If you remember the housing crisis that gripped the U.S. economy in the late 2000s, then chances are you’ve heard of derivatives – but what are derivatives exactly? In short, they’re an instrument that allow investors to access a class of assets, such as real estate, currency and commodities, without ever actually having to deal with the asset itself. Often referred to as “mortgage backed securities,” real estate derivatives represent either the equity or the debt associated with a property.
Here’s How Derivatives Work
When a homebuyer receives a mortgage from a bank, the bank then sells that debt to Fannie Mae (also known as Federal National Mortgage Association) in order to obtain additional funds that will be used to issue additional loans. From there, Fannie Mae sells mortgages in packages on the secondary market. These packages are the mortgage backed securities. Investment banks and hedge funds buy these securities and divide them into different portions and sell them to investors.
Companies are attracted to derivatives because of the option to “swap” them out in which one can can exchange debt for equity, in the form of bonds in exchange for stocks if the companies are publicly traded, with the intent of restructuring debt or to restructure their debt to equity ratio. Moreover, banks were allowed to behave like hedge funds following the deregulation that occurred in 1999, which enabled them to resell derivatives that were based on derivatives. This aspect of the market only added to the potential for disaster.
Did you know?
The governing body for real estate derivatives is The National Council of Real Estate Investment Fiduciaries Property Index (NPI) and sets the performance index for the commercial real estate market that consists of over 7,000 properties within the U.S. valued at over $500 billion.
The Financial Crisis Is Sparked
This practice might seem harmless enough, but in the case of real estate derivatives and the housing crisis that took shape between the years of 2004 and 2006, the unregulated nature of the market proved to be disastrous. When the Federal Reserve began increasing interest rates, many homeowners who had mortgages with an adjustable rate of interest couldn’t afford to make their payments and started defaulting on their loans. This in turn set the financial crisis into motion. As the demand for housing began to diminish, home prices dipped and many borrowers weren’t able to sell their homes in order to alleviate their debt.
The mortgage backed securities that were held by banks were quickly losing value and the banks were then unable to sell them. This triggered the shutdown of the secondary market and banks stopped loaning money to each other due to the fact that derivatives were often used as collateral. Because derivatives of mortgages were commonly bundled together in MBS, when borrowers began defaulting on their loans, the MBSs lost value or became outright worthless. In fear that they would no longer have the funds to cover daily operating expenses, banks ceased practically all lending and the housing crisis only worsened. The subsequent bank bailout bill was then issued and intended to get the derivatives off their balance sheets so that they could start lending once again.
Derivatives and Real Estate Investing
Prior to the housing crisis, investors were given access to portions of mortgage debt bundled into MBS, and many of them chose to then resell fractions of the same MBS to other investors. In many cases, this process was repeated numerous times creating derivatives of derivatives. The only collateral in place for the original derivatives was the property that was mortgaged. Unfortunately, the banks held exclusive rights to this collateral as the contract including the rights of ownership only existed between the borrower and the bank. Because of this, investors had no recourse when defaults began to occur and the number of people who suffered financial loss only multiplied.
While derivatives are sourced from various assets, it was those created from mortgage debt that came with serious repercussions. Banks were permitted to invest the funds of depositors into outside hedge funds in addition to lending to borrowers who couldn’t afford their mortgage payments. This was largely due to the fact that the Securities and Exchange Commission lacked regulation and oversight which created an unstable business environment and the opportunity for a financial crisis.