Suppose that in a weak moment you agree to lend a relative with a mixed record for keeping his word $500, on his promise to repay the loan with 10 percent interest in six months.
Other family members start ribbing you about your questionable judgment, whereupon you challenge them to put their money where their mouths are: “Fifty bucks says he pays me the money on time with interest.”
Six relatives take your bet, putting you in the position of being out as much as $850 if your borrower skips town, but putting you $350 ahead if he makes good on the deal.
You have just made a derivative deal, gambling on the outcome of another transaction. Your derivative in and of itself has no intrinsic value, any more than a seat at a poker table in Vegas has an intrinsic value — although theoretically you could win thousands in that seat.
Wall Street derivatives are bets on deals and sometimes just bets on bets — gambling, pure and simple. They add no value to any product or service.
Derivatives don’t grow the economy, create jobs or help anyone outside those relative few in positions to make predictable money off of them.
Going back to our in-family loan, do you suppose you might be tempted, both for face-saving and loss-minimizing reasons, to make very sure your relative repays you, on time, with interest? You might even be tempted to quietly slip him some extra money to help repay you, say, $200 or $250, telling him he can repay that money later on, with no interest. That way, you’re saved embarrassment and still come out ahead when you win your derivative bets.
That temptation to fix the outcome of your bet illustrates how derivatives inherently involve what are known as moral hazards — features with a high potential for causing people and businesses to do things they normally wouldn’t be expected to do, and in any case shouldn’t do.
Last week’s Senate Permanent Subcommittee on Investigations hearing provided excellent examples of moral hazard at work. Current and former powers that be at the two leading investment-rating services, Moody’s and Standard & Poor’s, were called to account by subcommittee Chairman Sen. Carl Levin, D-Mich.
Levin focused on how, before the housing bubble burst, major Wall Street players like Goldman Sachs had wanted their derivative bundles laden with toxic assets rated AAA. That rating would lead prospective buyers to believe the derivative bundles were virtually can’t-lose propositions.
Significantly, the rating service poobahs gave Sgt. Schultz responses to Levin’s questions (“I know noth-thing!”). They offered no credible reason as to how or why their ratings experts granted AAA ratings to paper contraptions so questionable they made three-dollar bills look legitimate. But a former ratings expert testified how he and his co-workers were under intense pressure from management to give the bad-mortages/good-mortgages derivative bundles good ratings.
Moody’s CEO came off looking even worse when Levin pressed him about why his firm continued to rate toxic waste as investment-grade paper, even after competitor S&P had started downgrading the stuff.
The point Levin was making — and made repeatedly — is that credit-rating agencies did whatever was needed to get lucrative fees, some as high as $1.4 million , for rating complex deals.
Fees might be the whole reason, but we’re suspicious more was going on. The hearing left us thinking dark thoughts about payola, kickbacks, the promise of cushy future jobs, and those sorts of things, although no such blatant corruption came to light in testimony.
Whatever the finer, dirtier specifics of the recent spate of robbing, raping and pillaging the hapless public by Wall Street’s well-dressed and super-well-heeled crooks, you get the picture.
Derivatives are gambling media, like dice and cards, except that they bring with them far greater potential for moral hazard — and infinite potential for harming millions of innocent third parties.
All of which makes derivatives unnecessary public menaces that Congress should outlaw. That all-out prohibition is the next step Congress should take after making its modest first steps toward meaningful financial industry reform.
I don’t think derivatives will be outlawed outright. There are some areas where they are a necessary thing. They should not be sold to any other outside speculator but kept as an insurance against things like crop failure and weather events.
Mortgages should be kept in house on a banks’ spredsheet. When I payed off my place it took the bank nearly a year to find the paperwork because it was sold so many times.
Banks need to be banks and investment firms need to be investment firms. Seperate them I say.That’s my opinion anyway.
Demeur makes a good point about separation of interests. My mortgage has swapped hands more times than I can remember, passed around like a party favor, each time someone makes 0.001 percentage profit, multiplied by millions of course and probably bundled with less attractive deeds for balance. You are right, they create nothing but money for themselves and a pot to sweeten their Congressman’s taste buds.
Until reading your post, I never quite understood what derivatives are. I don’t have much financial smarts; thanks for defining the term clearly. I’ve been following this, like everybody, but whenever an article describes what derivatives are, I’m always thinking “uh, OK, I think I get it.”
Yes, this practice definitely needs to be outlawed. I think the public would be demanding a law against this, if they knew what derivatives are. I can’t be the only person who didn’t have a clear grasp of it.
From one side we have Democrats talking about derivatives, and the public going “uh, OK…” And from the Right we have screaming Republicans going for the jugular with “Freedom!” “Government takeover!” “The Democrats want more bailouts for Wall Street!”
Demeur, I suppose crop insurance is a derivative of sorts. There is a legitimate need for crop insurance, so an exception could be made. The bulk of derivatives, deceptively referred to and handled as forms of investment, should be as illegal as wood alcohol labeled “vodka.”
Re: mortgages, I proposed in an earlier post that mortgage lenders be required to hold 20-year mortgages for seven years at least, and 30-year mortgages for 12 years. If a bank or other lender were to get in a bind, they could apply to the government for permission to sell early, but only after the mortgages get a thorough vetting, so buyers know the quality of what they’re buying.
Holte, I’ve heard that people whose mortgage particulars can’t be found because of having been through so many hands can refuse to pay any more. As in, “You say I owe you, so show me the contract.” That right there should be motivation for mortgage lenders to stop treating mortgages like bulk quantities of waste paper.
Thank you, Tom. Be advised that for the sake of clarity and brevity, I oversimplified a bit. But the gist of it is correct And as you said, it’s something nearly everyone should be very clear about.
If you want a much more thorough explanation, detailing exactly what brought the economy down, and how it did that, see Bad Money: Reckless Finance, Failed Politics, and the Global Crisis of American Capitalism by Kevin P. Phillips. It’s an excellent book.
I like the analogy, but would it be a bit more like the reality if you took out insurance–sorry, bet your relatives that the loan *wouldn’t* be paid off, especially if you took secret steps to make sure the relative couldn’t pay it at the same time you paid your best friend to tell the other relatives that betting against you would be a sure thing, a “AAA” gamble? Relatives beware, of course — promises are no guarantee of future performance and they’re all adults, right?
Jeff, that would be more like the double dealing Goldman Sachs engaged in. I wasn’t trying to do that so much as rail against derivatives generically. As you suggest, the possibilities for emptying the mine before giving others the shaft abound.
Derivatives I can easily disavow for its lack of useful value. I am disconcerted–but not surprised–at how we are repeatedly told that they’re too complicated to understand. Good cover for shady dealings! It’s not like it’s rocket science or anything.