The Widening Gyre

Derivatives - or what could possibly go wrong?

By: FLwolverine, 7:39 PM GMT on February 06, 2014

Over on Birthmark's blog, our friend tramp said no one had ever explained "derivatives" to him in a satisfactory manner. Since this is something I do know about - as opposed to weather, where I am a mere beginner - I thought I would give a try.

Derivatives are a type of security instrument - like the promissory note you sign when you buy a car or a house or a washing machine and promise to pay for them in installments. In those cases, your promise to pay is secured (backed up) by the item you have purchased - by the security interest created in the car or the washing machine, or the mortgage given on the house. If you don't pay as you promised, the seller or lender can repossess the item.

Derivatives follow this same principle, but with a lot more bells and whistles attached.

A short course in derivatives.

Before derivative became a dirty word, there was the secondary mortgage market. A bank (or other lender, but we'll keep this simple) would loan you, tramp/homebuyer, money to buy a house. In return the bank received your promise to pay back the loan with interest (promissory note) and a security interest in the house (mortgage, or in some states a deed of trust, but we'll go with mortgage here for simplicity's sake). Yes there are a lot of other papers signed at a mortgage closing, but these are the key.

The bank doesn't want all its funds tied up in mortgage loans, so it packages your loan with a bunch of others (Package 1) and sells it to FNMA (Fannie Mae), that is, it endorses the note and assigns the mortgage. In return it receives the amount of the mortgages, some "profit" based on interest rates, and various other chips and clips. As a bonus the bank gets to be the services on your mortgage - receiving payments, handling tax escrow, etc - and is paid a fee for that by FNMA. Theoretically, the bank now takes the amount it receives from the sale and turns around and lends it to other homebuyers.

So far so good. Worked fine for many years.

But Fannie Mae also needs to raise money so it can buy more packages, so it takes Package 1 (with your mortgage in it), bundles it with other packages (to create Big Package 2) and sells the whole lot to a group of investors, or a big pension fund, or a BIG BANK. Fannie Mae endorses the notes and assigns the mortgages, receives payment in the amount of the mortgages plus some profit based on the interest rate, and turns around to buy more mortgages from the banks making the original loans. Your bank continues (usually) to service your loan, so you have no idea any of this is happening.

Problem is: investor groups and pension funds don't really want to hold notes and mortgages. So someone comes up with the idea of creating a new form of security - basically a promissory note backed by the Package 2 and other big packages. This is the derivative, because it is a single promise to pay backed up a bunch of other security interests.

Let's say BIG BANK has bought Package 2. It bundles that with other big packages, and creates a promissory note for $x. X in this case being the amount of income BIG BANK expects to receive from the mortgages in all the packages, less some income stream that BIG BANK intends to keep for itself. An investor or investment group or pension fund or another big bank then buys this new note from BIG BANK, who also gives the buyer some kind of security interest in the packages of mortgages. Notice that BIG BANK does not endorse your promissory note or assign your mortgage to the buyer. No, BIG BANK keeps those, and receives your mortgage payments, which it uses to pay back the promissory note to the buyer.

What's in this for BIG BANK? It doesn't have to wait for you to make your mortgage payment in order to recover its money. If it paid $100,00 for your mortgage, it has received $100,00 from the buyer, and it can go on to use that money for new investments. It will pay the buyer back when you (and a thousand other borrowers) make your mortgage payments. (Yes, I know, there's a lot of discounting and future calculating going on so tramp's $100,000 mortgage isn't really sold for $100,000 - but let's keep this simple and just look at structure for now)

What's in this for the Buyer? It's an investment; Buyer will (theoretically) receive back its entire initial investment with interest. (BIG BANK gets the money to make the interest payments from the interest payments tramp and others make - in the simplest scenario.)

There's nothing inherently wrong with this scheme so far. But here's where things start to get interesting.

A short course in derivatives - round II

So here's Buyer - let's say, an investment group like, oh, say, Bain Capitol - now holding a promissory note from BIG BANK $100,000,000, secured by all those mortgages. But Buyer doesn't own the mortgages (Buyer never wants to own the mortgages); it just wants BIG BANK to use the income stream from the mortgages to pay off the promissory note.

