How's this for a Guest Blogger?

There's this individual that perhaps some of you may be familiar with.  He's a bit of an intellectual.  He's a bit of a comedian.  He's a bit of a verbal genius.  Despite the vicious rumors of his demise, this man is alive and well and living in a sweatbox in a remote part of Scrappy Corner, NJ.  Seriously though, no introduction is really needed.  Enjoy the fruits of greatness:

 

My Mother Loves Derivatives

By Andrew J. Lenza

 

My mother called and asked me for a layperson's definition of a derivative, in light of the global financial fiasco. (Most residents of New Jersey, long mired in our state's financial fiasco, feel warm and fuzzy over the increase in party guests.)

 

Mom is spooked about credit default swaps and collateralized debt obligations (CDO's) wreaking Holy havoc.

 

What is a derivative?

 

Posing the same question to former Fed Chairman Alan Greenspan might produce the phonetic response akin to dropping the bag of Scrabble letters into a fish pond. A lot of Q's and Z's and X's wrapped around wannabe sushi.  How can the average person understand such an obtuse financial construct when all we hear from our revered economic leaders is three parts ‘gobbly' and one part ‘gook'?

 

"What is a derivative?" is a complex question beset by any number of multiple choice answers that look good on the SAT - until, that is, you're pumping gas for Lukoil. Let's talk to the hand. I doubt half of Congress can explain a derivative without an aide and a head start.

 

My explanation bears two parts, thereby saving you two parts gobbly-gook. Mine is a bargain-basement blog.

 

Part I -- What "it" isn't.

 

A derivative is the opposite of any financial transaction is which you're done when you walk away. In a non-derivative trade you know emphatically and empirically where you stand. Your known risk is 100% of your investment.  There's no inherent additional risk like a sand beetle hiding in Aunt Gertie's ashes.

 

Unlike a derivative in a simple purchase you're not expected to walk back with additional money. Most of us conceptualize buy-low-and-sell-high and the painful buy-high-and-sell-low.

 

But a derivative is anything but simple and straight forward. Let's use scalping a ticket at an AC/DC concert as an example.

 

SCALPER:     "I got two. Need two?"

YOU:           "How much for two?"

SCALPER:    "Buck fitty."

YOU:           "I'll pay a honey for two."

 

You haggle. He haggles. You walk away in a huff. He follows. But you both you close the deal. You're strolling your vamped-out middle-aged date into Madison Square Garden after purchasing two "hot" floor seats for a hundred and twenty five dollars. You exchanged one Franklin, one Jackson and one weary Lincoln.

 

You're not expected to "inject additional capital" into the trade: a simple goods-for-currency transaction with each contra-party - opposing side - walking away with little future liability to each other.

 

Part II -- A derivative is any transaction in which a third party stands to lose or gain if the original deal goes awry.

 

Now let's say an investment banker standing outside Barney's across the street observes your buy and approaches you.

 

"I can insure those tickets for you."

 

"Insure me against what?"

 

"In case the Garden is closed for botulism or the lead singer pulls a Britney."

 

"So I'd recoup my $125 investment if the show doesn't go on?"

 

"Affirmative. I'll charge you 10% of each ticket's value to insure your $125."

 

"Let's say the concert is outright canceled with no rain date. How do I get to see AC/DC and their wicked light show?"

 

"I've procured two tickets for the identical show at the Rock in Newark for next week. Those tickets on the street go for roughly the same. You're covered."

 

Sounds like an excellent "asset protection plan" so you fork over an additional $12.50 to protect your initial investment. Now the savvy investment banker has indeed purchased two tickets to AC/DC at the Rock for face value, $35 per seat, on the wholesale market.

 

But he's already sold them for a hefty mark-up of $80 per ticket to another scalper who'll "retail" them out for one Ben, one Tom and one Abe.  He has also purchased insurance for himself at 5% of "market value" or $4.00 - just in case your Garden concert is canceled. His replacement tickets are for the Buffalo concert; no one is sweating the distance between venues because no one expects any of the concerts to "non-perform."

