CDOs and all the mortgage backed \”derivatives\” people keep talking about are not OTC products, and have nothing to do with the \”derivatives\” regulation the press talks about.

and then goes on to call CDOs derivatives: “For a longer — and very useful — introduction to credit derivatives (like credit default swaps and collateralized debt obligations, both of which had a particularly central role in this crisis) …”

I agree that the definitions of derivatives and securities are not super clear, but there are widely accepted ways to refer to these securities. There are mortgage pools, which is a collection of mortgages with similar characteristics. These pools go into a CMO, which will have tranched up cashflows. Some of these bonds will have a fixed coupon, but have special pay rules about the order they receive principal (first, second, according to some schedule, etc). Those are referred to as fixed rate CMOs. Other bonds, such as the ones in the SEC complaint, have coupons which move with respect to libor and those are called mortgage derivatives. If you call the fixed rate CMOs derivatives you’ll just confuse everyone. The value of a stock is dependent on the performance of the underlying company, but that doesn’t mean it should be classified as a derivative (although it can sometimes help to think of it as a call option on a company).

Here’s the part that I don’t get in the complaint: they were levering these guys up 10:1! That’s insane. These are bonds with base case yields of 15%-25% and option adjusted yields between 8% and 20%. You’re getting stock market level returns without leverage. Probably better. If they hadn’t levered up these positions most of these people would be doing much better than if they had invested in the stock market. In fact, they probably would have had phenomenal returns if they hadn’t been forced to liquidate because of margin calls. Either way though, these are very risky, complicated bonds and it sounds like they tried to pretend like they were conservative products. There’s a reason you make 20% a year – it’s because you can lose a lot of money very, very quickly.

You can follow this down the rabbit hole. A stock is simply a call option on firm value with the debt as the strike price. A mortgage is a risk free rate with an option to default (call option on household) and an option to prepay (put option on household). Are mortgages and stocks derivatives?

Zach – a good key is to follow ownership. I buy a GE bond, I loan money to GE. I buy a GE stock, I own a part of GE. I buy a CDS and a call option on GE’s bond/stock, I’ve made a bet with a third party related to how GE will do. I’m not transacting with GE.

An example from “The Types ofCMOs Traded in the CMO Program”:

“Inverse Floaters are variable rate securities with a coupon that is inversely related to a short-term interest rate index, typically the London Interbank Offered Rate (“USOR”). As the index’s interest rates rise, the Inverse Floater’s interest payment falls, and vice versa. Inverse Floaters can have poor liquidity and erratic pricing. Inverse Floaters purchased for a premium (i.e., at a price over par) or sold before maturity present price risk to investors (i.e., the investor can lose their original investment).”

For purposes of regulation under the 1933 Act, it is therefore both a derivative and a Security.

However there are some commonalities in the definitions. I have never before seen anyone give a definition of security that didn’t require it to be a negotiable financial instrument. Therefore a bilateral bank loan contract would not be a security, but an otherwise identical bond would be. If the bank securitised its exposure via a credit-linked note, the CLN produced would be a security. That’s kind of what the word securitisation was invented for. A derivative may or may not be a security depending on its form (eg futures are, bilateral Contracts-For-Difference aren’t).

Defining derivative is even more fun. I don’t think the definition Felix gives is adequate. After all, what is the difference in cash-flows between a collateralised CFD and a highly leveraged direct investment in an asset? Both require an up-front contribution of cash, regular interest (or “notional interest”) payments and then a settlement cash-flow at termination. Almost everyone would call a CFD a derivative, and few people would call the leveraged investment a derivative. This is not captured by Felix’s definition.

I know little about US regulatory law, but isn’t there some sort of difficulty for the SEC in regulating pure derivatives, as opposed to securities (the word that is in their name)? Possibly the items in question could be described as both. For the legal proceedings they described them as securities because that is in their enforcement scope under relevant law, but for the press release they chose the more commonplace description of calling them a derivative.

Can you explain how counter party risk figures into zero sum derivatives like CDSs?

Can you explain how a bundle of synthetic MBS (made up of zero sum derivatives) is not a derivative?

These aren’t rhetorical, I feel I missing something.

A derivative is an instrument that is derived from one or more other instruments.

http://en.wikipedia.org/wiki/Derivative_  (finance)

Where do you get your definition from?

Before you close that book, look up the word “security”. Pretty broad isn’t it?

Using those standard definitions, all derivatives are securities. Also, all securitized products, such as CDOs, are derivatives by those definitions.

Not surprisingly, if you make up your own definitions, you’ll find that not everyone else uses words the way that you think they should.