Buyer can then use the repayment to repay its investors or to make new investments.

If Buyer acquires several of these promissory notes, it may not want to wait for repayment. Maybe Buyer wants to make more investments right away. So Buyer bundles (again) the promissory notes from BIG BANK and others - let's say totaling $500,000,000 - writes up one big security instrument (actually a kind of promissory note on steroids) and sells 50 shares in it at $10,000,000 each. Who buys the shares? Other investors, pension funds, banks. In our example, let's use a municipal pension fund, although there were plenty of cases where the buyer here was another investor who went on to create yet another layer of derivatives.

Did I mention that when this was going on, there were a lot of wealthy people in the Middle East and Far East who saw the US as the safest place for their money? And everybody knew that the American homeowner had an excellent record of paying for their home and not going into foreclosure. Next to US Treasuries, what better investment could there be.

This last point is important, because this is where insurance comes in. When Buyer goes to buy the promissory note from BIG BANK, Buyer may say "look, I never want to end up owning a bunch of mortgages, and I don't want your guaranty, because even BIG BANKS can fail. So instead of giving me a security interest in the mortgages, buy me some insurance". Buyer and BIG BANK go to insurance company (let's call them AIG), which rubs its hands together greedily and says, oh, yes, I'll insure this for a properly large fee - all the while thinking, I'll never have to pay up on this; whoever heard of American homeowners defaulting on their mortgages en masse?

Same thing when Buyer wants to sell shares in its $500,000,000 steroidal security. In return for a sizable premium, AIG insures those transactions too.

Now things really start to get kinky. Gambler is standing by watching all these transactions thinking: there's really a chance for this to go bad, but nobody seems to see it. So Gambler goes to AIG and says "I want you to give me the same insurance you just gave Buyer, that is, I want you to insure me that BIG BANK will not default on the promissory note it owes Buyer. No, I don't have an insurable interest - I'm not part of the transaction - but I'll pay you a good premium. If BIG BANK pays up, you keep the premium. If BIG BANK defaults, you pay me the insured amount."

AIG thinks "American homeowners are not going to default" so it sells the insurance to Gambler.

And did I mention that AIG (and others) has managed to convince the US Congress that these transactions are not really insurance policies, so AIG does not have to set up any cash reserves to back them up?

A short course in derivatives - Round III

So what could go wrong?

Let's start with those original mortgages. Fannie Mae guidelines require certain backup with each loan before they will buy it: acceptable title work, survey, credit checks, and appraisals. For a long time, this system works fine. But as more investors, banks, and mortgage companies see the profits to be made by selling the derivative securities, and as more people (in other countries especially ) keep looking for relatively safe places to invest their money, the system breaks down.

Appraisals and credit checks in particular get very dicey, to the point of being fraudulent in many cases. But no one is looking at that. The realtors and mortgage brokers and lenders and appraisers and credit bureaus are looking at the money to be made. So lots of loans are made that shouldn't be made - to people who don't have the income to repay, on terms that are too onerous to be repaid, on houses that will never be worth the amount of the mortgage.

And then when the tramp is laid off because the company he works for moves oversees, or when the mortgage interest rate kicks up to 12% after five years but tramp's income is still the same, or when tramp incurs $500,000 in medical bills for a condition his health insurance won't cover:

- tramp and thousands like him get behind on their mortgages and a lot of properties go into foreclosure;
- original lender bank can't collect any money to send to BIG BANK (which still owns the notes and mortgages);
- BIG BANK doesn't receive any money to repay the promissory note to Buyer;
- Buyer doesn't receive any money to pay to pension fund on the steroidal security;
- Buyer and Gambler go to AIG to collect on their "this is not insurance" policies - to which AIG says: I can't pay out that much money - and declares bankruptcy.
- pension fund says to its members: sorry, but we just lost $10,000,000 of your money.

OK - this is really simplified. There are as many complications and variations as there are people involved. But I hope this helps someone (maybe tramp?) understand derivatives better.


Updated: 8:03 PM GMT on February 06, 2014


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