Richard Buckminster “Bucky” Fuller was an American architect, systems theorist, author, designer and inventor (the only thing he did not do was become a rodeo clown); he developed numerous inventions, mainly architectural designs, including the well known geodesic dome. His observation, quoted above, indicating the effect of ‘leverage’ on a ship’s rudder is classic engineering theory and practice. This principle applies equally to financial systems where the application of ‘leverage’ has extended, in recent years, the ingenuity of ‘financial engineering’ beyond reasonable limits and into the financial stratosphere. In the financial world ‘leverage’ or ‘gearing’ is an euphemism for “borrowing money to invest in risky securities”; it is synonymous with that of a lever, with which most people will be familiar, allowing a lesser effort to apply greater force. A screwdriver is a good example of this type of leverage where the work effort applied at the hilt is magnified several times at the head in contact with the screw.
Financial engineering is a multi-disciplinary field involving financial theory and refers to someone educated in the full range of tools of modern finance especially the use of ‘leverage’ as a major part of their tool set and who are often mathematics graduates and PhDs involved in the financial world in general. These ‘engineers’, known sometimes as ‘Quants’ (how quaint!), are often associated with the invention of exotic new financial products and strategies which are used by bankers and financial institutions to improve their profits on investments although they do have other objectives which will become clear as this lesson unfolds. For those who would like to know more there is an excellent book, especially for those uninitiated into the weird world of financial engineering, which describes the work of these people titled: “The Quants” (The maths geniuses who brought down Wall Street); by Scott Patterson.
One way to illustrate ‘financial leverage’ is by using an example in the stock market. Instead of an investor buying so many shares of a company directly, a contract may be made with a broker to agree to buy the shares, at a date in the future, at an agreed price for a small percentage (premium) of the prevailing share price, usually around 5-10%. This is known as an ‘option’ and literally allows the investor to take a gamble on the share price appreciating over a period, say six months, during which time the investor has the option, but not the obligation, to exercise the purchase of the shares at the option price and thereby make a profit. Of course, if the shares stay the same or fall in price there is no profit, maybe even a loss, then the investor will allow the contract to expire without any further liability; the loss is restricted only to the original premium paid.
It can be seen that, in its simplest form, by investing, say, $100 in an option contract to buy $1,000 worth of shares which go up in value to $1,200 during the option period; a gross profit of $200 is made for the risk of losing only $100, or a one-off, 100% return; nice work if you know how!
All these financial instruments are known collectively as ‘derivatives’ because their value is derived from some underlying financial product such as a company share. They are the most prevalent of all financial instruments and globally are estimated to be valued at over USD 800 trillion, twelve times the estimated total GDP of the world! There are many and varied derivatives traded on exchanges around the world which, in London, is the ‘London International Financial Futures and Options Exchange’ (LIFFE). LIFFE was taken over by the NYSE in 2002 and effectively leaves this exchange under the influence of the American model. Five of the biggest U.S. banks — JP Morgan, Goldman Sachs, Bank of America, Citigroup and Morgan Stanley — account for more than 90% of derivative contracts. Regulators estimate that nearly half of derivatives are traded outside the United States; more on this will emerge later in the lesson.
We have already met a ‘futures exchange’ in the first lesson when commodity trading was discussed and how it assists farmers and producers in selling their produce ‘forward’. There are many markets and exchanges for this kind of derivative, even for trading currencies, but one is of particular interest because it has an influence on the ‘price of money’ and will enable a deeper understanding of money markets in general; it goes to the heart of financial engineering, first though a reminder about futures and spot prices.
“Futures contracts” (futures), are standardized contracts for delivery (the seller delivers) or receipt (the buyer receives) some fixed quantity and quality of a commodity. Futures contracts are available for each month of the year; thus a contract for delivery of December wheat can be purchased in, say, May. The “Spot Price” is simply the price of the ‘futures contract’ of the most active month which is generally the current month, that is, the price of the product in the present. The market for gold metal (bullion) serves as a useful example.
