Posts Tagged ‘Derivatives’

The Real Bubbles



“It is the measure of wealth itself [the Dollar] that is overvalued, not the goods that it represents”



I’m beginning to understand what is going on. I hope this article will shed some light on a variety of issues, some of which have been fairly complicated for the common investor to digest.

I will begin with a paragraph of adages and mantras being proclaimed on Wall Street, followed by a thorough analysis of why they are either baseless or misconceived. For the sake of simplicity I won’t use references but they are all available.

Mr. Market says

“The Commodities Bubble has begin to blow over, with everything from gold to oil to potash collapsing from their artificially inflated prices to mediate norms. Much of these gains have been driven by speculator demand, from hedge funds and the like, as well as consumer demand, including China, India and Russia.

“Investors have bought in every premium into these contracts and optimism is high. Furthermore, commodities have been a very poor investment relative to stocks and bonds. Even gold has underperformed inflation. As equities recoup its gains and inflows of capital return, pushing inflation down with it, commodities will be a relic of the past.

“Recessions are times of diminishing consumer demand and this will further help in reducing prices. With much of the investing community already discounting shares due to recession we can expect a bottom in the stock market with a rally beginning just as the economy is officially in recession. Financials and Homebuilders are set to gain the most as they have been beaten down severely, looking awefully cheap from a value prospective.

“The Dollar is set to rally as stark pessimism has oversold it. Recession will strengthen the currency. This will bring in investment flow previously allocated to Euro, Yen and Gold.”

The Problems With Mr. Market and the rest of the Wall Street gang (CNBC)

1. Wrong Biases
Wall Street as we know it is not a the Mutual Fund Industry, a group Hedge Funds or even large network of multi-national corporations. It is simply the media’s opinion of the former. There are few companies that end up becoming large corporations and even fewer speculators-wanna-be-billionaire-investors who actually live up to their own aspirations.

This is due to its ill-conceived sentiment, nothing more. It has all the facts (most do at least) yet the small investor constantly fails to make the integral judgments necessary to fulfill his lifelong ambition of success, or even of financial independence. They run after Enrons, Devalued Russian Rubles and dot coms believing beyond any doubt that they have it made for themselves and they have indeed “beat the street“.

However, the only way to real gains is to bet against the crowd, to look where no one else is looking, or even better, to see past the unsound biases that have plagued investors since the Mississippi Scheme in the early 18th century.

2. Confusing Short and Long Term
This is probably the most extreme variable, one which offers the most profits to he who can see past its vile inadequacies. Many (not all) of the arguements presented in favor of the Dow 36,000 were in one way or another grounded fundamentally. The problem with the gushes of cash inflow was they were based on an economic phenomenon that was years into the future, results that we are only beginning to see today – and interestingly enough by quite a different group of influences. While investors were placing bets on Yahoo and Juno, Google wasn’t yet a public company.

3. Forgetting Premium and Discount
In addition, shares were discounted many times over yet speculators failed to realize it. Any price was a great price because in the mind of these irrational gamblers the gains were infinite it seemed. It was hard for investors themselves to understand that they were betting that the company of purchase was one of sound safety that would last, and therewith deliver on its earnings 100-1000 times over, without any interruption whatsoever.

4. Wall Street too has Seasons
There are financial equinoxes, waxing and waning over decades. Warren Buffett himself cautioned Saturday not to expect big gains from the stock market in future years. Indeed, there are periods when year after year people move from the New York Stock Exchange to the commodity pits of the Midwest in search of better returns.

5. In The Dollar We Trust
A currency is present only to act as a constant method of exchange between goods. Yet the U.S. currency is nothing of the sort. It has become a staple of growth and a signal of everlasting creditability. Unfortunately for many this will not last. Contrary to many pundits the present rally in the Dollar, however great it may seem, is a mere decoy and will be short-lived.

Even Treasury Secretary Paulson has advocated that a weak dollar is in America’s best interest. While this may or may not be a positive development, one thing may be guaranteed by any student of financial history dating back to Cicero in ancient Rome: every fiat currency has failed, frequently bringing its empire down with it.

6. Action and Consequence
Finally it pays dearly for the prudent investor, who has the sole initiative to first protect and only then appreciate his capital, to understand the elements of check and balance. Every action that does not act as a stimulus for long term growth but merely for short term gain will inevitably be met by an equal and opposite loss. Failing to understand this will, for the ignorant, deplete capital faster than you can say “Bear Sterns”.

