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Derivatives Defined. Thrice.

The The Wall Street Journal catches an embarrassing slip over at the Securities and Exchange Commission: A press release they put out quotes their Los Angeles office director referring to "derivatives" when she meant "securities." Yipes. It's all the worse because the SEC doesn't have the authority to regulate derivatives, even though that appears to be what some of its employees think the agency is doing.

Felix Salmon, as is his style, decides this to be a teachable moment and offers a quick line on the difference between securities and derivatives:

the line between securities and derivatives is quite easy to understand: derivatives are a zero-sum game, while if a security goes to zero, no one else makes a concomitant profit.

Another way of saying that is that securities represent financial value. A share of common stock, say. If the firm goes bankrupt, the stock is worthless. Derivatives -- think a credit default swap on whether the New York Times will go bankrupt -- tend to be a bet on an outcome, and if one party loses, the other gains.

For a longer -- and very useful -- introduction to credit derivatives (like credit default swaps and collateralized debt obligations, both of which had a particularly central role in this crisis), read this paper by David Skeel and Frank Partnoy. But since a lot of you won't read the paper -- and shame on you! -- I'll quote their definition of credit derivatives, too: "credit derivatives [are] financial instruments whose payoffs are linked in some way to a change in credit quality of an issuer or issuers."

By Ezra Klein  |  June 2, 2009; 11:16 AM ET
Categories:  Financial Crisis  
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Comments

Derivatives -- think a credit default swap on whether the New York Times will go bankrupt -- tend to be a bet on an outcome, and if one party loses, the other gains.

Derivatives is not a dirty word. The regulated futures market provides a needed economic function and that is one of liquidity and the ability for those who don't want risk to hedge their position. It all started with farmers who knew what their seed costs and what their labor would cost, but couldn't predict the grains markets a year into the future.
The same now holds for those holding portfolios of stock and other assets. Who knows what the future will bring. The speculator that you believe is sooooo....evil provides the will to take on the risk in expectation of a profit and makes the market that makes all of this possible.
So, the next time you write about derivatives, understand that they serve a purpose, they provide a 'market in the future' and a place to shift risk to others. And they are as good as the undelying commodity.

Posted by: ElViajero1 | June 2, 2009 11:25 AM | Report abuse

From Seeking Alpha:
[http://seekingalpha.com/article/34606-buffett-on-derivatives-a-fool-s-game]

Buffett On Derivatives: 'A Fool's Game'
....
In fielding a question about derivatives, which he once referred to as "financial weapons of mass destruction," Mr. Buffett told shareholders that he expects derivatives and borrowing, or leverage, would inevitably end in huge losses for many financial participants.

"The introduction of derivatives has totally made any regulation of margin requirements a joke," said Mr. Buffett, referring to the U.S. government's rules limiting the amount of borrowed money an investor can apply to each trade. "I believe we may not know where exactly the danger begins and at what point it becomes a super danger. We don't know when it will end precisely, but...at some point some very unpleasant things will happen in markets."


Note that there is no organized market for derivatives, and their are no rules/laws or regulators. Free Market heaven! And they like it that way - enough to have bought not only the Congress but three successive executive-branch administrations.

Posted by: JimPortlandOR | June 2, 2009 11:34 AM | Report abuse

Jimbo,

No one forces people to participate in derivatives. No one forces people to invest in stocks or bonds or real estate either and all have lost money. Yet there is no complaints about those vehicles.

I'm sure you also believe a gun can pull it's own trigger.

Posted by: ElViajero1 | June 2, 2009 12:51 PM | Report abuse

Let me betray my ignorance for a minute:

Okay, let's take the credit default swap on whether the New York Times will go bankrupt. And let's assume I'm taking the position taht the Times will go bankrupt.

How does it work? With stock I'm buying 100 shares at X dollars per share. With a credit default swap, I presume I'm "gambling" a certain amount of money on my Times bankrupty position. But what do I get if the Times goes bankrupt. Are there "odds"? If I "bet" $1,000 on Times bankruptcy, and the "odds" are 50 to 1, do I get $50,000 if the Times goes bankrupt?

Teach me.

Posted by: pbasso_khan | June 2, 2009 1:18 PM | Report abuse

The instruments in the SEC's complaint were CMO's (Collateralized Mortgage Obligations) derived from RMBS (Residential Mortgage Backed Securities). That makes them derivatives. Typically, before the market blew up, RMBS were registered with the SEC for a year, using disclosure based on unstructured non-standard ASCII text, and then de-registered; derivatives created on top of those "temporarily public" or "psuedo-public" securities were typically exempt from registration because they were only supposed to be purchased by "sophisticated" investors. (Sophisticated! Ha! Participants in the shadow banking system may have been many things, but apparently only the folks who were short the RMBS, CDOs (D is for debt), CMOs, etc. were truly sophisticated. A good Wired story linked from http://paulwilkinson.com explains the genuine sophistication manifested by third parties who paid to manually structure the RMBS data, translating it from ASCII format to XBRL format, making it easier to detect the defects in RMBS and instruments derived from RMBS.)

The SEC's enforcement authority isn't compromised by casual semantics. Generally, it extends to fraud about any "security," defined as an investment of money in a common enterprise for profit derived from the efforts of others. There are specific statutory exemptions, but promoters can't hide behind jargon such as "derivatives." How can you possibly say the SEC lacks the authority to regulate derivatives? Yes, a clause inserted into a bill about a decade ago banned regulation of credit default swaps that weren't otherwise securities. It would have been a much bigger scandal if the clause banned enforcement against fraud in the offering of investments of money in a common enterprise for profit derived from the efforts of others. That is the heart of the SEC's business, and fortunately, that did not happen. The Post hasn't done much lately to explain the differences between regulatory policy, civil enforcement, and criminal enforcement. (See comment on yesterday's story.) An examination of how those concepts affect the shadow banking industry is long overdue.

Posted by: PaulWilkinson | June 2, 2009 10:05 PM | Report abuse

Clearly we had misuses and abuses of the various OTC products in the last 20 years (just as firms and individuals time and time again got decimated by trading exchange listed derivatives). Clearly dealers made massive amounts of money on OTC derivatives sometimes ripping off clients (similar to the way insurance firms profited from writing insurance). The knee-jerk reaction regulation is however not the answer. Clearing platform solutions, standardization, and disclosure to regulators are sometimes helpful but represent only a fraction of the answer. The key is sound margining procedures (such as the ones used by exchanges) and proper bank capitalization. Most banks already have such procedures in place and the Fed (as well as the OCC) should review and push for strengthening of these practices. The industry is already moving in this direction. Destroying or restricting various risk management tools provided by dealers is unsound, even if it makes for great press coverage. For those who prefer to understand rather than to react, please read the post called "Derivatives, the wrong war" on SoberLook.com

Posted by: SoberLOOK | June 7, 2009 11:34 PM | Report abuse

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