Thursday, March 27, 2008

The Tears of Reality

Examine a horse race with 10 horses and the winning horse getting $20,000 in prize money. Anyone can place a bet on one of the horses; all it takes is $2. Notice the disconnect here, the owner of the horse has a max gain of 20K. On the other hand the bettor has a gain on a win determined by the odds and the amount bet, he could bet thousands and win millions.

The owner of the horse that wins could be compared to the actually owner of a stock, the bettor represents an options position. The real game in play is not the stock, but rather the side bets. I could be shot again for this analogy, it isn't the greatest, but it gives you an insight to what follows.

A company sells stock to start up a business to build widgets. This would be labeled a business investment and would create jobs. Anyone buying options relating to the performance of the stock, is not creating product or any new jobs, this is speculative investing.

Let’s now jump to the commodity’s Market. The standard S&P 500 contract is 250 times the size of the current price of the index. If the S&S&P 500 is currently priced at 1,500 points, the value of this contract would be 1,500 * 250 = $375,000. The margin requirement for this contract would be $22,500 and maintenance margin would be $18,000. So if you wanted to participate in the SP 500 it would only cost you 22.5k to control 375K in the futures market. You are not buying even one share of stock; you just bought a future on the whole S&P 500. Plus you haven't created one widget or even one new job!

If the stock market took a 2,000 point drop in one day, it could literally vaporize the abstract markets (Futures like the S&P 500 and Index Options). The thing people gloss over here is that fact that these derivatives are abstract options linked to an “event generating item” (i.e. a stock like IBM). You are not in possession of an asset; you are in possession of an insurance contract at best. Some estimates suggest there are 52 trillion dollars worth of derivatives out there involving stocks, bonds, commodities, home loans, currencies etc.

Investing in these "derivatives" is kind of like swimming in a crocodile infested lake; you are going to get eaten alive. "Let's do Lunch," kind of sucks if you're on the menu!

If 52 trillion dollars turned into tears, it could give a new meaning to "Cry me a River." It would certainly add some reality to this "hypotheticated financial morass" that appears to be some fairy tale run amok. Maybe "Ben Bernanke" is the sequel to "Don Quixote."

9 comments:

Lisa said...

The things they leave out in econ 101...

SACKERSON said...

And I suppose that the ruined gamblers would then have to sell any real assets they owned, including stocks, so it's not just the funny money that would get burned up?

Is there such a thing as hyperDEflation?

drb said...

Can I ask a dumb question?

Just how do the options people go after the ruined gamblers? Have the gamblers signed a contract that is bankruptcy-proof? Can they seize bank accounts, or go for a civil judgement?

Or do the ruined gamblers just get to upset the game board and say "I didn't win, so I don't like this game anymore"?

I'm not a high-flyer, so my question is sincere-- I imagine other normal folks might wonder the same thing.

Anonymous said...

First off, equity options are traded on an exchange so there is no question as to what the actual value of such options are. Secondly, the value of these options are virtually "insured" by option writer hedging, cash on hand, or both. Worrying about market effects on equity options is a waste of time. The so-called "ruined gamblers" are small traders that made unrealistic bets without any understanding of the risk. I speak from experience.

What you want to worry about is OTC derivatives. This article doesn't add anything new or insightful on that topic, and as it has been covered extensively elsewhere, I don't look for that to change.

That being said, the "hyperdeflation" concept is something to think about. Since interest rate cuts can't stop a genuine deflationary debt collapse, they may well speed it up. Particularly when interest rates cuts cease and interest rates must be raised. It won't be long.

Jim in San Marcos said...

Hi Anon 8:29

I agree the stock market is pretty well supervised. I was using that as an example for the rest of the derivatives markets which are not managed.

Some of the banks that own derivative insurance on home loan defaults are finding out that it doesn't cover fraud. In essence the bank is not going to get paid anytime soon. The devil is in the details.

