Are Derivatives Really That Complicated?

I should preface this post by saying I know next to nothing about finance. What I do know I’ve learned over the past roughly two years by listening to NPR’s Planet Money podcast and reading books like the one I’m currently engrossed in, Michael Lewis’ The Big Short.

Last year my friend Steve wrote about the “complexity” of derivatives, arguing very convincingly that, even though the media liked to talk about how complex were the securities that nearly brought Capitalism to its knees, in fact they were generally being very lazy because these things weren’t really that complicated after all.

In The Big Short, however, Lewis describes how many of the traders who were trying to short mortgage-backed securities described them as being “complex,” even though they had spent a lot of time researching them. When these traders first encountered these securities, they had no idea what they were looking at, but they took the time and had the smarts to research them and figure them out. However, even after that effort, they still called them “complex,” not because the concepts were difficult to understand, but because no matter how much they researched them, they could never really determine the quality of the underlying raw materials (mortgages) in any given security.

The Wall St. firms that created and sold the CDOs deliberately made them obtuse so that it was difficult to determine the actual risk contained within. Part of the reason the firms loved selling CDOs was because they were able to take low-rated mortgage bonds they couldn’t otherwise sell and package them into higher-rated derivatives that they could sell. On “first generation” mortgage bonds, it might have been clear what the risks of investing in them would be, since the firms did publish stats such as average FICO score or % of no-doc loans in the bonds. But the firms sliced and packaged these bonds into CDOs many times over, such that it became very difficult for investors to get a real sense of the quality of the underlying raw materials in them. So then everyone just trusted the rating agencies.

It’s like trying to determine the quality of mass-produced ground beef. You may know that one particular cattle farmer’s practices are sustainable and humane, but once you grind up his meat and combine it with the meats from thousands of different farms and feed lots, and then portion that ground meat into little hamburger-sized patties, it becomes almost impossible to determine the quality of any individual hamburger. So then everyone just trusts the USDA ratings and goes on eating.

Read The “complexity” of derivatives « Steve Reads.