Island Investing
Cale Smith, MBA
July 25, 2009
KeysWeekly.com

We’re continuing to answer the question, “What are derivatives and why should I care about them?”

Last week I began to discuss the derivatives that contributed to The Great Recession we are now in. I described the entire multi-trillion dollar mortgage market as a three-story building in a flood zone. The most conservative investors owned the top floor and earned reasonable rent. For a long time, however, no one wanted to own the ground floors, because they’d get wiped out in a flood.

Enter the geniuses on Wall Street.

By effectively combining all of the ground floors in of all the buildings in the flood zone through the use of derivatives, investment banks were able to slice and package even the riskiest investments into bundled products that sounded much less risky than they really were.

Because the agencies in charge of rating those investments were paid by the same institutions that created them, ratings were inflated and even conservative institutional investors started to buy ground those floor properties.

After all, the logic went, if you own one building and it floods, you have a big problem. If you own a thousand properties and one floods, you’ll barely notice. Eventually, those institutional investors had bought every ground floor in every building in the flood zone.

Then the rain came. Risky mortgage investments started to show increasing defaults. The ground floor properties started to flood, sending those investors fleeing. The panic was contagious. After all, you only need to see a dozen or so of your neighbors running maniacally down the street before you drop the remote and start running, too. Chaos and gridlock descend quickly throughout the flood zone.

Because of derivatives, risks that were believed to have been eliminated actually got bigger – so big, in fact, that they ultimately destroyed our economy.

We’ve seen the effects of the failure of certain derivatives – RMBS, CDOs and CMOs, specifically. But still little has been done to address an even bigger class of derivatives known as credit default swaps.

And if you weren’t angry at Wall Street yet, wait until next week.

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.