Banning Derivatives and Other Such Foolishness 60 comments
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"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 chords 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 (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.
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This article has 60 comments:
Well they are a negative sum game when you take into account transaction costs (zero sum game otherwise) so that fits the definition of gambling.
A negative sum game is not a problem if you are using derivatives for risk management (hedging), however increasingly financial institutions view derivatives as revenue sources and profit centers -- that is where the problem lies.
I can see why you should spread the risk for some things. Insurance companies provide an incredibly important service at a personal level. But increasing my level of insurance will not cause me to take exceedingly stupid risks with my life, my car, etc. Derivatives promote HEAVILY increasing the risk with the assumption that the counter party knows EXACTLY what they are doing.
"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."
For example, what happens when someone with financial knowhow deviates from their area of expertise and comments on human rights and sociology issues as if they were dollars and cents? The minimum wage question and other labour laws are far more complex than mere dollars and cents and their impacts on the economy run far deeper than their impact on market forces and bottom lines. I don't mean to start a debate on this, just imagine the service or retail sector being represented by a union with the power and strength of the auto or steelworkers'... as opposed to having a minimum wage to appease the masses and prevent the chaotic conditions from which powerful workers rights movements arose. It's an issue beyond pure financials.
Also, in the wake of a deep recession caused by ridiculous asset bubbles that were fueled by the speculatory derivatives (pick your poison: oil, commodities, housing) you'll need to make a much stronger case if your point is that credit default swaps allow for a more accurate denomination of the pricing curve. Rhetoric about how these tools are supposed to work according to your financial insight once again ironically reinforces the driving point behind your article.
You blast for the politician for not understanding how the tools work, and he can blast you right back for not understanding how human nature will impact the true outcome of putting these tools to work.
To inverse your child metaphor... your argument here is the equivalent of a child's objection to his favourite toy being taken away.
"But mom! This toy is educational! It's made to help me learn my ABCs!"
"That's nice Paco, but all you've done is beat all the other children over the head with it and get suspended from school, so I'm taking it away."
Very interesting article to be quite honest, although the author could have taken is own advice and avoided the absurdly self-righteous conclusion.
CDS are by their nature an insurance transaction, and should be regulated as such, with a requirment of adequate capital on the part of the seller and an insurable interest on the part of the buyer.
You obviously don't have an understanding of insurance or the moral hazard created by the lack of insurable interest.
I mean its not like if you made a giant network of these things and one of the major nodes ceased to exist that it would wipe out more wealth than the exchanged assumption of unfunded liabilities generated right?
I mean clearly AIG has shown us that. They could have failed without any kind of bailout, and we would have been way better off as a whole than the slower growth we would have had without derivatives for the last twenty years.
Only an idiotic politican could think that maybe instead of charging each other fees for trading unfunded liabilities we might just, oh i don't know, accept slower growth?
You hit the nail directly on the head.
As long as you can not only buy as many "insurance policies" (CDS) as you wish, but, you can also cause the insured "houses" to be burned down through shorting illiquid debt indices and nefariously spreading negative, scare-inducing rumors through the endless channels of our mass media, then, you have an illicit, rigged system, no different than any other common fraud.
On Nov 16 12:00 PM Tom Armistead wrote:
> You are operting far outside your area of competence.
>
> CDS are by their nature an insurance transaction, and should be regulated
> as such, with a requirment of adequate capital on the part of the
> seller and an insurable interest on the part of the buyer.
>
> You obviously don't have an understanding of insurance or the moral
> hazard created by the lack of insurable interest.
But the current implementation of CDS is like letting other people buy 10 insurance policies of YOUR property. Needless to say, they have a very strong incentive to see your house going up in flames.
This was clearly fraudulent and should have been regulated through a dedicated and transparent Exchange on time to avert the AIG debacle and the meltdown of world finance.
As to the overall theme of your article, overlooking the pain inflicted on both shareholders and taxpayers while opposing compensation limits on the so called “talent” that wrecked the system is neither reasonable nor constructive. A "casino society" threatens capitalism at the core, leaving it subject to intervention by the same politicians that you believe are so misguided...
