Wednesday, May 20, 2009

Derivatives - A bad word

As I have watched the the financial markets melt down, I started to muse on what is now considered a bad word, Derivatives. As a person who actually worked in that market for a good 7 years, I understand the products that have been blowing up better then most. CDO's are bad, CDS are bad, Mortgage Backed Securities are bad. What is unfortunate about this, is these products in themself are not bad, but were used fraudulently over the last 4 years.

Fraud is the key word. When ever financial products or ideas get abused and used fraudulently, they blow up and everyone says how bad these products are. In reality, many of these products and structures provide a legitimate business purpose and have real value to consumers.

A perfect example is Enron and the use of off-balance sheet entities. The use of off-balance sheet entities and products is not what blew up Enron, it was the fraudulent use of those products. Accounting rules in themselves have a legitimate business purpose, to provide transparancy to the viability of a business. Again, when a fraudulent set of books is kept, you blame the fraud not the accounting rules.

Derivatives are a perfect example of a fraudulent use of product. Derivates themselves are not bad. They serve a legitimate business purpose. The simplest is to transfer risk. In recent years, it has also allowed companies and individuals to participate in a market or provide lower cost of funds.

You know those stock options you received at your company? Those are derivatives. They allow you to participate in the success of your company. When can options go bad? Where does fraud happen? How about the back dating of options by executives. To me thats fraud. Do you blame the product or do you blame the fraud?

Did you know mortgage backed securities have been around for 30 years? Yep, the first MBS was created in 1979. Sub-prime MBS have been around since the mid 90's. They serve a legitimate purpose, to provide funds for lenders to make more loans. The big dirty word of CDO, guess when the first CDO was created? 1990. Yep, it was a way of securitizing the junk bonds held by the defunt Drexel Burnham Lambert.

So what happened in 2007 and 2008? Can you guess? Fraud. Yep massive fraud. Who committed the fraud? Everyone. Yes everyone. The guy making $30,000 a year getting a $400,000 loan he couldn't afford. The guy who lied on his application about how much he made. The mortgage officer that pushed sub-prime product to the prime customer. The mortgage broker that changed numbers on the application. The investment bank that new the loans were fraud yet sold them anyway? The rating agency that new they were defaulting at new levels yet still rated it high. The administration that wouldn't let the regulators do their jobs or the congress that wouldn't give them funding?

See what happens when massive fraud happens? In this case it can take down an entire country if you are not careful. When I worked on a mortgage backed security desk in the late 90's, the customers who bought this product were very sophisticated. When someone not sophisticated bought it is when you got into trouble.

The investors who bought CDO's in the 90's were l arge insurance companies that drilled the investment advisor running the CDO before they would consider buying the piece of paper. A lot of times they never did.

The salesman who persuaded the municipality to buy a fraudulent piece of paper, guess what he was committing? Can you guess?



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