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Friday, April 22, 2011

A Modest (Financial) Proposal

I heard on the news that President Obama has instructed the Justice Department to conduct an investigation into the oil commodities market to determine whether the recent run-up in oil prices is the result (or partly the result) of market manipulation and/or speculating. I don't really have an opinion about this one way or the other -- at least for right now, I don't have sufficient information to form an opinion -- but it did remind me of something I've been thinking about for a while now.

Might there not be a recognizable benefit to eliminating (declaring illegal) all "naked derivatives trading?"

A large part of why the financial crisis became so bad, so big, was "naked" trading in Credit Derivative Swaps. Now, a "CDS" may sound complicated, but it essentially is just a type of insurance.

For example, suppose you own a bond (or a "market-backed security") or any other type of financial instrument that guaranteed a future payment in, say, 5 years and that had a face value of $100 million. Just as with regular Americans and their homes, this would be a pretty significant asset to have in your portfolio, and so you might want to take out insurance on it -- just the way regular middle-class Americans do on their homes. So, you could go to AIG, just for example, and purchase a CDS. And in exchange for a annual premium payment of, say, $2 million, AIG would insure that if the bond subsequently proved to be worthless AIG would pay you the full face value of the bond.

Five years of $2 million premium payments would knock your net payout on the bond from $100 million to $90 million, but you would have the security of having eliminated the risk that you might lose the entire $100 million. Not bad.

But "naked" derivative trading allowed Walls Street firms who did not own underlying bonds/mortgage-backed securities to purchase insurance on those same bonds anyway. AIG, which apparently believed the ratings agencies' AAA status on these things, figured the bonds could never fail and so thought the premium payments it was racking up constituted "free money." (It apparently never occurred to AIG -- or, more accurately, to AIG's subsidiary, AIG Financial Products, which was really issuing the insurance policies -- to wonder why all of these Wall Street banks, supposedly the brightest of the brightest, were willing to give it all of this "free money.") Accordingly, AIG issued insurance policy on insurance policy covering the same financial assets, happily taking home millions and millions each year in premium payments.

But think about what this means. Suppose AIG issued 20 different policies on the same $100 million bond. Now, instead of being on the hook for a potential $100 million loss if the bond defaulted, AIG would be on the hook for $2 BILLION. This is a substantial increase in liability, all of which turns on whether one single event occurs -- the same bond turns out to be worthless. No matter how unlikely you may think a future event is, the more money you gamble against that event occurring the more disastrous it will be for you if that event does, in fact, come to pass. This is exactly what happened when the music abruptly stopped in the game of financial musical chairs the big investment firms were playing a few years ago.

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But really, what social purpose did it serve to allow investment banks to purchase insurance policies on financial instruments that they were not themselves invested in? How is this not just sheer gambling?  Place a $2 million bet - once a year - with the chance of winning $100 million. If the banks actually owned the bond in question, then purchasing insurance on the bond makes sense, because they would just be limiting their risk.  But if you don't own the bond, then you are just making a gamble.

Generally speaking, I am not allowed to purchase fire insurance on my neighbor's home. For one thing, there is no social value to my doing so. For another, it does tend to give me a motive to engage in a little bit of arson.

And doesn't it seem to you that something similar may have happened with the financial markets? After all Bank of America was one of the banks most heavily invested in CDS's, which insured mortgage-backed securities that consisted of a whole lot of subprime mortgages all bundled together. Is it a coincidence that Bank of America had a substantial interest in Countrywide Mortgage, the single greatest issuer of subprime mortgages in America?

Similarly, we know that Goldman Sachs got together with one of its richest individual investors and created a mortgage-backed security that consisted of only the worst of the worst mortgages they could cherry-pick. These mortgages were expected to fail. And then the investor and Goldman Sachs sold the security they had created to other investors, purchased CDS's on that security, waited for it to fail, and then demanded full payment on their insurance policies.

In fact, the more you look at things like this, the less it looks like gambling. A closer analogy would be paying an electrician to install wiring in your new home, trusting he has done a competent job because you certainly are not competent to judge the wiring job yourself, and then -- when your house burns down due to substandard wiring -- watching as the electrician cashes in on the insurance policy he took out on your home.

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CDS's (or, as I prefer to think of them, bond insurance policies) are considered "derivative instruments" because their value derives from the value of some underlying security.  In the example above, if the $100 million bond you are insuring turns out to be A-OK, then the value of your insurance policy is zero; you will never be able to cash in on the insurance policy because the policy only pays off if the bond defaults.  On the other hand, if the bond turns out to be worthless, then the CDS has a value of $100 million.  The bottom line is that the value of the CDS depends entirely on the value of the underlying bond; if the bond's value goes down, the CDS's value goes up, and vice versa.  This is how you diversify risk away.

And, obviously, derivative instruments like CDS's do have a valid place in modern finance, in that they allow investors to reduce risk in exchange for slightly reducing their exposure when they invest.