Commodities will not blow over.
Long term investors understand the need for correction and rest. Things that go straight up are indeed called bubbles and we are not there yet. Like fire feeding off oxygen and fuel, so too do bubbles feed off of extreme optimism and public involvement, both of which can’t disappear over a few weeks. The perceptive analyst will look around and tell with utmost certainty there is no sign of a any euphoria. If anything the investor relies on solid fundamentals, all of which are intact, and buys when the crowds are telling him to be cautious. If he didn’t sell he is sorry but it is insignificant because a bottom is close at hand.

Has all the oil inventories been replenished with years of supply? Have investors the fear that would send each preferring a Krugerrand over a wad of hundreds? Are the cheerleaders over at CNBC telling you to buy Krugerrands and load up on more shares of Nemont Mining?

Market Norms
I have read through many books on markets, investment and financial history yet I have never seen evidence of such a thing. Everything has an intrinsic value and it either sells at a premium to that value or a discount. Professional Traders look for market “norms” in the sense that they seek a short term variable and attempt to trade within that range yet they abandon all affiliation when this trend is broken, that which all may be confident that it will.

The Real Bubble
With pundits of financially-based markets they seem to make two awfully wrong assumptions. Firstly, that the a Commodity Bubble exists in Dollar denominated form and secondly that it has been inflated by artificial and speculative demand.

The first misconception is one that one would almost fail to consider to begin with. After all, the U.S. Dollar has been on the center stage of international trade since the Bretton Woods Agreement shortly after the Great Depression in 1941. Yet since 1913 its intrinsic value relative to goods and services has fallen by over 93%. The fact that there is still any goodwill left to the Dollar at all resembles a Bubble of sorts. It is the measure of wealth itself that is overvalued, not the goods that it represents.

Thus, it is not the goods and services that rise but the Dollars that fall; their inability to maintain their value. Nevertheless instead of markets taking their natural course and correcting itself, the Government is artificially inflating the money supply whilst protecting the very economy that its currency stands for. This devaluing of the Dollar to be able to finance its debts is in no way different than if Enron was given the very ability to print its own currency to continue its business operations or pay out to its shareholders.

This explains the underlying developements we have seen in physical goods, not too different from what we experienced in the 1970s, with a dangerous undersupply of commodities, runaway deficits and financial derivatives of enormous proportions.

I ask of the conscious minded economist, “With over $500 trillion in financial promises, which now seems to be Dollar-backed and secured by the Federal Government, what meager value may be given to the price for real goods, that which feeds and sustains mankind? Furthermore, if demand for goods the world over is rising is it not reasonable to assume that prices rise with it, if not to curb demand, then to act as an incentive for the farmer to increase production? Finally, what would have offset the interest for the speculator to profit from these gains if the fundamental demand continues unabated?”

To quote Charlie Munger “We have convulsions now that make Enron look like a tea party.”

Critical Optimism
Does the financial community really believe that there is excess optimism in commodities? That gold bullion are selling off shelves? That people left and right are participating in buying goods that will benefit from real demand? On the contrary, I see that many have found an opportunity to sell the only gold that they may have in their possessions to take advantage of higher market. This denotes good business sense of buying low and selling high, but certainly not in the realm of exuberance that we have seen in previous meltdowns.

Physical vs. Fiscal
Commodities and Equities. Gold and The Dow. It is a subject that many seem to overlook from a generation-term prospective (considering that Buffett’s long term is 10 years). It is the flaw you will see in every commodity-bearish argument: “Commodities just don’t cut it relative to equities”.

But let us look at the origins for monetary protocol: Traders bartered goods in the marketplace. With many various items coming from numerous townships it was necessary to create a measure of value, a pivot whereby difference between supply and demand may mediate; a method by which payment may be expandable without the physical presence of currency.

Thus began the credit cycle. Producer sold to seller, who bartered with traders, who retailed to the marketplace, who took home their foods from their labor and fed their families.

This “Credit”, unlike the commodity-based currencies of old, had but one restriction: the tolerance of the lender. As long as the lender would risk would the industry borrow. It is of no coincidence that this cycle of credit take years to build and then years to crumble.

The “historical trend”, if we may call it, offers fairly simple advice to the novice merchant who wishes to conserve and grow his capital:

When in times of expansion… lend, invest and do business. In times of contraction and uncertainty… Pay debts, take inventory and accumulate capital.

Recessions of Supply and Demand
It is interesting how mainstream economists will focus on something specific in great detail and fanfare and at the same time fail to see its direct opposite exposure. For instance, it is assumed that a recession diminishes demand for goods and therefore lowers prices overall, not only in the U.S. but also in China. Consequently however, a loss of demand will hurt producers who may decrease production. This will have the opposite effect and raise prices.

