Derivatives - The size matters- Concentration matters too
From http://www.prudentbear.com . The office of the Comptroller of the Currency recently reported fourth-quarter U.S. Commercial Bank derivative data. For the quarter, Total Derivative positions (notional value) expanded at a 24% annualized rate to $71.1 Trillion. By type of risk, Interest Rate derivatives expanded at a 25% rate to $61.9 Trillion; Currencies at a rate of 16% to $7.2 Trillion; Credit at a rate of 61% to $1.0 Trillion; and Other at a negative 6% rate to $1.0 Trillion. By Product, Swaps expanded at a 28% rate to $44.0 Trillion, Futures Forwards at a 20% rate to $11.4 Trillion, and Options at a 12% rate to $14.6 Trillion. Total Derivative positions ballooned 57% over two years, with Interest Rate derivatives up 61% over 24 months. Over the past year, JPMorgans positions increased 30% to $37.4 Trillion, BofAs 22% to $15.2 Trillion, and Citigroups 26% to $12.6 Trillion. At the end of 2003, these three major derivative players accounted for 92% of total derivative positions. Fannie Mae is the largest buyer of derivative insurance. There is considerable controversy as to the size of derivative losses already suffered by Fannie. Some are convinced they have incurred massive derivative losses, while company management is quick to retort that losses on its hedges have been offset by changes to market values of its assets and liabilities. I will avoid this winless debate at least while we remain in an environment of historically low interest rates. .. See in full: http://www.prudentbear.com/creditbubblebulletin.asp Best, Sabri + P.S: 1) All mortgages are derivatives. They are contingent claims on your ability to pay your mortgages. Fannie Mae/Freddie Mac/Gennie Mae and the like combined together hold trillions of dollars worth derivatives, although nobody calls them as such. 2) There are many private mortgage lenders such as Countrywide out there. Their securitized loans are backed by huge mortgage loans, called jumbo loans, collateralized by overpriced homes in cities such as San Francisco, LA, New York and the like. 3) All your credit card loans, auto loans, mobile home loans, home equity loans, student loans and the like are securitized and constitute a huge portfolio of contingent claims, that is, derivatives, whose payments depend on the borrowers' future successes. 4) There is a huge credit derivatives market that this article does not even mention. Collateralized Bond/Loan/Debt Obligations are mathematical objects beyond the comprehension of even the best and the brightest, including Darrel Duffie at Stanford.This global market is growing at a rate beyond imagination. 5) And these contingent claims have nothing to do with the real economy nor with the money supply. Who supplied this market with these $71 trillions? The Fed, the US Treasury? Who?
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
Marvin: maybe they work for hedging purposes, but they still represent a potential source of catastrophic instability. No! This was not my point. My was not that maybe they work for hedging purposes. My point was that they may work for hedging purposes but not always. Size matters. Also my point was not that they still represent a potential source of catastrophic instability. My point was that they are causing a catastrophic instability, unless you don't realize yet. As a Turkish saying goes: Yanaklarindan operim, which translates to: I kiss you on the cheeks. Best, Sabri
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
I said: Marvin: maybe they work for hedging purposes, but they still represent a potential source of catastrophic instability. No! This was not my point. By the way, it happens that I was the last product manager of the Leland-Rubinstein portfolio insurance program. It died in my hands in 1999 because I had only two clients, one here in San Francisco, the other in Sydney, Australia. It was an APL (A Programming Language) program which was not Y2K compliant, and given two clients and the fact that it was almost impossible to find APL programmers in those days, I cut the diskette that contained the source code with a pair of scissors myself to put it to death. According to some, it was this hedging program that caused the 1987 stock market crash. Debatable of course but still. So much for hedging!.. Sabri
Derivatives
