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A short rough primer on leveraging and derivatives

By: Hugh Sunday September 28, 2008 12:06 pm


Leveraging means something like this. You sell $10 million in stock. You use this money as the basis to take out a loan so you can buy $100 million in mortgages. Now say you issue mortgage backed securities based on these and sell them. Now you have a $100 million in cash so you go out and buy more mortgages only this time you use your $100 million to buy a billion dollars of them. You have just leveraged your initial $10 million 100 times. This works if you, your banks, and the buyers of your paper are all sufficiently greedy. Why would banks loan you $100 million on $10 million collateral? The short answer is they wouldn’t for you or me, but they would and did to financial companies because of the fees and interest they made off of such transactions and because they “knew” those companies were good for it. This was all much easier to believe on the upside of the bubble because the value of the underlying assets (houses) kept going up. So even if a few percent of the mortgages defaulted, a) the house’s value is greater than at the start and you can sell it again and b) the overall value of the mortgage package on which all this was based kept going up as well. Banks were also making money in fees from writing loans and the companies they were loaning money to were precisely the ones who were buying these mortgages off them so that the banks could make more money in fees writing yet more mortgages.

As for derivatives, pertinent to this discussion, we are talking about two types. The first we have already mentioned. These are the mortgage backed securities. They are not the mortgages themselves but a financial instrument (or to use the technical term “thingy”) based upon or derived from them. (Buyers of these are not interested in the underlying asset but in the cash flow from it, i.e. the mortgage payments.) These can themselves be further sliced and diced into further generations of derivatives. For example, one that is based on 50% of this derivative plus 30% of that one and a final 20% of a third. And so on and so on. All this was to dilute and spread risk or moral hazard, but it also had the effect of putting vast distance between the mortgage title and the holders of the derivatives based on that mortgage. This raises two issues. First, it may be difficult to impossible to establish who is the ultimate holder of the last derivative in a chain of derivatives going back to the original mortgage backed security. Second, it is unclear that anyone in the derivative chain actually has a claim on the mortgage title.

The second kind of derivative is the swap. This was a kind of insurance policy in the event that some mortgages declined in value. This derivative basically said if you pay me a certain fixed amount say every 6 months I will make good on any difference between what you initially paid for your mortgage backed security and what it is worth when you come see me. When the housing market was going up, this amounted to essentially free money for the issuers of this kind of derivative. They could sell it as extra insurance to conservative institutions secure in the knowledge that the housing market would rise forever. Except of course it didn’t. The original idea was that if a package of mortgages or tranch loss value because of a high rate of defaults, the swaps or insurance buyer could demand a settlement from the swaps issuer to make up for the loss of revenue. Now on the upside of the bubble, default rates were low. Homes that went into default could be resold at even higher prices so there was no downside. However, when the bubble burst, default rates went up and issuers of these derivatives didn’t face payouts on one or two of them but on a huge number of them.

Now what is really amazing is that even as things got unsettled in the housing markets the unbridled greed of financial companies caused them to keep issuing swaps. And here’s the thing about them. Someone who wanted to take out this kind of insurance wasn’t limited to taking it out once but could take it out multiple times and so multiply their gains paradoxically off their losses. A derivative has often been described as a bet. You don’t need to own the horse to bet on it nor does it mean you can’t bet on it more than once.

And there is yet another thing. The issuer of the swap, the one who would be stuck paying out for losses, could go and buy another derivative which insured it against any losses which it might get hit with. Then the issuer of that derivative could go out and buy one to cover any potential losses it might have and so on and so on. Again amazingly all those things were out there and companies were often both buying and selling them so that they might be the seller of one of these swap derivatives and a generation or two later in the process be the buyer of one, and all of them involving the same initial deal.

You may be reeling about now and have decided this is madness. Well, it was. But it was a madness that took place out in the open in plain sight of governments and regulators around the world. And not one of them did jack to stop it.