The Intelligent Person's Guide to Derivatives and The Recent Financial Meltdown

You probably have a reasonable idea of what stocks are. Stock represents a fractional share of ownership of a company. If a company has issued a million shares of stock, and you own one share, then you own one millionth of the company, referred to as your equity. If the company makes a profit, and they distribute it to the owners as a dividend, then you will get one millionth of the amount of profits they distribute. When you own stock, your upside is unlimited, and your downside is, the company can go bankrupt and your shares will be worthless. However, you can't lose more than you invest, which isn't true of some other kinds of investments.

Bonds are pretty simple, too. A bond is a kind of loan note created by a company, saying that if you buy their bond, they will pay you back the face value of the bond on a specified date. This is called the maturity date, or when the bond comes due. Some bonds are sold at face value, but include periodic interest payments, called coupons, in a specified amount. (Once upon a time, bond certificates actually had some paper coupons printed on them that you had to clip off and physically redeem for your interest payment. Nowadays, for the great majority of bonds, you just register your bond and they send you the money.) Other bonds, called zero coupon bonds, or zeroes for short, don't make any periodic interest payment, and instead are sold at a discount to the face value. The interest is paid as the difference between what you bought the bond for and what the company repays you when the bond comes due. US Savings Bonds work like this.

Investing in bonds, like investing in stocks, has a downside limited to what you invest. The upside, however, is limited because when the bond matures, it's worth the face value and nothing more. On the other hand, when a company goes bankrupt, the stockholders have nothing, but the bondholders get first claim on the company's assets. Admittedly, that may not be much consolation.

Stocks and bonds can be bought and sold, and depending on how much people want to pay for them and how much they're willing to sell them for, the price may change with each transaction. When this happens to a share of stock, it represents a change in the market value of the company. When the share price goes up, it's because people think the company is more valuable, and when the share price goes down, people think the company is less valuable. The relationship between what people are willing to pay for a company, and what the assets and profitability of the company are, can be tenuous. Famous investors like Warren Buffett have made their fortunes by buying companies that have good profitability prospects when most people think their stock is a dog and it trades for some relatively small amount compared to its value. Everyone is familiar with the way stock prices go up and down, and it's reported every day on the news.

People are less familiar with the way bond prices fluctuate every day. A bond has a fixed interest rate, but we know that interest rates change all the time, though not quite like stock prices do, A bond that pays 5% when the prevailing interest rate is 10% is not a very good deal, and so its price goes down. In fact, its price goes down about 5% for every year to maturity, until the effective difference between the 10% interest you can get on a new bond and the 5% you get on the old bond is gone. Say you have a $1000 face value bond that matures next year, and it pays 5%. If the current interest rate is 10%, then your bond's price in the marketplace will have fallen to about $955, which is what that $1050 you're due to collect next year in principal and interest is worth as an investment that pays 10%. On the other hand, if the current interest rate is a measly 1%, then your 5% bond is a pretty good deal, and someone would probably pay close to $1040 to take it off your hands. So you see how bond prices change to reflect the current interest rate situation.

The other thing that affects the bond price is a change in the creditworthiness of the company issuing the bond. When you buy a bond from the government, you're going to get paid back barring something like a nuclear war or planet-killing asteroid, in which event you probably don't care much. Companies, on the other hand, have a nasty propensity to go out of business, or lose lots of money, and might not be able to pay you back. How likely a company is to pay back its bondholders is measured by its credit rating. Companies with excellent credit ratings can sell their bonds at relatively low discounts or alternatively, with relatively low interest rates, at or just above the rates on government bonds. Companies that have not-so-good credit have to offer a bigger discount, or higher interest rate, to interest people in their bonds. Crummy credit ratings lead to really high interest rates on bonds, which are usually called junk bonds and represent a real gamble.

So when a company goes from a good credit risk to a mediocre one, suddenly nobody wants to be a bondholder, and the price of its bonds goes down, raising the effective interest rate paid if you buy one at the new, lower price. On the other hand, if you bought a cheap junk bond and the company's prospects suddenly improve, you may be able to sell your bond for much more than you paid, and the effective interest rate on the bond will have gone down proportionately. You could wind up owing capital gains taxes on your bonds, as well as taxes on the interest! I suppose there are worse problems to have.

This is all preamble to the concept of a derivative. In general, a derivative is a kind of security with a value that represents some aspect of some underlying security. For example, a stock option is a kind of derivative. If a stock is currently trading at $100, and you buy an option for a dollar to purchase a share of that stock at $100 in a month, then as the price rises, the value of your option rises right along with it. If the price falls to $100 or below, your option is worthless. At the end of the month, if the price is above $100, you can buy the share for $100 and you pocket the difference in the price, less the dollar you paid for the option, as a profit. If the price is less than $100, your option just expires, worthless. The option is sold by someone who would rather have the dollar you paid for the option than the potential upside on the stock over the next month. If they think the price will be flat or fall a little, this is a way to make some extra money, but they risk losing out on the stock's gains if the price goes up. The option is derived from the price change of the stock, so we can call it a derivative.