Wow! good job you haven't strayed outside your own area of expertise, which apparently includes a profound understanding of social, philosophical, political and economic ideas.
Or perhaps you don't understand what you are saying, let alone the fields you refer to.
If you own the underlying asset, derivatives are an important means of hedging risk. If you don't own or have some interest in the underlying then you aren't hedging you are gambling.
When certain parties (pirates?) that have benefited heavily from the loophole whine and fight so much about closing it, even after seeing the damage it's caused, it only encourages heavy-handed lawmakers to overshoot and throw out the baby with the bathwater. Regulation is not the enemy of Capitalism. Fraud and piracy are the enemies of Capitalism.
Nor should CDSes be totally outlawed.
Proper tools for proper projects.
On Nov 16 12:00 PM Tom Armistead wrote:
>
> CDS are by their nature an insurance transaction, and should be regulated
> as such, with a requirment of adequate capital on the part of the
> seller and an insurable interest on the part of the buyer.
>
> You obviously don't have an understanding of insurance or the moral
> hazard created by the lack of insurable interest.
On Nov 16 01:37 PM William Legrand wrote:
> Unregulated derivatives are one half of the problem. Unregulated
> and ridiculously-high leverage multiples are the other half. It's
> a system where risk can be (or seems) relatively low for some but
> is nearly without bound for many. Bad things always happen at the
> most inopportune times. When bad things happen in today's derivatives
> market, everyone loses. It's the ultimate house of cards.
My commitment to the concept of derivative markets is only somewhat stronger than Mr. Ahlgren’s to democracy. Agreed, derivatives help provide needed liquidity and thereby promote the financing of their underlying assets. The experience with housing mortgage financing in the US over the past seven or more years, however, illustrates that a poorly developed and regulated derivative market can over stimulate the market for its underlying asset and this, in turn, can have many disastrous economic consequences. Doesn’t it follow, therefore, that there needs to be an appropriate legislative or regulatory framework for the generation and trading in derivatives that preserves the beneficial effect of creating appropriate liquidity but guards against abuses arising? To those that would argue that the free market alone is an adequate safeguard, I would response that the experience of the past couple of years make acceptance of that argument difficult.
In light of the forgoing Mr. Ahlgren’s condescension towards Congressman Peterson is counterproductive. If the Congressman’s legislative proposal is flawed, concrete proposals for a better solution should be advanced.
Before you can become the Walmart of risk storage, you ought to face some pretty tight regulatory requirements.
All others should be banned, as they are no more than a counterfeit
asset. Why not issue everyone a color copier and print your own $20 bills?
On Nov 17 08:14 AM pockyclips 2020 wrote:
> I'm all for derivatives that can be DIRECTLY tied to a tangible asset.
>
> All others should be banned, as they are no more than a counterfeit
>
> asset. Why not issue everyone a color copier and print your own
> $20 bills?
As for Soros, he is a very smart man.
Derivatives - I can remember when they didn't have them for crude (oil). The oil market functioned worse at that time than after derivatives were introduced.
As fór comparing so-called "economic equilibrium" with so-called "sub-atomic physics", I don't see what the __ economic equilibrium has to do at all with Heisenberg's uncertainty principle.
I don't know what to else to say.
On Nov 17 08:35 AM Ferdinand E. Banks wrote:
> All I know about Warren Buffett is that he is a genius, and if my
> finance students had a different opinion about him they kept it to
> themselves. Of course, as John von Neuman once said, they don't care
> very much for genius in the United States.
>
> As for Soros, he is a very smart man.
>
> Derivatives - I can remember when they didn't have them for crude
> (oil). The oil market functioned worse at that time than after derivatives
> were introduced.
>
> As fór comparing so-called "economic equilibrium" with so-called
> "sub-atomic physics", I don't see what the __ economic equilibrium
> has to do at all with Heisenberg's uncertainty principle.
