Letters to the Editor
MacK..
Published Letters: 477 Editor's Choice: 49
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eyesay -- strictly speaking you are wrong
[Read the article: Panic on Wall Street]
[Read more letters about this article: Here]You say:
"And strictly speaking, a derivative is not a doohickey. It is a financial instrument. Can we be grownups here, please?
A pool of mortgage loans grouped together into a security that can be traded on markets is a derivative. . . . Derivatives belong to what should be called -- but never is -- the unreal economy, a place where speculators make bets about what will happen in the real economy.
A securitized pool of mortgage loans may be a derivative, but more importantly it is a basket or portfolio security."
When you want to pick on other peoples' accuracy you need to be careful about your own. A mortgage backed security is not necessarily a derivative. A derivative is something that takes an issued security and turns it into a different tradeable instrument. The most basic derivatives are zero coupon bonds and strips -- to explain, a mortgage back security came in principle with an printed bond and dozens of cut off coupons on the bottom for the interest. This security could be converted into a derivative by striping off the coupons and selling them separately from the bond -- the zero-coupon-bond entitled the holder to collect the principle at a future date, the coupons just the interest.
Other derivatives are made by combining instruments together, or severing the rights for instruments in various ways.
You also say:
". . . the same games that Wall Street played with subprime are likely being played in every sector of the economy.
Every sector, huh? What is your evidence for that?"
Actually, there is a fair amount of evidence that similar games have been played in many sectors, e.g. private equity, hedg funds, etc. The issue is tranches (where you accurately indicate that the issue matters.) Debt is being split up into prime and sub-prime by splitting a "basket" of debt up, so that one group have a preference for payment (they get paid first) and the other get paid later. Assuming arguendo that say 20% only goes bad, the preference debt holders will always get paid, and the debt they hold deserves its AAA+ rating. The problem is, well, it all depends on how you slice the loaf, and how good or bad the loaf as a whole is. There is a lot of reason to believe that there are problems with a lot more debt than mortgage debt.
Second, baskets of assorted sub-prime debt have been assembled in many markets, which consist of packaging bonds from multiple transactions and then arguing that the combination diversifies risk enough to justify a better, even prime rating. The latter matters because many major sources of capital, especially pension funds, are often prohibited from investing any or more than a small proportion of their capital in sub-prime securities.
And it is that last point that has been the big driver and may mean that the sub-prime prime problem is widespread. There is a lot of capital out there looking for high returns, that can only be invested in what is technically prime instruments -- hence the huge incentive to make instruments look prime that are, well, perhaps not.
A final comment -- if you think the US has a lot of sub-prime mortgage problems, wait for the UK's dodgy mortgage problem to hatch -- UK lending practices have been suspect for at least 5 years.
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eyesay -- as you say a little knowledge is a dangerous thing
[Read the article: Panic on Wall Street]
[Read more letters about this article: Here]A bond issued at a discount of its face value at maturity is not strictly a Zero Coupon Bond -- FYI, many US government bonds have been sold that was for, oh at least decades.
Zero coupon bonds were created as derivatives - there is a tendancy to assume that standard bonds without coupons are the same thing -- but they are not. Sometimes the bond is traded, sometimes a derivative representing the bond as held in a depository without the coupons -- in any event it is derived from the bond plus coupons. Incidentally, it was trading in the other asset, strips, that landed Orange County in trouble when interest rates fell so much that people paid off the mortgages and the coupons fell in value (while the zero coupon soared.)
A derivative is what it says, a tradeable instrument derived or deriving its value from at least one other tradeable instrument (and maybe more.) Mortgage backed securities are not derivatives because the underlying asset is not tradeable as a "trade instrument" though you can sell individual mortgages on - they are often used to create derivatives.
Less knowledge is a dangerous thing -- and you are simply wrong in your statement of what a derivative is. Easay, have you learned the lesson yet, don't "twit" people unless you are sure of the fact you are "twitting with"