Everyone is counting on an orderly market and that could be a false assumption. Real estate always goes up--there is one market out of whack already.

The thing to realize is the money that has been lost is ours, not some bank in Africa. The derivatives market is collapsing.

I don't really see where hyper deflation would enter the picture, there are too many Democrats in Congress;>). More probably, everyone with any savings is going to see one or two zeros knocked off of their net worth.

I share your view that interest rates will eventually rise. The Feds massive infusion of cash into the banking system means that people are cashing out. We are beginning to see that now with home loan rates rising.

Thank you for your comments

Anonymous said...

VERY GOOD ARTICLE...

How To Fix It
By Michael E. Lewitt


One way of measuring how perilously close the U.S. financial system came to melting down in mid-March 2008 is to look at how low the rate on one-month Treasury bills fell at the depths of the crisis. That number is 12 basis points. 0.12%. The three-month Treasury bill rate, which our friend Jim Bianco of the highly respected Bianco Research points out is the "risk-free" rate for many models such as the capital asset pricing model, the arbitrage risk pricing model and the Black-Scholes pricing model, fell to a 50-year low of 56 basis points on Tuesday, March 25. 0.56%. As Mr. Bianco pointed out, these bills were yielding less than Japanese 3-month financial bills for the first time since July 14, 1993.

Since last summer, the Fed has cut interest rates by 300 basis points. The result? Mortgage rates have barely budged, but they are finally starting to move lower. Unfortunately, this comes too late for many homeowners who are losing their homes.

On December 12, 2007, the Federal Reserve created the Term Auction Facility (TAF) whereby the Fed will auction term funds to depository institutions against a wide variety of collateral that can be used to secure loans at the discount window. On March 7, 2008, the Federal Reserve increased the size of the TAF to $100 billion and initiated a series of term repurchase transactions that were expected to cumulate to $100 billion. As with the TAF auction sizes, the Fed said it would increase the size of these term repo operations if necessary. No doubt these facilities will need to be increased.

On March 11, 2008, the Federal Reserve created a $200 billion Term Securities Lending Facility (TSLF) whereby primary dealers could borrow Treasury securities for a period of up to 28 days using as collateral federal agency debt, federal agency residential mortgage backed securities (MBS) and non-agency AAA/Aaa-rated private-label residential MBS.

On March 17, 2008, the Federal Reserve opened up the discount window to the investment banks, which are not subject to the same regulatory limitations as the commercial banks that have traditionally had access to the window.

The Federal Reserve made a $29 billion line of credit available to JP Morgan Chase in connection with its takeover of Bear Stearns.

The Office of Federal Housing Enterprise Oversight (OFHEO) announced on March 19 that it would reduce excess capital requirements for Fannie Mae and Freddie Mac by one-third, from 30 percent to 20 percent. This is calculated to permit these two entities to add another $200 billion of mortgages to their existing $1.4 trillion portfolios (on an equity base of less than $70 billion). The two agencies shortly thereafter announced that they were authorized to raise an additional $5-10 billion of equity capital each, which would still leave them grossly leveraged by HCM's count.

The Federal Housing Finance Board announced that it would increase the limit on Federal Home Loan Banks' MBS (mortgage backed securities) investment authority from 300 percent of capital to 600 percent of capital for two years. This is estimated to enable these institutions to purchase another $200 billion of this paper.
While these moves were probably necessary to save the system from complete collapse, it is abundantly clear that these drastic steps are going to have enormous negative long-term effects on the U.S. economy. Among those effects will be higher future inflation and an extension of the high levels of leverage in the system that pushed the economy to the precipice this time. Does anybody really think it's a good idea to have Federal Home Loan Banks buy more MBS paper? Or for Fannie and Freddie to leverage their balance sheets further? All of these actions are going to have to be unwound at some point, which means that the day of reckoning is simply being delayed.8 It is clear that the authorities are engaged in a desperate attempt at economic triage that bodes poorly for the future economic health and stability of the United States. Looked at in this context, it is difficult to argue against those who believe in long-term U.S. dollar weakness. If you want to look at the end of American economic hegemony, just look at the list of desperate actions taken by U.S. financial authorities above. It is a sad commentary on how the greed and short-sighted actions and policies of U.S. politicians and businessmen have inflicted permanent damage on our economy.