For example, suppose you purchase Google stock at $100 a share because you expect the stock price to go up.  Even if you think this is pretty much a sure thing, you could always turn out to be wrong about Google; maybe a new antitrust suit is suddenly announced by the federal government (fat chance; we don't enforce antitrust laws anymore, but let's indulge ourselves) and Google plummets to $80 a share.   Now, suppose you bought 10,000 shares -- a $20 loss on 10,000 shares means that you've just lost $200,000.

So, to protect yourself from something unexpected like this happening, when you purchase your shares and take a long position in Google, you can also purchase a "Put Contract," which guarantees that you have the right to sell those shares for -- say -- $95 a share at any time within the next 6 months. 

A put contract is also a derivative security because the value of your right to sell stock at $95 depends on what price the stock is going for at any given time.  If the stock is trading above $95, then you just sell on the open market and you don't exercise your put option -- the value of the option is zero.  On the other hand, if the stock falls below $95 -- say, the stock crashes to $80 -- then the value of the put contract is $15, because now you can sell an asset (your stock) that is only worth $80 for $95.

In the hypothetical above, if each put contract costs $1 then purchasing this kind of "risk insurance" means you've just incurred an additional $10,000 in costs. (This sounds like a lot, but remember you purchased 10,000 shares at $100, which means your initial investment is $1 million. An additional $10,000 to reduce your risk only increased your original investment by 1%).

However, you also have limited your potential loss on this investment to no more than $60,000 (the $10,000 you purchased the put contracts for, and the $50,000 you lose when you sell 10,000 shares at a $5 loss on each.) On a $1 million investment, you've limited your total loss to no more than 6% of your investment; on the other hand, if Google plummeted to $80 based on a justice department announcement and you didn't have any put options, you would have lost $200,000 - a 20% loss on your investment investment. Purchasing derivatives in this way -- to hedge against risk -- does make a lot of sense.

* * *

And the same thing applies to commodity prices. The reason we have a market to buy and sell futures contracts on commodities -- like oil, beef, corn, wheat, soy, etc. -- is because the companies that are in the business of ultimately buying and selling these commodities want to manage their risk.

If you are in the business of selling oil, or grain, or cotton, etc., and are worried that six months from now when you have to sell your product the price on that commodity has fallen through the floor, then you might want to have a contract that guarantees your right to sell the commodity for a fixed price.  So, say, Agribusiness companies might want to -- at the beginning of the farming season -- lock in prices for corn six months from now, at least for part of the crop, because that way they know they are not exposed to too much risk of the price of corn falls through the floor when it is time to harvest the corn.  At least they won't have to sell all of their corn at a really low price.

On the other hand, if you are a large supplier of flour for bread-making companies, bakeries, etc., you might not want to expose yourself to the full risk that, when you need to purchase a large amount of wheat six months from now the price has gone through the roof. So to manage your risk, you buy a contract that allows you to purchase a certain amount of wheat at a guaranteed price.  That way you know that if the price of wheat shoots up, you won't have to lose your shirt to purchase the wheat to make the flour you have contracted to supply.

In each of these examples, however, the real value of the derivatives instrument/futures contracts to society arises out of the fact that the person/investor/entity purchasing these contracts has already taken a position on the underlying value of the good in question and is merely trying to manage his/her/its risk.  The ability to limit risk so that entire industries don't get bushwhacked is good for everyone as a whole.

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But I don't see any real value to allowing investment entities to simply gamble on derivative instruments. If Goldman Sachs does not own a particular bond, why allow it to gamble a few million buying insurance in the hopes of making hundreds of millions more if that bond fails? More significantly, why allow companies like AIG to issue many multiples of insurance policies, exposing not only itself but the financial industry as a whole to overly-leveraged catastrophe if AIG turns out to be wrong about the underlying bond being worth something? For what reason do we allow this practice to continue?

Which brings me back to commodities trading. These markets were originally created so that the buyers and sellers of commodities -- generally agricultural commodities, the supply of which can never be known with perfect accuracy months in advance -- to manage their risk.

But what purpose is served by allowing large investment banks to speculate in these markets? The banks aren't in the business of providing or buying wheat, oil, beef, etc. The banks are simply gambling that the price is going to go up (in which case they purchase contracts to buy at a locked in price) or that the price is going to go down (in which case they purchase contracts to sell at a locked in price).

And, in the modern age, when investment banks and hedge funds control hundreds and hundreds of billions of dollars, they now have the ability to substantially affect prices even though they have no actual interest in the commodity being traded.

For example, if Wall Street decides oil prices are going to go up because, for example, Libya is locked in a Civil War or al Queda might want to stir up some trouble in retaliation for bin Laden's death, then Wall Street firms can spend hundreds of billions of dollars buying up oil futures.  This increased demand means that the price of oil futures contracts goes through the roof.  And these are the "oil prices" that refineries and gas companies look to when they set the price of gasoline.

So, I ask the question again:  if investment banks and hedge funds buy up all the futures contracts out of sheer speculation (i.e., "gambling") and affect the price of commodities that people still need to buy, what purpose does this serve except for granting these firms the potential ability to move markets for their own benefit, and to the detriment of the rest of society? Why don't we simply outlaw people and firms who merely want to gamble in the commodities markets from doing so?

This is a serious inquiry. If any of the 5 people (maybe) who read this thing have an answer, I'd really like to hear it.

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