President Bush got YouTubed this week. He had asked that video cameras be turned off before his candid remarks but one was left rolling. He then proceeded to explain the current problems in the financial system in terms he knows, saying that "Wall Street got drunk ... and now it's got a hangover." He then went on to blame the current problems on "fancy financial instruments." When the YouTube video was discussed on Wolf Blitzer's "The Situation Room," Jack Cafferty interpreted "fancy financial instruments" to mean mortgage-backed securities, and one talking head made the comment that Cafferty's interpretation was more concise than Bush's.

"Wall Street got drunk ... and now it's got a hangover."  –President  BushBut I don't think Bush was just talking about mortgage-backed securities. Mortgage-backed securities are just one variety of fancy financial instruments also known as derivatives. Derivatives are financial products that derive their value from something else. Mortgage-backed securities are a bunch of mortgages grouped together, sliced up, diced up and sold as securities like bonds. Mortgage-backed securities are a large market unto themselves. Credit card receivables and student mortgages are packaged in similar ways. There are also mortgage bonds like the type Fannie Mae and Freddie Mac own or guarantee – about $12 trillion worth. Credit default swaps are probably the largest class of derivatives. These are either traded to insure a financial entity in a debt market or bought as insurance in case they default.

Some owe more than their house is worth...The danger is that when problems arise, as when sub prime borrowers default on loans, some of these products turn sour, and when you cannot sell something at any price, it essentially has no value. In the past year we've seen prime and alt-A defaults as well. A bubble in housing values burst and many people have lost money in the value of their homes. Some owe more than their house is worth, and for some it would cost less to just walk away from their mortgage and start rebuilding their credit.

...and for some it would cost less to just walk away from their mortgage and start rebuilding their credit.More broadly we've seen a credit bubble pop – more than just the housing bubble – but fancy financial instruments, or more accurately their misuse, are just a symptom of the disease. For example, the student loan bond market failed to operate early this year, selling no bonds in the first quarter. This was an inevitability. Two major series of rate cuts were made in 2001, first following the tech crash that sent us into a mild recession and then again after September 11th. Interest rates were held under 2% for over 2 years after previously standing at 6.5%. Letting banks borrow money for next to nothing invited them to re-lend the money and invest it in haphazard ways. All that liquidity flooded into the financial system and into asset bubbles and into share prices. Now the second wave of easy money in this decade is flowing into commodity prices, fueling price inflation but not wage inflation.

The global derivatives market has swelled to $1.14 quadrillion up $459 trillion just since last December (the combined GDPs of all the countries on Earth only amount to about $54 trillion). What happens when that bubble bursts?

“What you see is not a panic of the public. This is a panic of the sophisticated.”
[Wikipedia, TheSequitur, iStockAnalyst, MoneyCafe, NYTimes]