What Are Derivatives Anyway, And How Did They Screw Up Our Country?

I always liked Calculus for some reason. Not really sure why, but I felt like it was a very abstract method of thinking that was kind of cool. I even ended up tutoring Calculus while in college - it was quite a hoot. However, this experience didn't really prepare me for figuring out the financial mess we are now in and how we got there.

One of the first things you learn in Calculus is how to calculate a derivative. This calculation takes a line or curve and determines what the slope of a line tangent would be at any given point. There is evidently some reason you would want to make this calculation that may be of some benefit to somebody somewhere, but regardless, the value of the derivative is, in fact derived from the value of the original curve.

I just saw a tee-shirt advertised bearing the words, "I wish I were a derivative so I could lie tangent to your curves." I'll have to get that one.

This is similarly the case in the lovely world of finance where some sharp witted banker will occasionally take the bold approach of selling a security that is of no real value itself, but it's value is derived from the value of something else. Got it? Now give me all your money, I'll print up some notes derived from the value of my car loan and we'll be on our merry way. I'll call you in a few months with your pay-out.

I'm not sure why, but I spent some significant time trying to learn what a derivative was and how they screwed up our country. And through several hours of reading "derivatives for dummies" websites, I still don't really know, but I will do my best to give a somewhat coherent explanation.

A derivative is a security whose value is derived from the value of something else. They are often used as a method of shifting risk of a volatile item. When you buy the futures of a commodity, the value of that note is derived from the price of the commodity. It's kind of like a bet on where the value of the commodity is going to go.

I was trying to think of an analogy and the best I could come up with was this: suppose I placed a bet that Tiger Woods would shoot under 75 in the first round of the 2010 Master's golf tournament. I somehow roped somebody into giving me ten to one odds that Tiger would not shoot less than 75. So since I was nearly certain that Tiger would shoot less than 75 (he always does), my bet was very valuable in my mind. However I was little nervous. I asked some guy at the bar if I could give him twenty bucks to pay off my $100 bet should Tiger shoot over 75. This guy gladly took the bet because Tiger never shoots over 75.

Or maybe I should sell the value of my bet and then pay the bet and the guy I sold the security to should Tiger shoot over 75. I honestly don't know - this stuff is really confusing.

Not convinced? How about this one. When I worked for the steel company, we would have to bid a job well before we actually bought the steel from the mill. There is some significant risk here because the price of steel will fluctuate significantly. We would buy an insurance policy that locked in the price of the steel at the price it was during our bid. Now, that insurance policy would become very valuable if the price of steel skyrocketed, however, it would be pretty much worthless if the price dropped. So if I were to start trading on the value of that insurance policy, it's value would be derived from the price of steel. I think that's a little closer.

I know those examples kind of suck, so here's a little bit better description that may help.

The confusing nature of derivatives actually works to the advantage of the investment banks because they can falsely report the value of these derivatives to accountants or prospective buyers and nobody will be able to prove them wrong. They probably don't even know what they are worth themselves!

I think Warren Buffet had a funny feeling that we may be headed down the wrong path when in 2002 he said, "Derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal." I'll say.

So now that we know (or in my case, don't know), what derivatives are, we can accurately ascertain how they caused the financial and economic mess we are in. Uhhh, I can't quite nail down that one either. I presume that since the majority of the derivatives sold were tied to mortgages that defaulted, banks started to lose some serious money not only from the defaulted mortgages, but also the lack of value from their derivatives. Once the the cards started to collapse and the banks started failing, people started pulling their money closer and now banks are too scared to loan money which stifles any kind of economic growth.

Anyway, the real sad thing about this was that there were some of the smartest engineers and scientists in this country who were stuffed in cubes calculating derivatives instead of working in a truly productive setting of engineering, construction, or manufacturing. And why were they working for investment banks instead of engineering firms? It's because engineering firms don't pay shit compared to investment banks. So instead of our smartest people actually adding value to our country they were a bunch of crooked thieves stealing money. It's funny how really smart people do really dumb things.

What Are Derivatives Anyway, And How Did They Screw Up Our Country?