What are Derivatives ?

What are Derivatives? – Part 4

… by  Marilyn MacGruder Barnewall,    Global Financial Affairs Editor

Part 4:  US Debt Obligations Known as CDO’s, aka Derivatives

When one invests in derivatives, two entities are betting: The broker and the investor. Sometimes, the broker is betting against the investor to whom he is selling the derivative. If you doubt that, check out stories about Goldman Sachs being fined for doing exactly that.

Derivatives are synthetic. “Synthetic” means artificial. It means unreal, non-genuine. “Synthetic” means a thing made in imitation of something that is natural. Breast implants are a good example of “synthetic.”

In addition to being an imitation rather than an original, derivative investments also allow product developers to create securities that do not actually exist. What did I just say? You read it correctly.

Derivatives are imitations of a real investment… they mimic real securities but do not have to be real, and the security being mimicked doesn’t have to exist. If that doesn’t confuse you, nothing will.

What can be turned into derivatives? Life insurance, credit card debt – any kind of debt can be turned into a derivative… home mortgages were used in the last go around. Why does debt lend itself so nicely to being made into a derivative? Because people pay interest on debt so there is a ready-made income stream when it is used as an investment product.

The total notional value of derivatives contracts around the world has ballooned to an astounding $770 trillion. No, I’m not exaggerating. Yes, that much money does – or can – exist.

I said there are $770 trillion in “notional” derivatives contracts around the world. What does “notional” mean? Notional does not represent the actual amount of dollars invested in a derivative product; thus, the $770 trillion in notional derivatives is not the actual amount of dollars invested in derivatives contracts. It does mean that there are $770 trillion of derivatives for sale… that $770 trillion has been created if you’re stupid enough to invest in derivatives. It does not mean $770 trillion has been invested in these derivatives.

Other estimates of the notional value of derivatives puts the grand total well over a quadrillion dollars. If that sounds like a lot of money, it is; so much, it’s almost unfathomable. For example, U.S. GDP is projected to be in the neighborhood of around $17 trillion for 2014. So how many years would it take the U.S. to cover the derivatives debt of $770 trillion if 100 percent of our budget went to pay off these debts?

We would make no welfare payments, no Social Security payments, no money goes to the military – we would use the total budget to pay for derivative losses. It would take about 45 years if America’s total GDP was used to pay this worldwide debt.

According to official government numbers, the top 25 banks in the United States now have a grand total of more than $236 trillion of exposure to derivatives. But there are four banks that dwarf all of the others. The following are the latest numbers for those four banks…

JPMorgan Chase
Total Assets: $1.9 trillion
Total Exposure To Derivatives: $70,088,625,000,000 (more than 70 trillion dollars)

Citibank
Total Assets: $1.3 trillion
Total Exposure To Derivatives: $62,247,698,000,000 (more than 62 trillion dollars)

Bank Of America
Total Assets: $1.4 trillion
Total Exposure To Derivatives: $38,850,900,000,000 (more than 38 trillion dollars)

Goldman Sachs
Total Assets: $106 billion
Total Exposure To Derivatives: $48,611,684,000,000 (more than 48 trillion dollars)

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Let’s look at mortgage-backed derivatives – the derivatives product that caused the shock and awe of the financial services community and led to the near bankruptcy of our nation in 2007.

You want to buy a house and you apply for a mortgage with your local bank. You close on the property and move in and everything is fine (you think) until someone in the household loses his or her job.

You fall behind on your house payments and one day you receive a Notice that the bank is going to foreclose on your home. Did you know that there are tent cities outside of most population centers that have people living in them who have just gone through this experience?

Let’s go back and look at the process of your mortgage loan closing and what many people do not understand. If you have read your mortgage loan papers, you are aware that you signed a mortgage loan that gave your bank permission to sell your loan to another financial institution.

They probably didn’t tell you that the “other financial institution” was going to be named Goldman Sachs or Freddie Mac or Fannie Mae. If they’d have told you that, you might have become suspicious that your home loan was going to be placed in a package of mortgages that would create a mortgage-backed derivative.

