The Good, the Bad, and the Real Ugly

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Part 2 – the Bad

If derivatives are good, and they are, why am I feeling so poorly about them?  After all, even in my day-to-day world, I may have been provided a new, flexible product based on derivatives.  Think not?  Remember when you could get a mortgage and the mortgage company would let you lock in a rate for 90 days while you went house hunting?  In order to be sure that rate would still be there and at the same time protect the company offering the rate, they likely hedged the interest rate risk with a an interest rate derivative.    

Let us (seemingly) divert the conversation for a moment and consider another “culprit” in this conspiracy.  If you are reading this right now, you are using some kind of a computer which has complex software to access the Internet.  Computers are very powerful and constantly getting more so.  You probably have as much computing power in your PDA as was used by NASA for the moon shots.  The cost of this computing continues to plummet.  Having a 1 gigabyte backup hard drive in your home is not uncommon.  New processors are more powerful, and in some cases several can be strung together in one machine to make super powerful computers.  Supercomputers that had to be created to allow us to do things like forecast the weather are now sitting in the back offices of Wall Street.  Why?

Once again to my friends at Wikipedia, here is the beginning of the formula developed by Fisher Black and Myron Scholes, and later expanded by Robert Merton, to price an equity:

The price of the underlying instrument S_t follows a geometric Brownian motion defined by

, where W_t is a Wiener process with constant drift μ and volatility σ.

 

Got that?  That is Nobel Prize (1997) work and is the simple stuff.  There is no room here to write the formula for the derivative of an equity, but mention the Black-Scholes option pricing model to any financial geek and they will know what you are talking about.

 

The point?  The confluence of cheap computing and very complex, hard-to-understand valuation models meant that we turned the financial markets over to the Rocket Scientists.  No longer were mere mortals able to understand how prices came about, but as long as there were orderly markets we could take a mortgage, break it into pieces (interest rate payment, principal payment, and varying maturity), package a bunch of them together, and create a new derivative, which was sold on the market as a collateralized mortgage obligation (CMO).  Throw some derivations of this model into the computer with the instrument’s characteristics and we are ready to trade!

 

Unfortunately, no Chief Investment Officer worth their salt will admit that some newly minted PhD knows more about the value of an instrument than they do.  Ahhhhh, hubris.  There was little to stop the financial engineers.

 

So with the unintended consequences of the additional computing power combined with the complex formulas we have a New World Order.  But what happens when the underlying instrument of the CMO, the mortgage, can’t be valued, or drops precipitously in value?  Suppose the house is now worth less than you paid for it, but you can still continue to make payments, what then?  What happens when your formula has a properly calculated value, but no one will buy the CMO?  In other words, what happens when the markets truly do get disorderly? 

 

You get what just happened to us.

 By Jay Tee.  Jay Tee is not a financial advisor and this article should not be considered financial advice.  It is for information purposes only.  You should contact your financial advisor for any investment advice.  

This story is filed under: Business