If you want to know what is really going to sink the global economy, many economists and financial experts would say look to derivatives. No less an expert than Warren Buffett has been warning about derivatives for years. The type of derivative he talks about is the big business kind that is sold by large international banks to their corporate customers. These derivatives are, for the most part, monitored by regulators like the Federal Reserve, and reliable statistics on their growth and market importance are released regularly by the regulators and industry groups. But a whole other derivatives market has grown up under the radar of all these observers, and it is now doing a very good job of undermining the U.S. economy all on its own.

I’m talking about the unregulated, out-of-control derivatives that infested the home mortgage market in recent years. You’ve read about them – mortgages with teaser rates, no interest payments, negative amortization, and so forth. If you didn’t know these were derivatives, join the crowd, because the people selling them didn’t know either, much less the poor souls buying them. And therein lies the problem.

Just to keep things straight, a derivative is a financial contract which derives its value from some other more basic and traditional financial contract. A derivative is typically a swap of one interest rate payment for another over a fixed period of time, or a swap of one asset for another. Another form of derivative would be an option – the right of the buyer to purchase or sell some basic financial contract on a future date at a predetermined price. The basic financial contract that underlies the derivative can be any traditional instrument such as a deposit, commodity transaction, foreign exchange deal, or equity purchase.

In the mortgage business, the traditional financial contract is the 30-year, fixed rate mortgage payable in monthly installments. Principal payments as a percentage of the monthly payment start out very small in the life of the mortgage, but towards the end almost all of the monthly payment goes to paying principal rather than interest. Banks which sell this product do not usually hedge their cash flows by buying a 30-year fixed rate mortgage to match all inflows and outflows exactly. What they do is short-fund the mortgage; they issue short term deposits to hedge their mortgage portfolios.

Over the long life of a mortgage, this works out well for the bank. Short term rates are almost always lower than long term rates. This produces a net interest rate profit for the bank called the spread. Even for six months or so when the reverse situation might exist in the market (this is called an inverted yield curve – short term rates are higher than long term rates), the loss is usually not enough to outweigh all the spread profits over 30 years in the life of the mortgage. The only time this wasn’t true was around 1980, when U.S. short term rates ballooned to 18% or higher, well above long term rates. This situation destroyed the entire Savings & Loan industry in the U.S. and cost the taxpayers hundreds of billions of dollars to clean up the losses.

The other type of mortgage product – the Adjustable Rate Mortgage (ARM) – doesn’t really upset this model because banks are able to hedge their risk with adjustable rate deposits that earn less than the rate that is charged the mortgage customer. The bank still, over time, earns its spread on the mortgage.

It is important to understand the basic mortgage product because this is the base – the underlying contract – that is used to value any other derivatives that may be added to the product. Let’s take a low teaser rate mortgage as an example, and suppose that the bank is offering a 4.5% rate for the first two years, which will adjust afterwards into a 28-year fixed rate mortgage for the remaining life of the mortgage. Suppose further that the rate for a 30-year fixed rate mortgage for this customer would be 6.0% if they didn’t accept the teaser rate.

What the bank is doing is selling the customer a 30-year fixed rate mortgage with an option attached. The customer is buying the option, which gives them the privilege of lowering their interest rate for the first two years below what the market would normally charge them. In option parlance, this is a deep-in-the-money option. The customer is obtaining an immediate cash benefit when compared to the basic financial product.

If this were a regulated market such as an options exchange, the customer would pay an up-front premium just to buy a normal option, and they would pay a much higher up-front premium if they wanted to buy an option that was in-the-money and had immediate market value. In the mortgage market, the customer may have paid an up-front premium in the form of higher points, but because no bank or mortgage broker could possibly do business by charging the true price of this deep-in-the-money option, the banks deferred their premium.

They did this by adding on the premium to the interest cost the customer must pay when the mortgage converts after two years to a fixed rate loan for 28-years. So if the customer at the end of two years would normally then pay 6.25% as the going rate for the 28-year loan, the contract would call for them to pay something like 7.25% for the rest of the mortgage.

Because the bank is waiting for the two years to elapse in order to begin obtaining this extra premium, it adds a penalty clause if the customer wants to prepay and close-out the mortgage. This penalty is equal to all the deferred premium, plus interest, that the bank needs to receive to pay for the true economic value of the option. These penalties can be huge and often equal to at least a year’s worth of mortgage payments.

This same process applies to many other types of fancy products sold recently to home buyers. If a customer has the right to defer principal payments anytime they want, the bank will have to find a way to obtain the premium that would normally be charged for this option.

You can begin to see how trouble can develop with these products. Only a handful of very large banks could even hope to properly value all these different options, but the average mortgage broker certainly could not. Worse still, the banks and brokers didn’t really care other than to obtain a generous amount of fees and penalties to cover these risks. This was because most of these mortgages as soon as they were booked were sold by the banks as securities to investors who knew even less about the option risks, and were fooled by the Aaa ratings on the securities into thinking they were as risk-free as U.S. Treasuries.

And if the banks and brokers didn’t understand all this derivatives risk, you can bet the customers were not told about the risks, and if they were they didn’t fathom the fact that they had to pay for these options one way or another. Customers were lulled into thinking that ever-increasing home values would allow them to get out of any troublesome mortgage problem by refinancing. In fact, for awhile it would have, until home values plateaued in 2005.

You can see how this is playing out in an article in last week’s NY Times. Titled A Home Loan Trap. The article describes how homeowners are unable to refinance because they cannot afford to pay the penalties necessary to get out of teaser rate mortgages. They are trapped because they can’t afford the exorbitant rates that come into place once the two-year grace period is up.

This article makes it sound like the banks and brokers cheated the customers, and to the extent the customers didn’t truly understand these risks, the banks and brokers acted unethically and deserve the political storm that has arisen in the mortgage market. From the evidence so far, it does seem that there was massive deception or willful ignorance involved in the sale and distribution of these mortgages, which means the banks are going to be under pressure to waive the penalties. In fact, on the same day this NY Times article was published, Secretary of the Treasury Henry Paulson urged banks to begin accommodating customers facing foreclosure because of these products.

This means very simply that the banks aren’t ever going to receive the full, deferred compensation they were expecting on these derivative mortgages, and this also means that the investors who bought the securities containing these mortgages aren’t going to receive all the cash flows they were expecting. This involves millions of investors around the world, and it is easy to see how this has become a global credit crisis.

The mortgage problem in the U.S. is often described as a sub-prime credit crisis, which implies that poor black and Hispanic homeowners are defaulting on their mortgages and their homes are entering foreclosure. That is an element of what is going on, but it is a residual effect of something more sinister – the systematic abuse of derivatives by mortgage banks and brokers, and the Wall Street investment banks which packaged and sold the securities.

There is also a racist undertone to the commentary about this crisis - these people should never have been given mortgages in the first place. This crisis really has nothing to do with the segment of the market that was lured into these mortgages; it has everything to do with how these options were sold, and the degree of ignorance that was on display about the risks of derivatives.

This is, above all, a derivatives crisis. Until it is understood as such, no meaningful solution to the problems will be found.