How about a $600 trillion headache?

Coming Soon:  The $600 Trillion Derivatives Emergency Meeting (link).  The Prudent Investor posted the linked article on SeekingAlpha over the weekend.  It's a must-read.

Realizing that by no means is the entire derivatives market at risk, and that a good deal of the notional values of these derivatives net out (theoretically) should give some comfort.  But only some.  This is still a big problem.  Well beyond the ability of any government to "bail-out".  Not even all governments acting in unison could hope to bail-out the derivatives-related fallout should systemic failure spread.

Will it spread?  I wish I could say no.  But, right now, everything is on the table.

One interesting notion I'm hearing discussed more and more, including in the comments on that article, has to do with a purely legal solution to the looming derivatives defaults and unwinding problem.  It goes roughly like this:

Default swaps (and related instruments) were unregulated.  Those instruments were basically a form of trade-able insurance positions; sometimes used to insure, sometimes to hedge, often to simply speculate -- ie., to bet.  Not regulated by financial authorities.  Not regulated by insurance authorities.  Not regulated by gaming regulators.  Therefore, these things constitute a form of illegal gambling.  As such, they violate public policy, are not protected by any international treaties or trade agreements, and are subject to nullification by a court.  So, just nullify them all.  All; every single one.  Tell all the parties, "Tough, you should have known better.  Be happy we're not going to prosecute you for illegal gambling". 

Then, effectively, every party has what they have today, and we move foreward tomorrow.  Lot's of upset folks.  Lot's of rhetoric about the end of capitalism, the end of markets, the end of credibility.  But it will pass quickly.  Only a select, elite few ever played in this market to begin with, and they were just running giant bets against one another.  So, knock out the hundred trillion or so of default swaps and dependent derivatives and move on to the next crisis -- which is consumer credit defaults.

Thoughts?

Comments

[Brand]

Hey Randy, I'll bet you $45,000,000,000 that the Nittany Lions knock off Ohio State next weekend and go to the Rose Bowl*.

What a load of garbage. So let me get this straight. There is a huge number of outstanding "bets", in which both parties were completely unable to participate. At which point did these guys really think they'd have a payday? None of them had the money. It's nothing better than getting wasted in a bar and betting your buddy the moon against Heidi Klum that you can drop a quarter off your nose into that shot glass. Oh, snap! You owe me Heidi Klum, dude!

But let's assume that banks or massive institutions hold up one side of these billion dollar swaps, derivatives and bets. Are they idiots? What ever happened to the notion of counterparty risk? If they made a bet with some tiny hedge fund, who can sympathize when the hedge fund can't pay up? It's like Warren Buffet betting Joe SixPack a billion dollars that the S&P500 loses 20% next year. Buffet can pay; J6P cannot... but Buffet should sure as hell know better.

Make them all null and void. The hedgies and banksters can wail and gnash their teeth, but at the end of the day this is nothing more than a ridiculous experiment in unmitigated stupidity.

The thought that the U.S. Treasury actually wanted to buy some of this outrageous junk continues to rankle me to this very moment.

* Actually, I don't have $45T. If I did, I might consider buying Iceland. Not a solicitation for Internet sports gaming or hostile takeovers of Nordic states. Possibly a solicitation for the Buckeyes to lose badly.

[randolfe_]

Let's get this straight:

* All we have to do is turn the outcome of the Buckeyes beating the pussycats into a valid, business-related event.

* That event could be self-defining. We'll say that you and I have each bet $45T on the game results, and that I have other open interest with you as the counterparty. Let's say that I own 15% of your company, and you are essential to your company's financial success.

* Since you're going to lose $45T, I now have need to go out and take out [the delta hedge value] of $45T in default swaps on your company's failure.

* But the risk-component of the delta hedge is up to me, so perhaps I'm going to bake up a value more like $150T.

Now all I've got to do is sit back and watch Penn State lose. And if I'm wrong, well, go whine to Paulson. I ain' payin'. Dine-n-dash baby.

[Peter P]

Annuit cœptis

God will help us through this crisis. Hopefully.

[Brand]

Sadly, you have based your assumption of Buckeye victory on Moody's AAA rating. Their model incorrectly evaluated Purdue and Wisconsin as strong teams. Since Ohio State beat them by narrow margins, the models thought this was okay, but in fact these were subprime teams and the real risk of default is much higher.

Fortunately I have entered into a default swap with an overoptimistic Michigan State fund (seriously, have they played anyone credible besides OHST?). Joe Pa can't possibly lose to both. I am also looking to arrange a contract escape clause in case PSU goes to the National Championship instead of the Rose Bowl, anchored by the rising value of Penn State itself. I'm leveraged in at 100:1, but my model predicts only upside here.

If somehow this house of cards comes fluttering down, my plan is to lament an average secondary and then drink a Yuengling.

