Wednesday, 1 August 2007

Future, hedge or just a gamble

This is a really excellent article from The Dominion Post. Well worth the read:

They have been called the glue of the modern economy – and the financial equivalent of weapons of mass destruction. John McCrone ponders the $US500 trillion world of derivatives.

The world economy is worth US$50 trillion (NZ$65.3 trillion). The global derivatives market – the intricate network of bets taken on the world economy – now totals US$500 trillion.

Feeling nervous? Sound anything like a house of cards to you?

A derivative is a financial contract that speculates on something happening to a real-life asset. It is a future, an option, a hedge, a swap, an arbitrage, a securitisation – a gamble, to be blunt. Some say derivatives are the glue that binds the world economy. They explain the relatively smooth ride of recent years. Others say they are toxic, a timebomb, the financial equivalent of weapons of mass destruction. Either way, they have swollen to become the bulk of the financial markets. As in Las Vegas, the casino seems to have taken over the town.

And this must have implications for the ordinary investor.

Many will feel that they can afford to view the derivative markets with bemused detachment. They may have read about the recent subprime mortgage woes in the United States and its connection with exotic financial instruments called CDOs – collateralised debt obligations. Investment bank Bear Stearns is having to stump up US$3.2 billion to cover two of its CDO funds, whose value somehow evaporated overnight. When you hear of some of the crazy US mortgage lending practices, it seems less of a surprise. They have these ninja loans. No income, no job and no assets? No problem. Can't afford the repayments on one house? Well, we will lend you enough to buy five – an instant rental property empire. Your first two years of interest will be dirt cheap and when the real rate kicks in, you simply sell a few places. With rising house prices, everything will be covered. Sweet!

Plainly, some loose lending has been going on. Some of the institutions like Barclays and Merrill Lynch which have lost out big on the Bear Stearns CDOs should really have known better. But the subprime story seems remote. The equation changes, however, if this kind of financial sloppiness is now systemic; if the US$500 trillion stack of trades proves to be pretty much a mass of speculative froth. One man who should know is Sydney derivatives expert Satyajit Das, who has been working in the business since 1977. A former trader for Citicorp, Merrill Lynch, Commonwealth Bank and the TNT Group, Mr Das has written a couple of standard textbooks and now lifts the lid on the industry in his expose Traders, Guns & Money. Mr Das is feeling twitchy. "We have built an edifice that is extremely complex, extremely interlinked and extremely leveraged. Which means that ultimately a small shock could have absolutely unforeseen consequences. "Then it comes down to the question of whether there is enough wealth in the system, and enough political and regulatory will, to bail people out. At some stage – and I don't know whether it's in three months, three years or 30 years – there is going to have to be a day of reckoning."

Because of the size and global reach of the derivatives market, if it is one festering bubble of risk, then a market "correction" could be bigger than any other financial crash in history, Mr Das says. He is not the only commentator worried. Fabled US investor Warren Buffett labelled derivatives as weapons of mass destruction when it cost him US$400 million just to unwind a tangled legacy of deals in a company he had bought. Other derivatives pioneers, like Richard Bookstaber of the US hedge fund FrontPoint, have been muttering of the dangers of a market melt- down. And what the doomsters say is that ordinary investors cannot escape the fallout. Every pension fund, every high street bank and large corporation, will now have some exposure to the derivatives business. Mr Das says that for the first third of his career, the use of derivatives was relatively sane. Futures and options were employed to hedge risk.

Hedging strategies developed to smooth commodity prices like grain and tin then gradually spread to other areas of finance like exchange rates. Exporters would pay a premium to reduce their exposure to currency fluctuations. In the 1970s, things began to get really creative with interest-rate swaps. Mr Das says that as a large institutional investor, you might have the problem that you held a fixed-rate bond, but really you wanted a floating rate deal. The problem was your own company charter prevented you from doing this. A derivatives trader could arrange to swap the income from your bond for the floating rate that someone else was earning on some matching asset.

And the beauty of this virtual ownership was that it could be off the balance sheet. Who would know? Mr Das says the first time he was involved in an interest-rate swap, it was like winning the lottery. As the go-between, his bank picked up US$18 million in fees on a US$200 million deal. Everyone loved the ingenuity of this new financial engineering. It made almost anything seem possible.

