OK, so what are derivatives?

Some things are simply a mystery until you look a little closer (It’s like Vinny and the first time he sees grits) –

(Dialogue for the too lazy to watch:  What’s, what’s dis over here? [you never heard’a grits?]  Sure, sure, I heard’a grits … I just actually never seen a grit before …go ahead, honey, ya gonna try it? [you first] … what is a grit anyways?  [it’s made outta corn, them hominy grits]  Hominy … huh … how do you cook it?)

Q. Sure, I heard of derivatives … Warren Buffet … didn’t he say somethin’ about dem?

You may be like me and have heard the comment by Warren Buffett that he made back in 2002 that “derivatives are financial weapons of mass destruction”, which may have scared the living daylights out of you (as it did to me)  … but you never quite understood why.

Here is another more recent update from our buddy Warren, and please note that he has not changed his tune –

http://www.afr.com/markets/derivatives/warren-buffett-still-says-derivatives-are-weapons-of-mass-destruction-20150617-ghpw0a

Q. Where do deze things come from anyways?

At my former place of employment there were math wizards who measured and analyzed and optimized and wrote wonderful papers.  It was from one of these (a friend who has taught me a lot) that I became acquainted with the term “quants” (a term for his other math wizard friends, who did similar things … however, they did them on Wall St … and made GOBS more money [than him] by doing so).

He also acquainted me with the term “derivatives”.

You may also have heard this term “quants”, but perhaps were mystified about the financial products that they are responsible for [as I was] … or, perhaps you’ve never heard this term at all … in either case, I submit the following article for further explanation –

What do Quantitative Analysts (Quants) Do?

Well, for a long time, my knowledge about derivatives hovered at around this level (i.e., not knowing and scared to death) … with Warren Buffett’s comments as well as my understanding of quants being responsible for these products leading me to think that the subject of derivatives was beyond my grasp.

Then one day, I decided enough was enough … even if I could not understand the depths of the subject, I would at least try and see what information was available that I COULD understand.

Q. So, what are deze things anyways … whadda they made of?

One place that I naturally gravitate to (since it is easy to find people who opine about topics that you are likely to be interested in) is Seeking Alpha. Here is one article that I discovered –

http://seekingalpha.com/article/3665426-630-trillion-derivatives-market-snowflake-away-complete-meltdown

In this article there is mention that “more than 80% of the notional derivatives contracts relate to interest rates derivatives”, but they simply represent “(large notional numbers) and have very limited relational connection to actual risks”…

(If this sounds like a bunch of gobbledygook … hang on … let me distill it … at least through a filter based on my own understanding [so, fair warning given and “let the buyer beware”, as they say]).

So, NO WORRIES, right? (at least this is what the article seems to suggest, i.e., that derivatives are really no big deal).

Q: So dere’s nothin’ for me to be concerned about? … But I still don’t understand … 

But the gist of it may simply be a comment in the article that states “Evidently the OTC derivatives market is not very well-understood by ordinary investors” … yep, we ordinary folk cannot comprehend these things, so let’s just leave it to the sophisticated market manipulators who always have our best interests at heart. [ok … maybe I’m not being fair here … the article is actually fairly clear … but, so is my point]

Fortunately, there are a few other sites willing to share information regarding derivatives that we can look into (don’t get me wrong, though, the Seeking Alpha article really does have useful information, but possibly questionable conclusions … although that is just my suspicion … you can judge on your own from information contained by the following alternative articles or others, as you choose).

Q. So, dere’s more?

In this respect, here is another article for your consideration –

http://www.wanttoknow.info/banking_finance/derivatives_market_bubble_financial

This article states that “the $700 trillion financial derivatives market may be a time bomb waiting to explode with catastrophic consequences“.

Hmmm … this is a markedly different perspective from the earlier article (with a somewhat misleading title). It goes on to say that “the recent explosion of growth in the global derivatives market has created a huge potential for massive instability“.

Instability … of what sort? (you might ask) … can you please give me an example?

(And what about Global derivatives markets?  … you mean… like places where there might really be problems? Not just here in America?  … Sorry, if someone may read this from elsewhere on the globe… I am assuming the level of knowledge to be according to viewer’s location … so, please give your American reader’s some slack to absorb this, if possible).

OK…. how about this…

What impact would problems with the currency exchange rate  have on these products, for instance?  Please consider the following article as it may describe one potential source of instability  –

http://blogs.wsj.com/economics/2015/09/29/imf-flashes-warning-lights-for-18-trillion-in-emerging-market-corporate-debt/

It states (among other things) that “Compounding problems, many firms borrowed heavily in dollars. As the greenback surges against the value of local currency revenues, it makes repaying those loans increasingly difficult.

