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Sunday, Nov 8, 2009
The problem with any argument that starts "the derivatives market is just a betting shop", or a contradiction of that statement, is it's only going to be half right. Derivatives are tools that can be used to reduce ones exposure to risk, or to increase it.
A wheat farmer that wants to lock in a currently-favourable price for his produce can sell a futures contract on his wheat, for delivery at the time of his harvest. By doing so, that farmer has reduced his exposure to changes in the spot price of wheat. If the buyer of that contract is a baker, that baker has locked down the price of his raw ingredient. Everyone wins.
Similarly, a credit default swap (a CDS - one of those much-maligned credit derivatives) can be entered into by the owner of a bond to protect against the bankruptcy of the bond-issuer. The premia that the bond-owner pays insure against the risk that the bond devalues in the light of some credit event.
And yet: the market for CDSs and similar instruments is (was!) much larger than the size of the bond market, in notional terms. Look at the Delphi CDS fiasco if you want to understand why it's a bad thing to have $20bn of CDS outstanding on $2bn of bonds.
If you don't own a bond, and yet you enter into a CDS, you're speculating about the default risk of a bond; if you don't either produce or use wheat and yet you're dealing in wheat futures, you're doing the same on the price of wheat.
So speculation with derivatives is bad, but using them to hedge is OK? But the speculators provide a lot of the liquidity in that market. It's much easier for someone who needs to buy a hedge to do so, and for a better price, when there's a lot of action in the market. What's the value of that? No-one really knows.
What can be said for sure is that decrying all derivatives as 'betting' and the 'unreal economy' is missing at least half the point.
If you are not in the stock market your investments will barely keep up with inflation. The market can be a win-win situation, as opposed to gambling, because good companies increase their real value over time. I believe that the fat cats of wall street have a great tendency to try to shift their losses to their middle class investors, and/or to the government. So how does the small investor avoid being used as an insurance policy for the fat cats? Buying and holding is one way, and avoiding the big wall street operators as vehicles for investments.
The US has run out of Big New Ideas, temporarily. Financing the buying of a house is not, in the long run, a win-win situation. A house is not a profit-making investment like a new technology or a factory. It can only "make money" if house prices rise rapidly. That is self-limiting because incomes to pay for those houses only can rise with productivity. So for a few years the fat cats made it look good by running a scam, which enriched them, but screwed the rest of us. An awful lot of us were seduced by the "moral hazard" of the easy mortgages the sleaze balls created. Hillary's call for a bail out has to be looked at with jaundiced eye. Who does she want to bail out? Those funds that bought the mortgages could easily bail out the mortgagees. Of course that would drive down the "value" of the investment. Tough luck.
The three lessons from history are that leverage always works both ways; diversification is often an illusion in times of overall decline; and every seller needs a buyer most when one can't be found.
If there is any similarity between the current sub-prime illiquidity situation and the crash of 1929 it in the flow of investments from highly regulated investment vehicles to unregulated investments that are more highly leveraged.
We should heed as a painful reminder that the crash of 1929 was not simply the story of falling stock prices, but also the coming home to roost of the highly leveraged investment trusts that were the fashion of the day.
Like the derivatives of today's investment world, these investment trusts (the precursor to mutual funds) became a highly leveraged investment when traders started to create investment trusts that invested not in individual stocks but instead invested solely in other investment trusts. Thus giving you an investment trust made up of a basket of other investment trusts. On the surface this offered more diversity, but in the face of a rapidly declining market these trusts popped like balloons when buyers evaporated. Trusts that bought other trusts in the declining market in the logic that stocks were getting cheaper disappeared even faster.
(Me) Retired Military Patriot 1:33AM
Even though I’m sure that these clever scam artists have had plenty of wealthy lawyers help them cover their tracks, there has to be a lot of fraud involved with this whole mess. I’m not nearly informed enough to tell you the specifics although one small and simple example would be the Internet companies that helped lone applicants prove jobs and income that didn’t exist including even pretending to be the employer.
@Kathleen L. 6:25PM
What makes these securities worthless is the fact that people were encouraged to fib just a little to qualify for the loan -- and they went along with it. If enough people do that, the little fibs add up to one giant fraud.
@Anon 12:57PM
This is not about money and the market. This is about human beings.
Since I first raised it, it took 18 hours for someone to stop talking about technicalities and definitions to mention fraud again. It took another six hours more for someone to mention the real price to humans of this level of greed. Doesn’t that tell us something about the underlying problem? Playing with people’s lives whether through war or money should not be lost in cool technical discussions.
It is this kind of detachment that has made life miserable for millions and millions of people. And since this is posted late, the technical commenters will probably not read this and some might not care even if they do.
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