Monday, January 28, 2008

Are derivatives out to get you?

Financial Derivatives and Globalization of Risk - by Edward LiPuma, Benjamin Lee. I picked up this book on a sidewalk, to flip through after dinner today. Instead of having any calculations or mathematical logic (VaR, volatility smiles etc.) instead it was full of dense text. Impatient (as one might be after a hearty dinner, eager to go home) I checked out the back cover. Turned out that one author was an anthropologist and the other a philosopher and an anthropologist. Made me wonder how qualified these persons were to ponder on financial derivative trade and financial risk.

Turns out the book is not meant to teach you anything about derivatives or risk, rather is very erudite pondering on how the global risk market affects national economies and poorer nations at that. Back home I searched for the text and found it quoted vociferously in the anti-globalization, anti-derivative rhetoric.

One web author used it thusly: [On Picketing Henry Ford]
Barclays’ lightweight local philanthropy—fixing basketballs courts, further perpetuating the racist mythology that all blacks care about is “hoops” and that the only ticket out of the ‘hood is round and bouncy—withers in comparison to the destructiveness to real estate markets, pensions, and health insurance, plus the endless credit-card debt, wrought by financialization.

Thus I learnt of the neologism "financialization" as being "pattern of accumulation in which profit making occurs increasingly through financial channels rather than through trade and commodity production". And it's not a good thing, if the author Stuart is to be believed.

But why this mistrust of the derivatives market? Because one doesn't like the sound of pension funds going bankrupt at the drop of the ticker. Because provident funds and health insurances ride the slump with least grace. A lot of peoples' lives are ruined whenever a billion dollar write-off is made. That kind of thing should not happen.

Credit derivatives are meant to do away with the risk and bring stability, especially to investors like the pension funds and health insurers of the world. Then why do they sink? Why do people distant from the markets find themselves mired in bad trades they never consented to? That we can answer right off. Because they chose vehicles for investment that did not have the wisdom to trade away the risk, instead of buying into it.

It works in the same way as an electoral system. You vote for a candidate you think will represent you (in the US, an electoral college decides that for you). The candidate with the most votes has the power to go to the Parliament/Congress and vote in the lawmaking process, which may or may not favor you. The representative may not have been able to control the passing of the law or he/she may not have had your best interests at heart.

Similarly, in a pension/provident fund, you give your money to a company. Companies with a lot of money invest in one or more of the markets out there, which may or may not favor you. The company may not have had control over the market, or it may not have had your best interests at heart. For if it did, why would it use pension money to buy risk? Should it not hedge away whatever risks it was carrying instead? Is it the credit derivative that lost you the money or the fund manager? You are sure you won't buy a credit derivative ever again in your whole entire life, and that's great. But will you give your money to the same fund manager again?

Sadly, yes. You will end up giving your money to a similarly trained person and -- unlikely but not impossible -- even the exact same person. Because it is the pension funds that are betting your moolah, not the instruments. Equity has its own volatility, gold is not fast enough, commodities are again derivatives, there's not enough real estate to go around, excuses excuses.

Your pension/health plan/insurance/investment ambitions are as ambitious as possible. Any reason your fund's ambitions should be lower? After all, how can you expect steep returns on your money if your fund doesn't risk it?

In the end it comes down to micro-finance and not global risk. Global risk is meant for major banks and, sadly, it works very well. Which is why, during the sub-prime crisis, the ones to falter were not the original lenders but those who had bought up the risk. Imagine what would have happened if Freddie Mac had folded. As on August 2007, the company had held USD 120 billion in sub-prime loans, 12% of its total portfolio. As the crisis loomed overhead, the company predicted USD 1-5 billion in write-offs which later ballooned to USD 12 billion and stayed there. If sub-prime mortgages, mortgages that offer the poorer off, and therefore less credit-worthy, citizens a chance to own a home, are so bad then how come Freddie Mac survived? Having to write off 10% of loans is deadly and banks have been known to buckle under much less severe crunches.

Freddie Mac bundled sub-prime mortgages together and sold them as AAA mortgage backed credit derivatives. In plain English, it repackaged the risk and sold it to investment banks for a slightly higher interest. After selling the bundle if a certain (critical) number of loans defaulted from that bundle, the loss would be borne by the institution which had bought the bundle. In the meanwhile, Freddie Mac had to keep paying a certain amount of money to the buyer depending on the notional risk of holding the bundle.

Advantage #1: What is important here is that it sold them as AAA rating credits, which is the safest rating (lowest risk). Any one of the mortgages in the bundle would not have qualified for the high rating individually, but since there were many eggs and many baskets within the credit derivative, it was a much safer bet, when it was made. It made high rollers** want to buy that risk, which in turn gave Freddie Mac the ability to finance more loans, now that the risk was off its shoulders.

Advantage #2: When eventually a critical number of home loans defaulted and the credit went sour their risk was in possession of high rolling investment banks. None of them died either: they absorbed the sub-prime risk and are now on their way to recovery.

Advantage #3a: When the mortgages fell through, Freddie Mac did not shut shop because it did not lose all the outstanding cash.

Advantage #3b: When the mortgages fell through, the non-Sub-prime mortgages did not get affected since they were in a different risk category of their own.

Of course Freddie Mac suffered.
#1: Not all the credit risk had been traded off.
#2: It could not sell credit risk anymore.
#3: It's share price took a huge hit because their core business is in home loans, which is/was not doing well at all.

So all in all, there are two conclusions:
Conclusion #1: Do not buy risk if you crave security. It will lose you money, whether in risky derivatives or in risky equity or anywhere else: rule of thumb is that higher returns come at higher risk. It's not the security's fault that it's not doing well, it's your fault that you expected it to.

Conclusion #2: Credit derivatives, and derivatives in general, are special purpose vehicles for special financial needs. Just because one doesn't understand them does not mean they are no good. That sounds xenophobic.

** Pension funds, education funds, badly off economies of the world, health insurers should NOT consider themselves part of this group, which they do, and hence the debacles.


hana said...

please use words that come on Star movies only. maybe HBO

hana said...

and you evil person. poor people lose money.
why don't you write stuff about how financial derivatives allow people who never chose to be part of this whole thing that the world is doing to lose their bit money, to die of no food.