>
Why would anyone in Nevada, coffee in hand on a cool October morning, be thinking about the regulation of derivatives trading? Protracted economic epistles are usually a recipe for eye-rolling, yawn inducing, apathetic reactions, even with a heavy dose of caffeine. Not to extend the tease remorselessly, but one reason this should peak the interest line is that It’s Your Money “They” are Playing With. Let’s approach this topic gently, and let’s imagine that all too many people are put off by the financial services slang and jargon such that they believe they aren’t really capable of understanding those exotic markets. After all, the upper echelons of Wall Street management have benignly sneered on our TV monitors that these are not topics for “unsophisticated investors.” (Translation: Just let us keep wheeling and dealing, and when we screw up royally all those “unsophisticated investors” can pick up the tab.) A further definition of terms might be handy.
Our Little Glossary
Unsophisticated Investor = Any citizen of the United States who having the misfortune not to be beknightedly wealthy and is not familiar with the Wall Street jargon obfuscating mismanagement and prevarication.
Derivatives = pieces of paper with signatures at the bottom (contracts) whose value is based on a “traditional security” like stocks or bonds, or an asset like commodities (think pork bellies, cows, and orange juice), or a market index (think imaginary number based on weighted values of a list of companies, Dow Jones, etc.) We can go a little further here without bursting anyone’s brain: “Futures contracts, forward contracts, options, and swaps are the most common types of derivatives. Since derivatives are contracts, almost anything can be used as a derivative’s underlying asset. There are even derivatives based on weather data, such as the amount of rain or the number of sunny days in a particular region. Derivatives generally are used to hedge risk but also can be used for speculative purposes.” [FinDict] If this is sounding a little bit like a “numbers racket,” there are, indeed, points of comparison. However, before we go off half cocked and demand the outlawing of credit default swap-like derivatives in general let’s look at how they work:
Suppose for a moment we are among those “sophisticated investors” who run an investment fund – Desert Beacon Investment LLP. Suppose that Desert Beacon LLP buys some mortgage bonds from FlyByNight Mortgages Inc. Hmmm. We know that business hasn’t been exactly booming in Las Vegas and Reno so we decide to “hedge our bet” on those mortgage bonds, because if those bonds go into default then we go – so to speak- into the toilet. What to do? Desert Beacon LLP purchases a credit default swap (derivative) from Big Boyz Investment Fund. If the FlyByNight bonds tank we’ll lose our investment BUT we’ll get a payoff from Big Boyz Investment Fund to compensate for our loss. On the delightful possibility that the FlyByNight bonds are actually good for something – then we’ve paid Big Boyz Investment Fund for the comforting knowledge that while we might lose our jackets we won’t lose our shirts. The risk management part is the happy side of the equation. There is, however, the speculative side that frankly isn’t so pretty.
What would happen if Desert Beacon LLP knows deeply and truly that the mortgage market in Las Vegas and Reno is a big bubbly thing that is very likely to burst and splatter defaults all over everybody. Ta Da! Desert Beacon LLP buys a credit default swap, but this time Desert Beacon LLP pays Big Boyz Investments a higher premium (like an insurance policy) for the swap – because there’s more risk. So, FlyByNight Mortgage bonds crash as expected, but Desert Beacon LLP which owned the bonds (not the mortgages) could actually make a profit by cashing in the “insurance policy” on the default. Heads Desert Beacon LLP wins, Tails Desert Beacon LPP wins. Desert Beacon LLP should be happy, but there’s a big cloud on the horizon. What if Big Boyz Investment Fund had piled up a huge batch of those credit default swap/insurance policy like contracts, and when the Housing Bubble went very very flat they couldn’t pay off all those credit default swap/insurance policy like contracts? Answer: Lehman Brothers.
Leverage = Use “leverage” in a sentence: “Most of the speculative credit default swaps on asset based securities were highly leveraged.” Leverage is a loan or some kind of debt in which the money is reinvested in the company to earn a higher rate than the cost of the interest on the loan. Most businesses have some leverage. Think of a company selling ice cream; if it can make more sales with a new truck then the payoff from increased sales will offset or be greater than the cost of the loan to buy the vehicle. If Desert Beacon LLP can earn more money (jargon: return on assets) than the cost of the loan, then its return on equity (jargon: ROE) will be higher than if it didn’t take on the debt. The good news is that if the ROE is up then Desert Beacon LLP can reward its investors more than if it hadn’t taken on the indebtedness. Bad news? If the interest on the loan comes in higher than the return on the assets (garden variety business operations) then the investors in Desert Beacon LLP take a loss. Worse still? If the investment made with the borrowed money crashes then Desert Beacon LLP still owes the loan principal and all the interest on the loan it took out. Once again, think Lehman Brothers, Wachovia, etc.