A gold future’s price should be the price at which bullion can be purchased, at some time in the future, because a ‘futures contract’ is a legally binding agreement to deliver the actual, physical metal. Exchanges, an example of which is the ‘COMEX’ as reviewed in the last lesson, have registered warehouses where physical gold is stored prior to delivery should the buyer ask for delivery at the appropriate time. It is important to note that exchanges allow traders to buy or sell contracts at a fraction of the commodity’s price, just like the options we discussed earlier, which is known as ‘trading on margin’ – the margin being the small percentage or premium paid by the buyer – and so only a fraction of the actual contract value is required to trade, whether buying or selling. This system works well but can be manipulated by unscrupulous traders, mainly massive American and European banking cartels, for example J P Morgan et al, who have the financial muscle to distort prices and have an insider’s advantage by working in conjunction with the exchanges and their regulators.
When the price of gold rises, through normal market demand to own the physical metal, it signifies a declining value and confidence in paper money generally in the form of the US dollar in which gold is generally priced. Gold has always been considered valuable by mankind since time began and unlike paper money it has no counter-party, as explained in the first lesson, therefore it is in the interests of the issuers of paper money, the Fed for example, to ensure a devaluation of the dollar is minimized to maintain a reasonably stable unit of currency*. They do this by forward selling large quantities of ‘paper gold’ contracts which causes the physical spot price to fall as both the prices are linked and affect each other.
Most traders, banks and financial institutions dealing in futures end up not taking delivery of the metal because most are simply speculators interested only in profiting by gambling on price movements and trading on margin; they are dealing with paper contracts much like the example of the ‘apples trader’ in the last lesson. It is possible for the ‘apples trader’ to increase his profits by extending his dealing to create a futures contract which becomes a derivative of the original contract to purchase apples. This is how it would work bearing in mind that the supply of apples is seasonal and we assume that the original trade deal in the last lesson was closed during a time of abundant apple supply; in man countries it’s September, when the wholesale prices are low, (in economics: if supply exceeds demand the price falls and vice versa).
Remember, the trader at the top of the street has a good supply but less demand for his apples so the price is lower than that at the bottom of the street where there are many more buyers and demand is high. You could strike a deal with the trader to buy, say, 10 tons of apples for delivery in December when there is likely to be a shortage of apples. The forward price will generally be higher than spot price to reflect the cost to store, insure and transport the apples until delivery. The spot price had already been agreed at $2.25/lb so you agree a futures contract to buy at $2.50/lb knowing that the trader at the bottom of the street is likely to pay more for apples in December when his stocks are low. Also you have inside information that the apples crop has suffered a partial failure due to poor weather and therefore the chances of higher prices next spring are increased. You pay the trader 10% premium ($2,500), trading on margin for the contract.
Note that a significant risk arises if investors do not have the balance of the funds ($22,500) available to pay in full at delivery time; they will have to borrow the money (‘leverage the contract’) and in order to do so they will need to ‘post collateral’ (deposit the contract as security) with a bank or trade lender. If, in the meantime, the price of apples moves against the investor (the contract is worth less now) he will be required to ‘post more collateral’ which is known as a ‘margin call’. This can cause traders to become bankrupt in extreme cases if additional collateral cannot be found, however we will assume that all goes well.
In the following months the market for apples moves in your favor and you note that the trader at the bottom of the street has increased his prices to $6.00/ kilo with the likelihood that prices will increase further. You can now offer the trader your contract at $2.75/lb for 10 tons deliverable in December which he finds attractive and closes the deal. You have now made a profit of $0.25/lb on 10,000 kilos or $2,500 and doubled your money. This principle applies to all the markets throughout the world although they become extremely complex when financial instruments are involved. This is how it works in the gold market in real life.
There are a lot more paper contracts for the sale of gold on the COMEX than there are for real, physical gold. The traders are betting that most buyers on the other side of the contract (the counter-parties) will not want to take delivery of the physical gold. The COMEX remains the largest and most sophisticated meeting place for buyers and sellers to express their gold price opinions, in the form of bids and offers, on what the market price should be set at any one time; COMEX remains the beating heart of gold ‘price discovery’ throughout the world. Gold futures contracts are referred to as “paper-gold” because the size of this market is estimated to be over hundred times greater than the market for physical gold available above ground!
