Posts Tagged ‘derivatives’
This is a complex article at ProPublica that in simple terms illuminates all that was wrong with CDO’s and synthetic CDO’s. These instruments allowed investment bankers like Magnetar to circumvent insider trading rules. The story of Goldman Sachs being charged by the SEC for fraud is only the beginning. Financial reform is the last thing many financiers and bankers will have to worry about as this story takes hold.
Magnetar involved all the big names and most are listed here. You will see many recognisable names, eg. Citi, Wachovia, Deutsche, Lehmans, UBS, Mizuho, JP Morgan. At this point it appears to be only guilt by association, however there is nothing good or right in this tale. Propublica quote this participant. “The deal was a disaster. He shook his head at being reminded of the details and said: “After looking at this, I deserved to lose my job.”
Magnetar’s approach had the opposite effect — by helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.
Magentar founder Alec Litowitz speaks at a private equity conference held at Kellogg School of Management at Northwestern University in February 2007. (Nathan Mandell)
What Magnetar were able to do was fund the housing bubble and bet against it bursting all at the same time. They were able to do this using CDO’s and building them all the while knowing the bubble would burst. The beauty of what they did was to create cash flow to fund their short selling of their own CDO.
Magnetar’s (Nearly) Perpetual Money Machine
By buying the risky bottom slices of CDOs, Magnetar didn’t just help create more CDOs it could bet against. Since it owned a small slice of the CDO, Magnetar also received regular payments as its investments threw off income.
This piece on internet and evolution of financial services has the best quote I have seen for some time.
“these companies have merely built nice UI’s to Wall Street”
How To Disrupt Wall Street | The Business Insider
As I see it, these companies have merely built nice UI’s to Wall Street: Mint connects to your banks and Square to Visa and Mastercard and the bank that issued the credit card. If people at farmers’ markets use credit cards instead of cash, that means more money for Wall Street, not less.
Brilliant. I take no issue with the likes of Mint, and Square which are nice new innovations. which may well result in big changes later. However they are hardly game changing today. Game changing would mean that in 20 years time we might see future headlines such as:
- Headlines – 2030
- bank branches are no longer ….
- banks have largely been replaced by ….
- customers obtain financial services today from ….
- Hedge funds have replaced …..
- A new type of investment fund has …..
In order for such headlines to appear new sets of new companies will be needed, but more importantly companies that are based on dramatic shifts and simplicity in how money moves around. Money moves today amongst people and banks in a certain way today. This is the plumbing of banking. Payments networks, clearing systems and ATM networks are how money moves around. Mint for example does nothing to change that. In fact arguably Mint makes banks stronger by providing new reasons to stay with the current bank because the functionality Mint offers is based on access to existing plumbing.
The financial systems that comprise the plumbing and the operators who sit over the plumbing such as Banks, aggregators (eg Yodlee, Cashedge), Card companies (eg Visa, MasterCard), all serve to actually increase the complexity and also the probably, the cost of moving money around. More players means more competition, and it also means more aggregate costs in the system. For consumers they must beware new sets of fees which in total increase the overall costs of their financial services.
Let us not forget that one of the causes of the financial crisis of 2008 was the lack of transparency embedded in the financial products that served the securitization markets. Those markets remain, and the methodologies have yet to be re-invented. Government regulation will not fix that problem.
For me true innovation will only occur when plumbing changes. Despite the recession the world is awash in cash, seeking better returns, yet the ‘system’ generates very very low real returns on cash investments when compared to the interest rates which are paid by people on loans, credit cards and to a lessor extent mortgages. The interest rate differential between that paid, and that earned is being eaten up by more and more players. This has resulted in a shift to more and more fees because the interest spreads just don’t offer enough return to fund the ‘system’. This is a snowball effect that can never be good for people. Forget about bank bonuses. Those are asymptomatic of an inefficient system that is driven by driving people harder and paying them with large bonuses to make an inefficient system work by creating ways to hide the inefficiency – lipstick on a pig. Bonuses are just one element of cost in an inefficient system.
Thus true innovation can only occur when we see elements of plumbing removed, costs removed, and money able to move between people with less steps and costs thus eliminated. Included in the plumbing are banks and their systems, payment networks and their systems, card providers and their systems, and unfortunately this includes the new UI providers referred to in the article above.
When we see players changing plumbing such that existing systems are bypassed, and made no longer relevant to a transaction, we will have innovation. When that happens players will change and eventually be eliminated, and those headlines may begin to appear.
A new concern has arisen over the growth of ‘dark pools’ or private unregulated trading exchanges, where banks and large investors are trading derivatives off balance sheet. IT is significant enough to have come to the attention of this weeks G20.
The world’s stock and derivatives exchanges on Tuesday warned the Group of 20 leaders that the continued “proper functioning” of their markets could not be taken for granted because of a proliferation of alternative trading venues such as “dark pools”.
This is relevant because the near $ 1 trillion in worldwide derivatives remain a risk to some banks’ stability and survival. One company which failed because of derivative exposure was Lehman Brothers last September, and fear of another was part of that which brought us to the ‘too big to fail’ problem.
It is impossible to comprehend this amount of money. $531 UPDATE $684 trillion represents 3 or 4 times the combined value of the worlds equity markets, bond markets, and world GDP. It is a stunning number.
There is a possibility that we need to add in the combined value of homes and other assets in the world to come to terms with the number, but then we risk double counting assets which are already valued in equity markets. Need to think that through some more.
This can only be described as ponzi money – money that is levered and based on multiplying and levering other money. The underlying assets have been long forgotten. This remains the unsaid problem with banks, and I believe represents a large part of why banks are not trusting each other yet.
That $531 $684 trillion represents off balance sheet lending by banks. Each contract in those derivatives are guaranteed by a bank somewhere. If added to bank leverage, banks would be bankrupt.
More on this as I root around. Meantime here is the data from ISDA since 1987 to first half of 2008.
UPDATE: Information from Bank for International Settlements where they track a more complete view of Derivatives.
My next target is to try and highlight the derivatives market, and the status. The size of the derivative market and in particular the infamous Credit Default Swaps represent a gigantic ponzi scheme of artificial liabilities between banks around the world.
Quietly banks have been unwinding those contracts, which by the way they could only do if there is no substantive asset behind them. One dollar of debt can be translated into $3 + of derivatives as if by magic.
This from the Financial Times in January that I missed then. But read on – this is only the beginning (yes that is 30 trillion)
Banks’ efforts to clean up credit default swaps began with modernising and speeding up the processing and confirmation of trades, then moved last year into pruning the large volumes of older, outstanding trades. The $30,000bn excised from the market last year was three times the $10,000bn taken out in 2007.
The first half of last year saw the first decline in outstanding notional volumes, which shrank from $62,300bn to $54,600bn by June 30 2008, according to the International Swaps and Derivatives Association, the main lobby group for the industry.
We are so accustomed to trillions now, so lets place these amounts in perspective.
- The total market capitalization of all publicly traded companies in the world was US$51.2 trillion in January 2007 and rose as high as US$57.5 trillion in May 2008 before dropping below US$50 trillion in August 2008 and slightly above US$40 trillion in September 2008 (wikipedia)
- World GDP $55 trillion (wikipedia)
To place in perspective the derivative markets referenced here were valued more than the entire value of all the stock exchange values in the world or more than all the GDP in the world. The amount just unwound in this FT story is worth 60% of the entire World GDP. Such is the insanity of financial markets over the last 20 years.