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.