In theory investors and speculators are able to take delivery of the futures contract on expiry (contract expiration), although few do, instead choosing to roll over to the next contract month; although it remains that all the buying on COMEX cannot be settled in physical gold. (By the way, ‘rollover’ means to take their existing contract and move it into another without closing the contract). They* can issue an unlimited supply of paper contracts whenever they wish to suppress the price and if required, can indefinitely roll contracts over, artificially reducing the price, until the counter-parties (the buyers) are unable able to meet their margin calls and leave the market, often with severe losses, which keeps the price of paper gold suppressed as happened in April 2013 when the spot price of paper gold dropped USD 250 in 48 hours!
So… just who are ‘They’. Is ‘They’ an acronym like T.H.E.Y, which stands for some dastardly organization? Stay tuned! You’ll find out ; )
YOUR CHALLENGE FOR TODAY IS TO DISCOVER WHO ‘THEY’ MIGHT BE!
All these contracts we have discussed are derivatives and were famously described by Warren Buffett as: “financial weapons of mass destruction,” because they can become like time-bombs embedded in the financial system waiting to explode if conditions allow, for example, if interest rates suddenly rise as happened prior to 2008 and briefly in July 2013. Because these contracts are highly complex, often running into hundreds of pages, they are little understood even by those investor/speculators actually dealing in them. A further complication is that a large percentage of these financial instruments are not traded through an exchange but remain as private contracts between the parties and are known as ‘Over The Counter’ (OTC) securities. OTC contracts cannot be easily valued because there is no market for them and therefore no ‘price discovery’ but because they remain on a banks’ or financial institutions’ balance sheet the valuation (using computer modeling) by the institution itself is rendered uncertain and referred to as ‘mark-to-model’.
Derivatives can also be used not only to produce outrageous profits but also to deceive banks, investors and even governments by hiding the true nature of sovereign debts, mortgages and bonds as well as their rates of interest. Indeed some derivatives are created only for deception and are the only reason they exist which allows those who own them to evade taxes or accounting rules. Banks use derivatives which they create to help their clients deceive the public or even enable banks to deceive their own clients!
One example of ‘deception by derivative’ came in Italian government documents leaked to two newspapers, La Repubblica and The Financial Times. The Financial Times reported that it appeared Italy had used derivatives in the 1990s to allow it to make its budget deficit seem smaller than it actually was thus enabling it to qualify for admission into the Eurozone. It seemed that these derivatives, now restructured, could have exposed the Italian government to losses of some eight billion euros. La Repubblica further noted that the director general of the Italian Treasury Department at the time, Mario Draghi, moved on to become President of the European Central Bank which leaves observers to question the very nature of financial markets operations.
This is similar to something that we already know about Greece. Rather than borrow money in the normal way by issuing government bonds, which would increase the country’s reported budget deficit, Greece entered into a derivatives contract, led by Goldman Sachs, that required the lending banks to make large, upfront payments to Greece in return for even larger payments later on down-stream. This had the effect of ‘deferring’ the debt allowing Greece to understate its financial status; it is an accounting gimmick well known to practicing accountants and colloquially known in finance circles as: ‘kicking-the-can-down-the-road’.
So how do these derivative instruments differ from traditional loans? In practice they differ very little but are much more to do with accounting rules and how published accounts are presented to shareholders and the public. It is ‘creative accounting’ or ‘smoke-and-mirrors bookkeeping’ which allows creditors to keep their loans away from their published balance sheet by residing in the hidden corners of the accounting labyrinth; by calling a loan a derivative it is kept ‘off balance sheet’ or if kept ‘on balance sheet’ it is described in a misleading way. In hindsight the Financial Times report was right on target as this arrangement ultimately caused Italy’s ‘reported budget deficit’ to be much smaller than it really was just at the time when the country needed to join the Eurozone. It can be contended that the ‘chickens are now coming home to roost’ as these derivatives are becoming toxic and are revealing losses which have been hidden for many years.
The unintended consequence of this deceptive accounting is similar to that of a student cheating in an examination. Although the student may be undetected and enter university, some will be unable to compete with competent colleagues and the deception comes to no avail.
