Derivatives

[NW-Bound]

Talk about investing in things that one can understand, I remember reading about another rule. That is "one should not invest in things that eat".

I don't know if anyone has put down the following rule, but I have not read it before and will claim that it is my independent original idea.

"Do not invest in things that require periodic staining" - NW-Bound​

Do I obey my own rule? Surely I do. I bought mine not as an investment but as a consumption item. That's my story, and I am sticking to it.

 

[imoldernu]

"Do not invest in things that require periodic staining" - NW-Bound

YES!... Just finished my 400sf deck and side grillwork.... after 8 hours of power washing. Hopefully last time.

As to Derivatives?... In line with the gentle hints, will cease and desist.

 

[NW-Bound]

The deck would be the easy part for me, and my wife could also pitch in to help. The house itself is more bothersome.

You are new here, but 3 years ago, I caused quite a stir with a post on this home maintenance activity. See this, and the subsequent responses. This and subsequent exchanges too. Heh heh heh...

 

[imoldernu]

The deck would be the easy part for me, and my wife could also pitch in to help. The house itself is more bothersome.

You are new here, but 3 years ago, I caused quite a stir with a post on this home maintenance activity. See this, and the subsequent responses. This and subsequent exchanges too. Heh heh heh...

Yeah... WOW! Butterflys in the nether regions, just reading the account... Perhaps wire walking over Niagara Falls next. You are not planning to do this again... are you? What about a lawn chair and 700 helium balloons with your bride holding the tether? or perhaps rapelling from the chimney top.

Will save the excellent instructions in case we ever live in a 2 story house.
Am thinking more about living in a cave when the money runs out... Only problem with that is that I suffer from acute claustrophobia.

Thanks for sharing.

Nice looking home, and the location sounds great.

 

[Lsbcal]

Some reading on financial sophistication and what could happen to smart people:

Nonfiction, on LTCM debacle which was partly responsible for the late 1998 market decline:
Roger Lowenstein, When Genius Failed, the Rise and Fall of Long Term Capital Management

Fiction, about a brilliant physicist and his algorithmic trading hedge fund:
Robert Harris, Fear Index

 

[NW-Bound]

Well, people would not believe it, but I suffer from acrophobia too. Last time we were up in Grand Canyon, I kept telling my wife that she walked too close to the edge.

It's just that after very careful calculations and deliberations, should an engineer not trust the principles of math and physics, and do what his education tell him that it is OK? How did we build skyscrapers, things that fly, go to the moon, etc...? Mind over fear!

Oh, it was scary up on that ladder. I will not deny it. The thing is painters and carpenters do not even take the precaution I did, and they still live. How? Now, that is a mystery to me.

Anyway, the stain coat is still looking good. I do not know if I still have the stamina to do it again, so will wait for that time to come around to see if I should hire a painter.

 

[imoldernu]

Couldn't resist this...
UPDATE 2-Berkshire Hathaway profit falls on derivative losses | Reuters

Just a wee bit about stuff we don't see, why derivatives aren't necessarily as simple as futures or commodities, and how the risk factor for banks, brokers and investors like Buffet doesn't show up on balance sheets. Note the "long term" notation.

Derivatives are not all based on time limit transactions, not always on commodities or weather, and not always finite. Complex derivatives and offsets may deal with concurrent payouts that may extend over years or decades.

While the problems that occurred with LTCM, AIG, and Lehman have been treated as solvable situations, they represent only a tiny portion of the transactions extant in the market.

Types of Financial Derivatives

The "Types" mentioned here are the simple underlying types. In fact the "variations on a theme" can and do extend to hundreds of specialized contracts with risk calculations sometimes running to 4 or 5 pages of math formulas.

From our standpoint, it's a matter of trust, as to who, what, and how much. I would suggest that even the advisory boards, for pension funds, endowments, insurance companies, municipal funds etc, are invested in leveraged funds about which they have little knowledge, where they rely on trust.

I look at derivatives in the same way I look at housing values that have not been marked to market.

The fact that the financial markets don't share my fears is a puzzle to me.
As more and more of our leaders indicate that the markets are safer and more stable than they were in 2007-2008, I have to believe that something is behind the confidence. The reports that banks have solidified their positions... improved their balance sheets and reduced their risk, must have basis in fact.

It appears to me that Dodd Frank has been watered down already, and may suffer some more hits. The CFTC is facing some tremendous hurdles, not the least of which is funding.
Two main points are still up in the air... open swaps trading, and liquidity requirement. Both likely to be defanged.

Before I get beat up any more, I admit to not being good at finance. I'd just like to understand.

