Speculators and derivatives
Posted on Friday, October 3, 2008
Mention the words mortgage
crisis and the panic nerve in
every red-blooded, working-class American starts to twitch. After all, millions of us have mortgages. But for 97 out of every 100 homeowners, there is no mortgage crisis. Among the 3 percent facing foreclosure, many were using their mortgages as short-term, wealth-building schemes, not long-term dwelling investments. For example, ABC’s “Nightline” did a special featuring a neighborhood in California, where the housing price index is down nearly 30 percent since last year. All three of the homes in foreclosure there had been bought for more than $ 1. 3 million by people who thought they could “flip” the houses and get rich quick.
One of the foreclosed homeowners candidly admitted that he wanted to make $ 1 million in a year or two and use that money to fund his retirement. He’s no homeowner, he’s a speculator. And we’re supposed to feel sorry for him ?
Even though historically high, a 3 percent foreclosure rate doesn’t represent anywhere near $ 700 billion. Aggregate mortgage figures are somewhere around $ 11 trillion. Three percent would be $ 330 billion, but most foreclosures retain half of their face value or more, so the bottom line on all these foreclosures is more like $ 165 billion.
The difference between $ 700 billion and $ 165 billion, $ 535 billion, is not in mortgages, but in derivatives.
The shadowy world of high finance has a glossary all its own, and taxpayers need to brush up on terms like derivatives, counterparties, leverage and forward contracts, just to name a few.
Derivative is a fancy term for a contract between two parties. Its price is supposedly “derived” from underlying assets, e. g., bundled mortgages, but the security for a derivative is purely dependent on the faith and credit of the contracting parties. Investopedia’s online dictionary says most derivatives “are characterized by high leverage.”
Highly leveraged firms are defined by Investopedia as having “significantly more debt than equity.” Leverage is the difference between buying 10 shares of Microsoft stock for $ 1, 000 or controlling 500 shares by purchasing five options contracts. Leverage magnifies both gains and losses.
I ran across an informative, amusing and enlightening parable about all this in the Baltimore City Paper, written last week by Edward Ericson Jr.
“To get a picture of how the face value of derivative trades can be multiples of an underlying asset,” he wrote, “it helps to think of yourself not as a sober, riskaverse citizen, but as a financial and probability expert.”
In short, a speculator. Imagine yourself at the track, Ericson said, where Murray the Drunk (another financial expert ) offers you 1, 000-to-1 odds on the trifecta in the third race. You agree to put up $ 2, 000 on the race if Murray will accept your fake Rolex as collateral. (You tell him it’s valued at $ 11, 000. )
Inking the deal on a napkin, you and Murray the Drunk have just made the equivalent of an over-the-counter transaction. “The track and its managers have nothing to do with this bet,” Ericson explained. “It’s just you and Murray, a drunk you have known and done business with for years.”
A minute later, the trifecta wins and Murray owes you $ 2 million. Expecting $ 10 million to materialize in another deal by Friday, he offers you an IOU, plus 10 percent interest, payable in full at 3 p. m. Friday. Slipping the IOU in your pocket, “you now have a forward derivative based on the value of your ‘winnings’ documented on the napkin, backed by the full faith and credit of Murray the Drunk,” Ericson wrote.
After leaving the track, you run into your friendly loanshark, Louis, and inform him that Murray will be worth $ 10 million on Friday, of which $ 2 million is yours. You offer to sell him Murray’s note for $ 1. 8 million cash. Instead, Louis says keep the note, he’ll lend you $ 1 million on it, and you can pay him $ 1. 1 million on Friday.
“You’ve now parlayed your $ 15 watch into $ 1 million in cash,” Ericson explained.
As a professional, you take 20 percent ($ 200, 000 ) off the top as “appropriate” compensation. On Thursday, you manage to dwindle the remaining $ 800, 000 down to $ 350, 000, but because you still have a $ 2. 2 million asset in your pocket—and owe only $ 1. 1 million on it—you’re not worried. When 3 p. m. Friday arrives, Murray the Drunk’s system has failed and he defaults. This jeopardizes not only him, but also you and Louis the Loanshark. Louis’ portfolio has a $ 1. 1 million “asset” in it—your note—and he feels reasonably secure because he prudently only loaned you 50 percent against your “asset,” Murray’s $ 2. 2 million IOU.
But now, with only $ 550, 000
left, you can cover only half what you owe Louis. His asset is now worth only 50 cents on the dollar. “This is how the magic of derivatives can create $ 3. 3 million of ‘hard-to-value assets’ from a bogus Rolex and a $ 1 million loan,” Ericson wrote. The proposed bailout is the equivalent of taxpayers funding the purchase of Murray’s IOU and your note to Louis, both at near-face value, which “recapitalizes” Louis and “saves” the system ! Pretty funny, if it weren’t so serious. The “mortgage” in Ericson’s parable is the original $ 2, 000, and its being paid back is a drop in the Treasury’s $ 3. 3 million exposure bucket. Lesson: Talk of pay-back isn’t worth the hot air it rides on.
—–––––•–––––—Dana D. Kelley is a free-lance writer from Jonesboro.
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