Derivatives, those destructive instruments that caused the 2008 financial crisis, are back. Actually, they never went away. Despite handwringing over how Dodd-Frank regulations have crippled banks' ability to compete, derivatives are just as dangerous as they've ever been.
First, what are they? These complicated financial products derive their value from an underlying asset or index. A good example of a derivative is a mortgage-backed security. Remember those? If not, here's a chilling reminder of how they created the subprime mortgage crisis:
- A bank made an interest-only loan to a homeowner.
- It sold the mortgage to Fannie Mae, giving it more funds to make new loans.
- Fannie Mae resold the mortgage in a package of other interest-only lonas 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.
- The MBS was bought by a hedge fund, which then sliced out a portion of the MBS. It might sell just 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 combines these slices with similar risk levels of other MBS and resells just that portion, called a tranche, to other hedge funds.
- All went well until housing prices fell, interest rates reset, and the mortgages defaulted.
Derivatives are super-risky because they still aren't regulated by the SEC. There are no rules or oversights to help instill trust between the banks that use them. 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.
And now, there's $693 trillion of them -- more than in 2008. The Federal Reserve recently issued a report that said only 13 out of 19 banks could report on how many derivatives they had, how they'd sell them if they had to, and what they would do if they couldn't sell them. In othe words, there are as many as 6 Lehman Brothers bank failures potentially out there. The Bank of England was one of them. (Source: WSJ, Banks Are Still Vulnerable Over Derivatives, January 21, 2014).
Derivatives aren't just based on mortgages, but also on just about any other type of loan or assets. Here's a sample of the most popular:
- Collateralized Debt Obligations are based on corporate debt, credit card debt or auto loans.
- Asset-backed Commercial Paper based on debt that is due within a year.
- Credit Default Swap based on insurance for debt.
How It Affects You
It won't affect you, until one of the banks starts to go bankrupt, like Lehman did. Think back to Monday, September 15, 2008 -- the day that Lehman crashed. Warnings of potential collapse had been occurring since April, when Bear Stearns was bailed out. They continued throughout the summer, and Fannie Mae, Freddie Mac and AIG were on the ropes. Keep alert to these kinds of signs, and don't think it can't happen again. It can, and unless these bank derivatives get better regulated, it probably will.
- What Are Securities?
- Did Hedge Fund Housing Losses Cause Economic Slump?
- How Hedge Funds Affect the U.S. Economy
Examples of Derivatives
- Asset-backed Commercial Paper
- Call Option
- Credit Default Swaps
- Collateralized Debt Obligations
- Commodities Futures
- Futures Contract
- Mortgage-backed Securities
- Oil Price Futures
- Put Option
- Stock Options
Photo: Wall Street, the birthplace of derivatives. Credit:Spencer Platt/Getty Images.