Many people respect Mr. Buffet and Mr. Soros beyond their job scope, for their characters and other valid reasons. For example Mr. Soros pre 2nd term political judgment about President Bush has been validated by the mess from the economy and wars Americans have inherited.
I bought shares several decades ago in GE because they made pretty good light bulbs. Years later they got in trouble over something that had nothing to do with electricity.
The problem it seems to me is not that "I" have strayed into my area of incompetence, the problem is I cannot avoid it even if I sell GE and put all my cash in a crooked bank that is very competent at the "shell game." And most financial institutions were involved and I have extreme difficulty finding a safe haven not tainted by greed and fraud, or at the very least manipulation and misdirection.
On Nov 16 03:02 PM Wildebeest wrote:
> dividend_growth and The WaveNET Perspective give good examples.<br/>
>
> If you own the underlying asset, derivatives are an important means
> of hedging risk. If you don't own or have some interest in the underlying
> then you aren't hedging you are gambling.
They saw a chance to rake in ridiculous amounts of money in "commissions" and didnt give a damn about the systemic financial risk they were creating. I only hope one day they are hunted down, drug into the streets and hung.
The average person has no concept what these instruments even are or how they work...and the "experts" love to talk down their noses when asked to explain them....like we are all too stupid to understand. The day will come when many more understand these products, WHO mis-used them and the negative impact they have had on ALL of us.
Do you deviate into a realm where those intimately knowledgeable of the history of nations might consider your generic defense of derivatives a case of giving aid and comfort to an enemy of the people of the United States of America? Might you too, then, be saying, "Do as I say, not as I do?"
> So I write an article. And in it I carefully explain the similarities
> between the uncertainty of economic equilibrium, and I compare it
> -- using evidence -- to Heisenberg's Uncertainty Principle. And you
> respond with "____" as an ersatz for profanity.
>
> I don't know what to else to say.
...obviously, otherwise you may have responded to the many other substantive comments made on your article rather than respond in such a trivial manner.
This article frankly seems like an attempt to show us how smart you are rather than logical discussion of the merits of derivatives (and other foolishness).
As I understand CDS's they are off balance sheet arraignments and the seller/creator of the CDS does not show the liability to perform to the buyer yet they conveniently show the profits-dispersed as bonuses to the employed traders and the CEO and to dividends for share holders. Because the CDS’s are not called “insurance” they avoid regulation and are not required to have reserves to perform should the buyer have a claim (Bank of America bought CDS’s from Merrill Lynch against failed CDO’s bought from Country Wide). This is why some financial derivatives are fraudulent-specific performance contracts that are unable to perform because not enough of the collected premiums were placed in reserve status so as to pay out for losses. Then we have the leveraging of such instruments, tranching them and selling them as AAA bonds (no assets, just non performable contracts). The systemic failure is now impossible to unwind even if RICO laws were invoked and all the assets of the sellers were seized. Now address the moral hazard issue of To Big To Fail crowd and there is no incentive to change the conduct of the misdeeds. The actual players continue to make money and can fail the business without harm to the personal players as they have drained the monies for their own gratification.
Chase Bank has $14 trillion in protection yet only has assets of less than $3 trillion. They will have a greater benefit from a failure of assets than the assets maintaining solvency, assuming the seller of the protection can perform. This puts Chase in an awkward alliance as a capitalist-we will make more money by failure than by prudence.
But maybe the above can be dismissed as I have ventured out of my area of expertise.
Let’s hope so.
"Moral hazard" is the great broom for sweeping everything into the domain of state control. Americans seem to know as much about markets as they do about dealing with Islam (for those of you wondering...this is "almost nothing").
"Let's all remember that without the state, markets--and people--cease to exist." --Dr. McCrazypants
"Regulatory authority doesn't prevent collapse, it only creates regulatory authority." -- Dr. McSanepants
Well... that AND how smart I am.
>>This article frankly seems like an attempt to show us how smart you are rather than logical discussion of the merits of derivatives (and other foolishness).<<
Capitalism is quite consistent with homelessness and poverty.
Buffer simply acknowledges the truth. And it hurts (you).