Sabri Oncu provided some unhelpful comments about my queries on derivatives. 1) If he were advising the government of Cuba would he immediately recommend it drop its sugar derivatives program -- and, by extension, advise other poor countries to do the same in relation to their own resources? 2) It's not enough to sarcastically point to the dangers they pose to the world economy. What can be done about what the bourgeoisie itself, notably Warren Buffet, describes as a ticking time bomb? Anything? -- a) prohibit the $130 trillion trade in derivatives altogether (fat chance), b) endorse efforts to regulate the the more exotic opaque instruments by requiring greater transparency and mark-to-market accounting standards, or c) wait for the whole house of cards to collapse so we can say told you so. I have a genuine interest in the issue, want to know more about it, and have no ax to grind. I think it was good of Juriann Bendian to raise it, and bad for Sabri to curtly dismiss his effort as a bad essay without any explanation except derivative are dangerous (indeed) and to invite me to kiss his sweet cheeks for pursuing the thread. Marv Gandall
Re: Derivatives
1) If he were advising the government of Cuba would he immediately recommend it drop its sugar derivatives program -- and, by extension, advise other poor countries to do the same in relation to their own resources? I, for one, see nothing wrong with hedging on the futures market to try to lock in a price on some -- but not all -- of a country's crop. (Not all because it makes sense to diversify.) This kind of derivative is what farmers have been doing for quite awhile. It's basically the same thing as taking out insurance. 2) ... What can be done about what the bourgeoisie itself, notably Warren Buffet, describes as a ticking time bomb? Anything? -- a) prohibit the $130 trillion trade in derivatives altogether (fat chance), b) endorse efforts to regulate the the more exotic opaque instruments by requiring greater transparency and mark-to-market accounting standards, or c) wait for the whole house of cards to collapse so we can say told you so. It seems to me that (b) is the obvious solution for the bourgeoisie. Not that they'll do it in the near future, because given the current balance of power (the lack of a serious labor or social-democratic movement) the short-term and particularistic thinkers and their neo-liberalism will dominate regulation. Jim Devine
Re: Derivatives
Thanks. This is more what I was looking for. I wouldn't discount efforts towards some form of self-regulation in the overall self-interest of investors, however, and especiially by the big banks who are forced to take a bath to take when heavily leveraged big players like LTCM bet wrong and can't cover their trades. The systemic risk resulting from LTCM situations is a real concern. But I think the real question is whether this huge shadowy market can be effectively regulated. Marv Gandall - Original Message - From: Devine, James [EMAIL PROTECTED] To: [EMAIL PROTECTED] Sent: Sunday, March 14, 2004 12:00 PM Subject: Re: [PEN-L] Derivatives 1) If he were advising the government of Cuba would he immediately recommend it drop its sugar derivatives program -- and, by extension, advise other poor countries to do the same in relation to their own resources? I, for one, see nothing wrong with hedging on the futures market to try to lock in a price on some -- but not all -- of a country's crop. (Not all because it makes sense to diversify.) This kind of derivative is what farmers have been doing for quite awhile. It's basically the same thing as taking out insurance. 2) ... What can be done about what the bourgeoisie itself, notably Warren Buffet, describes as a ticking time bomb? Anything? -- a) prohibit the $130 trillion trade in derivatives altogether (fat chance), b) endorse efforts to regulate the the more exotic opaque instruments by requiring greater transparency and mark-to-market accounting standards, or c) wait for the whole house of cards to collapse so we can say told you so. It seems to me that (b) is the obvious solution for the bourgeoisie. Not that they'll do it in the near future, because given the current balance of power (the lack of a serious labor or social-democratic movement) the short-term and particularistic thinkers and their neo-liberalism will dominate regulation. Jim Devine
Re: Derivatives
- Original Message - From: Marvin Gandall [EMAIL PROTECTED] Thanks. This is more what I was looking for. I wouldn't discount efforts towards some form of self-regulation in the overall self-interest of investors, however, and especiially by the big banks who are forced to take a bath to take when heavily leveraged big players like LTCM bet wrong and can't cover their trades. The systemic risk resulting from LTCM situations is a real concern. But I think the real question is whether this huge shadowy market can be effectively regulated. Marv Gandall Wouldn't the transparency issue run into intellectual property-firm specific proprietary concerns? Ian
Re: Derivatives
I think it was good of Juriann Bendian to raise it, and bad for Sabri to curtly dismiss his effort as a bad essay without any explanation except derivative are dangerous (indeed) and to invite me to kiss his sweet cheeks for pursuing the thread. Don't worry about that. Sabri is really talking about something different. Sabri is a good guy anyhow. Sometimes he just overemphasises his need to be Turkish, that is all. J.
