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The “alphabet” derivatives-cds’s, mbs’s, etc.-were theoretically designed to spread credit risks among parties who were best able to bear that risk. In reality they brought about a financial crisis that may alter world power for decades. They have put the largest banks into actual, although disguised, insolvency (undeclared bankruptcy), have gutted American industry of capital, and incidentally put millions of Americans into poverty. What are these things and where do they come from?

“Derivatives” Defined

A “derivative” security is a legal right that is derived from some other right. Perhaps the most basic or familiar derivative is a stock “option.” Options come in two forms, “calls” and “puts.” A call is the right (but not the obligation) to buy something at a given price at some time in the future. A put is the right (but not the obligation) to sell someone else something at a given price at some time in the future. A simple example would be a stock call or put. If you think IBM stock is going to gain value, you can buy a call option. As the stock price goes up, so does the value of the call option. If the price of the stock goes down, so does the value of the call option. But options are much less expensive in general than the underlying stocks. It might cost you $200 to buy the right to buy 100 shares of IBM at $120 a month from now, whereas the cost of the stock itself would be $11,000 (assuming a price of $110 per share of IBM stock). So you can control more stock with less money through options.

Controlling more stock with less money is financial “leverage. It’s like using a megaphone: a small change in the stock price creates a large profit for the owner of the option. Under the right circumstances, a little money can turn into a lot of money in a short time with options.

Stock call and put options make a lot of sense. If you own the stock and want to insure against the possibility of it going down in value, you can buy a put option. At the end of the day, for a cost of a few dollars per share you can protect against a sudden wipe-out of an account’s value. If you happen to be managing someone else’s money this makes a lot of sense for everybody. On the other side of that equation, someone sells a put, signifying a willingness to purchase the stock if it goes down to a given price. For IBM, to continue the example, this might also make excellent sense. Buying and selling calls allows parties to divide up the future potential of a rising stock so that they can adjust their risks in a rational way.

Alphabet Derivatives-Some Background

The alphabet derivatives were clothed with the same rationality as stock derivatives and posed as a means to allow financial interests to split up the costs of financing the housing boom that developed in the late 1990s and early 2000s.

Let us start with the way houses have been traditionally purchased. Mr. Jones would find a house he liked and negotiate a price with Mr. Smith, the seller. After arriving at a price, Mr. Jones would then seek financing from a savings and loan or bank. The bank would have the house appraised and offer to lend Mr. Jones some of the price. Mr. Jones would, in the old days, have had to come up with 10 or 20% of the purchase price and would borrow the rest. The bank would have taken actions to protect itself-it required Mr. Jones to come up with a certain amount of money (establishing some “equity” in case of foreclosure and incidentally proving his creditworthiness), and it examined the appraisal to make sure the house was actually worth the money spent (so that if it had to foreclose it could get its money back by selling the house).

That kind of careful banking protected the purchaser, the bank, and the general market. But it did make it hard for people with less money, who couldn’t afford the large down-payment, to purchase a house. Of course the banks could not have cared less about that, but politicians did-they saw it as a means to improve the lives of their constituents. What the banks did care about, though, was making more money. For various reasons, the interest rates on money were being held down in the late 1990s (through the present), and it began to be difficult for banks to make the kind of money they wanted simply by lending money in the traditional way. They needed leverage. Read the rest of this entry »