Monday, June 14, 2010

Synthetic Derivatives -What are They and Who Cares?

A few weeks ago, the Senate interrogated the guys from Goldman Sachs, a Wall Street so-called "Investment Bank" The argument was about regulating Synthetic Derivatives. HUH? What are those and why does it matter anyway?

Here’s the easiest way to think about it - there is a real Football league made up of real football teams. In each game played there is a winning team and a losing team. And, in each game players do good or bad.

Then we have a Fantasy Football League, made up of the same teams but with the players on each team made up of peoples' "dream team" - players taken from any team and put together (only on paper). Based on how each player and the REAL TEAM he plays on does each week, these made up teams are ranked. People actually bet on these MADE UP TEAMS- "FANTASY TEAMS"- which are DERIVED from the real teams. A Fantasy League is a DERIVATIVE.

Now imagine a second "Fantasy Football League" made up of the same players and BUT instead being based on the outcome of the Real Teams, it’s based on the outcome of the FANTASY TEAMS and ranked according to how the players and the FANTASY TEAMS do each week. This is a Synthetic Derivative - it’s a bet about how well another bet will do! Will Pete win or lose on his bet on Fantasy Team #1. That’s what is being bet on.


Here's an example of REAL Derivatives and Synthetic Derivatives:

A bank (we'll call it "Bank 1") puts 10 mortgage loan together and creates what is called a "Collateralized Debt Obligation" abbreviated to "CDO". In this case, Bank 1 sells the CDO to an investor, possibly another bank called "Bank 2". Both Bank 1 and Bank 2 can actually see the collateral; go from house to house to be certain that the loan has collateral enough, that the houses are worth enough, to assure payment in case of a foreclosure (This is the way the "secondary market" used to run, but that was 20 years ago).

The key here is that while Bank 2 bought a "security", the pool of loans, called the CDO, it could actually see the collateral and was paying Bank 1 for the CDO (the 10 mortgage loans) based on reality. This was not a gamble but a true investment.

Now, let' take the CDO Bank 2 bought and make it part of a large pool of CDOs, maybe 100 of them, that a mortgage Bank puts together, a place like Goldman Sachs. . Now we have 1,000 mortgages comprising a "Mortgage Backed Security" ("MBS" for easy reference), spread out over a large geographic area. We have something that no one can really examine - the collateral is spread out over maybe 5 states, and there are 1,000 houses. It becomes a MBS because no one bank or institution bought this bunch of 1,000 mortgages as mortgages. Keep in mind that if each mortgage loan was originally for only $200,000, the MBS has a "value" of $200 million!

The MBS that was created by Goldman Sachs (in or example), is sold in pieces (of the $200 million MBS) to investors. For instance, a Mutual Fund that wants to provide a stream of income to it's customers who might be employees with a 401K or and IRA etc, might buy $10 million of the MBS. Another mutual fund might buy $20 million etc.So far, everything seems simple. Bank 1 puts 10 loans together and sells then to Bank 2. Bank 2 sells the loans, for a profit to a Mortgage Bank which is buying 100 of the CDOs like the one that Bank 2 bought and sold. The Mortgage Bank now has 1,000 mortgages (100 CDOs) and it calls them a "Mortgage Backed Security" or "MBS". THIS MBS IS A DERIVATIVE.

The MBS itself is nothing more than a security, something for sale which is DERIVED from the value of the mortgages that make it. Once the MBS is created no one thinks about looking at each house. Because of the number of loans, investors in the MBS are just betting that there will be an average number of mortgages defaulting and going to foreclosure. This is a gamble based on historical trends. Go back 4 years and think about what you considered the safest investment in the world - the value of your house!!

Now comes the weird part. There is a market for "investors" who will bet that the MBS will pay 100% of what it should and "investors" who figure that something will go wrong and the people who bought the MBS will get back only 80% of their investment. These Bets based on another Bet are bought and sold.

The price to buy one of these bets on a bet is based on hundreds of factors, like the disaster in the Gulf, the number of jobs created in a month, the value of the Euro in relation to the Dollar, the state of the war in Iraq, the problems in the Middle East as they can affect the oil supply, North Korea's testing of a missile, and on and on and on. These Bets on Bets are Synthetic Derivatives. Basically it is a bet placed on whether someone else's bet will pay off 100% or if it will pay only 80%.

That is what Congress is trying to regulate; the whole process that led to our economic collapse!

Maybe we should bet on whether Congress will get it done or not. I bet it won’t!!!

Author's Copyright by Richard I. Isacoff, Esq, June 2010

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