For Angry Dragon, a little on derivatives

[jmowreader]

Angry Dragon asked me for my "half-page" talk on derivatives I'll probably wind up sending to the Spokane Spokesman-Review. I'm going to have to sit down and crank that out, but in the meantime this will get you started:

A derivative is, according to the textbook, a security whose value derives (hence the name) from the value of another thing of value. According to me, it's one of the few ways a private company has to print its own money.

There are two real broad categories of derivatives: commodities derivatives and credit derivatives. Commodities derivatives are used to sell commodities (salt, sugar, grain, whatever) at a later date, and there are four kinds: futures, forwards, options and swaps.

A futures contract--never, ever a "future contract"--is a deal where you will, on a specified date, exchange a stated quantity of whatever for a stated quantity of money. Let's beat up on one of my favorite DUers: flvegan, who we're going to make the manager of a successful bakery. He is successful in part because he can control expenses, and one of the ways he does so is by knowing how much he pays for wheat. He buys futures contracts on wheat. For instance, right now he's got one out for December delivery at $7.10 per bushel. When this contract exercises, someone's going to show up in large trucks with 5000 bushels of wheat, and he's going to show up with a check for $35,500 to pay for it. There's a modicum of risk here, of course: if wheat for immediate delivery (the "spot market") is selling for $6 per bushel at the settlement date of this futures contract, he's going to pay more for the wheat than he otherwise would have. The advantage he's got is, if spot wheat is selling for $9 per bushel in December, thanks to his futures contract he still gets to pay $7.10 per bushel for it.

A futures contract has two major disadvantages if he's a farmer: it has to be delivered on a certain date and exactly the amount specified in the contract has to be delivered. If he sells futures on 20,000 bushels and 19,000 are harvested he has to go out and buy a thousand bushels of wheat. If 21,000 are harvested he's got to get rid of a thousand bushels on the spot market and hope he doesn't get screwed. And if he wrote the contract for delivery on September 15 and the crop has too much moisture to harvest on September 15, he has to buy 20,000 bushels of wheat on the spot market to meet his obligation. In this case, he would be far better off writing a "forward contract." It's like a futures contract, but just slightly different: he can write it to say "at the conclusion of harvest I will deliver my entire crop to Joe's Grain Elevator Service for $6.95 per bushel." Or it can say anything he wants it to. These are extremely custom contracts and no two are alike.

Back to the bakery. flvegan might need anywhere from 20,000 to 40,000 bushels of wheat this month. He knows he needs 20,000 and futures are sold in 5000-bushel increments, so he buys four futures contracts. If he bought eight and only needed four he'd have to make room for 20,000 more bushels than he'll use this month. If he buys four and needs eight, he'll have to buy 20,000 bushels on the spot market--which defeats the purpose of buying futures. Therefore, he buys four futures contracts and four options contracts. With an option you don't have to buy the wheat if you don't want it. If he only needs 25,000 bushels he exercises one option; if he needs 35,000 he exercises three. This gives him some assurance on price, but at the same time doesn't lock him into owning too much grain. (You can also trade stocks with options contracts.)

And finally there are commodities swaps. These are almost always written against crude oil--everything I've read says about 98 percent of the commodities swaps are oil swaps. These lock in price. So...let's say he convinced someone to sell him a grain swap on a million bushels at $7 per bushel. If the spot market for grain is $7.50 per bushel, he buys the grain for $7.50 and his counterparty sends him 50 cents, making the grain cost $7 per bushel. If it costs $6 per bushel, he buys for $6 from the grain company then pays the counterparty $1 per bushel. No matter what happens on the spot market, he pays $7 per bushel.

Some people use commodities futures as an investment, but speculating on grain prices has cost a lot of people a lot of money and will continue to do so, therefore I wouldn't recommend it.

So far I think this is pretty simple: commodities derivatives are basically a form of delayed gratification. Now let's talk about credit derivatives, the bane of the financial world.

There are two basic kinds: asset-backed securities and credit default swaps.

Asset backed securities come in a lot of flavors, like "collateralized loan obligations" which are based on LBO debt (they're essentially the junk bond for the new millennium) . The three you've probably heard of are asset-backed securities, mortgage-backed securities and collateralized debt obligations. They're all made in pretty much the same way:

1. Loan money to people.
2. Collect up the loan documents and separate them by credit risk into "tranches" (it means slices in French). You would ideally have four tranches: low, medium, high and extra crispy. All the debt you expect to default for some reason goes in the last one. The debt that's most secure goes in the most senior.
3. Create bonds based on the tranches, and sell them.
4. As the people who borrowed the money in the first place pay it back, distribute interest to the bondholders. When the loans are paid off, refund the principal to them and you're done.

The difference is the type of debt underlying: asset-backed securities are non-mortgage debt; mortgage-backed securities are mortgage debt.

I don't have much of a problem with these. You've heard of selling mortgages; this is the tool used to do it. Plain-vanilla senior MBS tranches are about as secure an investment as you'll find in the private sector and, so long as people are making house payments, they're fine.

Now for the collateralized debt obligation. I once called them the Island of Misfit Derivatives because this is where you send the other derivatives when you can't sell them. You can put anything you want in a CDO--MBS, ABS, cash, car loans, whole mortgages, Ponzi Notes, a Powerball ticket...

Once you've built the CDO, you might not be able to sell it. The only thing you can do in that case is...yes, put it into another CDO called a CDO-squared. Keep doing that until either you fool someone into buying the bond or someone figures out what you're doing, splatters it all over the Internet and causes all your depositors to pull their money out of your bank.

And finally come credit default swaps--insurance with a difference. Well, three: the seller isn't constrained by the insurance laws, the seller doesn't need to have enough money to make you whole (how could he? There's not enough money in the world to pay off all these derivatives, by a factor of somewhere around 20...), and the buyer doesn't have to own the asset in question. Let's say I was a Republican who owned a factory. When I finally got around to moving it to China, I would first take out a naked CDS on the mortgages covering my soon-to-be-ex-employees' houses. Doing this gets you sent to the eighth circle of Hell.

The real problem with derivatives is the way they multiply risk. Some people say they hedge risk, and they used to; but now if you have a $1 million loan that's been bundled into a MBS, then bundled into CDOs, which are rolled into other CDOs, which then have CDS both covered and naked written against them, you've got a multiple of millions of risk.

I'm going to come back to some cures for this disease later.