Bear's Nest

Let’s say that I have a $100,000 remaining balance on my mortgage and that I am in the fortunate position of being able and wanting to pay it off. However, a high penalty may make prepayment a poor financial decision, or prepayment may not even be allowed in the contract.

Imagine, however, that my lender is willing to borrow $100,000 from me for the same remaining term as the existing mortgage. The loan payments cancel, or more likely there’s a small monthly net payment from one party to the other because of the interest-rate difference when each loan was initiated. The new loan advance of $100,000 to my lender negates my mortgage economically, but from a legal standpoint there are $200,000 of loans outstanding.

The frightening derivative totals being bandied about are based on similar arrangements.

a derivative usually isn't cancelled when it is no longer wanted. Rather, a new, mirror-image derivative is created to offset the first one. Banks also balance offsetting exposure with different counterparties, reducing their overall risk. So out of that $455 trillion [of derivative contracts], net credit exposure is a mere $2.3 trillion.

As noted above, what distinguishes the current crisis from my simple mortgage-offset example is that borrowers and lenders use different counterparties to offset their positions. If my loan is from Bank A but I “cancel” it by making the loan to Bank B, my monthly net cash flow is zero or near-zero; however, I still have a $100,000 asset (loan to Bank B) and a $100,000 liability (loan from Bank A). Most of the time everyone performs, and the situation is about the same as if neither loan existed. However, if Bank B defaults, my net worth takes a $100,000 hit; worse, this event may trigger my own default and bankruptcy.

Even if we had the time to pore over balance sheets of companies we invest in or do business with, specific receivables from investment-grade companies (debt rating of triple-B or higher) are not normally disclosed in public financial statements. That’s what made the problem of Bear Stearns such a mare’s nest. All companies who held receivables from BSC would be hurt by its default, and some could have been pushed over the edge themselves, creating a snowball of bankruptcies.

We are awash in a sea of information, yet it never seems enough or the right kind. © 2008 Stephen Yuen

Vaillancourt Fountain on 4/16: visual jumble