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Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen
Old 03-11-2008, 04:03 PM   #1
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Buffett and Gross warn: $516 trillion bubble is a disaster waiting to happen

I was reading this article today and some of the numbers are stunning.
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To grasp how significant this five-fold bubble increase is, let's put that $516 trillion in the context of some other domestic and international monetary data:
  • U.S. annual gross domestic product is about $15 trillion
  • U.S. money supply is also about $15 trillion
  • Current proposed U.S. federal budget is $3 trillion
  • U.S. government's maximum legal debt is $9 trillion
  • U.S. mutual fund companies manage about $12 trillion
  • World's GDPs for all nations is approximately $50 trillion
  • Unfunded Social Security and Medicare benefits $50 trillion to $65 trillion
  • Total value of the world's real estate is estimated at about $75 trillion
  • Total value of world's stock and bond markets is more than $100 trillion
  • BIS valuation of world's derivatives back in 2002 was about $100 trillion
  • BIS 2007 valuation of the world's derivatives is now a whopping $516 trillion
Do you all think this is as serious as the author makes it out to be?
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Old 03-11-2008, 04:13 PM   #2
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Another piglet sodomizer, IMO.

The big spooky number is notional value, not market value. In the overwhelming majority of cases, derivatives reduce risk. The real issue is that more of these instruments need to be traded on an exchange so there is less chance of counterparties falling down on trades.
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Old 03-11-2008, 04:15 PM   #3
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Just to be clear, nowhere in the article does Buffett or Gross refer to derivatives as a "$516 trillion bubble".
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Old 03-12-2008, 11:28 PM   #4
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While Bill Gross may be the world's baddest bond trader, he has a tendency to shoot off his mouth about the stock market-- I'm still waiting for his "Dow 5000" prediction of 2002.

While Buffett IS the world's greatest investor, he also tends to talk down the markets and investor's expectations. The world would have to be a really nasty place for Buffett to say great things about market opportunities, and he'd only say it after he'd invested his $45B cash hoard. Most of his time is spent preaching fiscal responsibility the way Mother Theresa preached service & vows of poverty.

Paul Farrell... well, good for the basics but pretty much deadline sound-bite journalism. I think you'd be better off reading Bernstein (EfficientFrontier.com) or Siegel or even Swedroe & Ferri.
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Old 03-13-2008, 07:43 AM   #5
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Originally Posted by Nords View Post
Paul Farrell... well, good for the basics but pretty much deadline sound-bite journalism. I think you'd be better off reading Bernstein (EfficientFrontier.com) or Siegel or even Swedroe & Ferri.
"EVEN" Swedroe & Ferri? Nords, they may not be right 100% of the time, but gee, you're sure a tough audience for these investment guys to impress.
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Old 03-13-2008, 08:38 AM   #6
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Why ask here? We on this board are the piglets, compared to the likes of Gross and Buffet. Their opinion is worth reading.
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Old 03-13-2008, 09:43 AM   #7
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I would like to offer a glimpse into how the derivatives are used for foreign currency in an S&P500 company with a myriad of foreign entitities under it's umbrella and how reducing income statement risk can actually increase cash-flow risk.

Division A is a US dollar denominated foreign entity which has had a properous run for a few years, with a very low local tax rate. Division B is a relatively new foreign division denominated in Japanese yen looking for 100 million in capital to expand in Asia.

MegaCorp could have Division A declare a dividend to Megacorp (100% whole subsidiary of megacorp) and pay 15 percent tax on the dividend in the US and then be free to invest the money as an equity investment in Division B. The advantage to this method is the resulting fluctuation in currency on the investment does not effect the income statement instead the investment on the books is converted at the prevailing rate for megacorp and offset in the unrealized gains and losses in the equity section.


