DERIVATIVES FOR DUMMIES

A long exchange on Bill Quick's blog triggered this one.

OK, here's a derivative. You grow corn. You are allowed to sell your corn to somebody else BEFORE you grow it. You collect the cash as a part of the contract and you have to deliver the corn after harvest to complete the contract. That contract is called a futures contract IF it is executed on a Commodity Exchange. It is called a "Forward Contract" if it is private. Both are "derived" from the corn being grown. Now, there are also options on these "futures contracts" or "forward contracts" which are "derived" from the futures contracts, not from the corn being grown. Most options are Exchange traded. Some are off exchange private contracts.

NOW DERIVATIVES FOR THE HIGH IQ

So what's the problem? The problem is that somebody figures out there is a link between the price of corn and the price of German Bonds. Further, the figuring shows that 100,000 bushels of corn will equal in dollar movement ten million dollars German Bonds. So this derivative "hedge" is put on. But they get worse. Somebody also figures out that the German Bond will move inversely one point for every two pennies Arabian Light crude oil moves. So another "hedge" (derivative) on off Exchange Arabian light is put on. You readers can't follow this and neither can anyone else. Only the smart guys with their computers can follow it and also follow any "deviation" from the formulas that take place. Now it gets hairy. When these "deviations" happen more of something is either bought or sold. These "links" can go deeper and deeper. Most times these complicated transactions actually work out. It's rare that they don't, which means a FEW do not work out. When a commodity or bond misbehaves so badly that you can't "unwind" the position (sell or buy it back), you are forced to "over hedge" somewhere else. The result can be a loss of hundreds of millions, billions, or in the case of a Fannie Mae, maybe a trillion or so.

The fact that these extended "derivative" positions are not revealed has everyone concerned. The people doing these "derivative transactions" or hedges, claim that secrecy of their proprietary formula is what makes these complex transactions work. They are called "black box" formulations, meaning they take place within a closed system. Whatever the claim, it is the secrecy of the transactions and the mis-representations of the risk to investors that is a problem.

There is nothing wrong with the derivatives we know about, it's the ones we don't know about that put companies at risk. The only way to track how they are doing is with complex computer programs. Get it? OK, now to the mortgage derivative problem. All mortgages are securitized, meaning wrapped into a giant mortgage bond of a hundred million or more. Then another bank or firm takes that mortgage bond and loads it up with credit card debt and student loan debt (payments guaranteed by uncle sucker) and they have a billion dollar security. Then another firm will take that bond and add to it car debt etc. etc. etc. til you have bonds floating around out there that are absolutely impossible to figure out---lack transparency to use the current jargon. This is compounded by bond rating services being bribed so that the bonds are labeled AAA that should be BBB at best. This shit is going to blow up and blow up big time because we are talking trillions of dollars here not billions. I know you think I'm crazy or blowing this up out of proportion, but trust me, this is a house made of tissue paper.