On Nov 17 11:38 AM User 73203 wrote:
> You have got to be kidding me. Derivatives, and the derivatives
> of derivatives, and the devices that were insurance on derivatives,
> were dreamed up by the thieves and charlatans on Wall Street simply
> to make money - and a lot of it - off of everyone else. They should
> be banned, along with naked short selling, and - quite frankly -
> the idiots who dreamed them up should be in jail.
What about artificial scarcity. Case in point - Oil. There is a glut in the market and the demand has been diminishing this past summer.
How can demand and supply work if a big entities like banks, ETFs and big oil corner 70% of the market (Right now they have cornered 70% of the oil). And sell it at whatever price they want. Is this fair market or a hoarders market. Experts call it investing... its hoarding for a simpleton like me.
We are giving away our nations wealth to other countries even though they don't demand $80/barrel of oil. I hope someone in the govt wakes up and starts real "position limits".
I am with Warren Buffet in so far his leftist tendencies are concerned. Some govt oversight is required in all trading. Unfettered capitalism is no panacea for today's problems.
-Matt
On Nov 17 09:55 AM hock wrote:
> Apply what you said to yourself, and you will see the wisdom of your
> thoughts.
> Many people respect Mr. Buffet and Mr. Soros beyond their job scope,
> for their characters and other valid reasons. For example Mr. Soros
> pre 2nd term political judgment about President Bush has been validated
> by the mess from the economy and wars Americans have inherited.
But not to worry, the Administration is captured. To mess with the financial sector would cause a drop in the GDP and a loss of confidence in the dollar. The financial sector will emerge untouched, bigger than before and with less regulation. In addition, they will be 100% backstopped by the taxpayer, forever, including trading, self-dealing, broker-dealer activities, insurance and anything else they innovate. They may even do a little lending.
It doesn't take a rocket scientist to recognize shell games, no matter how many fancy titles they are given. Whether they are on the street, or in the board room.
These so called free markets have destroyed a great deal of middle class wealth, on a global scale. Millions of people that were NOT speculators. If you yourself truly believe in "free markets" it would seem that you would be in favor of truly free markets, instead of the series of boom/bust/bailout cycles and rewarding failures that have been constant for more than 30 years. It isn't about the products that Wall St firms invent, it's how they are abused. These are facts...not party lines.
There are many well thought out and supported responses in rebuttal by several people much smarter than myself, but it seems telling that your responses so far are only addressing a couple of the "angry" posts. You haven't addressed any of the criticisms or defended your point of view.
Of course, you could be joining the ranks of the Rush, Beck, Olberman, Maddow, or even Stern, gaining followers and selling stories by trying to incite people, pro or con. Getting people upset perpetuating myths of free markets, while picking on people with derogatory comments, sounds like the standard operating procedure for a souless salesman with no interest in anything but your own gain. Come to think of it, it might explain alot about your articles.
We would not be in this mess without derivatives. The notion that these toxic waste products allow for price discovery is just as stupid. They allow for over price fantasy. Nothing more.
He is thinking just like a banker. They want to make money with no labor. They just create tools of manipulation and parasitic siphoning of wealth from the economy within which they operate, at risk to the people in that economy, but not to them selves.
Everyone but bankers and gamblers would be better off with out them (unregulated derivatives). We would be better off today if the gamblers who couldn't pay were in jail, not globe trotting with our stolen wealth.
Thank you for stimulating the discussion about the role of derivatives in the market-making process.
Aside from the social comments, which you and your responders have every right to make in whichever direction, my interest is in the implications inherent in efforts to improve on the badly flawed current financial situation. After spending 30+ years making a living from the stock price insurance business in a 50+ year investment career I may have some observations useful to ponder.
There has existed since the mid 1970's a derivatives market that has managed to make itself a model of functionality and integrity. It is the listed stock options market.
Make no mistake, this is an insurance market. The original motivation of the investment community was a hope that the investing public would return some much needed market liquidity (after once again being burned by a market cycle). The lure was an option's ability to offer operationally highly-leveraged fliers on a stock's near term price moves.