 

[Nords]

Just a wee bit about stuff we don't see, why derivatives aren't necessarily as simple as futures or commodities, and how the risk factor for banks, brokers and investors like Buffet doesn't show up on balance sheets. Note the "long term" notation.

I think you're going far out on a mighty thin limb to compare Berkshire's "derivatives" to the products that other financial firms are using.

They're long-term puts with minimal required collateral. Berkshire got billions of dollars to play with for the duration, and they're expected to (at least) break even. However even Buffett has said that he's tired of explaining the quarterly spikes in an option's valuation, and if he'd realized how the media would obsess over the GAAP reporting then he never would've sold them.

Worrying about quarterly market variations on a multi-year options contract makes about as much sense as checking your home value on Zillow every month and then getting upset about the dips.

 

[Meadbh]

I know enough about derivatives to understand that misuse of overly creative ones had a big role in the US housing collapse. My IPS is annotated with specific instructions to step away from the fancy shmancy stuff.

 

[Lsbcal]

...(snip)...
Before I get beat up any more, I admit to not being good at finance. I'd just like to understand.

I hope my comments will not seem at all unfriendly. I'd like to understand derivatives a bit more too. But more importantly, I'd like to have a plan in place that protects my investments.

What I do hope is that my investments will survive a bad market that might be exacerbated by some derivatives mishaps. That is another reason why I have a mostly buy-hold portfolio. I have a plan for periods of weak business that have followed periods of strong business (and stock markets).

What I cannot protect for is short sharp crisis caused by geopolitical events or sudden market panics. Just have to ride those things out. Examples are the 1987 market crash, the 1998 Asian & LTCM crisis. So if derivatives are involved in a market crash that seemingly comes out of nowhere, I'm afraid there is nothing to do but worry.

 

[imoldernu]

It is not my purpose or intent to introduce an end of the world conspiracy theory into a forum that is largely centered about the building and maintaining of capital to insure a safe and happy retirement.

Hopefully our leaders recognize the dangers inherent in an unregulated system, and will continue to work in the interests of the country and the world, put into place controls that will diminish the current risks, and to forestall future threats to the world economy.

Those who champion less regulation, indeed, make good points about the strangleholds being placed on businesses, that inhibit the free enterprise system that has served the US and the World for so long.

That being said, few can explain the outrageous numbers that show up in discussions about "money"... Dollar amounts totaling 600 to 800 Trillion Dollars. Passed off as "notional amounts" ... as if it were "Much Ado About Nothing". Who even knows whether that number represents derivative contracts or derivative trading volume?

Calming words such as "Zero Sum". and "Insurance".

We hear "counterparty risk" as if it were a bet in "texas hold'em". The common perception of derivative traders, is that of nouveau riche young guys helicoptering from the Hamptons to their office in the "City".

And then there's "leverage"... the "money" that is put up... up front, to effect a transaction. Remembering LTCM... with equity of 4.7 Billion, borrowed 125 Billion, and ended up with balance sheet assets with a notional; value of 1.4 Trillion dollars.

So yes... thinking and talking about derivatives is a botheration, but to dismiss the subject because it is not easily understood puts us in the same boat with more than 300 million Americans who calmly and passively
"trust".

Everyone I know who invests, (mostly older persons) claims to to be aware of high risk instruments... and follows conservative investing rules.
On that subject, I wonder how they, and their brokers/advisors actually know the involvement of these entities in the derivatives markets.

Beyond the private investments, how does one estimate the risk of public businesses, and government risks... municipal and federal.

So the purpose of a derivatives discussion? Well, maybe just to rattle cages, but I would really like to hear from others, about their concerns, or lack of concern.

There are so many good enlightening threads here that go on for pages and pages about decisions that are part of our daily lives. Is the thought of a worldwide monetary crisis just too far out to consider?

an older, but still valid primer:
Derivatives Primer

 

[MichaelB]

It is not my purpose or intent to introduce an end of the world conspiracy theory into a forum that is largely centered about the building and maintaining of capital to insure a safe and happy retirement.

Then why end with this?

Is the thought of a worldwide monetary crisis just too far out to consider?

 

[imoldernu]

Then why end with this?

Because I have hope. With congressional approval at an all time low, the thought of a passive nation accepting a plutocracy saddens me.

I do believe there are things we can do to help avoid the kind of losses that happened in 2008/2009. Part of that could come from knowing more about the risk factors than what we know today.
This site:
Problem Bank List | Tracking Problem Banks and Failed Banks
offer email notifications that give some insight into the status of banking, pensions, and market moves. To date, none of the early warnings have affected me, but those several failed banks that were not covered by FDIC insurance were tagged as questionable. We just changed banks because of our main bank being put on the watch list. Not so much because of worry about losses, but from the inconvenience or possibly having to go through a changeover. At the present time, we are also waiting for our MetLife Bank to transfer accounts to GE ... if it ever happens.

