Corn and hogs in the Midwest seem a long way from condos in Florida. There is, in fact, a direct link and it's one worth contemplating in light of the pursuit of Goldman Sachs by Congress and the Securities and Exchange Commission.
Derivatives—the new bad word—used to be called "futures." They've existed since the Civil War, invented basically to protect farmers, traders, and merchandisers from ruin when they could not sell a crop to cover their costs because a bumper harvest created a glut, or, conversely, to protect buyers when a bad harvest led to price inflation. Hence the creation of contracts with third parties who agreed to buy or sell at a certain price, whatever the future might bring. This stabilized the market and freed farmers from looking around for a buyer in what might be a frantic market.
The original futures markets in commodities functioned virtually without incident throughout our recent roller-coaster financial crisis. Put simply, this was largely because the markets had evolved a guarantee system following periodic defaults on futures deals by one party or another. Middlemen stepped in to assume that risk for a price, provided the parties posted collateral. In this way, clearinghouses minimized both the risks and the interconnections brought about by derivatives transactions.
In the evolution of these necessary instruments furthering stable trade, financial traders came to bid on the value of the paper guarantees: Bid offers went up if the risks seemed high, and down if they seemed safe.
We have come a long way from the original trading in futures contracts for corn and hogs, first standardized in Chicago in 1865. A huge market also emerged in mortgage bonds. Today the new derivatives account for trillions of dollars in face amounts, and were a significant factor in the financial panic that swept the world in 2008.
These are mortgage-backed securities fundamentally transacted between "shorts" and "longs." The "shorts" judge that the price of the security will go down, so they promise to buy it at some price lower than current. If they judge wrongly—if it goes up, or goes down more than they assumed—they suffer, since they have to deliver the security at a loss. The "longs" judge that mortgage bonds will strengthen in price, so they stand to earn more for the security than they paid. A perfect illustration is the now-famous case involving Goldman Sachs and a buyer and seller. One was betting that the housing market would collapse, another that it would continue to rise.
Synthetic CDOs (collateralized debt obligations), of which we have heard a lot, are really instruments for betting on the housing market; their value is linked to a series of mortgage bonds. Again, if the price of those bonds declines, one set of investors will win, whereas if the mortgage bonds strengthen, the other side wins. This is the way in which a player bets on the success or failure of other people's investments—a financial version of high-stakes poker.
These securities also reduce the costs of the loans that lubricate our economy. They make them more affordable and available by enabling lenders to offload risks to other investors with steadier nerves—in short, to hedge their bets.
When the U.S. housing market collapsed, so too did the value of investments in residential mortgage-based securities, especially those tied to subprime mortgages of borrowers who could not meet their payments.
Not so long ago, these mortgage-based securities were viewed as among the safest investments in the market. Before the housing bubble burst, the overwhelming view of investors, rating agencies, and economists was that the housing market was strong and would continue to strengthen. Average housing prices rose by double-digit percentages in every year from 2002 to 2006. Investment-grade, mortgage-backed securities between 2005 and 2007 were considered almost as safe as U.S. Treasury securities but paid a higher interest rate. Defaults on these investment-grade securities, most of which were rated AAA, were virtually nonexistent.