In order to be more efficient with megacorp's dollars a Wall Street banker walks into megacorp's treasury department instead recommends an intercompany loan from Division A to Division B. This will result in no remitance of taxes to the US for a dividend payment. Indeed it forecast by the banker that it will be cash flow positive as the interest earned in Division A is at the lower local rate and the income expense deduction in Division B is at a higher marginal rate. So Division A lends 100 million dollars to Division B at 3.5 percent per annum in Japense Yen at a rate of 130 yen to the dollar or 13 billion yen. Division B is going to be rolling this loan for at least 10 years before it meets it's forecast for cash generation to repay.

Unfortunately GAAP for megacorp the intercompany loan does have to be restated for currency fluctuations in the gain or loss on currency in the income statement Therefore megacorp goes to its Wall Street banker and enters into a series over the 10 years of 1 year forward currency hedges. So that as the value of the intercompany loan rises or falls it is closely offset by the hedge and there is no net income statement impact under GAAP rules. Note the counterparty to the Wall Street Firm in this 100 million notional hedge is the megacorp company. Most likely they have another customer looking to hedge in an opposite direction so the Wall Street Bank has no net derivative risk itself for currency fluctuation.

Now take the current unusual situation where the US dollar is making a prolonged one way move down. What is the effect on Megacorp?

On the income statement there is no net effect. However at the end of year one with the Yen falling from 130 to 100 megacorp has a loss of 30 million dollars on their hedge and must provide 30 million dollars to the Wall Street banker. This is offset by a gain of 30 million on the intercompany loan to division B but since Division B is still encountering negative cash flows it cannot repay a portion of the loan early to meet the needed cash for the hedge offset. Indeed Division B actually needs to roll the 455 million yen in interest (now worth 4.5 million) on the intercompany loan into the loan as well.

So megacorp goes to it's Wall Street Bank and requests a 30 million loan to pay the hedge and now must enter a new one year hedge for 135 million notional value currency hedge. If the dollar continues to decline the cash flow problems on the notional hedge becomes a Wall Street banker concern if the dollar were to fall another 30 percent in year 2 megacorp will need another 40 million dollars to assist in the cash flow.

This is the scenario where a low risk derivative will cause unintended consequences in liquidity. To avoid a 15 million dollar tax, megacorp could end up with 75 million in loans in two years and an exposure to the US dollar and a continued increase in the notional value of hedges, as well as the interest expense the loans require. So that in the end megacorp has leveraged itself due to currency derivatives taking a one way road.

Almost all of these derivatives work best when they are fluctuating around the mean as opposed to a one-way move. One way moves will show up as strains against counterparties at some point.
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Old 03-13-2008, 10:08 AM   #8
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Quote:
Originally Posted by Running_Man View Post
I would like to offer a glimpse into how the derivatives are used for foreign currency in an S&P500 company with a myriad of foreign entitities under it's umbrella and how reducing income statement risk can actually increase cash-flow risk.

Division A is a US dollar denominated foreign entity which has had a properous run for a few years, with a very low local tax rate. Division B is a relatively new foreign division denominated in Japanese yen looking for 100 million in capital to expand in Asia.

MegaCorp could have Division A declare a dividend to Megacorp (100% whole subsidiary of megacorp) and pay 15 percent tax on the dividend in the US and then be free to invest the money as an equity investment in Division B. The advantage to this method is the resulting fluctuation in currency on the investment does not effect the income statement instead the investment on the books is converted at the prevailing rate for megacorp and offset in the unrealized gains and losses in the equity section.


In order to be more efficient with megacorp's dollars a Wall Street banker walks into megacorp's treasury department instead recommends an intercompany loan from Division A to Division B. This will result in no remitance of taxes to the US for a dividend payment. Indeed it forecast by the banker that it will be cash flow positive as the interest earned in Division A is at the lower local rate and the income expense deduction in Division B is at a higher marginal rate. So Division A lends 100 million dollars to Division B at 3.5 percent per annum in Japense Yen at a rate of 130 yen to the dollar or 13 billion yen. Division B is going to be rolling this loan for at least 10 years before it meets it's forecast for cash generation to repay.

