Why Were Banks Allowed to Bet on Derivatives?

BY busadmin  May 20, 2009 at 10:10 AM EDT

houses; via iStockPhoto

Question: How did the dollar volume of U.S. mortgages get to be such a huge dollar problem? Did derivatives do that? Why are investment banks allowed to bet 34 dollars for only one they have?

Paul Solman: First, a word on behalf of “derivatives.” A few hundred words, in fact. (Consider this fair warning that the following answer is long-winded.) As law professor and author Frank Partnoy put it simply in a story of ours a few years ago:

“Derivatives are financial instruments whose value is linked to something else.” So, almost ANY financial instrument is a derivative.

“Futures” are derivatives, for example. And while they’re often portrayed as a symptom of our “casino culture,” they serve a real economic purpose. To make things a little clearer, we went down on the farm to give one of our typically oversimplified demonstrations, from which I paraphrase. (If you already know this, skip ahead a dozen or so paragraphs.)

Say Old MacDonald has a problem. He’s fattening his hogs today, but they won’t be ready to sell for six months. A hog like Wilbur will cost, say, $100 to keep and feed until slaughter time, when, if there’s a God in hog heaven, Mac will get $150 for Wilbur— a fat profit.

But now suppose the worst: A bumper crop of pigs comes to market just when Wilbur does and/or pork loses its pull. At any rate, Wilbur and kin fetch only $50 apiece when they have to be sold. Big Mac could go broke. But not if he hedged his bets on the commodities market with a derivative.

Imagine those human pens you see on TV because they’re so lunatic-looking, with all those traders acting like real pigs, though they make more sophisticated gestures with their limbs and their grunts are apparently intelligible.

Such venues are marketplaces where farmers can sell their pigs, corn, wheat, what-have-you, at a date in the future, at a locked-in price.

So, in Mac’s case, if Wilburs are going for $150 today, he can enter into a contract that promises him, say, $150 per pig six months from now. It’s really a bet on the future price of pigs. But for Mac, it’s insurance against the risk that the future market price will go down.

As Professor Partnoy put it in our story: “Old MacDonald can enter into one of these contracts to lock in a future price. He no longer has to worry about whether the price goes down.”

Now contracts in this market don’t just protect producers of pork, or any other commodity. Think about someone who needs to buy pork, like Kevin Bacon, for his hot dog business. The risk to him is that the price will rise. So he could take the other side of a contract like Mac’s, and lock in a price of no more than $150.

In effect, the parties would be swapping risks at a minimal cost— basically the commission the market takes for brokering deals like these, using derivatives. Again, in our story, Professor Partnoy provided the soundbite.

FRANK PARTNOY: Both sides love this agreement. It’s great because it eliminates risk for the farmer. It eliminates risk for Kevin Bacon.

PAUL SOLMAN: And the market thrives because it charges something for doing this.

FRANK PARTNOY: There’s always an intermediary putting these two together, and that intermediary, whether it’s the market or an exchange, makes a few pennies off of both people so that everybody is happy.

I went on to explain that these contracts are essentially bets on the price of something in the future, that you can use them to lower the price risk of something you make or buy.
The problem, of course, is that anyone can just gamble with them — speculate. And that’s the cause of the current crisis: too much gambling. But even IT has an economic function, we pointed out.

A speculator thinks he can see the future, and wants to bet on his vision. In his mind’s eye, perhaps, he sees Mad Cow Disease sweeping the land, killing the cattle industry, and thus forcing desperate meat eaters to switch to pork, driving the price way up. So, he can take the other side of the Big Mac contract, just like Kevin Bacon did, promising to pay $150 six months from now, and rooting for the price to rise. That’s speculation.

But whether it was producers and consumers hedging their risks, or speculators taking risks, the commodity markets evolved to enable such trades, making a commission on each.

“And that’s what makes markets efficient,” Professor Partnoy explained. “Because the price will reflect all information that’s available in the market. The speculator has certain information that the farmer and Kevin Bacon might not have. As long as you allow speculators to come in and participate in the market, all the information that the speculators have will be reflected in market prices.”

The above is my attempt at an exhaustive (although perhaps exhausting) justification for derivatives that are often though malign. But now on to your question: Did derivatives balloon the mortgage problem?

Well, mortgage-backed securities ARE derivatives, so in a sense derivatives made the problem possible. But let’s be careful: in the case of housing derivatives, we’re not talking about “futures” in which there are equal and opposite bets on both sides, but plain old loans that have been very widely syndicated. Mortgages are pooled and shares of the pools are sold off to investors, who knew nothing about the riskiness of the loans they are buying into and thus helping bankroll. (The value of the shares “derives” from value of the mortgages themselves, which in turn derives from the value of the houses that are the collateral standing behind the loans.)

With these housing “derivatives,” in other words — mortgage-backed securities — pretty much everyone was betting one way: that prices would continue to rise. When they dramatically did NOT, pretty much everyone took a beating.

So, in that sense, yes, these sorts of housing derivatives, if you want to call them such, made the crash possible, by making possible the boom that led to it. But when you think about it, isn’t a stock market mutual fund crash the same sort of phenomenon?

The answer to your second question: The investment banks lobbied for and got an exemption from regulation that allowed them to take on as much leverage as THEY felt comfortable with, a state of affairs the Obama administration was no longer going to tolerate. You noticed, perhaps, that the two major investment banks, Goldman Sachs and Morgan Stanley, changed themselves into regular and therefore regulated banks some months ago, meaning they can no longer borrow 34 dollars for every dollar of their own? Want to know why? They were forced to.