So what does this have to do with derivatives? Simply that TBTF, may involve spin offs, and then the safety of many investments could change without good warning. If it were just the financial wackos that were stirring the pot, the it would be easier to dismiss the risk, but the warnings are coming too fast and too often to ignore.

Then there are questions that come up here, just about every day... Wait a few years, or retire now... Pension or Lump Sum? I Bonds or stocks?
Land? Real Estate? Rent or Buy? Pay off or payments?

If derivative problems should come to pass, and more of the unthinkable should happen (using OPM to cover bad bets) ... what kind of a time line will be available to "get out"... months? weeks? days? hours? minutes?

Is it Maria Bartiromo who says "Do you know where your money is?"

Should that be changed to "Don't Worry, Be Happy"

 

[Texas Proud]

I think that the problem is you seem to lump all derivatives in the same boat... but there are many out there that are used for exactly what they were intended... to take away risk...


A farmer sells his future production at a fixed price... he now has a good idea of the income he will make at the end of the season... he knows how much he can spend and still make a profit... (sure, there are other issues like the weather out there, but if he wants to protect from that he can also buy some protection)....

Now, the company that needs the farmer's output is also happy with this price... he can make longer term price commitments for his products and might even be able to get some sales he otherwise wouldn't have gotten...


Another thing that a derivative can do is shift risk... say Comp A is in the Euro... but has big sales in the US... they do not want to take on the exchange risk of the US dollar... they can do an swap with an American company who has big sales in the Euro... both have now protected themselves from their respective risks of the Euro/Dollar exchange rate changes... both are happy...


The thing about the second example is that one company might show a big loss on their derivative, but it is offset by the gain they had with their products...

Sure, not all are like these examples.... but I would bet that most of the companies are doing derivatives to offset risk somewhere else in their company... not as a tool to gamble.... even the big losses that JP Morgan has mentioned.... we were told that it was to hedge against loan losses they might have to the top companies... sure, it went wrong, but at least the info given has not indicated that it was a pure bet on the direction of the underlying index....

 

[imoldernu]

I think that the problem is you seem to lump all derivatives in the same boat... but there are many out there that are used for exactly what they were intended... to take away risk..

I agree... and not "many", but most. A major factor in the growth of business over the past 25 years.
As to the profits from derivatives, there is no question. When a single trader can earn $4 Billion in one year, that is certainly opportunity. There is no question that the success of the industry is what leads investment funds of all types into the business.

Having agreed to the success, also comes with the caution that derivatives are zero $ gain instruments, that come with a downside risk.

When the losses occur, except for those involving fraud there is little news.

A five minute "news" search brings up a few of the larger recent losses that represent the "other side".

ANALYSIS-Banks face valuation losses as Libor discarded | Reuters

Some fallout for EU Libor banks

U.S. regulator raps Enbridge on safety - The Globe and Mail

Enridge $300 million derivatives loss

http://in.reuters.com/article/2012/07/13/us-jpmorgan-earnings-idINBRE86C0G420120713

JP Morgan Losses

http://www.theglobeandmail.com/globe-investor/enbridge-profit-drops-on-derivative-losses/article4457261/

$1 Billion loss - Sicily

http://www.theglobeandmail.com/globe-investor/enbridge-profit-drops-on-derivative-losses/article4457261/

Royal Bank of Scotland $723 Million Loss

http://www.theglobeandmail.com/globe-investor/enbridge-profit-drops-on-derivative-losses/article4457261/

Japan Banks $750 Million

http://www.iii.co.uk/news-opinion/reuters/news/45613

MF Global and Peregrine

I guess my concern comes from the fact that everyone I know, talk to or write with comes back with the same answer...
Basically that concerns about derivatives belong in the same room with endtime prophets.
...and so, getting used to being a human pincushion.
Fortunately some company here in the sewing box... Born, Warren, Krugman, Buffet and a few others....

 

[Nords]

My IPS is annotated with specific instructions to step away from the fancy shmancy stuff.

I've experimented with lots of different investing styles just so that I can learn the mechanics of the execution and see the flaws in person.

That way when I'm 75 years old I won't still be curious about triple-inverse-leverage beever cheeze futures, and hopefully I won't con myself into thinking that it might be a good idea to put all my portfolio into them.

The main thing I've learned is that active investing is a lot more work... and I'm getting lazier every year.

