Banning Derivatives and Other Such Foolishness

Includes: BRK.A, IAI, IYF, XLF
by: Paco Ahlgren

"Knowing a great deal is not the same as being smart; intelligence is not information alone but also judgment, the manner in which information is collected and used" -- Dr. Carl Sagan

There are a surprising number of people in the world today who believe derivatives are nothing more than gambling instruments, whose only function is to deprive innocent and uninitiated investors of their hard-earned money. And then there are those of us who know better.

When I was much younger, we had a family friend -- a brilliant neurosurgeon, who made a lot of money. It’s typical for neurosurgeons to do well, financially; tinkering with brains and spinal cords is a whole lot more complicated than replacing a carburetor. As such, none of us were unduly astonished by his lifestyle or wealth.

What was somewhat perplexing was the turn his life took later.

I lost touch with the doctor when I left home to begin my own adventures, but when I was in my early twenties, I learned that he had been financially ruined. He had become involved with commercial real estate in Texas, and the subsequent market collapse wiped him out. About two years later, more news came: his misfortunes had taken an enormous toll on his health – to the extent that he was unable to continue his career as a surgeon. His condition declined and he died relatively young -- in his late forties.

Why am I telling you this story? To illustrate a vital point: Sometimes smart people venture from their areas of specialty, and do not-so-smart things. The man I'm telling you about was a great surgeon, but he was a terrible commercial real estate speculator. Please don't think I'm being insensitive; he was a nice man, and I was sad to hear of his catastrophe. But he deviated from his expertise -- undoubtedly driven by a misapplied confidence that came from his success as a surgeon.

As difficult as it is to see one person suffer from the effects of his own miscalculation, there's an even more dreadful form of this phenomenon – which I’m going to label the disease of over-confident intellect. And the consequences are far-reaching, indeed. It happens when successful professionals – like doctors, lawyers, scientists, and captains of industry -- abandon their professions to seek public office. The problem derives from the fact that we gravitate like lemmings to their charisma and success -- allowing them to make decisions for all of us, in areas far outside their realms of specialty.

This is the tragedy of democracy, and yet it is a mistake we willingly make -- over and over -- to our collective detriment. Are some politicians stupid? Sure. Are most politicians stupid? Almost certainly not. Does a politician’s intelligence, however, guarantee he or she will make sound decisions?

This is obviously a rhetorical question, but I’ll answer it anyway -- just in case any stupid politicians happen to be reading this: no, it does not.

Case in point: a proposed ban some months ago by Minnesota Congressman Collin Peterson on about 80% of all credit default swaps. I'm not ignorant of the role CDSs played in the current financial crisis, but I'm also not oblivious to the fact that CDSs also play an important role in creating liquidity and facilitating price-discovery.

I'm sure Congressman Peterson is a smart person. His proposal, however, was just stupid. But hey, so are salary caps, short-sale bans, “too-big-to-fail” schemes, forcing children to learn Creationism in school, Cash-for-clunkers, same-sex marriage bans, and even the minimum wage.

The sad fact of the matter is that most politicians just don’t know any better. These men and women represent the collective finger being pointed haphazardly in every direction by their constituencies – desperately looking for anything, or anyone to blame. For everything.

Politicians, however, are not the only societal leaders who – with good intentions or not -- try to foist upon us ridiculous “solutions” to problems that may or may not even exist. It seems to be the imperative of every successful human being: “My achievements are monumental! Therefore I am brilliant! Society has problems! It is my duty to fix those problems! That’s how I’m going to ‘give back!’”

If any successful people are reading this, can you do us all a favor? Please don’t “give back.” Just keep doing what you do best. We’ll all be a lot better off.

Consider Warren Buffett. For twenty years, this man has been one of my most important role models. When I began gravitating toward finance, I became fascinated by Buffett and the people who influenced him – like Ben Graham, Phil Fisher, and Charlie Munger. I read all the Berkshire-Hathaway (NYSE:BRK.A) annual reports, and meticulously picked apart every single book I could find offering insight into the methodology of this brilliant investor and his ilk. I adopted their principles, and I found a great deal of success for myself and my clients in subsequent years.

My respect for Warren Buffett, however, has its limits. In other areas of thought, Buffett is a borderline fool. Economically and politically, he is a rabid leftist -- often denouncing the very system from which he has profited so handsomely, for so long. He has condemned futures and options markets, for instance, and even proposed a 100% capital gains tax on any security sold within a year of purchase. I understand that Buffett's acumen as an investor is nonpareil, but how on earth can he not see the damage his proposals would do to market liquidity -- and ultimately to the economy as a whole?