Re: Derivatives
a) prohibit the $130 trillion trade in derivatives altogether. It is not a $130 trillion trade in derivatives, if you want to be precise. The trade is a contractual assurance exchanged for a fee. That BIS estimate, refers to the value of the underlying asset (tangible or financial), which is itself not part of the trade. The actual appropriation of gross income from hedge contracts would be more like a tenth of that value, but even if that is correct, the amount is still astronomically and gigantically big. It means many things, e.g. that the deregulation is not just lucrative, but also raises total costs from the point of total social capital and that it adds to the capital which is tied up in activities which do not create additional employment. The topic of derivatives is extremely important to understand from the point of view of how the bourgeoisie aims to solve the world debt crisis. Financialisation means that you can transfer the financial burden of asset ownership to somewhere else in space-time, that is the point. People do not understand the significance of derivatives, also, because they do not understand the gigantic difference between currencies in rich countries and in poor countries. Even a value of US$1 billion is a gigantic, astronomical amount, from the point of view of poor countries, as regards real buying power. With that sort of money, you can have a gigantic effect in poor countries. Suppose that you would revalue food imports into the USA according to price norms applied by American food producers. The difference would be gigantic. At the moment in India, derivatives are being used as an instrument to encourage primitive accumulation, no less. It is better than selling kidneys, of course. Naturally my friend Melvin would dispute all this, but yep, in the real world it's happening. In the old days, you might go to the pawnshop, but these days, there is a derivatives pawnshop and it's global. What used to be called pawning is now called derivatives or another fancy label, but the important thing to understand is that pawning could now occur on a very large scale, in fact, it is possible to pawn a whole country financially. The development/underdevelopment discussions in the haute bourgeoisie are in truth different from what Marxists think they are. J.
Re: Derivatives
Jurriaan Bendien wrote: Don't worry about that. Sabri is really talking about something different. Sabri is a good guy anyhow. Sometimes he just overemphasises his need to be Turkish, that is all. That's because he is in exile. Joanna
Re: Derivatives
That's because he is in exile. Yes, I knew that. My own exile is more self-imposed, to the extent that, after what happened to me, basically I just want to shut a lot of stuff out, so that I concentrate better on saying and doing what I mean, and not what I do not mean, or what other people think I should mean etc. (but this is just difficult for me, and it is difficult for me to relax correctly, and so on). From my point of view, Sabri is a very skilled guy, with whom I'd share a lot of interests and philosophies, I'm sure. At least he's interested in things like love and poetry. I met Sungur Savran once, very impressive guy too, reading through things I realised there was a very sophisticated economic and political tradition in Turkey which I didn't know (but then I don't speak the language or anything either). From a scholarly point of view, I may take a different view about using statistical tools and game-theoretical tools, but that is just a trivial difference really, and anyway he's a better statistician and mathematician than I am (I am more interested anyway in the interpretation of aggregates, and only in a few specific mathematical issues) so little point in arguing on about that. J.
