You know dad is in trouble, and that mom is crying, and that the order for the Oyster 100 has had to be cancelled, and that the Bentley Arnage convertible is out, and that Graciela and Baby are on their way back to Manila and we’re just left with Candy to help out, and that you probably aren’t going to Choate after all, and it might be hard to figure everything out. But it’s not.
Here’s how it works. Think about gumdrops. They are no different than sub-prime home mortgages, and they illustrate how such a tiny segment of the housing market in the US could cause so much trouble for the world economy.
You used to be able to buy two gumdrops for a penny but now the price has gone up. They are a penny each. You want a gumdrop, but you don’t have a penny. But I will loan you one because I know you want the gumdrop. I am not asking you if you have a way to pay off the gumdrop because I think you will pay it off, or I did before your dad got into trouble. I don’t need to. But let’s figure out if I can get some collateral. Collateral is a big word for something I can grab if you can’t pay. That would be the gumdrop.
But collateral doesn’t really matter. I know you signed a paper with your little six-year old hand that you would pay back the penny. Your father is rich, or was until the current unpleasantness, and I think you’re good for it anyhow. So just like your father at the hedge fund, I have an IOU that represents the gumdrop. We can call it a mortgage.
But surprise. As soon as you gave me your little signature, I sold the paper to an 8th grader.
The kid who bought it from me has a great idea. He takes the gumdrop mortgage, and collects lots of them. Then he puts them into a fund that everybody can buy. A smart investment banker figured out in the 1980s that you could take lots of little IOUs, called mortgages, and bundle them together into bonds. These are called derivatives because they are financial instruments derived from the original mortgage. Then whoever buys them slices and dices them into different components.
The kid who bought your gumdrop IOU from me is like that.
So what kind of derivatives can we derive from your gumdrop? Well, the kid who bought the gumdrop IOU split it into a whole bunch of new financial instruments. They are called collateralized debt obligations. He sells securities on the gelatine in the gumdrop for 1 cent. He sells securities in the dye in the gumdrop for 1 cent. He sells securities in the sugar for 1 cent. He sells securities in the aroma for 1 cent. He sells securities in the appearance of the gumdrop for 1 cent. He sells securities in the squeezability of the gumdrop for 1 cent. Your gumdrop, which you bought for one cent (although it’s really only worth half a cent because of speculation and inflation) is now worth 6 cents.
But that’s just the start. Each of the buyers of the gumdrop securities breaks them into component parts and sells them on to other kids. The kid who buys the gelatine security breaks it down into its separate chemical components and sells each of the chemical component securities for one cent each. That creates five new securities each worth a cent. The kid who buys the dye security takes a prism of the color and breaks it down into each of its component colors. The possibilities are nearly endless. Colors can be separated split into endless variations using color separators. Magenta and cyan are components of red. Yellow and cyan can produce green. Each one can represent a new security.
The kid who buys the sugar security got a great deal. Sugar is a disaccharide that breaks down into glucose and fructose. It breaks down after that into something called C12H22011, with the systemic name of D-fructofuranosyl or D-glucopyranoside. Each one of those is broken down again. Over and over. It’s fun! Each of the people who breaks these down into individual securities says the security is backed by your one-cent gumdrop mortgage – the collateralized debt obligation.
In your dad’s world, this is called “creating new financial instruments.” By now, the total market value of the securities built on the value of your one-cent gumdrop is somewhere around 50 times that. But in a bull market, when everybody gets concerned that their snouts aren’t deep enough into the money trough, they start to panic and buy more, forcing the price up even higher. So your half-cent gumdrop now represents maybe US$1.
Way down at the bottom is you. The whole thing is built on your gumdrop, but I remember that you haven’t paid me the penny you owe me, maybe because you’re scared to ask dad, who is very grouchy these days. So I’d like the gumdrop back. Unfortunately, you ate it.
There was another man who was a lot like that investment banker who figured out how to securitize mortgages. His name was Carlo Ponzi. But that’s another story.