"We view them as time bombs both for the parties that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." - Warren Buffett - 2003
Asset-backed securities are created by pooling something of value, like mortgages, barrels of oil, bushels of corn, piles of wheat, money, or anything else that has value, and then selling shares of the pools of assets. These are not, in themselves, bad things, but you are betting that the value of the assets backing the securities will go up. They do allow you to invest in things like mortgages with a few thousand dollars instead of hundreds of thousands of dollars.
Derivatives are nothing more than a piece of paper, a contract, which promises to buy or sell things at a certain price on a certain date. Unlike asset-backed securities, stocks or bonds, derivatives are only as valuable as the signature on the contract. When you buy or sell a derivative you are buying or selling a promise to convey ownership of the asset, rather than the asset itself. The sellers of the pieces of paper do not actually even have ownership of the things being sold. They are betting that when they have to convey ownership, their buying price will be below their selling price. The buyers of the pieces of paper do not even have the money to buy the things that will be sold to them. They are betting that when they have to buy the assets, what they have to pay for them will be less than what they can sell them for and they are also betting that they will have the credit to buy the things temporarily while they resell them.
Sometimes, the betters bet that the prices will go up so they sell derivatives guaranteeing the assets at higher prices than what they are currently. The buyers of these derivatives bet that the actual future value of the assets will be even higher. Sometimes, the betters bet that the prices of the assets will go down so they sell derivatives guaranteeing assets at a lower price than they currently are. The buyers of these derivatives are betting that the prices of the assets will actually go up.
These bets, the derivatives, are mostly not regulated so, most of them are made in secret. As a result, no one knows for sure who has bought the bets and who has sold the bets. The buyers and sellers watch the prices of the assets that they have agreed to sell or buy all day, every day, constantly recalculating the amount of money that they are going to make or lose. It’s like watching a basketball game with your heart jumping with joy or sinking with despair with each made or missed basket when you have millions of dollars bet on the outcome.
While sub-prime mortgage backed securities are getting all of the attention as the current culprit, what really caused the problem was that derivatives based on these securities were a really hot product. Wall Street and bankers wanted more and more. As a result, they placed extreme pressure on lenders to create more and more sub-prime mortgages so that these could be converted into securities and more derivatives could be created to be sold. Then, people who had been approved for loans started defaulting and everyone started getting stuck with their bets.
When something happens like the burst of the housing bubble, all the betters get nervous that the dropping home prices and foreclosures that are killing the value of mortgage backed securities will have an adverse effect on other assets and they immediately start trying to recover their perceived future losses by betting that the value of everything will go down. This betting causes the actual price of the stock sold to go down along with the value of the companies that the stock represents. When a company’s value goes down, its lines of credit get reduced or cancelled. It is no longer able to buy inventory or make payroll even though it may be very profitable. A company’s profits have normally been extended to its customers in the form of credit. So, unless the company is able to get its customers to pay their bills ahead of time, the company has to close. Many times the customers are also companies and they have used the credit to finance their customers so, they don’t have the money to pay.
Since the derivatives have been sold and purchased in secret, the banks are not even willing to loan each other money because the borrowing bank may have bet to much with derivatives and might go out of business. If banks can’t borrow money, they can’t loan money. Banks get so nervous that they are not even willing to loan you money because they start to imagine that you may be overextended, may overextend yourself, might lose your job, or commit suicide over the economic crisis. Besides, the banks might need the money before this is over, so they hoard it. If you can’t borrow money, you can’t buy things like houses, cars, furniture, airplane trips, or whatever else you would use your credit cards for. This means that all of the companies that make or sell these things can’t sell them and the economy’s downward spiral quickens.
In the saga that is currently unfolding, the collapse of the housing market and value of mortgage backed securities is not even the tip of the iceberg. This is a problem that could be managed solely by the banks. The problem is that the total amount of derivatives that have been sold, bets that have been placed, worldwide to sell assets is around $520 trillion. The value of all the GDPs, real estate, and company stocks in the world is around $225 trillion. Bankers and Wall Street have agreed to sell the world for over twice what it is worth and they don't even have the money to buy the world in the first place. Just buying and selling the the entire world wasn't enough for them. They had to have more. They know this and they are very nervous now that the mortgage crisis has exposed their greedy gambling.
$700 billion given to the banks is not going to fix this. $10 trillion given to the banks is not going to fix this. All of this money just devalues the currency and makes things worse. A meeting is not going to fix this. Neither Obama nor McCain will fix this. This is why the bank bailout was just an exercise in futility. Just wasted your money, your children’s money, and your grandchildren’s money and you and your country are very likely to need this money before this is over. They would have protected you and the economic well being of the country, by passing a law that made derivatives illegal long ago. Instead they are busy trying to accomodate banking greed.
"We view them as time bombs both for the parties that deal in them and the economic system .. In our view ... derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." - Warren Buffett - 2003
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