What is a mortgage-backed derivative? A stock broker or an investment bank takes a number of mortgages – let’s say they use 100 mortgage loans just like yours – and they package it and sell it to investors. Why do investors want such an investment? Because people are paying loan interest on their mortgage loans – and as everyone who has ever paid interest on a mortgage loan knows, almost the total house payment is loan interest during the early years of a loan.

Though these numbers are low, let’s say your home payment is $900 a month. Interest during the first ten years of the mortgage payment may be as high as $750 or $800 (depending on whether your payment includes principal, interest, taxes and insurance). Let’s say there are 100 mortgages which average $800 per month in loan payments… some payments are higher, some are lower, but they average $800 monthly.

Every month, that package of mortgage loans provides $80,000 in loan interest to investors. Though the investment return goes down slightly each month as the up-front interest is paid and the equity amount increases, as any homeowner knows, that happens very slowly and income from this investment was supposed to pay investors for the 30-year term of the mortgages contained in the derivative.

But let’s go back to the process your bank used that got your home mortgage included in a derivative with 100 people who are total strangers to you. The bank sold your loan to a stock broker, immediately getting the bank’s money back – plus they got all of those fees you paid at loan closing.

That’s a pretty sweet deal for the lending bank. They have no loan loss risk and they’ve made an almost immediate profit. The stock broker who purchased your loan now owns it and puts it into the derivative package – so now investors own the loan. Or, do they?

Most people assume that a foreclosure results from non-payment of a loan.  That wasn’t always true during the mortgage-backed derivatives problems that began in 2007.  I know people who didn’t have a mortgage on their home, who paid cash for the property, who were foreclosed on and were kicked out of their homes.  

How did this happen?  The previous owner had a mortgage that got into a derivative and when the house was sold it was not removed from the derivative package.  When payments on the old mortgage loan ceased, there was such bad record keeping and tracking of the mortgages involved, the Sheriff served foreclosure papers and the courts upheld it.  You will be happy to learn that in one such incidence the owners sued Bank of America and won their suit.  

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BofA was supposed to pay damages to the couple and did not — and the people who had been put out of their mortgage-free home filed foreclosure papers against the bank (in Florida) — and the bank quickly paid its damages.  The point is, about 46 percent of foreclosures were unlawful for a variety of reasons.

Low interest mortgages were designed to get people to buy homes so the bank could sell the loan and the stock broker could create a mortgage-backed derivative package to sell his or her clients.

It lit a fire under property values. People began investing in real estate because it was worth $100,000 one day and $200,000 the next day. That – along with one other thing – caused the system to collapse.

Brokers, especially in London, began re-selling the same mortgage-backed derivatives package to other investors. In some cases, the same package was estimated to have been sold 40 times. That caused economic chaos and the result was that a lot of people lost their jobs as companies went out of business and that resulted in a lot of bad mortgage loans that were now going into default. Those mortgage-backed derivatives packages that used to pay investors $800 a month – or $9,600 annually — suddenly couldn’t pay the investors and the entire pyramid scheme collapsed on itself.

Millions of Americans were foreclosed on by – guess who? The bank that made the original loan and sold it to the stock broker and got its money back when the mortgage was first sold.  The bank may have created a mortgage collections service and turned it over to the service agency, but it’s still pretty much the same thing.

The broker who put the loan into a package of mortgage-backed derivatives sold it to investors and got its money back, too. Good people were evicted from their homes like yesterday’s trash. When they went to court, the bank walked in with its note, signed by the person who is facing foreclosure, and demanded that the court evict the people who had lost their jobs and stopped making house payments and also demanded the house be given back to the bank – yes, the same bank (or a service company belonging to the bank) that sold the mortgage and had no money invested in the property being foreclosed.

When they went to court, the bank walked in with its note, signed by the person facing foreclosure, and demanded the court find in favor of the bank that made the loan. The bank loan (or note) does say that the borrower is pledging as collateral for the loan the house that is being foreclosed for non-payment.

What most people didn’t – and still do not – realize is that the loan and the Deed of Trust and the Title are different documents. People felt helpless to fight foreclosure because they didn’t realize that to foreclose, the foreclosing party must provide the court with a Deed of Trust or Title to the property to prove ownership — to prove that it has the right to foreclose!

