Financial Reform Explained: What The Heck Are Derivatives?

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As Congressional negotiators work to finalize details of the massive financial regulatory reform bill, there’s intense debate around what was arguably one of the central causes of the near-meltdown of our financial system: derivatives.

Let’s take a quick look at just what these things are, what they do and what all the hubbub is about.

What is a derivative?

While the word “derivative” is enough to make the average person’s eyes glaze over, derivatives are really not that complicated. A derivative is simply a security (think “piece of paper”) whose value is “derived” from the price of something else.

For example, consider a commodities futures contract. A futures contract is nothing more than the right to buy or sell some underlying commodity at a specific price for a specific amount of time. The value of the contract is “derived” from the price of the underlying commodity. So commodity futures are derivatives.

Let’s bring the point home with a specific example. As I write this, August crude oil futures are trading around $76 a barrel. (You can get quotes at any number of websites; I got this one from this page at CNN/Money.) Crude oil contracts represent the right to buy or sell 1,000 barrels of crude oil until the contract expires: for example, in August. At this moment the price for that contract is $76 a barrel. So the value of the contract (the derivative) is entirely dependent upon (derived from) the price of crude oil between now and the August expiration.

Who trades these things?

There are two classes of investors in derivatives: those who want to gamble (speculators) and producers or consumers of the underlying commodity who want to lock in a price (hedgers).

You already know what a speculator is: an investor who has no interest in oil, for example, other than making a highly leveraged bet on the price to try to make some quick cash.

Those who hedge aren’t gambling; they’re trying to insure their cost and/or profit from something they either sell or buy in the course of business. For example, if Exxon is afraid that the price of oil is going to fall between now and August, the company can effectively sell 1,000 barrels of crude oil at today’s price of $76 by selling a futures contract. If United Airlines is afraid that oil is going up, it can buy a futures contract and lock in today’s $76 price.

Both those who hedge and those who speculate are essential to the market to keep it “liquid” – a fancy word that just means having enough people at the auction to keep prices competitive. Think of any auction: The more people bidding, the more likely prices will resemble what’s fair – the “market price.”

When a good system goes bad…very bad

When it comes to commodities or other derivatives, the problem isn’t when they’re traded on exchanges such as the Chicago Mercantile Exchange. It’s when they’re not.

When derivatives trade on public exchanges, everyone can see the prices and who’s doing the buying and selling. In addition, everyone involved has to meet minimum capital requirements – demonstrate they have enough money to back up their bets. If it turns out they don’t, the exchange will stand behind both sides of the trade to make sure everybody gets paid.

But there’s another entirely different, hidden way to trade derivatives: one that isn’t open, isn’t regulated and is a way bigger market (some say $600 trillion) than the regulated exchanges that trade commodities. This hidden trading contributed to the near-collapse of our financial system a couple of years back.

The now-infamous AIG was one of many private companies that traded in derivatives by creating custom-designed and highly complex contracts, often taking the other side of the bet. It was a strategy that made the company a lot of money – until something unforeseen happened, namely a collapse in the housing market.

A simple example of a contract AIG might have created: Suppose you’re a hedge fund with a few billion dollars to gamble. You’d like to make a $1 billion leveraged bet that housing prices are going to drop nationwide and mortgages will go into default within the next year. You don’t really want to make this bet on a regulated exchange, because you don’t want other hedge funds to know what you’re up to. In addition, the standardized contracts offered by exchanges don’t represent the exact type of bet you’d like to place.

Solution? You approach AIG (or Goldman Sachs, JP Morgan, Bank of America or any number of other financial firms) and ask the company to draw up something custom-made. AIG is happy to do this, since the company is charging you $10 million. Now you’ve made your bet and AIG makes $10 million.

Fast-forward a year. Twenty percent of American homeowners are underwater on their mortgages and millions are defaulting on their loans. Your $1 billion contract is now worth $10 billion. Congratulations.

But there’s a problem. When you made that bet, AIG executives remembered to pay themselves big bonuses, but they forgot to hedge their risk. In other words, they didn’t protect themselves by doing what any decent bookie would have done: lay off a portion of big bets with other bookies so they’re not wiped out if they lose. There was no government regulator to make them hedge their risk, and no law that said they had to. It’s free enterprise: They’re big boys (with advanced degrees from Ivy League schools, no less) and should have known better. But they gambled and they lost.

Now they owe you $10 billion and they don’t have it.

In the world of bookies, a few legs might be broken, or you simply wouldn’t be able to collect – you can’t get blood from a stone. But in the world of Wall Street, you may not be able to get blood from a stone, but you can extract it from the American taxpayer.

That’s essentially why $150 billion of taxpayer money went to bail out AIG: to make good on bets the company made that it couldn’t back up. Why did the government think it necessary to pay for the company’s stupidity? Because of the ripple effect all these defaults would have created throughout the financial system. In other words, you might have borrowed the $1 billion you used to place your bet from an FDIC-backed bank, and the bank might have collapsed if you hadn’t been able to repay it.

That’s why financial reform exists – to prevent the American taxpayer from ever again having to lend money to idiots who should have known what they were doing, but didn’t.

How financial reform is supposed to prevent a repeat

Now that you (we hope) understand what derivatives are and how unregulated trading in them cost us all a ton of money, let’s return to current events: the financial reform legislation now in final negotiations.

The proponents of financial reform see a simple solution to the devastation caused by companies like AIG: Simply force most derivatives onto regulated exchanges, where the trades are transparent and a guarantor will stand behind both sides.

Wall Street firms, however, hate this idea. Creating custom contracts for derivatives traders is hugely profitable. Plus, they argue, these off-exchange, secret contracts will continue to be traded. If it’s illegal here, those who want them will simply move overseas.

The Senate version of the bill will still allow for some transactions to escape the transparency of exchanges: For example, commercial end-users, like Exxon or United Airlines, will still be able to get custom contracts away from exchanges. But financial players like AIG or Goldman Sachs – companies that don’t have a commercial interest in the underlying assets from which the derivatives are derived – would have to stick to exchanges. In other words, hedgers would still be able to work away from the exchanges; speculators, not so much.

The House version, however, is more liberal, allowing the banks to hedge “balance sheet risk” the same way an airline would hedge the price of fuel. That would result in far fewer derivative contracts ending up on transparent exchanges.

Which version should you support? If you want to prevent a repeat of what happened to both AIG and the American taxpayer, you’d probably prefer the Senate version. But if you think the less regulation the better, support the House version.

Either way, we’ll know within days how it comes out.

As for me? As a consumer advocate, I’d prefer to do everything possible to prevent a repeat of the travesty that was AIG. As an investor, however, I’m not one to bet against the power of the banking lobby. That’s why I’ve hedged my bets by owning shares of bank stocks in my portfolio: you can see what I personally own by clicking here.

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