Island Investing
Cale Smith, MBA
July 18, 2009
KeysWeekly.com

Q. What are derivatives and why should I care about them?

A. Consider yourself warned: reading about derivatives can make you narcoleptic. Usually the phrase “collateralized debt obligation” is followed by the drool that comes only from deep REM sleep. But to understand the credit crisis we just went through, you need to know more about derivatives. So I’ll answer this question in two columns.

A derivative is a financial instrument whose price depends on something else. That could be an asset, like a barrel of oil, a share of stock or a resold mortgage, or in the case of credit derivatives, it could be a loan or bond. Derivatives exist only on paper and come in an exotic range of acronyms.

One class of these derivatives effectively separated the issuing and pricing of a mortgage from the evaluation of its underlying risk. In other words, derivatives marginalized the role the local banker used to have in loan approval. Mortgages used to be issued by lending officers who knew both borrower and property. Derivatives enabled them to be mass-produced like widgets on an assembly line.

Picture the entire multi-trillion dollar mortgage market as a three-story building in a flood zone.

The most conservative investors own the top floor of the building, and earn reasonable
rent from their tenants. More aggressive investors own the middle floor and can charge
more rent because their tenants are slightly less dependable when it comes to writing
checks every month. The most aggressive investors own the ground floor and charge
the highest rent of all because their tenants sometimes do not pay rent.

Whenever a storm comes in, the ground floor (representing the most risky mortgages)
will flood. The investors that own those floors get nothing. But they’re not stupid. They
know a flood zone is probably going to be a poor place to invest.

So who on earth who would buy a high risk mortgage?

For a long time, nobody would. But then Wall Street created an answer – one that ultimately destroyed our economy. Next week I’ll discuss how exactly it happened.

Cale Smith is the portfolio manager for the Tarpon Folio and Gecko Folio. His firm’s website is www.islainvest.com and his blog is www.caleinthekeys.com.