[randolfe]

Well, I have thoroughly backtested the OSU-PSU time series by exposing it to a barrage of technical analyses which I have then fed as inputs into my artificial neural network. At first I was concerned because the n-1 sample predictor was not showing a distinctive bias towards the Buckeyes. But then I retrained the ANN with a genetic algorithm to optimize the inputs, which I allowed to execute over the weekend.

The results show that I am certain to collect my side of the bet, so I've proceeded to purchase 100:1 swaps, as you have, though my purchase of those levered swaps was done with 40:1 margin from my prime broker.

So, if Joe Pa pulls off the black swan against the ghost of Woody, you can just call me Nick Leeson.

[Brand]

Was your neural network proprietary or open source? :o

[Brand]

Actually, if we're going to dismiss these contracts as illegal gambling, could we just deal with it mobster-style?

"Me n' Guido is from Lehman Bruddahs. We believe youse owes us some debts?" (cracks knuckles)

[astrid]

This would be hilarious if it wasn't so scary. The derivatives market is exactly like a casino where everyone thinks they cracked the "code". The whole sector should be outlawed.

[randolfe]

Astrid,

That's taking it too far. Much of the derivatives industry is fine. Take simple equity stock options. There is nothing mysterious there. They are traded in a transparent, liquid market, the rules are known and enforced, the values are discoverable, the accounting is standardized, and the notional values are not readily manipulable.

The truth is that lots of derivatives serve a very important, valid purpose. Hedging being the most common:

* Investors often will buy stock-option puts as insurance against stocks they hold long.

* Companies often will buy forward currency contracts, currency futures or currency options to hedge against currency fluctuations, thereby removing that risk from their operations.

* Airlines will buy future contracts on jet fuel to hedge against price risk. Not that long ago everyone was chastising American, Delta and United for _not_ hedging their fuel purchases while Southwest did. None of that would have been possible without a derivatives market.

I think what you might mean is the over-the-counter derivatives market is problematic. But even that shouldn't be outlawed, in my mind. You cannot broadly outlaw the right of two parties to draw up a private contract. What is a "derivative"? Clever lawyers could probably argue that lots of sales-channel agreements are derivatives of some sort if you try to outlaw the entire notion.

[Brand]

So how did Glass-Steagall regulate these derivatives markets, prior to its repeal?

Typical vs. exotic is difficult to define by legislation. It seems more useful to cap the size of the derivatives, or require that they be precisely balanced, etc. For example, the total sum of derivatives against an MBS tranche could not exceed the absolute value of the loan pool x N. Or we could put laws in place that a derivative used for hedging can only be owned by whoever controls the underlying security--i.e. if you have taken insurance against the asset, then you must own the asset itself.

Alternately, we could also just regulate how many derivatives the banks are allowed to issue, and who they can use as a counterparty, and improve the rules on counterparty verification.

[randolfe]

I don't know RE: Glass-Steagall. If I get time I'll look into it more.

The problem limiting hedging to actual asset owners is that it's actually tough to define "own". Doesn't having a legitimate financial interest pass as sufficient?

I can see an issue with corporate hedging. Take fuel price hedging. If an airline hedges against future price movements they are also using some sort of forecasting technique to estimate future demand. That forecast will be inaccurate. So should the airline also be allowed to hedge future demand with options on indices? Add currency translation risk into the mix and it gets very complicated very quickly.

[alia]

that solution sounds lovely and simple. probably means it isn't. ;) ...but it does sound nice.

[astrid]

I know that there are some legitimate business reasons to use derivatives, mostly having to do with energy prices, climate, and currency fluctuation.

Perhaps in those situations, derivatives could be used if it is at least as tightly regulated as insurance. But I think it has to be very restrictive - maybe for airlines, under SEC supervision, to issue very specific options to address short-run fuel price fluctuations. Any further than that, and you have the recipe for another financial instrument of mass destruction.

I don't think anyone should be allowed to hedge stock prices. The best way to avoid the inherent risks of holding stocks is to diversify. People who are forced to hold shares and are sophisticated enough to hedge are high-level officers and/or major stakeholders, those folks should rise and fall with the company.

[randolfe]

First off, there are a lot of misconceptions about how "high-level officers" within public companies trade their own stock. This is important, because the sort of thing you said above gets repeated over and over and is no better than exactly the sort of distortions and lies you complain about the right wing wackos parroting all day and night.

Disclosed insiders, which includes all "high-level officers", and also includes many people in accounting, finance, sales, and on merger teams within a company are prohibited from trading their stock at all except during a couple of open days (usually once per quarter) during the year.

Practically every public company has a strict policy against ever trading anything short against their own stock, including using any form of derivatives to synthesize a short position. For individuals disclosed above, which includes all "high-level officers", this is strictly enforced (because it must be disclosed to the SEC).

When these corporate types I hear complained about all the time do sell, it is usually stock options or preferred shares, not common stock.