There seems to be no end to the ingenuity of the financial geniuses to generate exotic derivatives, which often become ‘toxic’ (they go bad and lose money), to manipulate and deceive investors; some common ones are known as ‘Mortgage Backed Securities’ (MBS). Once again they come in all kinds of colors, shapes and sizes and are certainly appropriate to be considered as part of our jigsaw picture. The principle is relatively easy to understand. Consider your own house… OK, your parents house… or maybe the house of someone that a friend of a friend may have known which might have a mortgage attached to it.
Financial institutions collect together a large number of these mortgage contracts (called a ‘security’ because the loans are backed or secured by houses and land as collateral) and combine all their income streams in one place (these are the monthly payments householders make on their mortgage) creating one large security which is sold to investors by dividing them into pots, called tranches, according to their size, geographical and risk-assessed groupings. Thus there are tranches of risky, low quality mortgages (known as sub-prime mortgages), others mid-range known as mezzanine tranches, as well as the best quality, prime mortgages which are rated as the least risky.
The rules of this game of ‘securitization’ are both complex and extensive but, in their simplest form, allow the least risky prime group to attract a low rate of interest but claim first in line to receive their allotted income. Next in line for the income is the mid-range, mezzanine tranche, with a higher rate of interest as they are at greater risk of default, and the final part of the income stream is allocated to the sub-prime tranche, the highest risk group. It can be seen that, regardless of which individual household defaults, the prime tranche investors will always have their income stream to be certain before the other tranches and it is only when most of the mezzanine and sub-prime tranches fail, an unlikely event one would presume, that the prime investors start suffering losses. This is good news for the prime tranche investors because they have an almost guaranteed return on their investment; they are said to be risk-free or rated by credit rating agencies as AAA, the risk is equivalent to government bonds. The other tranches are usually rated lower on the credit scale but receive a higher rate of interest in return.
Certainly not many people recognized the hidden risks because this type of financial product spawned a whole new industry centered on a group of financial institutions know as ‘Real Estate Investment Trusts’ (REIT). These are companies that borrow money to buy MBS and earn the difference between their cost of borrowing and the interest paid on their MBS. When interest rates are going down and MBS are performing well these companies make fortunes for themselves and their client investors. But when interest rates go up and bond prices fall, their excessive debt leverage causes them to lose money fast. They were, in fact, among the earliest casualties of the 2008 crisis and now, in the summer of 2013, they and their ‘memory-impaired’ investors are finding themselves back in the same financially toxic cesspool.
Much did and could go wrong with this simple plan because the creators of the these derivatives, the major banks and financial institutions, became so enthusiastic about this easy way to make massive fees and commissions that they lost touch with their original mandate and started to combine vast numbers of only sub-prime mortgages using the rationale that all mortgages, regardless of their degree of risk, would never default all at once. This is the same logic that bankers use when justifying the very banking system they use: “not everyone will want their money back all at the same time”.
This is exactly what caused the 2008 financial crisis which started in the USA because of very poor quality mortgages that had been granted to people who had no chance of repaying and they defaulted in droves, causing house prices to fall, causing more defaults – a chain reaction – otherwise known as systemic failure. In spite of all the lessons that should have been learned since the 2008 catastrophe the financial system continues to face a high risk of this type of failure, on a global scale this time, due mainly to the excesses and greed of bankers and their toxic derivatives. Warren Buffett certainly knew what he was talking about when he made that famous quote mentioned earlier and went further when he said: “It is only when the tide goes out that you see who is swimming naked”. But then again, never judge the character of a man by the insights he’s willing to provide.
This of course is only the beginning of the derivative story but the principles remain the same: combine a lot of little loans into one big loan and divide it up by selling off different rated tranches to a range of gullible investors to match their individual requirements of risk and return. The bankers did not stop at the mortgage market; they went on to securitize anything and everything that had an associated income stream, known as ‘Asset Backed Securities’ (ABS); they can be: motor car loans, credit cards, student loans, commercial loans, corporate bonds and they even have involved government loans and bonds, in fact any debt instrument which lives and breathes ‘income’ is a target; sadly the bankers are insatiable in their lust for profit and mega-bonuses.