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
I didn't ask the question to be provocative. Someone raised it with me in a discussion. Your answer seems to be maybe they work for hedging purposes, but they still represent a potential source of catastrophic instability. That's essentially what I replied, wondering whether I'd missed any intrinsic arguments against their being efficient hedges, which might have been more persuasive. Anyway, don't sweat it;there are more important issues, but thanks for replying... Marv G - Original Message - From: Sabri Oncu [EMAIL PROTECTED] To: [EMAIL PROTECTED] Sent: Saturday, March 13, 2004 12:11 AM Subject: Re: [PEN-L] An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc. Marvin: Sabri: How would you answer the argument that most derivatives are used for hedging operations and are therefore a source of stability for the system? Dear Marvin, I was tempted to open up with the following: Are they? I did not know this! But if I do that you may get the impression that I am attacking you. But no! Even if I opened up like that, my intention wouldn't have been to attack you. It would have been to attack the standard finance text books which claim the above. Those books are not only based on unreasonable rationality assumptions but also they ignore the effects of size. Soros was able to attack the UK government and beat it when he bet against the pound but I don't think even he has the ability to bet against the US market. The US financial market is a monster against which no one has the ability to bet. And that is the problem. Controlled chaos is fine as long as those who are at the reigns have the ability to pull them. But if the horses go crazy, it does not matter how good a rider you are. They decide where they want to go and they may even choose to jump of a cliff. There are trillions of dollars worth of derivatives out there with no connection to neither the real economy nor the money supply. Anyone create money in these markets by signing derivatives contracts, as long as they have the credibility to sell them. This global gambling casino grew so big that none of the owners, including the US Treasury and the FED, really own this casino anymore. It became uncontrollably chaotic despite denials of the alleged owners. And the casino always wins, and if nobody owns the casino, everybody loses, sooner or later. Best, Sabri
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
Frank Partnoy's book suggests that most derivatives exist in order to get around financial regulations. -- Michael Perelman Economics Department California State University Chico, CA 95929 Tel. 530-898-5321 E-Mail michael at ecst.csuchico.edu
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
- Original Message - From: Sabri Oncu [EMAIL PROTECTED] To: [EMAIL PROTECTED] Sent: Thursday, March 11, 2004 9:42 PM Subject: Re: [PEN-L] An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc. Marvin Gandall: Hungarian, but a good essay nonetheless. :) No! It is not a good essay. It is a wonderful demonstration of lack of understanding of derivatives, as the following statement of its author demonstrates: the rate of profit on capital can be significantly higher, and the risk much lower, than if you invested in any tangible or productive asset - derivatives allow many bigger capitalists to make more money faster, with less bother and less risk. The above is true only if they have the reigns in their hands. Just as they can make more money faster, they can lose more money equally faster, if they don't have the reigns in their hands. So Buffet is right: derivatives are time bombs and financial weapons of mass destruction And this system, under the domination of strured finance and derivatives, is heading towards its self-destruction, assuming that until that happens we can avoid an ecological collapse or a nuclear disaster. Watch Fannie-Mae in these days. Best, Sabri
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
Sabri: How would you answer the argument that most derivatives are used for hedging operations and are therefore a source of stability for the system? I agree with your point about the downside; while all markets are a gamble, a wrong bet on highly leveraged derivatives -- as LTCM showed -- poses a real systemic risk. Marv Gandall - Original Message - From: Sabri Oncu [EMAIL PROTECTED] To: [EMAIL PROTECTED] Sent: Thursday, March 11, 2004 9:42 PM Subject: Re: [PEN-L] An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc. Marvin Gandall: Hungarian, but a good essay nonetheless. :) No! It is not a good essay. It is a wonderful demonstration of lack of understanding of derivatives, as the following statement of its author demonstrates: the rate of profit on capital can be significantly higher, and the risk much lower, than if you invested in any tangible or productive asset - derivatives allow many bigger capitalists to make more money faster, with less bother and less risk. The above is true only if they have the reigns in their hands. Just as they can make more money faster, they can lose more money equally faster, if they don't have the reigns in their hands. So Buffet is right: derivatives are time bombs and financial weapons of mass destruction And this system, under the domination of strured finance and derivatives, is heading towards its self-destruction, assuming that until that happens we can avoid an ecological collapse or a nuclear disaster. Watch Fannie-Mae in these days. Best, Sabri
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
Marvin: Sabri: How would you answer the argument that most derivatives are used for hedging operations and are therefore a source of stability for the system? Dear Marvin, I was tempted to open up with the following: Are they? I did not know this! But if I do that you may get the impression that I am attacking you. But no! Even if I opened up like that, my intention wouldn't have been to attack you. It would have been to attack the standard finance text books which claim the above. Those books are not only based on unreasonable rationality assumptions but also they ignore the effects of size. Soros was able to attack the UK government and beat it when he bet against the pound but I don't think even he has the ability to bet against the US market. The US financial market is a monster against which no one has the ability to bet. And that is the problem. Controlled chaos is fine as long as those who are at the reigns have the ability to pull them. But if the horses go crazy, it does not matter how good a rider you are. They decide where they want to go and they may even choose to jump of a cliff. There are trillions of dollars worth of derivatives out there with no connection to neither the real economy nor the money supply. Anyone create money in these markets by signing derivatives contracts, as long as they have the credibility to sell them. This global gambling casino grew so big that none of the owners, including the US Treasury and the FED, really own this casino anymore. It became uncontrollably chaotic despite denials of the alleged owners. And the casino always wins, and if nobody owns the casino, everybody loses, sooner or later. Best, Sabri
