San Diego Housing Bubble News and Analysis

In simple terms, a derrivative is a contract that binds one party to pay another based on measureable future outcomes. There are derrivatives based on stock prices, commodity prices, harvest levels, currency exhange rates, interest rates, and even weather events. They can get very complex, and you can even have derivatives based on derivatives, or combinations of derivatives.

This video clip isn't a direct answer to your question, but it is useful nonetheless.

http://www.youtube.com/watch?v=lQsC-F9YRxk

It is Ron Paul on CNN American Morning today talking about the financial cluster bomb that we are in. At about the 4:15 mark Ron Paul starts to talk about the pyramiding of derivatives and how Warren Buffet says that he stays away from them because they are so complex.

To illustrate - suppose an orange grove owner is worried that an early freeze could ruin his crop. So he might buy weather derivatives that would pay money if the National Weather Service reports a temperature at one or more reporting locations at 29 degrees or lower. In that sense, they can operate a lot like insurance.

Now, suppose you are an investor (or bank) who sold a bunch of these derivative contracts in one geography, and you think - one year it is going to freeze over there and I am going to get hit. I will sell some of these contracts to others so we can share the costs if winter is cold. Maybe the guy selling derivatives in California swaps some contracts with the guy selling derivatives in Florida. Sounds sensible, right?

Now suppose Florida and Cali BOTH have a brutal early freeze, the oranges are wiped out and the derivative guys take losses on the entire portfolio, and say - "damn, we lost our shirts on that, we have to stop selling derrivatives to the lettuce growers, avocado growers and strawberry growers". And because they appear to be in big, big trouble no other derivatives traders want to be on the other side of any agreements with them - who knows if they can pay or not?? Meanwhile, without some guarantee, the lettuce, strawberry, and avocado growers cant get loans to hire people to plant and operate thier business and the entire thing comes crashing down.

That, in simple terms, is what is happening with the mortgage market and financial institutions now. Derivatives are like matches - essential tools for a modern economy, but you gotta use them responsibly and keep the away from the children.

I believe the PTB is primarily concerned with credit-default swaps (CDSs).

A credit default swap is like insurance on underlying debt. An issuer (might be an insurance company like AIG or Ambac, etc., or a financial firm or some other issuer) of a swap is basically saying, "if your borrower defaults, we will cover $XX of your loss."

The issuer might have issued many swaps. In order to protect themselves in the event of a payout/triggering event, they will often use a reinsurer and/or buy swaps from another issuer. This can go on and on down the line.

At some point, **somebody** is on the hook in the event of a default. Problem is, that final bag-holder might not actually have the money to cover the agreement, and all the players down the line get screwed. Multiply this by billions++++ (derivatives market is in the tens of trillions, IIRC), and you see why everyone is freaking out.

BTW, they use math models to predict probabilities (that's basically what insurance companies do). If the actual events differ greatly from their models (as it is now), the sh!t will hit the fan.

You'd be surprised how deep everyone is in these derivatives -- pension funds, bond funds, mutual funds, banks, corporations, insurance companies, financial firms, municipalities, etc. The list is endless and these derivatives are entrenched in our financial world.

That is why everyone is freaking out right now. It's not so much the FBs who default on an individual basis, but the amount of paper that was traded based on a model that greatly underestimated what the FBs would do (unlike the common sense bubble bloggers who had this all pretty much figured out from the get-go. Where are our
4$$multi-million$$$ golden parachutes???).

To make this even longer...(sorry)...it is these swaps which enabled the leverage to grow like it did because they had found a "new and glorious way" to "manage risk". The players honestly believed they were immune from losses, so they extended the leverage...until it could go no further. We are witnessing the snap-back of the largest and most dangerous credit bubble in the world, IMHO.