When "high-level officers" do sell, they are doing so according to an arm's-length safe harbor plan, which they have assigned to a custodian to execute for them. They are *required* to do this by the SEC. When you read some bullshit about "Mr. Fatmoneybags CEO sold X stock, so he knows something" it is almost always utter crap. The SEC closely investigates all deviations from 10b5-1 plans.

More than anyone else, "high-level officers" do rise and fall with their company. In my opinion, they should be allowed to hedge their positions the same as anyone else, so long as it doesn't violate 10b5 insider rules.

Sorry to come down so hard, but I irks me when anyone repeats inaccuracies, distortions and lies, regardless of their ideological bent. I'm not saying you are, but this is the sort of crap I hear from the anti-corporatist left which is just as bad as the radical right running around demonizing college professors as anti-American.

[astrid]

It's alright. I just happen to disagree and it's not about gaming the market, but bonding high level officers to the fate of their companies. I think that's what both side had negotiated for during the salary compensation discussion - they could have negotiated all cash, but they didn't. Compensation packages at that level are never just about paying for time served, the performance aspect always comes in and officers should not be allowed to hedge against risks that are intentionally built into their contact.

As for my disapproval of the derivatives market. I think the chance of abuse is just too high...derivatives are comparable to insurance and there are laws against taking out insurance on the life of unrelated persons, etc.

[randolfe]

I'm not sure I understand the distinction on corporate compensation. Of course there are a small handful of egregious abuses. And there is also a terrible income disparity. I agree with those points. But, where exactly does the average corporate senior management or executive get away with these hedges as you put it?

Let me give you a personal example. My wife is one of these terrible, horrible corporate executives. She reports to the CFO in her role as a VP of Finance. When CFOs change she runs an extreme risk of losing her job due to factors entirely unrelated to either her performance or the company's. So why should she be beholden to a whim of a new CFO who'd come in and just replace everyone with his/her own team out of the gate? Instead, the company makes a commitment to her for all the 70+ hour weeks she's burned making the company exceptionally profitable for its shareholders by giving her an assurance in her compensation package that pays her if a new CFO terminates her without cause.

Why is that bad? Seems there's a terrible double standard from the radical left when it comes to corporate management: they wish to have labor protected like a German union worker, yet they want management to be hauled out with the trash.

It's nothing but the same kind of disgusting populism I hear from the right with all their elitist-bashing. If the left can't be honest that management is important and serves an important role in the structure of a firm then they're no better than the Palin supporting troglodytes.

[randolfe]

On derivatives: they are not all that much like insurance in most cases. They have very different probabilistic and statistical properties. Insurance operates on actuarial analyses which rely on intense, standard statistical methods. In other words, the shape of the curve is known in nearly all insurance matters.

Derivatives are stochastic in nature, and are modeled by a "random walk". That's why they aren't just insurance products. You can't insure uncertainty, only risk.

Risk is not the same as uncertainty. Risk is the chance that the known occurs at a well understood rate. Uncertainty is the chance that the unknown hits you out of your blind spot.

[Brand]

Randy, while derivatives might not behave exactly like insurance, many such products are intended to hedge specific risks. Legitimate uses include smoothing the volatility of certain commodities for large industries like airlines, refineries, chemical manufacturers and construction firms. I personally believe there needs to be further regulation so that large-scale derivatives traders should be required to have some interest in the primary product. Otherwise you aren't hedging, you're just gambling. On the small scale the casino attitude might work, but when people start placing bets approaching or exceeding the value of the casino itself, certain rules need to take effect.

Re: executives

I tend to find executive pay appalling in proportion to their contribution, especially with respect to the extended executive team. I have less of a problem with golden parachutes for specific instances (like dismissal without cause), because those risks are inherent to a certain level of management, and it can take a very long time to find another similar position.

I am completely against German-style protections for American white collar workers. I've seen it firsthand, and it is in direct conflict with a merit-based system of advancement.

[randolfe]

Brand, I think we agree. I should also clarify that I am for more regulation where appropriate, such as with the over-the-counter derivatives market. The OTC derivatives are fine, they just need to be transparent and traded in an open market like the CME.

My point above was more about the mathematical and statistical properties of derivatives used in hedging versus insurance products.

Think of it like this: you couldn't profitably run an insurance company that sold "fuel price insurance" to an airline without the existence of derivatives. That's because you can't create an actuarial-based insurance product for future fuel price moves. Insurance is not a forward-looking futures instrument. It is a backwards-looking risk adjustment product. For things where market values move by a stochastic process something other than an insurance product is necessary.

[GK]

"I tend to find executive pay appalling in proportion to their contribution, especially with respect to the extended executive team. "

Compensation that corporations pay are a function of supply and demand, at market rates.

No corporation would pay a Senior VP $500K if they could get away with $200K.

Capping corporate salaries will result in corporations run by the same incompetent buffoons in congress.

I strongly oppose any talk of executive salaries being too high.