Ratings Agencies = Good Housekeeping Seal of Approval companies who stamp various securities with nice labels like AAA, AA, A, etc. The ones stamped with more A’s are supposed to be better risks than the ones stamped with fewer A’s. Bonds, for example, with lots of A’s have lower interest rates, but they are less risky (more likely to pay off). OK, that’s the easy part that everyone pretty much understands, but how do the ratings agencies determine how many A’s to stamp on the financial product. Unfortunately, we have a system rife with conflicts of interest (and not the money kind). For example, Desert Beacon LLP decides to tranche* up a lovely batch of mortgages it has purchased and repackage them as Desert Beacon Inc. Securities. DB Inc. then goes to the ratings agencies (Moody’s Standard & Poor, Fitch) and asks them to “rate” the shiny new packaged securities. If Moody Blues rates them AAA, Standard Poorly rates them AA, and Itchy Fitchy rates them A, then Desert Beacon Inc. will contract with (and pay!) Moody Blues Ratings for its services. And people thought that Grade Inflation in colleges and universities in the late 1960’s was bad….
Tranche = from the French “tranche” for “slice.” The fancy definition is “One of a set of classes or risk maturities which comprise a multiple class security, such as a collateralized mortgage obligation (CBO) or REMIC (real estate investment conduit). [InvestorWords] In English that would be a package of paper (mortgages, contracts) sorted out from several sources, repackaged, and sold as “new.” Imagine that DB Inc. purchased mortgages from several banks, some were AAA, some were AA, and some were SubPrime. The happy elves at DB Inc. created a mixture of these mortgages from a formula (remember those Algebra I “mixture problems?” in which we were supposed to calculate how many ounces of peanuts would be mixed with how many ounces of pecans to make a mixture worth $1.20 per pound?) The new mixture (tranche) was then packed off to shop around for a ratings agency that would stamp it with as many A’s as possible, and then our newly minted little tranche would be sold to other investment companies like Desert Beacon LLP. What the heck, investors could even use their leverage to buy our tranches and someone might even buy a derivative credit default swap in case our little packages (slices) didn’t prove to be worth what we thought they were, or what the rating agency decreed they might be when they stamped the A’s on them.
Who’s Watching The Store?
The following excerpt from Bloomberg News summarizes the current political/economic situation succinctly: “The battle over derivatives legislation is a test for the Obama administration’s efforts to tighten financial rules to prevent a repeat of the financial crisis that shook the global economy, a situation exacerbated by unregulated derivatives trading. Opaque financial products, including some derivatives, have contributed to almost $1.6 trillion in writedowns and losses at the world’s biggest banks, brokers and insurers since the start of 2007, according to data compiled by Bloomberg. Among fallen companies are Lehman Brothers Holdings Inc., the investment bank that filed for bankruptcy, and insurer American International Group Inc., which has been surviving on government loans.”
If the “glossary” has cleared things up for you – a hopeful thought for those of us who are not “sophisticated investors,” then you might wish to take on the recent output from the House Financial Services Committee. In particular, you might want to look at the summary of H.R. 3890, the Accountability and Transparency Rating Agencies Act, which passed out of the committee on a 49-14 vote. You may also want to take a gander at the press release from Chairman Barney Frank (D-MA) on the Consumer Financial Protection Agency Act that was passed by the House Energy and Commerce Committee.
Speaking of the Consumer Financial Protection Agency Act, H.R. 3126 was “marked up” by the House Energy and Commerce Committee on Wednesday, October 28, 2009, and reported out on a 33-19 vote. The Energy and Commerce version is the most recent, however the July 8, 2009 Congressional Research Service summary is helpful in a general way toward understanding what the bill would do. The Treasury Department has information on its website specifically on the topic of Financial Regulatory Reform, and suggested improvements to financial services oversight.
There are many weeds through which to navigate in the financial services sector reform proposals, but a good place to start are some fact sheets prepared by the Treasury Department and available on subjects like “consumer protection,” investor protection,” and “independence for compensation committees.” DB, which has no intentions of starting up an LLP or selling tranchey little products, will keep watching this topic.
desertbeacon.blogspot.com
Desert Beacon 