Party Talk Foul #223 – Some say… that you’re very person is securitized by your Social Security Number (SSN). Such speculation is highly frowned upon, and will not get you the date you’re looking for – rave or not.
For bankers the world is their’s to play with, because they can invent any form of derivative they wish including taking a large number of MBS, and combining them into an even larger group of securities measured in billions of dollars at face value. These securities are known as Collateralized Debt Obligations (CDOs) and using the same principle, create an even greater risk of systemic failure than MBS alone. There are even CDOs of CDOs, called ‘CDOs squared’ and really exotic, beyond measure, synthetic CDOs all which must be left for another time. It is enough to know that an immense spider’s web of toxic debt bundled into securities pervades the world of finance which has created the greatest risk of global economic failure known to man.
But it doesn’t end here, there is so much more to tell although this must wait for another time, suffice to say that the hubris and greed of bankers knows no limit, so if the learner will bear with ShopSquawk a little longer on this somewhat tedious subject, another example of financial engineering at its best is illustrated by the ‘financial instrument of grand deception’, par excellence, which is the ‘Credit Default Swap’ (CDS). Here again is an exotic title for what is in essence a simple insurance policy the principles with which most of us are familiar. The insured person pays a regular premium, usually monthly, to cover for a one-off payout in the event of a specified loss such as a house fire, loss of a ship or car accident. In just the same way the CDS provides insurance to a lender in the event of a default on a loan of any type. This can be any sort of loan from government bonds to derivative contracts of many kinds including MBS, ABS and their assorted mutant offspring. However there is one major difference between a CDS and a regular insurance policy and it has to do with the stringent rules associated with insurance in general; so now a brief diversion.
When ShopSquawk was a wee little bird who had just left the nest (house), it was naive enough to be unaware of the underlying rules of insurance. It figured out that the last time a nest in its area became a total loss due to fire was some centuries ago… so it was paying for fire insurance which it really didn’t need… that is, if it was prepared to take a small risk. However to guard against even this small risk it thought that by approaching the neighbor birds we could combine all our small risks and take out just one policy (at far less cost than each individual policy) covering all our nests against fire which remained a very tiny risk because the risk of all the trees burning down is no greater than just one nest. This is sort of the opposite of the bankers’ mortgage backed securities scam which we covered earlier. Guess what? The insurance company advised wee ShopSquawk that this was not possible because “ShopSquawk did not have an insurable interest in all the nests”. This is a fundamental rule of insurance in general which prevents people taking out policies on things they do not own or in which they have no interest, that is, an insurable interest. It is sensible that insurers will not allow more than one policy on any item otherwise many people could insure your house against fire and make a huge profit by setting it on fire!
Not surprisingly the bankers have thought about this problem but have ignored it in the case of CDS. Anyone can take out a CDS contract against default of any loan at a given premium so that if default occurs many claims can be made against the insuring party. ShopSquawk knows this sounds so simple as to not be possible but it is exactly what brought down The American International Group (AIG) in 2008, as part of the MBS meltdown. This massive insurance company was brought to its knees because of the many contracts it had written on loans issued against defaulting mortgages and not having sufficient reserves to back these contracts. Perhaps we should not offer these megalomaniacs the imposing title of “Masters of the Financial Universe” after all.
Party Talk Foul #322 – Talking in public about CDS, MBS, or CDO may make those around you think you have a bowel problem, or worse, a gastrointestinal disease.
The current (distorted) accounting rules in the United States go so far as to allow banks to hide debt obligations that are classified as ‘derivatives’. They do this by off-setting their derivative valuations, which are currently profitable, against valuations that have losses and show only the net value in their accounts. This has several effects by not only artificially reducing the total gross value of their declared ‘assets’ on their balance sheet (that is, loan obligations in the case of banks) but also obscures the risk of the bank itself defaulting by understating its leverage or gearing ratio.
As you may by now realize the banks have done an excellent job of persuading the Financial Accounting Standards Board (FASB), the accounting standards regulator which sets the rules, to look the other way when examining the banks’ published accounts. The reason for this is that the ‘To Big To Fail’ mentality has swept the regulatory industry causing them to be ‘captured’ by the big banks as well as being hand-in-glove with government and politicians in order to avoid what is likely to be yet another crisis in the future. The FASB even proposed new accounting standards for insurance that would force many contracts not called ‘insurance’, being basically the same thing, to be accounted for in the same way as insurance contracts. However CDS were exempted from this rule and one does not have to look too far to know why.