Furthermore, it is assumed that as we move into recession, investors have already discounted all the possible losses and write downs. At first glance this possibility seems preposterous. How can a market, however “efficient” it may be, properly and throroughly account for the very speculations that everyone from the companies to the Federal Reserve can only guess at? Besides, it’s quite humorous that Wall Street can call the middle of a recession when they can’t even call the beginning, let alone its happenstance altogether.

It goes without saying that the same case may be made for commodities, in the sense that recessionary results have already been discounted and accounted for, or that they even sell at a discount relative to post-recessionary time-tables.

Capitalism that would make Marx smile?
Capitalism works. And for he who says it doesn’t should look no further than every innovation and technological advancement since the Middle Ages. Nevertheless, it is a process and it may not be looked at point blank. There are times when the advantages of Capitalism may overextend its true worth, while there may be times that it will seem to underestimate it (much like your average share price).

For the last 28 years we have lived in a credit expansion. Yes, there have been pitfalls – the Crash of 87, LTCM, the DotCom collapse – yet we have rolled on. The world has undergone quite a change in that time and has made people sentimentally and physically wealthier than ever before. Liquidity was fluid, credit was available for anyone who needed it, lending was commercialized and industrialized allowing the investor in China to buy equity in a startup in Australia. What the lender would risk would the industry borrow.

Yet now the payments are due, and the funds we have borrowed to finance this wonderful world we have built for ourselves must be paid in full. We are not veering off a path of success, not failing at our ambitions, we are merely paying for what we have taken.

Our past actions have now brought about the future results. For years we benefited when investors fled from commodities to purchase equities and financial paper, suppressing prices through shorting, or “selling forward”, neglecting the farmers and producers. Now we must compensate those to increase supply in order to feed a larger, hungrier, wealthier, more innovated world.

Inverted Economics II – Hedging

In Part I, we discussed the ramifications of being long or short in today’s markets. Today I wish to reflect on Hedging.

A Hedge is when a company, fund or individual will buy or sell one asset to offset a possible loss in another. This occurs often in the futures market, when one will transfer liability to a second party. The second party may be a speculator (who accepts the risk of the trade) or it may be another party who has reason to accept the contract. These contacts are signed months and sometimes years in advance, so it is understood both why these agreements are made, as well as the risks involved.

The more commonly known Hedge Fund, is an investment fund designated to such vehicles. However, although it would seem inherently safe to invest in, the rules and regulations regarding them are quite strict. For instance, to invest in such a fund one must have either a net worth exceeding $2 Million (excluding main residence) or receive an income greater than $250,000 per annum.

Why? What risks can possibly lie beneath the apparent?

In truth though, these funds are highly risky and the reason being is two-fold. Firstly, many times a hedge fund may place their bets improperly. If, for instance, a bet is made by selling a perceivably overvalued asset and buying an undervalued one, the spread between the two assets may further increase. In addition, the entire basis for valuation may be ill-advised and could cost a fund millions.

However, such risk are the risks investors and speculators alike take on daily. What enables these funds to amass (and in many cases forfeit) their fortunes is Leverage. In a high-net-worth system the markets have established a derivatives market. This market is far more speculative even then the stock markets of old, inasmuch many of the trades involved are both unregulated and highly leveraged.

This means that the trader may gain or lose many times his initial investment, and in relatively short amounts of time.

An example from Minyanville

At the notional levels we are talking about, tenfold the notional value of cash markets, there is no such thing as benign derivatives. Interest rate swaps, the most benign of all derivatives because of past low volatility, are huge. Counter-party A enters a swap with counter-party B to hedge a rise in fixed rates. Now that A is hedged it allows them to take on more of some risk. B sells futures to hedge their price exposure. Fine. But the problem is both A and B only require only a small amount of collateral posted to do this trade. If the volatility in interest rates picks up and B defaults to A, A is not hedged and the risk they took because they thought they were hedged must be unwound. This multiplies to other counter-parties.

It’s as complicated as it sounds and it’s for no reason that the famed investor Warren Buffett labeled these derivatives as “financial weapons of mass destruction”.

The derivatives market involves north of $400 Trillion worth of speculative trades. Like a good game of poker the amount limited on the table is the amount the cumulative party will bet. But when the cards go down, so do the hopes of many.

Furthermore, imagine that you are in a casino with many tables each enjoying their own game, with horse-shoes lending as much as players will accept and the pit bosses smiling from the “eyes in the sky”.

But as anyone knows the game does end. And those who don’t recognize this, go home only with their head in their laps… and a bill for the drinks.