An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
The derivatives market has expanded enormously in recent years, with investment banks selling billions of dollars worth of contracts to capitalists as a way to minimise loss of their capital through unforeseen market fluctuations that could possibly lower its value (what Marx called devalorisation, Kapitalentwertung, which typically happens in a recession or depression, as market prices must adjust to paid labor hours worked). Forbes 400 magnate Warren Buffett has claimed however that derivatives are time bombs and financial weapons of mass destruction that could harm not only their buyers and sellers, but the entire capitalist system. Some derivatives constructions, this doomsayer opines, indeed appear to have been devised by madmen. He has warned that derivatives can push companies into a spiral that can lead to a corporate meltdown, like the demise of the notorious hedge fund Long-Term Capital Management in 1998. Blind greed could lead to ruin. But what are derivatives anyway ? Derivatives are basically just financial obligations which allow investors to gamble on the future market prices of commodities, interest rates, currency values or shares - without investing in any tangible or productive asset at all. They are just legally sanctioned and legally enforced financial claims to income without any tangible property ownership or real production being involved. Derivatives such as futures, options, hedges and swaps reduce capitalist risks in financial markets. You effectively buy yourself a bit of insurance against adverse market fluctuations, and the broker pockets his fee, in order to make even more money, on the basis of his superior market knowledge. Derivatives are a commercial idea which possibly originated in agriculture - as a contractual obligation used by farmers to assure the price of their produce in advance. Before they started sowing, they would make a deal to sell their goods at a guaranteed price, come harvest time. This then enabled them to budget farm operations on the basis of a definite income, allowing them to economise. After the harvest, goods would be sold at the pre-agreed price, regardless of the movements of market prices and the effect of bad harvests (including their own) on those prices. The contract might earn less income than the actual market prices permitted, but, at least, it allowed farmers to eradicate market uncertainty. In the wake of the 1930s depression, many governments decided to offer farmers guaranteed prices in this sense, and this became a real gravy train for many, until farming was deregulated; after that private investors stepped in, and created many more financial products of a similar type, permitting a range of possibilities. In the 1980s, financial futures began to dominate trading. Futures on commodity prices, bonds and currencies are nowadays traded on exchanges all over the world. The main US stock market indices, the Dow Jones and the SP 500, are really traded as futures contracts, involving a mathematically calculated guess as to where the profit averages will be in the future. These investments are called 'derivatives', because they are derive from an asset the value of which is maintained by the living work effort of the working classes and the peasantry. But, nowadays derivatives have become a very popular means of investment in their own right, rather than just as an insurance policy, simply because: (1) the rate of profit on capital can be significantly higher, and the risk much lower, than if you invested in any tangible or productive asset - derivatives allow many bigger capitalists to make more money faster, with less bother and less risk. The reason is that derivatives can be 'leveraged' to be worth many times the value of the tangible asset to which they refer - so that, if the market price of the asset goes up $100, the value of derivative goes up by $1,000, whereas the industrial rate of profit might only be 12-15%. (2) derivatives are used, because they are much more flexible than the underlying tangible asset. Their value is based on the price of the underlying product, but most contracts are settled in cash terms, so you can bet on price movements without having any bother of having to deal with real assets and the stupid people (sic.) that still use them to produce something tangible. Why invest in producing new wealth, if you can consume it, with extra money from your derivatives investment ? The beauty is that you win both ways, you cannot lose, you can only win more or less. at least if you own assets. These days, you can speculate not just on currency fluctuations, but actually you can speculate on the speculation in currencies shaping modern money markets. All it takes, is some financial and economic nouse, basic maths, intuition, and a PC Internet connection. The banks actually have computer programmes based on statistical models which tell them how much they could lose, if the market moves by a certain amount
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
Hungarian, but a good essay nonetheless. :) - Original Message - From: Jurriaan Bendien [EMAIL PROTECTED] To: [EMAIL PROTECTED] Sent: Thursday, March 11, 2004 6:31 PM Subject: [PEN-L] An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc. George Soros, through his Quantum Fund, became famous when his fund 'bet' millions that the UK would be forced to devalue the pound in 1992. He won his bet, made lots of money, and became famous as the Greek who broke the pound. Yeah.