 

That would be unimaginable.

 

Therein lies a curious and devious cycle. The same assets are bought and sold in a fuzzy after-market. Each is embedded with a future risk and reward. To the guy on the street this is difficult to understand; it's all "opaque."  To the investment banker or hedge fund trader this is crystal clear "opportunity."

 

None of this transpires in a physical setting. There's no Exchange, no trading session on television signaled by a happy-face corporate bell-ringer.  We have no tiny derivative ticker marching across the screen. Not even a website. You and I can gamble online "in" a Costa Rican casino with a credit card; we just can't "see" derivatives.

 

Sort of like riding a unicycle in a cave.

 

The "insurance" you purchased for $12.50 represents both "premium income" and a future liability for the investment banker les "market forces" require him to deliver those replacement tickets. Repeated hundreds -- if not thousands of times over - the outstanding balance of all these side deals quickly eclipse the total value of the actual goods or services-for-currency trade.

 

The murky side deals are "derived" from the original transaction.  A house of cards? Plastic laminate is sturdier; this amorphous financial storm is a mist of fog wrapped within a cloud of smoke.

 

When the financial system starts buying and selling "synthetic" scenarios pegged to a future event you can see the potential harmful affect of AC/DC band members splitting up in a nasty tiff and canceling all the shows on their Northeast tour. What happens if a major labor strike closes all concert venues in a 500 mile radius for six months?

 

Your "insurance" is worthless because "performance" is impossible. There will be no show.

 

The investment banker is now forced to reimburse the original ticket purchasers or renege entirely.  Attempts by the investment banker to raise new capital by selling other "unencumbered assets" or borrow in the market fail, leading to insolvency. There are very little "unencumbered assets" on his Balance Sheet because every asset is "cross collateralized" to bring in additional trading revenue.

 

You knock on the investment banker's door for repayment. He knocks on Uncle Sam's door for relief.

 

The tail ends of the Bell Curve are those catastrophic consequences when the unimaginable occurs.  When we transact at the "mean" the norm prevails and we innocently, blithely go about our lives.

 

What are the odds of getting struck by lightning while riding a unicycle in a cave? Quite low -- until the freak accident occurs and does so in stark, shocking regularity.  Now everyone is bolted off their bikes. The seeds of our Panic have been sown in the nightmares of our Bliss.

 

Take a mortgage. At the closing table you thought you were all alone with your lawyer and closing agent. Yet there are several hundred invisible voyeurs (traders and speculators) looking down your blouse or up your pants leg from behind a two way mirror, divvying up the short-term and long-term body parts of your note.  Your loan walks in like a perfumed Vestal virgin and stumbles out like a scythed Venus de Milo.

Unless the originating institution holds onto the loan, not only is the principal amount of the transaction sliced, diced and repackaged into another financial contract; even the stream of interest payments on these credit transactions is "synthetically" bargained.

 

And no one asked you if they could carve up Baby.

 

As a taxpayer you're still trapped in that fog. Unbeknownst to you, however, an army of well-dressed Wall Street cannibals follows stealthily along, each sporting night vision goggles and a new set of Ginzu's.  Yum.

 

Further, the advent of a digitized International banking system allows for the rapid buying and selling of these instruments with a phone call and a keystroke.

 

A derivative can be spawned from any financial contract, so long as there are traders and bankers willing to gamble and profit on a future event.  Mortgages, stocks, bonds, commodities, precious metals are all open to the ingenuity of perky Ivy League MBA's with Excel spreadsheets. The Age of Financial Engineering now gives way to the Age of De-leveraging; that capital which we created easily is destroyed in like fashion within days if not hours.

 

That's how I perceive derivatives anyway. For what's its worth I do have an MBA from a gritty Jesuit college. Alas, I am past the Age of Perky. 

 

You?  You just wanted to take your date to a hip concert. Who knew?  Cheer up. There's always free public television.