What Is A Derivative

No one is asking the right questions.

Since the government has now committed to purchase $700,000,000,000 (I think I’ve gotten all the zeros right) in the toxic paper that the banks, domestic and foreign, are holding as assets on their books, I felt it was time to give my vast audience my view of what the government will be purchasing with our tax dollars.

Dictionary.com explains simply: a financial contract whose value derives from the value of underlying stocks, bonds, currencies, commodities, etc. Riskglossary.com defines derivative as: A derivative instrument (or simply derivative) is a financial instrument which derives its value from the value of some other financial instrument or variable.

OK, that tells us that a derivative is a contract-on-a-contract. But what is in these contracts that the average American will now own. Why have the banks cut the value in financial instruments to the point that causes them to go out of business?

Money was raised for home and commercial mortgages by issuing bonds. The banks that originated the mortgage would sell it to someone like Fannie, Freddie or one of the other commercial banks. They would bundle the mortgages and send them to the rating agencies. The rating agencies would rate the best of the bunch as AAA and the rest could be divided up into 15 lower ratings. Since many pension funds, insurance companies, financial institutions or investment groups require a AAA rating on the bonds they purchase, the lower rated bonds have to pay a premium interest rate to entice the sale of these bonds.

That’s where derivatives come in. Thanks to the Community Reinvestment Act of 1977 and its’ reworking in 1995, Congress allowed the banks to become more inventive with the way they sell and fund mortgages. The lower rated bonds are re-bundled with other contracts that could be anything from options and warrants (a contract allowing the purchase of stock at a future date at a specified price), or other types of debt obligations to other bonds themselves. This process snowed the rating agencies to re-rate 96% of the lower rated securities as AAA.

We don’t know what we’re buying. We don’t know what we’re paying for it. But we’re sure it is going to work and hey, we could even make something. This is from the people that voted multiple times against increased regulations to control Fannie and Freddie.

The point is that no one is asking the right questions. The banks and the rating agencies have records to show what is in each of these bundles, but I have not heard one banker or politician ask for that information. It’s time a little light is thrown on this stuff. How can we effectively regulate if we don’t know what we’re regulating. No more free passes.

Bear Stearns And The Fed

The question is can the Fed keep these banks afloat till after the election.

Last week BS was forced to close two of their funds that were leveraged 32 : 1. The current trend was to issue very short-term low-interest notes to pay for their higher interest debt that they had purchased, allowing them too subsequently book the difference in the interest rates as profit. When the market for these short-term notes dried up they lost their ability to redeem the ones that were coming due, creating a devastating margin call. This was the game that most of the investment banks were using to build their bottom lines over the last five years.

The next headache happens when the Fed is forced to react to inflation and raise interest rates to the point where these guys can no longer cover the cost of the longer term debt, which they are holding, with lower-rate short term money. Each time the Fed cuts rates, the game keeps going. It has only been a little over two years when the Fed started raising rates and the “biggies” started having troubles, this will happen again and again as long as the Fed feeds the cycle and prevents the unwinding of these debt instruments.

There is no Housing Crisis

There is no real estate crisis. There is a wash-out of speculators in the areas where prices were driven by that speculation along with a serious lack of interest for property in the great shrinking rust-belt. Quality loans at extremely low rates are readily available to “A” borrowers.

What it should be called is the “bad exotic vehicle bubble”. The investment banks made a ton by repackaging high-risk/high-interest mortgages into a more complicated structured investment vehicles like CDO’s and SIV’s. When a mortgage becomes part of one of these, the normally straight forward mortgage accounting rules get fuzzed-up, allowing the bank to book a greater portion of the anticipated interest as an asset. This became the trough that the fattest of the hogs ate.

The write-downs that are dominating the financial media space are just a reversal of the “profits” that these investments banks have already booked that would of never happened if normal accounting rules had applied in the first place. The 25 top players in this game lost more than $100 billion in 2007 and that number could be doubled if you add in the next 100 or so regional banks, retirement funds and investment trusts that bought into the higher rates that the CDO’s and the SIV’s offered.

As the default rate for exotic mortgages started to increase and the market for these securities dried up, the speculators lost their biggest tool that allowed them to acquire their properties. When the speculators were stymied, housing prices flattened out and in the most active areas, declined. This gave the creators of these investment vehicles, having New York as their play ground, an opportunity to blame their potential negative exposure on a housing crisis.

Our largest investment banks enticed the financial media by leaking the assumption that they had billions in exposure, all because of unscrupulous and corrupt mortgage brokers. The fact that none of these brokers would exist if it weren’t for the eagerness of the investment banks to purchase these loans, with very lucrative commissions attached, from the very brokers they now blamed. With sub-prime, alt-a and jumbo mortgages becoming prohibitively expensive, the housing market produced a constant supply of bad news that eventually sucked in even Congress. As expected they produced a landmark deal with the Treasury that accomplishes nothing, a months grace after three months of non activity is just the solution that will definitively save the market.

The financial media was also instrumental in determining the Feds current disposition. By presenting one economist, guru, potentate and mogul after another calling for rate cuts, they created a public ground swell that anything but substantial cuts would have demonstrated that the Fed was out of touch with the real world. This frenzy to inject liquidation into the economy has little to do with the housing crisis and all to do with the fact that Wall Street loves cheap money. These same investment banks are now able to book enormous profits because their cost of capital has come down so low.

When thecost of money comes down and liquidity is added to our system, the banks have money to put to work and credit standards loosen. The resulting effect of “easy credit” is always an upturn in the default rate and the banks respond by tightening those same standards. Our economy has always had swings from loose credit to tight credit and back again, the difference here is we are just entering a period where credit is starting to tighten and the Fed is literally dumping liquidity on top of a tightening market. At this point it just doesn’t matter how much money is available, if someone doesn’t qualify they will not get the loan.

The credit crunch is definitely spreading; lenders are tightening standards on all types of loans and investors have lost their appetite for “exotic” instruments that can’t be accurately valued. This is just a normal swing that happens after an abuse. The fact that “UBS AG and Credit Suisse Group last week announced the write-down of a combined $400 million” should not come as a surprise. In this atmosphere where write-downs are expected there will never be a better time to clean-up your books. They could even be tilting the books to favor future profits; this is not an unknown concept to investment banks.

As far as these write-downs being a forward looking indicator of the future doom that our corporations will experience, is quite a stretch. Our economic slow-down will have it’s casualties but for the most part our corporations are sitting on enormous cash positions, the street anticipates them to start spending these cash hoards providing the impetuses for another growth cycle in our economy.

Bear Stearns

Part of a series The Great American Write-Down

Bear Stearns (BSC) wrote $820 million off in the third quarter and will take another writedown of $1.2 billion in the fourth. Moody’s and Fitch have stated that Bear Sterns still has too much exposure to subprime and CDOs.

Articles:
Ex Bear Stearns co-president Spector gets no severance
Bear Stearns sued over mortgage losses
UPDATE 2-Moody's warns on Bear Stearns, Fitch cuts