Hmmm … does anyone recall an earlier blog post discussion that mentioned the potential impact of the debt supercycle and a rising dollar on the emerging markets? (hint:  they are not going to make out well).  Maybe some of those credit default swaps (CDS) might be a little questionable?

Here is another article that describes these CDS instruments in more detail –

http://www.investopedia.com/articles/optioninvestor/08/cds.asp

Here is a straightforward description of “all that you ever wanted to know about derivatives” –

http://www.rediff.com/money/2005/apr/19perfin1.htm

Q:  So, dey sound pretty scary … but what ARE dey?

However the BEST description (you knew I would save it for last) comes from the Khan Academy and their discussion of derivatives (CDS) –

https://www.khanacademy.org/economics-finance-domain/core-finance/current-economics/credit-crisis/v/credit-default-swaps

I love how it shows the (almost arbitrary) mechanism by which “sub-investment grade” company bonds can be designated “investment grade” in spite of their “sub-prime” credit rating (ok … maybe a little overstatement  … but not really by too much) and thereby made suitable for retirement accounts and insurance funds and the like.

By the way … didn’t they do this with CDO’s [collateralized debt obligations, e.g., pooled worthless mortgages] on Wall St where they “bundled” [too many] sub-prime mortgages with [too few] “investment grade” mortgages and sold them to pension funds (i.e., that precipitated the “Great Recession” in 2008)?

The presentation starts with “let’s say I am a pension fund” … yeah, right! … a potential pot of money to be sucked dry … eh, Wall St?

In case you think this is an overstatement, I submit the following (although not directly related to the topic of derivatives, but illustrative, nonetheless) –

http://www.marketwatch.com/story/how-the-teamsters-pension-disappeared-more-quickly-under-wall-street-than-the-mob-2016-04-04

Q:  OK, now your talking about somethin’ I can relate to  [hey, come on! …. I’m from New Jersey!] … but, what’s gonna happen wit’ dem?

OK… I assume  you have just viewed the Khan Academy presentation, so what does it mean?

I think it means that derivatives (which were meant to minimize risk in the market) actually may be the catalyst for serious market disruptions (as per Warren Buffett)… since they may not be able to deal with black swan events that (by definition) could appear unexpectedly at any time.

My gut feeling is:  WATCH what happens when these instruments unwind during the next crisis … it may not be pretty (just a hunch on my part … although it seems I am in good company along with Warren Buffett).

The watchword may be:  “counterparty risk”.  (By the way, there is NO counterparty risk with gold, which is one reason that it makes for such excellent insurance in a portfolio … but, this might be suitable for a topic for a future post). Like “party A” needs settlement from “party B” in order to settle with “party C” … but “party B” is located in Venezuela and has just gone under.

Don’t worry though … derivative holders have ALREADY been designated ABOVE  depositors (as part of Dodd / Frank legislation, I believe).

Q:  OK … so da banks are gonna be involved somehow wit’ dis?

In case of problems with (the solvency of) the banks, then the derivatives will be settled FIRST  (Ok? … that’s great,  but where are they going to get the money from since the bank is in trouble?).

Well, now … this opens the way for the mention of bank “BAIL INS”, which may be a potential topic for future discussion. In the meantime, if interested, please check out this excellent article –

A Crisis Worse than ISIS? Bail-Ins Begin

So, if you read the article above, you’ve learned that your bank deposits will be tapped before any derivatives in order to keep the banks solvent (whew! the banks will be safe! I’ll bet that let’s you sleep better at night) … also insuring that bank losses will be kept to a minimum (can you think of a better purpose for your bank deposits, anyway?).

(Actually, if you are below the $250K FDIC limit, you might be OK … but, what about money market accounts in funds like Vanguard that are not insured? … just label me “worried”).

And so now (back to derivatives) you can rest assured that any Wall St losses will be minimized, and find comfort in the thought that assets of the top .1 percent are being kept secure.

On the other hand … maybe you are beginning to suspect that you might be stiffed should everything hit the fan … if so, you are resonating with my thoughts precisely.

It’s also possible that I might be getting too cynical as I am aging … but, I don’t think so.

p.s. I would  make sure that funds kept in any account remain below the $250K FDIC limit (ok, for most, I know this in itself is laughable … but maybe a few of the “one  percenters” out there will be reading this … or maybe just a small business owner, like the ones in Cyprus whose business accounts were tapped and who really got shafted by their bail-ins).

p.p.s. I might also consider keeping my cash accounts in something other than a ‘too-big-to-fail’ bank (e.g. local banks and credit unions).

p.p.p.s. See postscript in previous post for reference with explanation of “dis” / “dey” / “dem” seen in the above, if needed.

 

 

 

 

 

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