University of Pennsylvania researchers put it this way:First, a credit default swap is a private contract in which private parties bet on a debt issuer’s bankruptcy, default, or restructuring. For example, a bank that has loaned $10 million to a company might enter into a $10 million credit default swap with a third party for hedging purposes. If the company defaults on its debt, the bank will lose money on the loan, but make money on the swap; conversely, if the company does not default, the bank will make a payment to the third party, reducing its profits on the loan.
Lehman is in the top 10 players in the global credit default swap market.
Insiders watch credit default swaps as a way to know when a borrower’s credit is tanking. They read the balance sheet looking for changes in the stability of the loan. The less stable the loan, the more they have to pay for the swap.
COLLATERALIZED DEBT
There is another kind of derivative called a collateralized debt obligation (CDO). This is similar to the first swap but there are other assets at stake — real hard assets, not just credit. To make things more complicated, there can be a “synthetic” CDO. Learn more about synthetic CDOs in this 2004 briefing paper from the Federal Reserve Bank (PDF).
Standard & Poors said Lehman and AIG are included in 2,634 pieces (financial folks use the word “tranches”) of 1,889 synthetic CDOs.
Let me explain the whole “credit tranche” thing and you will get an idea of just how complex this can become. The Federal Reserve issued the above-linked paper trying to be sure everyone understood the risks involved in derivatives. As you read the following paragraph, just keep telling yourself: The riskier the underwriting, the higher the potential return. As you read about tranches, the lower the level, the more risky the investment. If it all crumbles, it will crumble in a remarkable way, as we have seen this week. The Fed warned/explained:
A defining feature of both cash and synthetic CDOs is the tranching of credit risk. The risk of loss on the reference portfolio is divided into tranches of increasing seniority. Losses will first affect the “equity” or “first loss” tranche, next the “mezzanine” tranche(s), and finally the “senior” and “super-senior” tranches. CDO “investors” take on exposure to a particular tranche, effectively selling credit protection to the CDO “issuer.” The CDO “issuer,” in turn, hedges its risk by selling credit protection on the reference portfolio in the form of single-name credit default swaps. Parties on the other side of these hedging transactions are the ultimate “sellers” of credit risk to the CDO “investor,” with the CDO “issuer” acting as intermediary.
So, derivatives are mostly a way to sell risk. They are not really selling shares of a tangible thing, like stock does. With stock you are buying a share of a company. But with derivatives, you are buying a share of risk of something that may or may not fold.
But if a bank is worried about a loan folding, why not just sell the loan and be done with it? Sometimes they do, but banks don’t want to harm lender-borrower relationships, so they hold on to the loan and just secure it with a CDO. Investors like CDOs because they can turn big profits, but can also be on the hook for way more than they invested if the loan they have underwritten fails.
Want to learn more? Sure you do! Here is an easy-to-read primer from the Federal Reserve Bank of Boston (PDF). It includes a glossary and graphic that help you to understand some of the more exotic forms of derivitives.
Investopedia also has some nice resources.
$516 TRILLION IN DERIVATIVES
It is pretty easy to see why all of this might crumble in a big, smelly, smoking heap.
In 2002, Warren Buffet said derivatives were a “financial weapon of mass destruction.” See more of what he says here.
Marketwatch says that in 2007, there were $516 trillion of derivatives in play. That is a five-fold increase in five years. Marketwatch puts that number in perspective:
To grasp how significant this five-fold bubble increase is, let’s put that $516 trillion in the context of some other domestic and international monetary data:
- U.S. annual gross domestic product is about $15 trillion
- U.S. money supply is also about $15 trillion
- Current proposed U.S. federal budget is $3 trillion
- U.S. government’s maximum legal debt is $9 trillion
- U.S. mutual fund companies manage about $12 trillion
- World’s GDPs for all nations is approximately $50 trillion
- Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
- Total value of the world’s real estate is estimated at about $75 trillion
- Total value of world’s stock and bond markets is more than $100 trillion
- Bank of International Settlements valuation of world’s derivatives back in 2002 was about $100 trillion
Recently Pimco’s bond fund king Bill Gross said, “What we are witnessing is essentially the breakdown of our modern-day banking system, a complex of leveraged lending so hard to understand that Federal Reserve Chairman Ben Bernanke required a face-to-face refresher course from hedge fund managers in mid August.”
In short, not only Warren Buffett, but Gross, Bernanke, the Treasury Secretary Henry Paulson and the rest of America’s leaders can’t “figure out” the world’s $516 trillion derivatives.
In short, not only Warren Buffett, but Gross, Bernanke, the Treasury Secretary Henry Paulson and the rest of America’s leaders can’t “figure out” the world’s $516 trillion derivatives.
Why? Gross says we are creating a new “shadow banking system.” Derivatives are now not just risk management tools. As Gross and others see it, the real problem is that derivatives are now a new way of creating money outside the normal central bank liquidity rules. How? Because they’re private contracts between two companies or institutions.
While the more exotic derivatives are relatively new, the idea has been around for centuries. The Initiative for Policy Dialogue explained:
As a testament to their usefulness, derivatives have played a role in commerce and finance for thousands of years. Derivatives contracts have been found written on clay tablets from Mesopotamia that date to 1750 B.C. Aristotle mentioned an option type of derivative, and how it was used for market manipulation, in the 4th century B.C. … Derivatives trading on an exchange can be traced back to 12th century Venice. In the early 17th century, futures and options were traded on stocks and commodities such as tulips in Amsterdam. The Japanese traded futures-like contracts on warehouse receipts for rice in the 18th century. In the U.S., forward and futures contracts have been formally traded on the Chicago Board of Trade since 1849.
