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"Strictly speaking, a derivative is a financial doohickey whose value derives from some underlying asset. A mortgage loan is an asset. A pool of mortgage loans grouped together into a security that can be traded on markets is a derivative."
Strictly speaking, Andrew Leonard gets it right and then immediately wrong. All financial instruments are based on pieces of paper which slice up assets or cash flows. A share of stock is the ownership of a zillionith of a company. A bond is just a loan that is chopped up into bite sized pieces. Stocks and bonds aren't derivatives. Neither are pools of assets or shares of mutual funds.
Derivatives aren't little pieces of real things. They occupy a less tangible realm -- pieces of paper whose price depends on the price of something else. A simple derivative is a stock option whose price is based on something you could buy or sell, but other derivatives are more complex and are based things that can't be bought or sold.
In general, securitization is a good thing. In the bad old days, banks held mortgages, and your interest rate depended on what the local banks were charging. You got 3% on passbook savings, and borrowed at 6% and the local bankers pocketed the difference. Things are just more efficient now, and no one seriously thinks vanilla securitization is a bad thing.
However, it was just too tempting to see how far securitization could be pushed. Think of stage 1 as putting assets on a chopping block. You start with an onion or a piece of garlic and end up with nice little pieces -- and everyone knows what they are. I suppose you could use a food processor or blender. Then someone turns the blender on puree and tosses in whatever is in the fridge. And someone else decides to reverse the process and turn the goop into things that sort of look like food, but not like anything found in nature. And I suppose you could find someone to certify that they contain the same number of calories, vitamins, etc. Then, someone decides that the newly created goop is more valuable then the various pieces. Sort of like all those bizarre cuts of steak that are showing up these days (just what the hell is a cowboy cut? where's my tbone?).
The problem with securitization is that what was supposed to make things better (slicing/diceing with a vegamatic) went too far, and overpaid financial engineers made it impossible to figure out exactly what was in the pooled assets (lack of transparency). And so on and so on until you end up with antifreeze in the toothpaste.
Derivatives have other problems -- you have to collect from your counterparty -- but that's another story that will end badly.
Toss in a lot of leverage and that explains some hedge funds going belly up. That, by the way, is a good thing. You can't get rid of excess without a little blood in the streets. Pooling tends to reduce risk, leverage increases it.
Not a bad article, but we don't have a real crisis. Yet.
No real point in this letter, except to get rid of the stupid gambling analogies and think of it as food. Stay out of the financial McDonalds and head over to Whole Foods.
