Comments on: Securities are not derivatives http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/ A slice of lime in the soda Sun, 26 Oct 2014 19:05:02 +0000 hourly 1 http://wordpress.org/?v=4.2.5 By: Walter Kurtz http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2495 Mon, 08 Jun 2009 03:26:11 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2495 Clearly we had misuses and abuses of the various OTC products in the last 20 years (just as firms and individuals time and time again got decimated by trading exchange listed derivatives). Clearly dealers made massive amounts of money on OTC derivatives sometimes ripping off clients (similar to the way insurance firms profited from writing insurance). The knee-jerk reaction regulation is however not the answer. Clearing platform solutions, standardization, and disclosure to regulators are sometimes helpful but represent only a fraction of the answer. The key is sound margining procedures (such as the ones used by exchanges) and proper bank capitalization. Most banks already have such procedures in place and the Fed (as well as the OCC) should review and push for strengthening of these practices. The industry is already moving in this direction. Destroying or restricting various risk management tools provided by dealers is unsound, even if it makes for great press coverage. If you want to understand instread of reacting, read a blog post entitled “Derivatives, the wrong war” at SoberLook.com

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By: taxpayer http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2339 Wed, 03 Jun 2009 16:06:04 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2339 You should split the world into two types: securities, and OTC trades. The word derivative just means value derives from some reference source, and hence derivative can be either a security or an OTC trade.

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.

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By: Anon http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2320 Wed, 03 Jun 2009 00:50:18 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2320 For proof positive about how ridiculously confusing the terminology is, check out Ezra who cites you approvingly: http://voices.washingtonpost.com/ezra-kl ein/2009/06/derivatives_defined_thrice.h tml

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) …”

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By: a reader http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2319 Tue, 02 Jun 2009 23:46:07 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2319 S Bayer is right here. I’ve actually traded this product and these bonds are referred to as “mortgage derivatives.” That’s because the coupon is set based on where libor goes, hence the value of the bond is a derivative of libor. It also includes interest and principal only strips, which aren’t obviously derivatives, but are far enough away from the normal cashflows of CMOs that they fall into the mortgage derivative category as well.

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.

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By: Rortybomb http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2306 Tue, 02 Jun 2009 19:52:13 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2306 I agree with Nate.

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.

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By: Anonymous http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2296 Tue, 02 Jun 2009 18:15:58 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2296 These words have one definition for legal purposes and another definition in finance textbooks. I suspect that this is true of many other financial products too.

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By: Nate http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2292 Tue, 02 Jun 2009 17:42:58 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2292 I agree with Felix that a garden-variety MBS is not a derivative as such – unless you expand your definition of “derivative” to include all structured finance as well, but then the term is too vague to be useful. I think Felix’s definition of “derivative” is pretty good actually. Unfortunately, the press seems to have adopted the term “derivative” as shorthand for any sort of guilty-until-proven-innocent Wall Street hocus-pocus.

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By: S Bayer http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2291 Tue, 02 Jun 2009 17:42:33 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2291 Read the SEC complaint. These were derivatives in the most common sense of the word. They were collateralized by Mortgage Backed Securities. It is the press release’s headline that is misleading, and it is the WSJ writer who is confused.

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).”

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By: Dollared http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2289 Tue, 02 Jun 2009 17:32:38 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2289 A Derivative is an item whose value is determined by reference to an (ultimately, in some cases) underlying security.

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

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By: JH http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/comment-page-1/#comment-2287 Tue, 02 Jun 2009 17:19:41 +0000 http://blogs.reuters.com/felix-salmon/2009/06/01/securities-are-not-derivatives/#comment-2287 Ah – another fun flame-fest about terminology. The problem is that there are no internationally-recognised bodies issuing universally-accepted definitions of technical jargon for the world of finance.

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.

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