Derivatives Are Complicated, Unnecessary to Know About
Matt Levine is back on NPR’s Planet Money blog talking about being a banker, and this time he is explaining derivatives. He only uses three graphs and four footnotes, which is promising. But my very favorite quote is the most promising of all: “But if you don’t want to trade derivatives on Wall Street, there is no particularly burning need for you to learn about those things.” That’s all I need. Thank you, Matt. We’re done here.
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Previously on The Billfold
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I thought Matt’s explanation of derivatives was a good one but I’m going to have to disagree with him about the quote that you’ve pulled out saying that it’s not really important to understand these things, because these derivates contracts are really at the heart of the financial crisis.
Matt would be right that these things don’t really matter to you or me IF AND ONLY IF when the bill came due for these contracts the parties that made them either had to pay out or go bankrupt. The problem of 07 and 08 was that the bill came due and none of these people could pay – neither the banks nor the insurance companies that backed them. So instead of letting them go bankrupt, we (the government) bought these trash contracts. That’s more or less the problem at the heart of this, although it gets more complicated and horrific the more you explore it in detail.
One other quick aspect to note regarding these derivatives and why they’re important to understand. In the link Matt says that one of the problems with the crisis was that all of these banks were taking derivate contracts out on basically the same position – that housing would go up. So why would they all think housing would go up? Welllllllll the answer to that is because the government adopted a concerted policy to create a situation where housing prices would rise. They dropped interest rates to close to zero on government bonds, which pushed money out of that sector and into the housing market. Then you had a situation where all these policies got implemented to push people into buying houses. They did this by easing the conditions with which people could borrow (easy credit, tax incentives, etc.), which lead to both a building boom and to rising prices across the board.
SO these big positions (via derivate bets) on housing growth happened because the government essentially ensured that it would happen. But you can’t understand how that whole process worked without understanding derivates, which is a key part in this.
Everything that Alex Sachon said. And also,
Derivatives can be profoundly complicated. Banks hire phds to write these algorithms! But one doesn’t need to understand every intricacy that goes into the formation of every type of derivative, nor even be a banker (or federal regulator) to know that something is rotten is afoot, if you consider using taxpayer money to clean up after disasters caused by rampant speculation in the private sector to be rotten.
Here’s another article about the derivatives market and why we should care about it.