Site Presented By
Sunday, Nov 8, 2009
Where's that odious troll when we need him?
Of what's happening in the market right now around.
Thanks Salon.
MacK, you say “A bond issued at a discount of its face value at maturity is not strictly a Zero Coupon Bond.” This disagrees with the way the term is used. A zero coupon bond is a bond that makes no periodic interest payments and is initially sold at a discount from the face value payable at maturity. Usually, the term is restricted to bonds with a maturity in excess of one year. A zero coupon bond could be issued directly by a corporation or government, or it could be created synthetically by an agency selling the maturity payoffs from one or more coupon bonds, and selling the coupon payments to other investors.
You define derivative as "a tradeable instrument derived or deriving its value from at least one other tradeable instrument (and maybe more.)" Even if that definition is technically correct, in common parlance, the definition is broader. For example, a future, forward, or option on the CPI would usually be called a derivative, even though the CPI is not a tradeable instrument.
Regardless of the exact definition of derivative, I agree with you that mortgage backed securities are not the best examples of derivatives. In fact, I said in my original posting “A securitized pool of mortgage loans may be a derivative, but more importantly it is a basket or portfolio security.”
"...This long episode of market mania, running for seven years, was based on the idea that non-performing loans could be turned into money by removing them from their point of origin and dressing them up in respectable clothes -- like taking all the winos in downtown Los Angeles, putting them in Prada suits, and passing them off as the faculty of the Harvard Business School. It was a transparently ludicrous racket and the wonder is that America proved to be so utterly bereft of regulating authority -- not to mention plain decency and self-restraint -- at every stage."
"It's really hard to account for the stunning failure of responsibility. What you had was a whole industry that surrendered the standards and norms that brought it into being and enabled it to function in the first place. Mortgage lenders stopped requiring house-buyers to qualify for loans; bankers stopped caring what stood behind the paper they issued; dubious loans were bundled and resold like barrels of rotten anchovies -- in such numbers that no individual stinking minnow would stand out -- and the barrels were traded up the line, leveraged, hedged, fudged, fobbed, and fiddled until, abracadabra, they were transformed into so many Tribeca lofts, Hampton villas, Piaget wristwatches, million-dollar birthday parties, and Gulfstream jets."
"It worked for the Goldman Sachs bonus babies, and the private equity scammers, and for the corporate CEOs and their board members, and for the politicians who parlayed their votes into cushy lobbying jobs, and even for the miserable quants in the federal government's termite mounds of statistical reportage. It even worked for about 18 months for millions of feckless US citizens gulled into contracts for houses they could never hope to pay for, under arrantly false and ruinous terms."
As Nouriel Roubini and others have pointed out, Frank Knight wrote 85 years ago (in Risk, Uncertainty and Profit) that risk is the prospect of loss that you can measure based on experience and put a price on. Uncertainty is the prospect of loss that you can't measure. And, I would add, inevitability is what happens when those two are commingled.
This is hardly a new observation, and as before I draw your attention to Martin Mayer's trenchant observations eight years ago, when the new dotcom economy was erasing the old economics and the most important political question was who done what to who in the Oval Office pantry. Mayer had been writing about derivatives for the better part of a decade before this 1999 interview. He stated in part,
"I’ve worked on a fourth law, but haven’t come up with the right aphorism. That law will hold that the more abstract the instrument, the less it depends on real developments in real economies, and the more likely it is to be a vector of contagion. When you are comparing things that are extremely dissimilar, and when you have correlations without causes, you are creating the opportunity for contagion—and in a dynamic hedging environment you are indeed creating a virtual certainty of contagion."
http://www.derivativesstrategy.com/magazine/archive/1999/0899qa.asp
That inevitability is what we now have to worry about.
With regard to Aynatt: Your distinction is generally ok, but doesn't investing for the long haul involve "betting" that the entire economy will not tank any time soon?
As for the SEC, CDOs and the like how about everyone's GREED? No acronym intended.
What's up with all the hair-splitting about betting vs. investing? Look, when you buy a hamburger you're gambling you won't come down with salmonella.
You say:
"You define derivative as "a tradeable instrument derived or deriving its value from at least one other tradeable instrument (and maybe more.)" Even if that definition is technically correct, in common parlance, the definition is broader. For example, a future, forward, or option on the CPI would usually be called a derivative, even though the CPI is not a tradeable instrument."
Technically you can call options derivatives (though option is just a better name for a simpler instrument) -- but the key point about derivatives is that they do not go through the standard issuing procedure -- prospectus, etc. This is important because they have more complex risk profiles that buyers often do not really understand. Zero coupon bonds are different from regular-bonds sold at a discount (e.g., US Government Bonds) in a number of respects because they are created by stripping existing bonds, usually mortgage instruments of their coupons. In part they can behave differently because they are redeemed differently -- as people pay off their mortgages early, the bond gets paid off in small lumps -- get a 2% or more downward change in prevailing rates and they get paid off in big lumps as homeowners refinance (while the strip holders get hosed, since the interest dries up.) Bonds by contrast have tio be redeemed in typically one entire issue.
Derivatives are tricky because their behavior can be unpredictable -- in exactly the way the Zero Coupon Bonds are different from discount bonds -- they seem normal most of the time, but then can undergo sudden shifts in behavior that do not tract the typical instrument.
In any event, it is plain English, a derivative is what it says on the label -- something derived from something else, a different security.
By the way, tranches of debt are not strictly speaking derivatives, since each is issued separately, with its own prospectus, issuing documents and explanation of its preferences and associated risks. The underlying problem is that some of the supposed low risk tranches appear to be rather high risk, while derivatives made by combining high risk tranches to, by supposed diversification, to lower risk, turn out to be bundling similarly based risks, so they were mis-rated.
The same issue applies to program trading by Quantitative Hedge funds -- in reality there are so many that they have trouble identifying enough opportunities from their models (that other funds have not spotted) and have often resorted to simple picking (and truth be told a fair bit of activity that looks close to insider trading.) Moreover, they are all working with the same historical data set, and even though some very brilliant mathematicians and math-physicists are building the models, at least some research leads one to wonder if the models, tested and perfected against the same dataset are in fact equivalent - and driving self-fulfilling prophecy, especially because so much price setting trading is indeed done by the hedge funds.
Much of the initial coverage about Fort Hood turned out to be wrong. Is there anything wrong with that?
The accountability imposed by another country for the CIA's kidnapping and torture reveals much about our own.
Fox News' morning show plays to type, talking about whether Muslims in the Army should face "special debriefings"
219 Democrats and one Republican join in favor of the legislation, which passed by a narrow margin
The survivor and author is upset about comparisons some on the right are making to genocide
Salon headlines in your mailbox
