Derivative market failure could lead to higher rates

MSN Money writer Jim Jubak wrote a great article today about the importance of the derivative market.  Little is known about derivatives outside of Wall Street but he makes a compelling case for government intervention because of the role that these financial instruments play in encouraging foreign investors to invest in US based financial securities.

Put simply, derivatives are insurance contracts that an investor can purchase from a “counter-party” which would require the counter-party to pay the investor a sum of money should a specific event occur.  For example, a sovereign wealth fund who was purchasing a large pool of US mortgage-backed bonds could purchase a derivative contract from a financial institution which would pay out a sum of money should defaults on mortgage increase past a certain level (say 5%).

These derivatives then act as hedges for the sovereign wealth fund should this pool of mortgages go bad.  In essence, they reduce the risk involved for foreign investors in making investments into an economy they may not be familiar with.

Without derivatives foreign investors who we rely on to buy up mortgage-backed bonds and other US financial securities would be far less likely to invest in the US.  Without their demand for our securities we would sit back and watch mortgage rates and other interest rates rise.