Unfortunately GAAP for megacorp the intercompany loan does have to be restated for currency fluctuations in the gain or loss on currency in the income statement Therefore megacorp goes to its Wall Street banker and enters into a series over the 10 years of 1 year forward currency hedges. So that as the value of the intercompany loan rises or falls it is closely offset by the hedge and there is no net income statement impact under GAAP rules. Note the counterparty to the Wall Street Firm in this 100 million notional hedge is the megacorp company. Most likely they have another customer looking to hedge in an opposite direction so the Wall Street Bank has no net derivative risk itself for currency fluctuation.

Now take the current unusual situation where the US dollar is making a prolonged one way move down. What is the effect on Megacorp?

On the income statement there is no net effect. However at the end of year one with the Yen falling from 130 to 100 megacorp has a loss of 30 million dollars on their hedge and must provide 30 million dollars to the Wall Street banker. This is offset by a gain of 30 million on the intercompany loan to division B but since Division B is still encountering negative cash flows it cannot repay a portion of the loan early to meet the needed cash for the hedge offset. Indeed Division B actually needs to roll the 455 million yen in interest (now worth 4.5 million) on the intercompany loan into the loan as well.

So megacorp goes to it's Wall Street Bank and requests a 30 million loan to pay the hedge and now must enter a new one year hedge for 135 million notional value currency hedge. If the dollar continues to decline the cash flow problems on the notional hedge becomes a Wall Street banker concern if the dollar were to fall another 30 percent megacorp will need another 40 million dollars to assist in the cash flow.

This is the scenario where a low risk derivative will cause unintended consequences in liquidity. To avoid a 15 million dollar tax, megacorp could end up with 75 million in loans and an exposure to the US dollar and a continued increase in the notional value of hedges. So that in the end megacorp has leveraged itself due to currency derivatives taking a one way road.

Almost all of these derivatives work best when they are fluctuating around the mean as opposed to a one-way move. One way moves will show up as strains against counterparties at some point.
Your example would apply to any situation where an underlying "physical" entity is hedged with a forward (or futures) contract. Someone hedging an S&P 500 portfolio or a Treasury bond portfolio with futures would face the same cash-flow risk if the market ran way up. This risk can be hedged to a large degree by under-weighting the hedge (using a lower notional value of futures contracts).

From the fact that US multinational companies are currently benefiting earnings-wise when they transfer their profits back into $, my guess is that they may not be hedging at all, or perhaps hedging with options.
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Old 03-13-2008, 11:51 AM   #9
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"EVEN" Swedroe & Ferri? Nords, they may not be right 100% of the time, but gee, you're sure a tough audience for these investment guys to impress.
Sorry, I like Rick Ferri, but it's not helping either of them when they indulge in their face-slapping contests on the Diehards board. Kinda like the Siskel & Ebert of bonds & commodities investing.

Swedroe, in particular, must have a typist and two copy editors before anything he writes ever gets into print. The guy has some of the most garbled phrasing & typing I've ever seen on a computer monitor and it's difficult to get past that to appreciate his ideas.
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Old 03-13-2008, 12:53 PM   #10
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Sorry, I like Rick Ferri, but it's not helping either of them when they indulge in their face-slapping contests on the Diehards board. Kinda like the Siskel & Ebert of bonds & commodities investing.

Swedroe, in particular, must have a typist and two copy editors before anything he writes ever gets into print. The guy has some of the most garbled phrasing & typing I've ever seen on a computer monitor and it's difficult to get past that to appreciate his ideas.
Well, I had noticed their little games over there but it's kind of interesting. To follow your analogy, how far would Siskel have gone without Ebert, or vice versa? Their discussions do help me to see both sides though usually Ferri makes more sense to me, which is odd because I really like both of their books. But then sometimes Swedroe makes a great point when responding to Ferri, too. I guess what I am saying is that either of them is so far ahead of the usual media types that they are nearly demi-gods to me (even when they don't agree).
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