Re: An essay on economic basis of bourgeois risk and gambling culture - parasitism as derivatives, options, swaps, hedge funds etc.
Marvin Gandall: Hungarian, but a good essay nonetheless. :) No! It is not a good essay. It is a wonderful demonstration of lack of understanding of derivatives, as the following statement of its author demonstrates: the rate of profit on capital can be significantly higher, and the risk much lower, than if you invested in any tangible or productive asset - derivatives allow many bigger capitalists to make more money faster, with less bother and less risk. The above is true only if they have the reigns in their hands. Just as they can make more money faster, they can lose more money equally faster, if they don't have the reigns in their hands. So Buffet is right: derivatives are time bombs and financial weapons of mass destruction And this system, under the domination of strured finance and derivatives, is heading towards its self-destruction, assuming that until that happens we can avoid an ecological collapse or a nuclear disaster. Watch Fannie-Mae in these days. Best, Sabri
Buffet warns of derivatives
Buffett warns of derivatives threat to financial system By Ross Gittins March 10 2003 They don't call Warren Buffett the Oracle of Omaha for nothing. He's always issuing warnings and they're almost always borne out - on the dotcom madness, dodgy accounting practices, executives' options schemes and much else. But right now his prescience is bad news because he's used this year's letter to his shareholders in Berkshire Hathaway to issue a chilling warning about the threat that the increasing use of derivatives poses to the stability of the economic system. His phrase is time bomb. As Buffett explains, derivatives are financial contracts that call for money to change hands at some future date, with the amount to be determined by one or more reference items - such as the level of interest rates, share prices or exchange rates. If, for example, you're on either side of a share price index futures contract, whether you gain or lose will depend on what the index does over the specified period. Buffett says derivatives contracts sometimes run for 20 years or more, and their ultimate value is often tied to several variables. It's tempting to think of derivatives as gambling for businessmen. But whereas it's possible for some people to use derivatives to take on risks they didn't have before, it's also possible to use them to shift risks from those least able to bear them to those more able. For instance, a futures contract between a wheat farmer and a miller - counterparties with opposite risks - that locked in today's price on wheat to be delivered in six months' time gives both parties increased certainty and reduced risk of an unpleasant (or a pleasant) surprise. Such contracts should make the world more stable rather than less. Buffett agrees that, at a micro level, this can often be the case. At the macro level, however, he argues that the situation is dangerous and getting more so. (And, in practice, many derivatives contracts aren't nearly as benign as the farmer/miller example.) His first concern is that, like Hell, the derivatives game is easy to enter and almost impossible to exit. You're usually stuck with the contracts you've written until they've run their term. So you can't usually sell out but may have to wind down your commitments over a number of years (as Buffett is finding with a derivatives trader that he acquired as part of a package). The next problem is that, though you won't know whether a multi-year contract ultimately yields a profit or a loss until it expires, you're required to account for the unrealised profit or loss in each accounting period using a mark-to-market approach (ie, you judge whether you're ahead or behind by using the market price prevailing on balance date). That's fine - except that, in the case of many sophisticated contracts, there isn't an actual market price you can use to calculate the paper profit or loss. In this case you have to develop a mathematical model that tells you how you're doing and thereby mark-to-model. See the problem? Firms face a huge temptation to pick a model whose assumptions make the contract look profitable - particularly because derivatives traders' and CEOs' remunerations are often geared to the profits they're claimed to have made. You could easily have a situation where, thanks to differing assumptions, both parties