Instead, the market-makers soon realized that their needed liquidity to handle the big block transactions being thrust at them by pension funds and mutual funds, came instead from being able to lay off their temporary positioning risks by using listed options.
The essential agent here is the Options Clearing Corporation, which ensures at every day's market closing that there is a seller for every open interest contract and that the sellers have the capacity to perform on the obligations that they have undertaken.
As "Adam Smith" observed in his classic "The Money Game", if you don't know who you are, the stock market is an expensive place to find out.
Every market trade of an item of intrinsic value requires both a buyer and a seller. The same is true of a derivative of the intrinsic-value item. With options, the buyer of the option has the privilege of acting or not, but the seller must perform if called upon.
An option buyer is buying insurance, the seller is selling insurance. Players in this game better know which role they are in, and whether it is what they intend, and whether it is appropriate, given their business mission. The centuries-old British bank, Barings, lost sight of this and it ruined them.
Counter-party risk exists in all insurance transactions. What the Options Clearing Corporation does is to assume that risk, minimize it by careful record-keeping, elaborate rule-making, and an adequate (but reasonable) transaction fee structure that maintains its own war-chest for contingencies. The rules, and their diligent enforcement, keep any contingencies quite manageable.
The OCC is the cop on the beat. With recognized and credible credentials.
When I came into the investment business in 1958, it was clear that if you wanted to have a career there, you followed the rules, which were avidly enforced. But the cop on the beat was not the SEC with its tiny nationwide staff of 300 clerks and lawyers.
As Harry Markopolis (with whom I worked daily in a 10-year strategic business alliance) pointedly identified in the Madoff affair, the SEC for years has been all show and no go. The real cop on the stock beat during most of the 20th century was the New York Stock Exchange. They maintained the market-surveillance crews, flagged miscreants, and had the New York District authorities pursue measures of justice.
Where is the NYSE now? Then it was a self-regulatory organization owned by active members of the investment community, who treasured the public's trust. Now it is
a publicly-owned (and traded) for-profit organization more intent on maintaining its competitive position internationally, vis-a-vis possibly more technically advanced exchanges, than it is with matters that ought to be the purview of the government.
So there is no real cop on the beat, nor has there been for several years. Years in which credit derivatives were manufactured and peddled by merchants that apparently knew, and attested to by rating agencies that apparently did not care, about how fraudulently misrepresented the contracts were, in an environment where there was no central clearing activity to provide any risk controls, or even basic records.
Fear and greed operate all across society, not just in marketplaces. Until the public comes to recognize that trust in markets is essential to the survival of a capitalist society, and fear for that survival can be transmitted to the political establishment in terms of fear of termination by election (or worse, social revolution) we will be confronted by financial and criminal miscreants who have no fear of getting caught or punished for further misadventures.
Present-day global markets, and their integration in practice by arbitrage using instantaneous communications, makes the beltway turf tussles over who will arrange the chairs on which deck of the Titanic a pathetic comedy.
There can be only one effective captain of the regulatory ship, and he needs to have the breadth of coverage and contemporary technological resources to do the job. That means existing vested interests will be displaced, so they will resist. So its not an easy job, but it's got to be done, and can't be deferred, or it simply gets harder.
Peter F. Way, CFA
On Nov 16 01:05 PM dividend_growth wrote:
> CDS by nature is not evil. It's just like your home insurance. <br/>
>
> But the current implementation of CDS is like letting other people
> buy 10 insurance policies of YOUR property. Needless to say, they
> have a very strong incentive to see your house going up in flames.
Paco; glad so many people made so much money on CDS's.
Paco; sad to see so many people still pimping Wall Street Ponzi scams; sadder still to see so many buying into the b.s.
A short but insightful (and frightful) read.
Yours truly, LaVern Isely, Overtaxed MIddle Class Taxpayer and Public Citizen Member
In the strict macroeconomic sense, the business of insurance or the act of taxation are both wealth redistribution mechanisms, and not "wealth creation" concepts. Believeing otherwise is naive and simply misguided.
