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Kimberly Amadeo

Role of Derivatives in Creating Mortgage Crisis

By October 13, 2008

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A reader asks:

I have been reading that the reason for our economic downturn is the proliferation of "Derivatives" in the last decade. Can you explain to me exactly what is a derivative and how it works?

Derivatives are complicated financial products that derive their value by reference to an underlying asset or index. A good example of a derivative is a mortgage-backed security.

Here's how it works:

  • A bank makes an interest-only loan to a homeowner.
  • The bank then sells the mortgage to Fannie Mae. This gives the bank more funds to make new loans.
  • Fannie Mae resells the mortgage in a package of other interest-only mortgages on the secondary market. This is a mortgage-backed security (MBS), which has a value that is derived by value of the mortgages in the bundle.
  • Often the MBS is bought by a hedge fund, which then slices out portion of the MBS, let's say the second and third years of the interest-only loans, which is riskier since it is farther out, but also provides a higher interest payment. It uses sophisticated computer programs to figure out all this complexity. It then combines it with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.
  • All goes well until housing prices decline or interest rates reset and the mortgages start to default.

Since no one really understood what was in the MBS, no one knew what the true value of the MBS actually was. This uncertainty led to a shut-down of the secondary market, which now meant that the banks and hedge funds had lots of derivatives that were both declining in value and that they couldn't sell. When this happened, they stopped making new loans, which meant houses didn't sell, which only put more downward pressure on housing prices, which then caused more loans to default.

Soon, banks stopped lending to each other altogether, because they were afraid of receiving more defaulting derivatives as collateral. When this happened, they started hoarding cash to pay for their operations. Then they stopped lending to other businesses. That is what prompted the Bailout Bill, which is really the only solution to get these derivatives off of the books of banks so they can start making loans again.

It is not just mortgages that provide the underlying value for derivatives. Other types of loans and assets can, too. For example, if the underlying value is corporate debt, credit card debt or auto loans, then the derivative is called a Collateralized Debt Obligations. A type of CDO is Asset-backed Commercial Paper, which is debt that is due within a year. If it is insurance for debt, the derivative is called a Credit Default Swap.

Not only is this market extremely complicated and difficult to value, it is unregulated by the SEC. That means that there are no rules or oversights to help instill trust in the market participants. When one went bankrupt, like Lehman Brothers did, it started a panic among hedge funds and banks that the world's governments are still trying to fully resolve.

Related Articles

Examples of Derivatives

Comments

October 16, 2008 at 12:17 am
(1) Brian Rogers says:

Please read, copy, and paste to every blog you know of.

Remember: “Together we Bargain- Divided we BEG.
So let’s get down to the real issue at hand. The economy

I’m against the $85 BILLION bailout of AIG.
Instead, I’m in favor of giving $85,000,000,000 to America in a ‘We DeserveIt’ dividend.

To make the math simple, let’s assume there are 200,000,000 bona fide U.S.citizens, aged 18+.
Our population is about 301 million counting every man, woman, and child. So, 200,000,000 might be a fair stab at adults 18 and up. Now, divide 200 million, 18+ adults into $85 billion – that equals $425,000.00 each!

Yes, my plan is to give that $425,000 to every adult as a ‘We Deserve It’ dividend.

Of course, it would NOT be tax free. So, let’s assume a tax rate of 30%. Everyone would pay $127,500.00 in taxes.
That sends $25.5 billion right back to Uncle Sam! It also means that every adult 18+ has $297,500.00 in their pocket.

A husband and wife would have $595,000.00!
What would you do with $297,500.00 to $595,000.00?
Pay off your mortgage housing crisis solved
Repay college loans what a great boost to new grads
Put away money for college it’ll really be there
Save in a bank create money to loan to entrepreneurs
Buy a new car create jobs
Invest in the market capital drives growth
Pay for your parent’s medical insurance health care improves
Enable Deadbeat Parents to come clean or else

Remember this is for every adult U.S. citizen, 18 and older (including the folks who lost their jobs at Lehmann Brothers and every other company that is cutting back) and of course, for those serving in our Armed Forces.

If we’re going to do an $85 billion bailout, let’s bail out every adult U.S. citizen!!

As for AIG liquidate it.
Sell off its parts.
Let American General go back to being American General.
Sell off the real estate.
Let the private sector bargain hunters cut it up and clean it
up.

We deserve the money and AIG doesn’t. Sure it’s a crazy idea, but can you imagine the coast-to-coast block party?!

How do you spell Economic Boom? W-e D-e-s-e-r-v-e I-t d-i-v-i-d-e-n-d!

I trust my fellow adult Americans to know how to use the $85 Billion ‘We Deserve It’ dividend more than I do the geniuses at AIG or in Washington,
D.C..

And remember, The plan only really costs $59.5 billion because $25.5 billion
is returned instantly in taxes to Uncle Sam.

Brian Rogers
btrogers69@yahoo.com

October 16, 2008 at 10:15 am
(2) Geometrix says:

Since when 85000/200 is 425000? Is there some kind of scale invariance involved here?

October 26, 2011 at 3:59 pm
(3) math genius says:

$85,000,000,000 / $200,000,000 = $425

You did a whole lot of nonsense here buddy

November 30, 2011 at 8:15 pm
(4) KittyM says:

What about CDS (credit default swaps)? You don’t mention these at all.

November 30, 2011 at 9:53 pm
(5) Kimberly Amadeo says:

Hi Kitty,

I did give a brief mention in the next to last paragraph. It links to an article that gives a more detailed description.

Hope this helps!

Kimberly

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