to a contract were recording it as profitable in their accounts. Eventually the truth will out, but this could be quite disruptive when profits are found to be non-existent. Another factor that's ignored until judgement day is that, unless contracts are guaranteed in some way, their ultimate value depends on the creditworthiness of the party that has to pay up. There's obvious scope for skulduggery - a la Enron - but Buffett says the errors will usually be honest, reflecting only the human tendency to take an optimistic view of one's commitments. The next problem is that the presence of derivatives can exacerbate trouble a firm has run into for completely unrelated reasons. This pile-on effect occurs because many contracts require that a firm suffering a credit downgrade immediately supply collateral to its counterparties. The downgrade implies you're already in a difficult financial position but the need for extra cash collateral could compound your difficulties, creating a liquidity crisis that triggers another downgrade. In the extreme, it becomes a downward spiral that leads to a corporate crash. But here's the biggest worry: widespread use of derivatives could create a daisy-chain effect. Like insurers and reinsurers, firms heavily into derivatives lay off to other firms much of the risk on a (large) individual contract. But years of playing this game means each firm ends up with huge amounts owed to it by the other firms in the game. And, under certain circumstances, an utterly unrelated event that causes the amount owed to you by Company A to go bad will also affect the amounts owed to you
Bush and Gore as derivatives
[James Buchanan meets Myron Scholes] Paris, Friday, November 10, 2000 Two New Options On Bush and Gore Agence France-Presse ZURICH - A Swiss bank is offering financial derivatives called the ''George Bush'' and the ''Al Gore'' options, made up of baskets of U.S. company shares that could profit if their namesake wins the presidential elections. Vontobel, Switzerland's fifth-largest bank, advertised the offers in Swiss newspapers Thursday. The Gore product is made up of shares in the pharmaceuticals maker Merck Co., mortgage loan specialists Fannie Mae and Freddie Mac, the tech-school operator Devry Inc., and United Technologies Corp. The Bush product includes the tobacco giant Philip Morris Cos., the pharmaceuticals company Pfizer Inc., Microsoft Corp., General Dynamics Corp., Lockheed Martin Corp. and International Paper Co. The options are to be quoted on the Swiss stock exchange at $122.
Fun Games w/ Derivatives
Dear Penlrs, As we watch the Amazing Market Rollercoaster, something else to keep in mind: what is all this--markets crashing, currencies roiling, etc.--going to do to the dervatives market? And what are the D's going to do to corporate america? I've been tracking the fights w/ the SEC and FASB over the new derivatives accounting/disclosure standards, and the impression I've gotten is that a hell of a lot of companies have a ton of derivatives that may blow up in their faces, and that not a lot of their CEOs may realize it (there was a wonderful piece in Institutional Investor describing the SEC's new rules on disclosing a company's derivatives position where, in passing, the Investor noted that the rules shouldn't be such a big deal because any sane company should already have this info at their fingertips, but few do). This won't show up for a bit, but when it does, it should be very educational. Speaking of education, if you're interested in getting a better grip on the bizarre world of derivatives, you should definitely check out Frank Partnoy's F.I.A.S.C.O., which just came out. It isn't as well written as Michael Lewis' Liar's Poker, but it's much, much more horrifying. It tells the story of how Morgan Stanley got into the business of aggressively selling various forms of toxic waste. Their attitude towards their clients was best summed up by the time when Partnoy's boss put a picture on his desk of cute little bunnies from a sporting magazine, the message being that if he wanted to succeed in this business, he needed to learn how to kill cute bunnies, 'cause that's what they were doing to their clients. Incidentally, F.I.A.S.C.O refers to an annual skeet-shooting event they had, as part of their overall effort to pump up the level of blood-lust. Anders Schneiderman Financial Markets Center --- Opinions here do not necessarily represent the views of the Financial Markets Center