Just between you and me...Buffett is much more that being left. He's a terrorist.
GL
Clearly there is a valid role for derivatives and therefore for derivative trading. That said, in this day of sophisticated information technology, global markets and large pools of short term money, unregulated (or ineffectively regulated) trading was a disaster waiting to happen and disaster clearly did happen with the results we can all observe. Wouldn’t you agree that the needed reform goes beyond the measures of regulatory agency clarification and diligence you quite properly describe?
Isn’t it necessary to better distinguish derivatives that serve a legitimate economic function from those that are essentially chips in a gigantic international market casino and exclude the latter from the market place by international cooperative action? In addition to setting and enforcing better standards of disclosure and limits on the extent of risk a bank, hedged fund or other near bank can assume, aren’t there other limits needed?
Answers to these questions from a person with your background would be very instructive.
On Nov 17 02:12 PM Peter F. Way, CFA wrote:
> Paco,
>
> Thank you for stimulating the discussion about the role of derivatives
> in the market-making process.
>
> Aside from the social comments, which you and your responders have
> every right to make in whichever direction, my interest is in the
> implications inherent in efforts to improve on the badly flawed current
> financial situation. After spending 30+ years making a living from
> the stock price insurance business in a 50+ year investment career
> I may have some observations useful to ponder.
>
> There has existed since the mid 1970's a derivatives market that
> has managed to make itself a model of functionality and integrity.
> It is the listed stock options market.
>
> Make no mistake, this is an insurance market. The original motivation
> of the investment community was a hope that the investing public
> would return some much needed market liquidity (after once again
> being burned by a market cycle). The lure was an option's ability
> to offer operationally highly-leveraged fliers on a stock's near
> term price moves.
>
> Instead, the market-makers soon realized that their needed liquidity
> to handle the big block transactions being thrust at them by pension
> funds and mutual funds, came instead from being able to lay off their
> temporary positioning risks by using listed options.
>
> The essential agent here is the Options Clearing Corporation, which
> ensures at every day's market closing that there is a seller for
> every open interest contract and that the sellers have the capacity
> to perform on the obligations that they have undertaken.
>
> As "Adam Smith" observed in his classic "The Money Game", if you
> don't know who you are, the stock market is an expensive place to
> find out.
>
> Every market trade of an item of intrinsic value requires both a
> buyer and a seller. The same is true of a derivative of the intrinsic-value
> item. With options, the buyer of the option has the privilege of
> acting or not, but the seller must perform if called upon.
>
> An option buyer is buying insurance, the seller is selling insurance.
> Players in this game better know which role they are in, and whether
> it is what they intend, and whether it is appropriate, given their
> business mission. The centuries-old British bank, Barings, lost sight
> of this and it ruined them.
>
> Counter-party risk exists in all insurance transactions. What the
> Options Clearing Corporation does is to assume that risk, minimize
> it by careful record-keeping, elaborate rule-making, and an adequate
> (but reasonable) transaction fee structure that maintains its own
> war-chest for contingencies. The rules, and their diligent enforcement,
> keep any contingencies quite manageable.
>
> The OCC is the cop on the beat. With recognized and credible credentials.
>
>
> When I came into the investment business in 1958, it was clear that
> if you wanted to have a career there, you followed the rules, which
> were avidly enforced. But the cop on the beat was not the SEC with
> its tiny nationwide staff of 300 clerks and lawyers.
>
> As Harry Markopolis (with whom I worked daily in a 10-year strategic
> business alliance) pointedly identified in the Madoff affair, the
> SEC for years has been all show and no go. The real cop on the stock
> beat during most of the 20th century was the New York Stock Exchange.
> They maintained the market-surveillance crews, flagged miscreants,
> and had the New York District authorities pursue measures of justice.
>
>
> Where is the NYSE now? Then it was a self-regulatory organization
> owned by active members of the investment community, who treasured
> the public's trust. Now it is
> a publicly-owned (and traded) for-profit organization more intent
> on maintaining its competitive position internationally, vis-a-vis
> possibly more technically advanced exchanges, than it is with matters
> that ought to be the purview of the government.