I have never understood why derivatives and derivatives speculators are so vilified. Yes, they have been responsible for extreme moves in markets – like the technology, housing, and oil bubbles. Nonetheless – and I apologize for being trite –what goes up does come down, and the same speculators who cause these anomalies in the first place are invariably responsible for (and subject to the perils of) the subsequent collapses. Warren Buffett's ire isn't required to elicit their penitence; market backlash is quite sufficient, and there can be no question that many, many speculators have met their financial demise in the reckless turmoil necessarily accompanying any grossly mispriced market.

Buffett is by no means the only billionaire with misguided social, philosophical, political, and/or economic ideas. George Soros actually studied with my all-time biggest inspiration – Sir Karl Popper. And yet, somehow, after Soros made his fortune, he became the antithesis of everything Popper stood for. And the most troubling thing about Soros’s imperative? He actually uses Popper’s work to justify his distorted and ill-founded concepts.

The thing that seems to elude people like Peterson, Buffett, and perhaps even George Soros (the latter two being – paradoxically -- quintessential capitalists) is the fact that speculators create tremendous liquidity in markets – dramatically narrowing spreads, and encouraging price discovery. Supply and demand do not cross at some constant, absolute point in space and time as your high school economics teacher would have you believe; the intersection is an amorphous, dynamic point, floating elusively through markets -- teasing us, but never revealing the precise scarcity of a particular good or service.

As some of you know, I like to compare so-called economic equilibrium to subatomic physics; it is impossible to ascertain both the velocity and position of a particle -- whatever you use to measure the particle actually changes its position and speed. We can know one or the other, but not both.

Likewise, the very price structures we use to gauge the scarcity of goods and services necessarily change the nature of supply and demand with every new transaction. We cannot know market equilibrium -- we can only approach it. The liquidity provided by speculators is precisely the mechanism needed to approach market equilibrium – to get as close as possible. And yet, people whose intelligence we respect denigrate these speculators unceasingly. Unfortunately, no matter how smart the critics may be, they do not fully understand the nature and complexity of markets. Surprisingly, people like Buffett and Soros – both of whom capitalized handsomely from specific expertise in extremely focused segments of the industry – are often the most vociferous critics of capitalism, as a whole. And they somehow remain ignorant, despite having immersed themselves in the system.

This is an almost perfect demonstration of how deviation from an area of expertise by only a very small amount – in Buffett's case, from understanding corporate wealth creation, to understanding the mechanics of liquidity – can generate colossal erroneous conclusions. And bear in mind that Buffett, himself, has often criticized companies for deviating from their own areas of expertise!

To expound, Buffett exemplifies only a small deviation from expertise: a value-investor criticizing derivatives markets. He clearly understands futures and options at a fundamental level -- and even employs them on a limited scale. Nonetheless, he lacks the complex knowledge of these specific markets to understand how critical they are to price-discovery. Again, the gap in Buffett’s knowledge is small: derivatives and equities are merely different segments of the same industry, and the leap shouldn’t be a difficult one for him. Yet it is.

Now let’s talk about what happens when a neurosurgeon decides to become involved with a completely foreign industry – like commercial real estate? Or worse still, let’s talk about the implications of a career politician – with no practical real-world experience of any sort -- deciding to start a crusade against derivatives.

What the hell does a career politician know about derivatives?

Imagine a world in which children dictate terms to their parents, and have the power to fire them if they don't provide results the children demand. That's the way democracy works; but as flawed as it is, the negative consequences of group-think are often compounded by the fact that our leaders are often so intelligent that they fail to recognize the limits of their own abilities. Sometimes "smart" just isn't enough, and when you couple ego-driven intelligence with irrational demands from a constituency of spoiled brats -- wielding the power to destroy political careers -- the problems snowball.

If the ideas of Warren Buffett, George Soros, and Collin Peterson genuinely stem from their ignorance of the consequences, then they really are just fools to be pitied. On the other hand, if such men make these absurd -- and even dangerous -- proposals with full knowledge of the consequences, then they are evil.

Either way, their theories should be dismissed as specious nonsense before they can affect the kind of change that causes massive price distortions, and still more widespread economic calamity. This entreaty would be urgent in any environment – but none more fragile than this.

Disclosures: Paco is long TBT and Gold. He also holds U.S. dollars by necessity, pending the advent of private gold-backed currencies.