Imagine you sell marijuana. That’s right, you’re a dope dealer. You have a supplier, Raul, who sells you a pound of weed every Friday. Raul always tells you the pot is from someplace exotic: someplace that inevitably brings to your mind a veranda surrounded by palm trees and sand where you imagine yourself drinking rum and listening to the surf — or to reggae. Every week you sit cross-legged on the floor of your apartment listening to reggae and filling Baggies with dope; weighing them on a little scale that dangles from your finger. You sell these Baggies to your friends and classmates, never failing to tell them the pot is from someplace exotic. The price of the pot Raul sells you varies from week to week. Usually it’s a little higher than the week before, but occasionally it’s lower. One week Raul tells you he’s short on cash and he proposes a deal.
According to Raul’s deal, you pay him this week’s price for two pounds of pot, even though he’s only giving you one. When he drops by with next week’s delivery, you’ll owe him nothing. The price of next week’s delivery will probably be higher, in which case you would come out ahead. However, there’s the off chance next week’s delivery will be cheaper and Raul would come out ahead. Sensing your hesitation, he sweetens the deal, offering to throw in a plastic 35mm film can full of buds from his very best private stash. “Dope will get you through times of no money better than money will get you through times of no dope,” he submits, quoting an old hippie comic book. You both laugh and, since marijuana is murder on short-term memory, write the agreement on a piece of paper.
Imagine it’s the Wednesday after you’ve made your deal with Raul and you find yourself out of cash. You happen to know a guy, Dave, who lives in a dorm and who also buys pounds of marijuana from Raul. He bags it and sells it to his friends and classmates, telling them it’s from someplace exotic. You phone Dave and explain to him that you’re broke and you have this piece of paper good for one delivery of a pound of Raul’s exotic smoke. Will he give you some money for it? “I don’t know, dude,” Dave demurs. Earlier that day you both heard that the local marijuana crops are being harvested and so, with all that extra supply, next week’s prices are sure to be lower. You’re hard up. You’re already out of beer and you used your laundry quarters to buy cigarettes. Your last bit of food, a slice of pizza, is curling up in its box as your no-frost fridge sucks the moisture from it. It’s a depressing decision but you agree to sell Dave the piece of paper for several hundred dollars less than you paid for it.
That evening you console yourself by doing what you do most nights. Your stereo blaring, you zone out in front of the TV amid a sea of beer cans, an empty pizza box and your ceramic bong shaped like a skull. The local news comes on and you spring up, fumbling for the remote control because, announcing the lead story is an image of a marijuana leaf and the words, “Biggest Pot Bust in History.” You learn that a collaborative effort among federal, state and local authorities has thwarted the marijuana harvest. That very minute the FBI, CIA, National Guard, police, Coast Guard, Scouts of America, several anti-government hate groups and members of a local funk-aerobic class are throwing bale after bale of freshly picked marijuana onto an immense bonfire outside of town. You slap your forehead with the heel of your palm. That piece of paper you sold Dave is worth twice — no, 10 times — what it was mere hours ago. Dave made out like a bandit. Next week he’ll trade the piece of paper to Raul in exchange for a pound of now very expensive pot. You, on the other hand, didn’t do so well. Come to think of it, at the higher price it will now no doubt command, you won’t even be able to afford a pound. You’re out of business! You barely have enough money to hold you over the two or three weeks it’ll take to find a real job. You are bummed. It’s just as well. Selling marijuana is illegal. But that’s not the point.
The point is, that piece of paper you bought from Raul and sold to Dave was a derivative. The value of a derivative is determined by some underlying variable. You can see how the price of marijuana determined the value of your derivative. You might recall derivatives are blamed for the loss of about $13 million that the University invested in one of Piper Jaffray’s funds. Those derivatives, mortgage backed securities, are more complex than yours. They derive their value from a bundle of mortgages. Mortgages, in turn, get their value from interest rates and the rate at which homeowners prepay their loans. To complicate matters, some of Piper’s mortgage securities were further distilled into elaborate and, frankly, elegant derivatives with names like “interest-only strips” and “principal-only strips”; “floaters” and “inverse floaters”; and the ultra-exotic “interest-only inverse floating rate securities.” Some of these derivatives lost a lot of their value when interest rates increased, just as yours lost value when the price of pot decreased.
Most journalists invariably preface the word “derivative” with “risky,” as if using them was on a par with selling marijuana. That’s because they only hear about derivatives when something bad happens. But derivatives are not inherently risky. In fact, they are designed to reduce risk. Bad things happen with derivatives when managers do not understand them; or when they use them to bet the ranch on some stupid opinion that, for instance, interest rates will never rise. It goes to show that there are some things you should never do. One is invest in things you do not understand. Another is, well …
In a couple of weeks the police kick in Dave’s door and find a pound of pot. He rats on Raul in exchange for leniency. The news breaks his mother’s heart and gives his father a fatal aneursym. He’s expelled from school. Raul’s associates come looking for Dave so he leaves town and finishes his degree at a crummy college in a tiny, boring municipality in Iowa.
It’s enough to make you swear off dealing pot forever.
Charles Foster’s column appears in the Daily every Thursday.