>
> So there is no real cop on the beat, nor has there been for several
> years. Years in which credit derivatives were manufactured and peddled
> by merchants that apparently knew, and attested to by rating agencies
> that apparently did not care, about how fraudulently misrepresented
> the contracts were, in an environment where there was no central
> clearing activity to provide any risk controls, or even basic records.
>
>
> Fear and greed operate all across society, not just in marketplaces.
> Until the public comes to recognize that trust in markets is essential
> to the survival of a capitalist society, and fear for that survival
> can be transmitted to the political establishment in terms of fear
> of termination by election (or worse, social revolution) we will
> be confronted by financial and criminal miscreants who have no fear
> of getting caught or punished for further misadventures.
>
> Present-day global markets, and their integration in practice by
> arbitrage using instantaneous communications, makes the beltway turf
> tussles over who will arrange the chairs on which deck of the Titanic
> a pathetic comedy.
>
> There can be only one effective captain of the regulatory ship, and
> he needs to have the breadth of coverage and contemporary technological
> resources to do the job. That means existing vested interests will
> be displaced, so they will resist. So its not an easy job, but it's
> got to be done, and can't be deferred, or it simply gets harder.
>
>
> Peter F. Way, CFA
As far as Buffet and Soros moving out of their "sphere of competence", Alfred Nobel (inventor of dynamite, and founder of the prize bearing his name), spent a large part of the money he amassed from explosives trying to grow square trees to cut waste in sawmills.
This is akin to the teaser rates given poor home owners who had no hope of being able to pay the increased interest on the higher rate after the first year.
This needs more regulation along with the need to better regulate the concept of mortgage bond insurance contracts.
What's really pathetic though is the fact that economists and financial wizards are almost always wrong when it counts the most, i.e. market turning points. Ninety-nine percent of economists never see a recession coming, which is why they "post date" the beginning of a recession.
Only those who are outside the main stream of Wall street who view only hard data and historical trends ever get it right.
First abuse of tools: The 1st degree derivative (CDO's) became damaged by congress's finance committees adjusting the debt-to-income ratios to unsafe levels-this collapsed the foundation.
Second abuse of tools: The 2nd degree derivatives (CDS's) were non performable insurance due to no regulation that would require reserve monies. The sellers of protection did not maintain enough money in reserves to pay out to the insured. Too much of the insurance premiums collected went to bonuses and dividends-too much greed, the dark side of capitalism.
Third abuse: The CDS's were tranched into AAA bonds, the 3rd degree derivative, and sold-fraud.
Fourth abuse: CDS's were sold to entities that were aware of the abuses to capitalize on their failures, regardless of the entity having a vested interest in the bad asset-moral hazard to create more bad CDO's, CDS's and 3rd degree derivatives, buy insurance against their failure and make money (Goldman Sachs did this and when AIG could not pay the benefit they hijacked the US Treasury to give AIG money for pay out).
Tools- if the hammer hits the nail, good. If the hammer hits the finger, bad, or if it hits your head, really bad.
Better to outlaw bad judgment, not the tool.
On Nov 17 11:38 AM User 73203 wrote:
> You have got to be kidding me. Derivatives, and the derivatives of
> derivatives, and the devices that were insurance on derivatives,
> were dreamed up by the thieves and charlatans on Wall Street simply
> to make money - and a lot of it - off of everyone else. They should
> be banned, along with naked short selling, and - quite frankly -
> the idiots who dreamed them up should be in jail.
You know you're in trouble when your detractor refers to you as "pal." I learned that from the Flintstones.
On Nov 18 11:40 PM CitizenPat wrote:
> Why exactly were you allowed to post this article on this site? You're
> on the wrong side of the argument, pal. Grow up.
Governments create markets through a stable currency, rules of the game and police and courts for enforcing the rules. Hopefully the point of the regulations is to ensure transparency and honesty and a modicum of safety.