Most of the banks doing the foreclosing didn’t have the Deed of Trust. Most of them didn’t have the Title. Why? Because it went to the party purchasing the loan from the bank: The broker. The broker doesn’t have the Deed of Trust or Title, either, because the investors now own the properties… but the investors aren’t the ones doing most of the foreclosures. Banks and brokers are/were doing the foreclosing – neither of which has proof of ownership. And the courts let them get away with it!

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You would think the courts would know the difference – they would know that to lawfully foreclose on a residence, the Deed of Trust or Title proving ownership must be provided to the court.

Was there collusion in the courts? In many cases, yes. In many cases it was sheer ignorance of the law by the judge making the foreclosure decision. Judges all over the country accepted as grounds for foreclosure the bank’s mortgage loan papers.

Those judges were wrong. Loan papers do not prove home ownership by the bank. Regardless, the homeowner was evicted from the residence – all because they didn’t understand the law or their rights under it.

Having a borrower’s signature on a loan document that says “I’m pledging my home as collateral for this loan” proves borrower intent to give up the home if the loan cannot be paid. It does not, however, prove the bank has legal Title – ownership – to the property. Only a Deed of Trust or a Title to the property does that.

This example of mortgage-backed derivatives doesn’t come close to covering the different kinds of derivatives packages that are put together for bond-backed and other forms of derivatives that are still actively being sold in the marketplace by these same high-risk investment banks which have merged with our commercial banks. It is that statement that makes the current structure of the financial services marketplace so dangerous.

It is what makes some banks too big to fail. It isn’t the failure of the investment banks (which are at the core of the derivatives problem) that could take down our great nation. It is the threatened take-down of the commercial banks that have been merged with investment banks (commercial banks are little-involved in the derivatives problem that caused the financial breakdown of 2007/08). How can that be? The Gramm–Leach–Bliley Act (GLB), also known as the Financial Services Modernization Act of 1999 made it possible.

The United States Congress did away with the Glass Steagall Act and replaced it with GLB. When that happened, consumers lost the protections under Glass Steagall. Good Republican Phil Gramm of Texas (who, along with his wife, is an economist) made it possible for investment banks to become part of commercial banks when he wrote GLB. Glass Steagall prevented such a joining between commercial and investment banks, and wisely so.

Investment banks can get very, very sick and the nation’s economy may get a bad case of the flu. If commercial banks get very, very sick, the nation’s economy may die. The two kinds of banking should have been kept separate – should once again be made separate.

As for derivatives, they are in my opinion unlawful because there is much evidence that securitization is unlawful and securitization is usually part of the derivatives process. That, however, is just an opinion. Here’s another opinion: Derivatives are largely worthless pieces of paper with no value attached to them.

Keep that in mind the next time you hear that all of the debt being taken on by the U.S. Treasury via the Federal Reserve System is collateralized by derivatives. In other words, all of that debt is collateralized by junk paper.

Editing:  Jim W. Dean

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Marilyn MacGruder Barnewall

Marilyn MacGruder Barnewall began her career in 1956 as a journalist with the Wyoming Eagle in Cheyenne. During her 20 years (plus) as a banker and bank consultant, she wrote extensively for The American Banker, Bank Marketing Magazine, Trust Marketing Magazine, was U.S. Consulting Editor for Private Banker International (London/Dublin), and other major banking industry publications. She has given speeches to bankers worldwide.

She has written seven non-fiction books about banking and taught private banking in Singapore; also at Colorado University for the American Bankers Association. She has authored seven banking books, one dog book, a biography, and two works of fiction (about banking, of course). She has served on numerous Boards in her community.

Barnewall is the former editor of The National Peace Officer Magazine and as a journalist has written guest editorials for the Denver Post, Rocky Mountain News, and Newsweek, among others. On the Internet, she has written for News With Views, World Net Daily, Canada Free Press, Christian Business Daily, Business Reform, the Post & Email, and others.

She has been quoted in Time, Forbes, Wall Street Journal, and other national and international publications. She can be found in Who’s Who in America, Who’s Who of American Women, Who’s Who in Finance and Business, and Who’s Who in the World.