You are feeling sleepy… you will repeat after me… ‘CDS’ means ‘Credit Default Swap’
The massive derivatives markets are so varied and extensive that many books have been written on the subject. ShopSquawk has found many of them readily understandable and readable even if the subject is of a specialist nature. For those interested in further reading, the book: “Too Big To Fail” by Andrew Ross Sorkin describes in detail the inside story of how ‘Wall Street’ duped a generation of investors. It is always the investors that suffer losses when these securities fail, never the banks and financial institutions who manufacture them, because they are underwritten by the taxpayer through government; which arises the well known adage: “Privatizing the profits, socializing the losses” demonstrates. Government, regulators and central banks will have a hard time reining in the excesses of these bankers and financial wiz-kids although they will have to regulate them at some time or another if a further crisis is to be avoided.
Banks all over the world are carrying the heavy burden of ‘toxic’ debt, mainly in the form of derivatives, leaving them highly vulnerable to any rise in interest rates as happened briefly in the summer of 2013. ShopSquawk cannot emphasize more that the global economy and taxpayers everywhere remain seriously at risk of losing their savings.
In 2007-8 a series of bank failures caused widespread public anger and humiliation of symbolic figures in the financial and political world. However the scandals keep coming and thus we enter another stage of what therapists call “bargaining“. A majority of the political class now recognizes the need for change but remain unable to see the need for a fundamental change in the very structure of the current financial system. Thus far only fixes and patches have been applied with small increases in banks’ leverage ratios and bonus claw-backs combined with “ring fences” for ‘toxic’ assets carried on the banks’ balance sheets.
Restoring the link between risk, reward and responsibility is a crucial step towards a robust and stable financial sector but the report’s focus on individual responsibility is also dangerously incomplete because it implies that the sector is merely out of control. This proposition encourages fixing the system by tweaking rules and realigning incentives or by bargaining. In reality, in ShopSquawks opinion, the financial sector is not out of control, it is beyond control.
The global financial system consists of a set of interlocking ‘cartels’ that divide the market among themselves and use their advantages to exclude competition. Cartels can and do extract huge premiums over what would otherwise be normal profits in a free market and part of those profits keep the cartel in business. By using massive advertising, marketing and public relations the cartel can ensure continuing, easy-to-gain profits without fear of failure or loss. Their gigantic cashflow offer talented regulators three or four times their normal salary to participate in their illusory derivative schemes which result in extraordinary bonuses and commissions for all these insiders. Here is the source of so many of the perversities in modern finance the solution to which is not only to denounce those who can’t resist its temptations but to actually to remove those temptations; creating smaller banks, smaller and independent accountancy firms and credit-rating agencies, simpler financial products, much higher capital requirements and much smaller government.
The problem of banking commissions in today’s world is that there are no politicians capable of doing things, no matter how just and justified they may be, against the implicit and explicit demands of the financial elites in their countries. So far as the most important political positions are concerned, they are available only to those who align themselves with these elites.
In essence the solution is simple and those that matter already know the answers. A financial world that cannot function without a constant flow of public funds is so obviously dysfunctional to anyone with modest common sense. A start has been made by putting a halt to the bank ‘bail-outs’ which we have seen in past years but now, in substitution, it has been decided to create ‘bail-ins’ as we witnessed in Cyprus. One option which has proven its worth in the aftermath of the Great Depression is to separate the operations of commercial banks from investments banks by not allowing investment banks access to depositors’ funds; they should only be allowed to gamble with their own funds.
Furthermore these massive banks should be broken down into smaller more manageable units and offer a simplified system which can be regulated effectively. But the question is not which are the proper measures but rather the question remains, who will execute these measures?
Changes will have to be found by the coming generations who have already been dispossessed of their rightful inheritance and will eventually have to organize in unity to defeat the present malignant and dysfunctional apparatus of our present system of financial governance.