Has the system gone mad? Have we lost it? Indeed we have, but its nothing new. We do this every 25 years or so. We pile in and we load up with a greed for fortunes, when we break-even – we thirst for more, but when we win – we double our bets.

But the chips are few, the night is no longer young and the casino is closing. Drunk men came to wager their life fortunes . Even the simpleton came to bargain with his children’s college money or take collateral against his prime residence. He also wants in, he too wants to be one of the rich boys. But he’s come too late. All that’s left by the tables are the lenders waiting for their money back.

On Speculative Losses

“Bear Stearns didn’t have a clue how much money it had lost. Nor would you if you had sunk all your money – or rather, all your clients’ money – in CDOs built upon CDSs reckoned against MBSs based on mortgage loans made to people with no hope of making their monthly repayments.
Adrian Ash

Yesterday, July 16, Bear Sterns was supposed to announce how much it suffered from the recent bust of two of its highly-leveraged hedge funds that were invested heavily in CDOs and other hazardous subprime-credit material. Still no word from Sterns.

13 Reasons to be Terrified of OTC Derivatives

As simple as Warren Buffett lets himself seem, he is a man of high intelligence with an intricate knowledge of the financial instruments. If he says that many of these are incomprehensible, I’d imagine that the average investor buying them doesn’t have a clue.

Without further a due, Jim Sinclair presents to us 13 reasons to be terrified of over-the-counter derivatives.

1) They have no regulation.

2) They have no standards.

3) Without standards there can be no viable market.

4) They are unlisted.

5) They are traded by private treaty negotiation.

6) They are valued by “mark to model,” which is a total cartoon.

7) They have no financial guarantee such as a clearing house.

8) They are unfunded special performance contracts floating in cyberspace. All funds in OTC derivatives are taken out as spreads and commissions.

9) More than 50 percent of the earnings of major international investment banks come from granting in the private treaty negotiation of these instruments of mass financial destruction.

10) Financial performance of OTC derivatives depends on the financial capacity of the loser in the transaction.

11) Control has been loose in interest-sensitive OTC derivatives because of multiple dealings outside of the initiating two parties until no one knows who has what.

12) The replacement value of these instruments is in the multi-trillions of dollars.

13) The massive expansion of these instruments has come in interest-sensitive and debt-guarantee instruments. Those are the most vulnerable.

The way the rich get richer, is by buying easy things they understand and working from there. Everyone understands commodities, many understand stocks, but very few understand the contracts being traded by the investment banks that offer them.

The advise is simple: Buy what you know.

Who Says Derivatives Isn’t a Zero-Sum Game?

Banks seen losing up to $52 billion on Subprime mortgages” whilst “Paulson’s credit hedge fund soars“.

Is there indeed a long for every short? Could this credit bust make those who understand its faulty base so many times wealthier? Something about 130% returns and $52 billion losses tells me it can.

On Finding We Were Wrong

“These derivatives were very complex and suddenly turned against us.”

– Pierantonio Arrighi, Spokesman for Italease

Italease is an Italian bank that was threatened by a massive margin call after interest rate rises in Europe.

“Risk; a reality which reaches further than a perception.” – my1ambition

A Derivative Universe

The BIS reports

“Outstanding positions on the derivatives markets are $415,000 billion, roughly seven times world GDP – and up 12 percent over the last six months. They grew 24 percent in the preceding six months”.

If shares sell at multiples of earnings, would it be plausible to say that Risk is selling at 7 times Production?

Quote of the Day

I wish to quote a paragraph I recently read in an article written in the Wall Street Journal.

“Goldman Sachs Group Inc. pumped up leverage by the largest degree in recent years. Goldman says it was just trying to catch up to the levels of its competitors after it shifted from a partnership to a public corporation. Its ratio of assets to shareholders’ equity, one common measure of borrowing, climbed to 25.2 to 1 in 2006, from 17.7 to 1 in 2002, according to analyst Brad Hintz of Sanford Bernstein. Goldman says it has a pool of easy-to-sell securities valued at more than $50 billion that it could tap if market conditions require it to raise cash”. (emphasis ours)

Talk about “The Great Unwind”. It seems that the ‘Big Boys’ are ready to bail themselves out at the expense of the individual investor.

The article hosted by GATA can be found here.

Staying Away from Credit Default Swaps

Joe Myask from Bloomberg says that Bond Issuers should take time to think over the swaps in the Derivatives market.

He says “Don’t do it at all. Perhaps you haven’t noticed, but there’s a massive investigation going on right now into what the Justice Department has only described as ‘anticompetitive practices’ in the municipal bond market.”

