All Things in Moderation

Apologies for the length of this post.

Since 2008, the term “derivative” with regard to the finance industry has become much maligned and has been regularly used, both in the press (which loves a simple story) and among politicians (who love to see someone else blamed for problems) as the all purpose villain in the story of our economic collapse of that year.  And this notion of “derivatives” as somehow to blame for our troubles has largely been absorbed by a public that in fact knows next to nothing about what a derivative actually is, much less the part they might have played in fueling the crisis which came in 2008.  So perhaps an explanation of what derivatives are and the role they play might serve to dispel some of the misinformation that our politicians and the press are happy to leave lingering in the public mind. 

First of all, the term “derivative” is a generic term that refers to any product or contract the value of which is based upon, or derived from, the value of another product.  What does this mean?  Well, consider perhaps the easiest to explain, a simple commodity derivative, or what is more commonly know as a commodity swap.  The current price of a barrel of oil is about $85, but we have no idea what the price will be in 6 months. Imagine a contract between you and I in which I agree to pay you $85 a barrel for 100 barrels of oil in 6 months, and you agree to pay me whatever the actual price is in that day, also for 100 barrels.  Now since we are each buying and selling the same number of barrels of oil to each other, there is no actual exchange of oil.  All that will be exchanged, or “swapped”, in 6 months is a cash flow.  I pay you $8,500 (85 times 100) and you pay me X  times 100 where X equals the price in 6 months.   The value of our contract is derived from the price of oil, even though neither of us is actually buying oil.  Hence, it is a derivative.  

How, you might be wondering, could such a contract have precipitated the demise of the housing market in 2008?  It couldn’t. And didn’t. In fact there are all kinds of different derivative markets…fixed income derivatives, equity derivatives, credit derivatives, commodity derivatives, etc.  These are all very distinct  markets, and most of them had nothing whatsoever to do with the collapse in the market in 2008.  

There was one financial innovation in particular which did contribute to the problems in 2008, the CDO, or collateralized debt obligation.  These were groups of mortgages packaged together as a single security and sold to investors. How did this contribute to the problems of 2008?  The demand for CDO’s greatly increased the amount of money available to mortgage borrowers, resulting in easy borrowing and thus helped fuel the buildup of the housing bubble.  The thing is, CDO’s are not derivatives.  They are securities. 

Now, there are, derivatives on CDOs, called synthetic CDOs, and as you might have guessed, are contracts that derive their value from underlying packages of mortgages.  They are essentially a form of credit derivative, wherein one party buys protection from the other contracting party regarding some underlying credit event. In a typical credit derivative, the underlying credit event is usually the default of a given company on a given piece of debt.  The buyer of protection will pay a monthly or quarterly premium to the seller, and the seller agrees to pay the difference between par and value of the referenced debt in the event of default.  In a synthetic CDO, the referenced credit event is the default on a package of referenced mortgages.  

It was these synthetic CDOs that were the subject of the infamous congressional inquiries which featured testimony from several Goldman Sachs employees, including Lloyd Blankfein.  Now, there are definitely some interesting ethical issues involved in creating these synthetic CDOs, because if the buyer of protection does not actually own the referenced credit risks, his purchase is little more than a bet that the referenced credits will default, and the sooner the defaults occur, the bigger the payoff for the buyer. So in a synthetic CDO, the buyer has an incentive to include the riskiest possible mortgages.  The seller, of course, wants the safest ones.  Generally speaking, this wouldn’t be a problem, as both sides have to do their own analysis of the mortgages involved, and they both must agree for a deal to get done.  But what if the seller is relying on the advice of the arranger, Goldman Sachs, and GS fails to advise them that the buyer does not actually own the underlying credit risks, and is therefore selecting the underlying credits based on the likelihood of default?  This was the nub of the criticism aimed at GS during it’s congressional testimony.  

But whatever you think of the ethical issues involved, these types of derivatives did not really contribute to the underlying conditions that led to the collapse of 2008.  Remember that, as derivatives, they weren’t actually adding money to the mortgage market, as regular CDOs did.  They were nothing more than either hedges as protection against the default of mortgages that were already owned, or they were bets against the performance of already written loans. And there is even a reasonable argument to be made that, had more people been willing to buy naked protection sooner (ie bet against the performance of mortgages), it would have been a signal that the real estate market was over heating and may have burst the bubble sooner.   

The one way in which derivatives can be said to have contributed to events is that they compounded the liquidity issues faced by financial institutions in the fall of 2008.  Most derivative contracts between market participants are collateralized, which means that, as the value of the contract changes, collateral must be posted on a daily basis to cover that value.  As markets became tumultuous in 2008, a lot of these contracts required larger and larger postings of collateral, at exactly the time that it was becoming more and more expensive, and in some cases impossible, to borrow short term money.  This is precisely what happened to AIG. It couldn’t borrow the money to meet its increasing  margin and collateral obligations. 

In any event, the point here is basically that the demonization of derivatives is much too overblown. While there are certainly legitimate questions to be raised regarding the structuring of certain kinds of derivatives, most derivatives played virtually no role in the collapse of the economy in 2008, and certainly were not responsible for the wider economic conditions in the nation, the consequences of which we are are still living with today. 

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