There is a way out, but it will not be easy. The way out is to accompany the drastic steps taken by the Federal Reserve and Treasury with a comprehensive regulatory revolution that addresses the flaws embedded in the system. HCM does not use the word "revolution" loosely, but nothing less than a drastic rethinking of our current system accompanies by action to change it is going to be required if we are to strengthen the global economic system for the challenges to come.

Michael E. Lewitt

Jim in San Marcos said...

The Article that refers to the Author Michael E. Lewitt above, was a very long post. I edited it to shorten it.

It's not nice to post 20 pages. Keep it to one page and people will read what you say.

Strategic Investor said...

DRB -

For what it's worth the futures markets are also highly regulated.

If you purchase a futures contract (or sell one) your counterparty is the exchange, not another person. The exchange guarantees the contract, so that if you are a big winner, you will get your money.

How can the exchange do this? By ensuring that it has someone on both sides of the transaction (there are an equal number of longs and shorts) and by using the margin account and marking to market every day.

At the end of the day, the contract has made money for one of the parties and lost money for another. The exchange takes money out of the margin account of the losing party and adds to to the account of the winning party. If the losses sustained by one party become so large that they eat deeply into the margin account (the amount in the account falls below the "maintenance margin"), then the exchange will demand more margin be put up, or it will liquidate the contract, using the extra money in the maintenance margin account to absorb any losses.

Closing out the contract involves getting a "long" to close out their account - basically buying a long out of his contract - to ensure that longs and shorts remain in balance.

While there is a very remote possibility during periods of extreme stress that the exchange itself could default, this is generally considered unlikely.

Far more problemmatic, as noted by anon 8:29 are the OTC contracts, such as forwards and other derivatives that are just agreements between two firms. Here the counterparty risk is much higher. Catastrophic failure of counterparties is what the Fed is trying to avoid.

Jim in San Marcos said...

Hi Strategic Investor

I agree with you completely, but maybe I need to be a little clearer with what I am referring to. The futures market that I used as an example allows 6 percent margin with 4 percent maintenance. Figure 10 percent in total, notice if you wanted to buy the SP stocks in the open market margin is set at 50 percent.

Figure your mutual fund decides to track the SP 500 with futures. With one million dollars they could track 10 million in futures. One serious pop the wrong way and the whole investment is gone.

It is the 10 to 1 leverage or maybe the 50 to 1 leverage that could become a problem. Agreed it is a zero sum game. Somebody is losing money, any ideas on who?

Other things can happen in a down market called "air pockets." Nobody is bidding on the item. It's not uncommon to have a $40 air pocket. Say Google is at 650 and you have a sell at 640. If it hits a 50 dollar air pocket, you still own it at 600; it never hit 640 to initiate your order.

The assumption that the markets will be orderly is a nice thought. In a panic they won't be.
Computer programs that many of the investment firms use may all try to do the same thing at the same time. Other communication systems could clog up from lack of band-with. Bank failures could hinder the transfer of funds. There is always someone who hits the wrong buttons and sells when he meant to buy.

Plus if you remember when the Hunt brothers cornered the Silver market the CBOT changed the rules so their members wouldn't face bankruptcy. I avoid the SOB-CBOT for that reason.

If the DJIA goes from 12,400, to 2,000 someone owns every share all the way down.

The 52 trillion dollars worth of derivatives have no real quality as assets. They are side bets on a real market.

Once you realize that all of the markets are intertwined, it is like a stretched out rubber-band coming back to its original state. The snap is going to hurt.

Thanks for your comments, and consider this as just an opinion, nothing set in stone.