This dear readers is why many careful investors are not investing in such issues. The risks invloved stem not because we don’t know enough about these “financial weapons of mass destruction” to quote Warren Buffett, but because no one does.

“Students of public finance have long suspected that there was going to be a problem with the widespread use of swaps and derivatives by municipalities.”

Bond Issuers Should Take Swaps-Derivatives Time Out
Joe Myask
February 21, 2007

What do we know?

What if tomorrow’s headline read…
“Interest rates are still at 1% and The Dow is more leveraged than it was in 1929″

I think we must first clarify a few things.

Inflation and Interest Rates.
Banks have the right to print as much money and credit as it deems fit. This may lead to an unhealthy economy. The Federal Reserve controls this expansion of the money supply with short-term interest rates, restricting the amount that must be paid by the Federal Reserve Banks as well as the amount banks must hold on margin.

The Fed has many techniques and factors that show an inflationary monetary system all of which have recently been above their “comfort levels”. The Fed has raised interest rates 18 times over the past few years, from a rate of a meager 1% to the current 5.25%. Although this “tightening” has raised the awareness level of excess consumption, which can be detrimental in a slowing economy, rates are considered to be relatively low by historical levels when rates rose above 15%.

When industrial buyers wish to hedge or secure themselves from rising or falling prices in a competitive market they can do this by buying a contract on the particular commodity of interest. If a jeweler worries that the price of gold may rise in the future he can buy a contract on the market for the current price of gold and will pay this amount even if the general market price for gold rises. This can be done with financial instruments as well, including interest rates.

The Derivatives market has exploded over recent years with an surge of speculators, especially since the late 90s when many experienced traders, primarily Hedge Funds bought derivatives to hedge themselves against a serious decline in stocks. In addition, these contracts can be bought on extremely low margins. For instance, it is possible for a trader to buy and control over 20 times his initial down payment. Thus the amount of credit or money lent on margin far exceeds the amount of actual materials, be it stocks, interest rates or commodities. It is for this reason that the wise have considered these “Financial weapons of mass destruction”.

A Nasty Combo.
When searching for a medium of success in addition to venturing all the possibilities of the future of that success, we must also consider all the historical reasons for failure.

Looking back at all the times that wrought havoc for investors, we see the same irrational yet consistent behaviors and mindsets.

* Markets reaching new highs with more jumping on board as the trend continues.
* Excess optimism regarding future rises in prices and profits.
* A publishing frenzy of books on investing and trading.
* Smaller allocations of cash due to excess invested capital.
* An insatiable apatite for risk and gains.
* Large sums of leverage and margin.
* More speculators focusing on the technical factors as well as
* More Momentum Investors deliberately riding the trends in the market.
* A lack of following, even an opposition towards the underlying fundamentals.
* Lastly but most importantly, the lack of vision to realize the potential pitfalls and risks.

We could probably go on to check almost every one of the above mentioned. But the reason for concern doesn’t apply as much to the traditional markets as they do the derivatives market in particular. It is with these instruments that many, including large speculators, hedgers, banks and institutions have the capabilities to wager not billions but Trillions of dollars in the market. Originally these conducts were reserved for those with large amounts of capital, but as the gains increased so did the “insatiable apatite” for the small investor become whetted.

I refer not only to the stocks markets, commodities or even credit-default swaps and other exotic contracts that many don’t even have the slightest idea of who holds the opposite promise to fill or fulfill the terms involved. I’m referring primarily to a tool used by the Federal Reserve Bank of the United States that has become apparently unknowingly “manipulated” and de-regulated – Interest Rates.

With modern day derivatives an organization or bank can place contracts on short-term rates to hedge against the possibility of a rise in rates. In 2001 the Fed lowered rates to fend off the severity of a 1929-like recession during the stock market debacle in late 2000 to supply credit to the markets and to free cash flow and loosen tied on monetary availability.

But many caught on. With rates at 1% lows, it seemed like an historical opportunity to lock in rates to benefit when the Fed would inevitable raise in the future. To date these contracts now total in the hundreds of trillions of dollars.

Now with these astronomical numbers there is nothing short of something just as phenomenal that must occur. An increase of rates muscling out many from their positions? A de-regulation in parts of the hedging industry? A collapse in the derivatives market? We don’t know. But such growth is simply unsustainable and caution – one that many probably won’t even consider – is strictly warranted. Remember, we don’t know. The same way investors didn’t know what would come out of all the millions of stocks they bought on margin back in 1929.

For if they had it probably wouldn’t have turned out the way it did. Don’t you think?