Another kind of derivative applies to bonds. One way to trade a coupon bond is to sell the right to collect on the coupon and the right to collect the principal separately. What you've done is split the bond into two separate securities, one that's called a strip that collects the interest, and another that's essentially a zero-coupon bond. Since these two securities are derived from an underlying one, they get called derivatives. They will have values that fluctuate along with interest rates and the fortunes of the underlying company, just like the regular bond, but with different properties which might be more valuable to various purchasers than the original bond. The company that creates the derivatives holds on to the original bond, but forwards the interest payments to the strip holder, and sends the principal due at maturity to the zero holder.

When you split off the interest payment on a bond like that, you can split it in more than one way, creating even more complicated derivatives. For example, you could take a regular coupon bond and sell a lower-interest strip and a higher-discount zero, or vice-versa. These will react in different ways to changes in interest rates compared to the original bond, so if buyers are looking for more volatility, or less, in their bond values, they can get what they are looking for.

Yet another way to create derivatives is to pool some securities together, then sell off new securities that represent some aspect of the underlying securities. For example, you could combine some treasury bills with some junk bonds and effectively create new bonds that are intermediate between the two in interest rate and creditworthiness. You can sell the high volatility and the low volatility aspects separately to parties that are looking for more risk and more upside, and parties that want less risk and will accept a smaller payout.

Now let's say someone has a big pile of mortgages. These all will have various interest rates and the payers will have various credit ratings and payment histories, but we can combine the mortgages into groups, and create new derivative securities that look like bonds out of them. Depending on how we group them, we can get low-interest, high credit rating ones together, or high-interest, lower rated ones, and create new bond-like securities with similar properties. The risk that a few of the mortgages might go into default gets built into the new mortgage-backed security's discount, effectively raising the interest rate. If the group has a lot of mortgages that might default, then the new security is more like a junk bond, and its price should drop and interest rate rise accordingly. The problem with these new securities is that it's hard for someone to tell whether a given instance really ought to be considered AAA or junk without going through all of the underlying mortgages and checking each one. One of them might have started out in good shape, but be composed of mortgages from somewhere that just had a big plant close, and suddenly lots of those houses are on the market for cheap, and how would you know? You rely on the credit rating agencies to stay on top of it, but this level of detail may be beyond them.

So, let's say you have some bond, and you're willing to part with some of the interest on the bond in return for a guarantee that you'll get your principal back, because you're worried about that more than you want a high return. Say someone comes along and says, I will agree to buy your bond from you at par (that is, the present value of the face value of the bond at maturity at the prevailing interest rate) if something happens to it to significantly change its value, such as going into default, and in return, all I ask is that you pay me all the interest your bond pays over and above what a treasury note with the same maturity pays, plus a little extra for my trouble. What you're doing is taking your bond and turning it into something more like a treasury note, because someone else has agreed to take on the default risk in return for a risk premium. This kind of derivative is called a credit default swap, and it's what got AIG into such awful straits.

What happened was, AIG and others were busy minting money by taking on the default risk for mortgage-backed securities, because they figured there was no way to lose - house prices just go up, right? And more and more financial institutions were willing to buy the mortgage-backed securities because companies like AIG were willing to sign up for the default risks, which were hidden inside and not really reflected in the price of the securities. And the mortgage companies that created the mortgage-backed securities and sold them to banks and insurers and brokerages, were busily plowing the money they got from selling them into making ever more mortgages to ever less credit-worthy borrowers, who were busy driving up the price of housing with their borrowed money.

And then the bubble popped.

Gradually, sub-prime borrowers, and a few prime ones, got in trouble as their teaser-rate variable mortgages started getting adjusted upwards, the economy slowed and house prices fell, and they couldn't refinance into something they could afford. More and more mortgages went into default, showing up as these mortgage-backed securities not making their interest payments and going into default even when they'd gotten high ratings from the credit rating firms. Financial institutions started looking into their portfolios and finding these hot potatoes and all started trying to unload them at the same time, and the market evaporated. They had to come up with more cash to cover the lost interest payments they weren't getting anymore on these things, to try and avoid going into default themselves, and cash started getting hard to come by. Firms like AIG that had guaranteed the securities without much of a cash reserve started getting viciously squeezed. Firms that had purchased the securities with borrowed money found that they had no way to get money to pay their lenders, since they couldn't sell them at any price. That's when the excrement really struck the rotational airflow facilitators.

When you buy something, and its price drops, the most you can lose is what you paid for it. When you buy something with borrowed money, and its price drops, you can lose more than you started with and find yourself in a deep debt hole. And if you can't service your debt, then whoever lent you the money feels the pain, too. If you're a major financial player and it's also going on with a bunch of other major players, it can snowball into a general financial meltdown. And so even though the underlying market value for houses has dropped by maybe 20%, and foreclosure rates are still just a small fraction of total mortgages, the number of firms that have had their capital wiped out as a result is impressive. Or perhaps depressive.