We hear a lot about “derivatives” as they relate to the economic meltdown of the last few years and the current effort to regulate the financial industry. Just what are derivatives?
A derivative is an asset which derives its value from another asset. One of the big problems with derivatives is determining how much they might be worth. Derivatives can be very complicated and confusing so let me use a tongue in cheek derivative to show how our banking system uses derivatives.
I have here a “solid platinum box” containing “financial instruments of value.” Derivatives are hard to value, because I’m not going to tell you exactly what is in the box. I am a financial institution, so you will just have to trust me – this is a valuable box. As a bank, I must tell you in very fine print that “the box contains financial instruments that may be worth something.” If I am a hedge fund, I am not regulated and I don’t have to tell you anything.
I’m going to sell this box to you, Mr. Investor, for $100 because I have convinced you that the box contains some really valuable stuff.
Then I’m going to work with you, Mr. Investor, so you can sell the box to your sister-in-law for $200. (Affix a bow!). She will buy this box.
But, alas, your sister-in-law is smarter than us. She puts this box inside a bigger box, wraps it nicely, and sells it to a bank for $1000.
Fast forward three to four years. The next Lehman Brothers or Merrill Lynch has purchased this very same box for $100 million dollars. The economy turns, and the company finally figures out the box is probably worthless. Let’s look in on a board meeting. Keep in mind that the President of this now-failing financial company earns $24M a year and each outside board member earns $100,000 for attending four meetings a year.
Since we all agree that this $100M loss is a great surprise, let’s turn the matter over to the “Find Someone Outside the Company to Blame” committee. All agreed!
Also, we borrowed the money to buy these derivatives so we’ll have to mask the debt at the end of the quarter just like we do with most of our other debt. Our quarterly results still have to look good. I suggest you guys cash in your options before somebody on the outside discovers this and the stock goes down.
We did fire that guy who told us we had better look inside the box before we bought it. Turn that matter over to the “Cover-Up” committee.
Point in fact, we can’t just lose this money. It’s almost half my yearly bonus! How can we get it back? Let’s have the lawyers get the money from the American taxpayers in a bailout.
Now that we have settled this matter, let’s go to lunch – in Hawaii. But we must show that we are cutting back in these hard times – we can only take four of our 10 company jets to lunch in Hawaii. Sorry guys, you will have to double up. Tough it out.
Let’s just suppose that financial reform has taken place. Before I sell you this box, I must disclose that I have a solid box of platinum color (not a solid platinum box) which contains five lottery tickets, money from Nigeria and Uganda, a few foreign coins, some outdated Swiss francs, and an uncirculated 1882 silver dollar.
As individuals we should not buy the box without knowing what is in it and how much the contents might be worth. And we should not allow financial institutions to buy the box with our money unless the contents can be valued.