 

[Texas Proud]

See comments in red.

I agree... and not "many", but most. A major factor in the growth of business over the past 25 years.
As to the profits from derivatives, there is no question. When a single trader can earn $4 Billion in one year, that is certainly opportunity. There is no question that the success of the industry is what leads investment funds of all types into the business.

Having agreed to the success, also comes with the caution that derivatives are zero $ gain instruments, that come with a downside risk.


Correct... but a lot of what we do are a zero sum game...... with a profit to the financial intermediary.... but I can say that about almost any kind of insurance.... it is a zero sum game... except for the profit that the insurance company takes out.... This in and of itself does not make them bad....

When the losses occur, except for those involving fraud there is little news.

That is true, but the point that they are doing what is intended does not make news... when a company makes a lot of money from a derivative (or loses a lot), they also have the opposite happening somewhere else in their company which is why they bought it in the first place...

A five minute "news" search brings up a few of the larger recent losses that represent the "other side".

ANALYSIS-Banks face valuation losses as Libor discarded | Reuters

Some fallout for EU Libor banks


This has more to do with the problem with LIBOR and how it was being measured than the derivatives.....

U.S. regulator raps Enbridge on safety - The Globe and Mail

Enridge $300 million derivatives loss


I did not see the article talking about their loss.... and if they did lose $300 million, it does not say if the derivative did what they wanted it to do...

JPMorgan traders may have hidden derivatives losses | Reuters

JP Morgan Losses

I had mentioned this already.... from what I have read, they were trying to hedge against the much bigger risk of their loan portfolio... but did it badly and wrong... not like they were gambling...

U.S. regulator raps Enbridge on safety - The Globe and Mail

$1 Billion loss - Sicily

U.S. regulator raps Enbridge on safety - The Globe and Mail

Royal Bank of Scotland $723 Million Loss

U.S. regulator raps Enbridge on safety - The Globe and Mail

Japan Banks $750 Million

The same article is quoted on these, so I can not comment.....

CME, burned by MF Global, "monitoring" Knight Capital | Interactive Investor

MF Global and Peregrine

Isn't this the fraud you were talking about And not fraud of the derivatives themselves... Not a problem with the derivatives .....


I guess my concern comes from the fact that everyone I know, talk to or write with comes back with the same answer...
Basically that concerns about derivatives belong in the same room with endtime prophets.
...and so, getting used to being a human pincushion.
Fortunately some company here in the sewing box... Born, Warren, Krugman, Buffet and a few others....

 

[FIRE'd@51]

I think you're going far out on a mighty thin limb to compare Berkshire's "derivatives" to the products that other financial firms are using.

They're long-term puts

+1

To me it seems only fitting that BRK, which has a large insurance business, sell insurance on the stock market.

 

[imoldernu]

The same article is quoted on these, so I can not comment.....

MY jumpy mouse got me into trouble.... I ended up doing do much cutting and pasting, that I gave up and watched the olympics...
It gets hard to sound intelligent, when ya end up talking to yourself...
Embarassing.

Don't think I can face doing it again...

...anyway... pleased to find someone who has been into derivatives (I haven't) which surely accounts for any misplaced paranoia.

A few questions (when you have time)....

First... Slicing and dicing? Who usually initiates this?

And a follow up... Where and how does tracking take place?

Let's say a portfolio of commercial properties.
............................................

My initial concern about the danger of derivatives was when I learned that Harvard University lost 12 billion dollars from its endowment fund between 2008 and 2009. Made me wonder if the Harvard brain trust wasn't smart enough to avoid this kind of loss, who would be?

Now the Illinois Teachers' pension fund is More than $40 Billion underfunded, taking a big hit in 2008. The current plan is to continue to invest in high risk OTC derivatives, to recoup the losses.

Risky investments further compromise IL TRS pension fund - Illinois Review

It's stories like this that make me question legitimacy, and the idea that derivatives are basically insurance instruments.

Of course, the final question that makes me nervous... In the case of a liquidity crisis (a possibility considering the TBTF stress test results) what happens when a counterparty cannot settle. I see Citigroup or Bank of America being a far greater problem than the entire EU, and cannot conceive of any way the Treasury or the IMF or even the return of Alan Greenspan could fix it.

Am truly not trying to win an argument, but to find some answers that others may be able to explain.

Thaks for your reply.
...........................................................
the missing links:

Enbridge profit hit by derivative losses | Investing | Financial Post

Sicily Swap Losses Burden Debt Amid Liquidity Crunch - Businessweek

IT and mis-selling losses hit RBS - CNN.com