Tom Friedman, the self-styled guru of everything and anything, got it right when he recently described financial markets as the interaction of greed and fear.

Unfortunately, this delicate balance between the two can turn poisonous and, just like that, take on the highly dysfunctional relationship of a bad “Cops’ episode. Over the past month or so, the latter happened and we find ourselves nearly naked and handcuffed on Wall Street. This time the drug behind all the shenanigans is not crack or meth, it’s the “derivatives.”

    Now, it was greed that brought derivatives to the forefront of the investment world, and that’s when the fear — as helpless investors watched nest eggs unravel minute by minute — kicked into overdrive and propelled the stock market and the economy to the very edge of the abyss. People are starting to ask just what are these derivatives and why are my “safe” investments suddenly at risk?

    First, people have to realize that outside of low-risk T-Bills and FDIC-covered bank deposits, there are no truly “safe” investments. All investments with a time horizon carry a certain amount of risk, even T-Bills. That risk is a built-in part on the expected return. So let’s say that you have a 5-year T-Bill with a “safe” interest rate of 5%. Now compare that to a five-year private investment that carries an interest rate of 10%.  The difference, that 5%, is your reward for taking a chance on a somewhat riskier proposition.

    That brings us back to derivatives. This investment product was primarily designed to minimize risk while still maintaining an attractive rate of return for investors. These investment instruments literally spread the risk of somewhat shaky debt around, allowing people or companies that carry a higher risk access to money to finance their project or, as we all recently discovered, a home.

    Think of Derivatives as an insurance policy that “derives” its value from the assets insured, with the risk often measured on the ability of the borrower to pay back the loan. One has to think that the investment gurus who packaged and repackaged all these mortgage and other loans never thought about what would happen if suddenly assets from which the book value of the derivatives were derived suddenly dropped in value.

    “Oops,” they all said.

    Think about it. No one saw this coming. No one saw the danger. Those who did quietly got out as fast as they could. Of course, there were occasional grumblings on CNBC, but traders and investors never questioned the validity of the assessed value of the mortgages. The danger was in the false assumption that the value of real estate was never going to drop.

    According to a recent New York Times article, the sum total of all derivatives in 2002 was about $ 106 trillion. Six years later, the amount jumped to $531 trillion. Thinking back to what happened over that time, it is not difficult to see there just may be a correlation between the expansion of derivatives and the explosion in the valuation of the nation’s housing stock.

    A little simple history is a good way to see how this current mess evolved.

Back in the good old days, when company pensions were plentiful, people paid only passing notice to what was going on with Wall Street. Then the Reagan revolution appeared with all that talk about personal responsibility. Which was a good thing when applied, as most middle class people probably thought, to welfare cheats. However, when all those safe company pensions started to fail, personal responsibility slammed down hard on Main Street. The middle class discovered that their futures were at risk. A good chunk of the greatest generation unexpectedly found themselves “personally responsible” for their own retirement.

    Unsatisfied with the meager interest savings accounts paid, investors started chasing higher returns and poured cash into the stock market. Of course, the market went up. Slowly, the sheer amount of money entering the stock market was determining the value of stocks and not the actual performance of the companies. Remember the crash of 1987?  

    Then came the mess made by the collapse of the lightly regulated Savings and Loans industry. Once again, the flow of money into those companies distorted true book value. Toss in a lack of meaningful regulation and a crash was inevitable.

    When the dust settled from the S&L crisis, the Dot Com craze appeared. Once again, the value of the stock was not based on the true accounting of the company, but simply on the demand for that stock. It was a brave new world, they all said. The old rules don’t apply. Well, we all know what happened there.

    In each case, the government stepped in to contain the damages caused by a lack of regulation and naked greed.

    Next up, real estate. What could go wrong this time? Real estate, after all, has real tangible value. However, the money pouring into the market was once again distorting the true value of assets. Of course, this caused furious activity in construction. But when the golden goose was about to be slaughtered by soft demand, the sub-prime mortgage was born. Suddenly, anyone could afford a home. Once again, the rules did not apply.

    Change, however, had to occur at the banking level. Rules about risk in relationship to assets owned by a bank had to be skirted. Literally overnight, a whole industry of off-the-book loan brokers appeared to ease that pressure. They still had to get the money somewhere, and that’s how the bundling of loans into derivatives entered the real estate market.

    But home values started to decline as the market was suddenly over built. Demand for housing fell further. This rippled through the system as banks suddenly were holding devalued derivatives. In order to shore up their balance sheets, the money to loan was needed to cover that loss in value. Thus began the crash of 2008.

    Of course, it is more involved, but you get the picture.

    The point is that every step along the way, greed blossomed. Get rid of regulations, they all said. Let the markets work their magic and every time fear started to rear its ugly head, the government stepped in to either right the market or actually bail out those responsible for whatever financial fiasco had just occurred. This time, as one would expect from the Bush Administration, the whole thing went too far because no one wanted to acknowledge the $ 531 trillion elephant in the room.