If, for instance, Britain had an inconvenient rule that foreigners must pay tax on share dividends, investors would use derivatives to create a virtual holding. For a fee, a British bank would buy the shares for them. The investor would then buy an option to buy the shares at some future date – an option priced to include the tax saving. Every year people found more tricks they could play with derivatives. Mr Das says the traders behaved like bandits and if a deal did blow up on a client – which was not infrequent – then all concerned would find ways quietly to bury the problem. It was rarely in anyone's interest to wash dirty linen in public.

He says the real shift came in the late 1980s when it was realised derivatives could be used to speculate as well as hedge. Instead of playing safe by balancing both sides of a deal, a derivative would just take a naked bet on some future event. And because the only cost to get into the game was the derivative's premium – you did not need to actually own an asset, just buy the option – the bets could be hugely geared. For every dollar put up, $10 or even $100 could be in play. It is leverage that allows the total of deals now to have reached US$500 trillion. Mr Das says if all the bets could be unwound, then only perhaps US$5 trillion of real money would be found. The rest would be an elaborate web of IOUs. The move to gambling with derivatives was quite deliberate, he says. The world had become hungry for returns.

Traditional stocks and bonds just did not have enough juice. Pension funds and other institutional investors were being expected to earn 10 to 12 per cent year in, year out, and so derivatives became a way to manufacture investments with a greater element of risk. Derivatives shifted up another gear in the early 2000s when credit derivatives – the packaging of loan and debt obligations – became the "newest, bestest, thing" in high finance circles. Again the first credit deals were hedges. Banks used credit default swaps (CDSs) to insure against the risk of clients defaulting on loans.

But once the risk element of loans had been separated from the loans themselves, Mr Das says, the fun with speculation and leverage could begin. Eventually the CDO was spawned. A CDO is a bundle of loans usually split into three tranches – equity, mezzanine and senior notes. Equity investors are promised the highest rate of return but also have to cover the first few loan defaults. For a smaller return, mezzanine investors suffer any further defaults once the equity investors have been wiped out. Senior note holders stand third in line, well back from the fray, so a CDO is a way to turn a pot of middling-grade loans into an apparently AAA structure with a skim of high- paying B and C-grade junk bonds. Banks loved CDOs because they were a way of getting their loan risk off balance sheet, enabling them to take on yet more lending. Mr Das says the ability to juggle risk also encouraged slack lending practices like subprime mortgages.

With a booming global economy, even the diciest bets have been paying off. But because of the highly leveraged nature of many of the CDOs – some of which are, in fact, CDO2s, or CDOs which combine the mezzanine and equity tranches of many other CDOs – any tightening of the markets can bring a sudden unravelling.

As has just happened in the past few months with Bear Stearns.

Mr Das says the problem is that derivatives are always based on models and future forecasts. And the more remote from real- world assets the derivatives market becomes, the more chance there is for excessive optimism to colour the predictions.

The question is: will we continue to see isolated collapses or some day a general tumbling of the dominoes?

The list of those hit by derivatives trading down the years is impressive: Procter and Gamble, Orange County, Gibson Greeting Cards, Barings Bank, Metallgesellschaft, Chase Manhattan, Allied Irish Bank, Sumitomo, Parmalat, National Australia Bank, Barclays Capital and LTCM. Of course, the ability of the financial system to shrug off shocks like the US$6.6 billion lost in a month last year by natural gas hedge fund Amaranth Advisors is cited as evidence that the global web of derivative deals is indeed acting as a glue.

Deutsche Bank market chief Anshu Jain recently told Economist magazine that during the past few years: "The market has been characterised by calm, continuous, and even benign conditions. Derivatives are a big part of explaining that phenomenon." However, Mr Das says the real story was that worried institutions rallied around to take over Amaranth's bad trades, allowing them to be liquidated slowly and quietly. If Amaranth's positions had simply been allowed to flop, then many other connected deals would have been knocked down as well, sparking a real market rout.

Mr Das says there is a limit to how many of these billion-dollar blow-ups the market can swallow. And the worry is that no one really knows what percentage of derivative deals are secretly junk.

Meanwhile every year, the monster grows 15 per cent or 20 per cent larger. Feeling nervous?
Traders, Guns & Money is published by FT Prentice Hall.

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