05/27/2008 Is it potentially dangerous and troublesome to market derivatives based financial products to consumers?

FAQ #15: Is it potentially dangerous and troublesome to market derivatives based financial products to consumers?

There are indeed many unjustified public misconceptions about financial derivatives. Every time the public heard of derivatives in the press was when some derivatives traders played mischief and caused troubles to others. They are usually headline news materials. Few reporters will spend time to write about how good derivatives are other than those sponsored by the industry promoters.

Banks have in fact been marketing derivatives to consumers for decades without calling them derivatives and have provided enormous economic value to homeowners. For example, a 30 year fixed rate mortgage with a prepayment option is nothing different from a fixed rate loan together with an interest rate derivative. However as you would recall that last time when you refinanced, the bank did not ask you to sign a derivatives contract on top of your loan contract. In addition, I am sure that you have never heard of any consumers ever got hurt by these benign interest rate derivatives that have already been built into the consumer financial products. That is the spirit behind the invention of HELM (Home Equity Locking Mortgage), the SwapRent (SM) embedded mortgage product, to package the economic benefits of real estate or property derivatives into the consumer financial products in a fool-proof, easy to understand and simple to use way.

Some market guru once called financial derivatives the WMD or Weapons of Mass Destruction. On surface it is actually technically correct (or he won’t be a market guru anymore). Same thing could be said about the real nuclear power. They could indeed be the powerful destructive weapons but as the Iranians or the North Koreans would be eager to tell you, they could also be powerful tools to generate electricity to benefit many of their citizens. A big percentage of many advanced economies’ electricity is actually being generated this way. So the question is really who are using it, how they are using it and what they are using it for. Same arguments apply to derivatives.

On the other hand, the ignorant interpretation of the guru’s comment to generalize that all derivatives are bad is a bit naive. It would be equally naive to call guru’s Graham & Dodd investing style stupid and bad simply because the guru had made many investment duds that the public have not yet focused much on. It is a perception or maybe a PR issue. Few people know that there are in fact good cholesterols and bad cholesterols but few have vested interests to defend and change the public image of the poor cholesterols.

Having said that, overly complicated structured derivatives are prone to be abused because they may be more difficult to understand. That is the root cause of most of the derivatives troubles, i.e. human abuse. So CDOs and CDS could be the case in point. Simple, transparent and well designed fool-proof derivatives such as fixed rate mortgage with prepayment options on the other hand, mostly deliver good causes and have less opportunities left open for participants to abuse than their more complicated counterparts.

SwapRent (SM) and its associated consumer finance products were specifically designed and created to keep only the economic benefits of financial derivatives in a fool proof and simple way for consumers to utilize. As fully explained in the various patent applications mentioned above, they were intentionally designed to be very different from the OTC derivatives practiced in the institutional inter-bank market, which are absolutely too complicated and dangerous for public retail consumption. To use another analogy again, if those interbank derivatives are race cars which could only be used with a stick or manual transmission to operate by sophisticated drivers, SwapRent (SM) and its embedded mortgage product HELM could be your auto transmission equipped sedan with anti-lock brakes and air bags for more consumer user-friendliness.

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