From a caveman to mega-structures, humans have progressed rapidly. The innovation and creative abilities of human have known no bounds. Humans have successfully found a way to vent their creative abilities in many ways and forms. Creativeness abounds in all aspects of human activity. From engineering to chemistry, from biology to space sciences, we see the remarkable achievement of human ingenuity.
In esoteric sciences, Man is represented as the most defiled. It just means that man is imperfect. And we have a story of Adam, Eve and serpent to coax us to believe that detail. It is also said that all the creations arising from the imperfect would be imperfect.
Now, combine the creative skill of human with the imperfection of his creations, you have - trouble.
Call it patriotism or war, humans have always found an ingenious way of killing people From the hand to hand combat to development of smart tools man has developed. Weapons are the tools developed for killing. Unfortunately, weapons have no sense if it is being used for good or bad purpose. From the simple tools to gunpowder to automatic-firepower to inter-continental missiles, humans have indeed progressed a long way.
Weapons are not the only example of human ingenuity being used for bad purposes. To be fair, it is not possible with human comprehension to realize the evil effects of the creative inspiration. Actually, weapons are not bad; it is the intention and the use behind it that makes it unethical. Who would accuse Einstein of detonating the nuclear device in
The whole point of this long digression is – humans are very skilled in using their imperfect imaginative ideas and -- cause trouble. Trouble, because it was either not foreseen or it was not brushed under the carpet of conscience.
One of the greatest creation of humans is the financial derivatives. It should rank as one of the most creative way to deny the existence of God and wisdom. In the history of financial markets this is as big a deceit as fiat currency.
Warren Buffet, the famous investor, also famous of his “derivatives are financial weapons of mass destruction” quote, gives some pretty good reasons why derivatives markets could be headed to deep trouble. Behind his world famous quote of WMD, lies some sensible arguments. Some of them are:
- Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counter-parties to them.
- With regards to wildly overstated earnings he says “the parties to derivatives also have enormous incentives to cheat in accounting for them.” And since most of the exotic instruments do not have liquid market/prices for “marking to market”, financial models are used to arrive at fair values. Buffet says “mark-to-model degenerates into what I would call mark-to-myth.” [this was quoted around the collapse of Worldcom and Enron]
3. To quote Mr. Buffet, “The derivatives genie is now well out of the bottle and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts. In my view, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”
Let us just have a brief background of the derivatives and on how it stands today.
Derivatives have existed in financial markets in many forms. They have been traded in commodity markets since medieval ages. But it was in 1970’s that derivatives took off among the general public and set the traders’ imagination on fire.
Financial Engineers: Creators of the street
Financial engineers are the ones who built up the great derivatives bazaar. With their ability to innovate on package and bundle and achieving seemingly impossible objectives, they are cynosure of Wall Street. Many scientists believed, famously Michael Faraday, that every thing in the world are based on mathematical points. But unfortunately the universal theory is still out for grabs. We have still not been able to engineer all the possible variables or program a perfectly learning system which self-adopts to different scenarios. One of the crowning jewel of financial engineering is Black Scholes formula.
Black Scholes and options pricing revolution
Options is a big reason why the Derivatives became popular with crowd. When first introduced the volumes were very low as most stayed away. There was no way of pricing the option. When the Black-Scholes formula came on the public arena the general public were fired with imagination on the various uses of options for risk-management. This set off a record breaking growth in the options and its traded value.
But there was one tricky problem. The formula helped you to price the options when all things (variables) said and done were in perfectly efficient trajectory. Unfortunately, even though markets are rational and efficient over a long periods of time they can shake off complacency vehemently. The cracks in theory were noticeable even before the great 1987 crash. 1987 stock market crash brought out the first evidence that Black-Scholes was not meant to be used as the actual calculator of the option prices but as an indicator of the possible fair-value.
But there is huge army of traders and derivative experts who continue to use BS equation to value every option under the sun. It’s a scary thought even to imagine how many of these trillions of dollars worth of notional value are mispriced and these trades are completely unprepared for a 5 or 6 sigma event.
Perfect storm, the waiting derivative storm
Buffet in one of his speech states the following: “Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons.”
One of the effects most financial engineers tend not to incorporate or realistically cannot incorporate in to the markets are the large number of variables. For example, in the above quote Buffet continues “This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counter-parties.” It is very hard and almost impossible to incorporate the credit standing of the counter-parties. Since the credit standings are very fickle in the electronic age of commerce, the static models or nearly static models do not do full justice to the associated risk. If you take the argument further, we cannot model the credit standings of the associates of the company. In other words, the world as we know is a daisy chain of events, where the impact on firm is cascaded across companies, some of which are completely unrelated.
It’s a stark realization that most of these billions of dollars worth the companies are relying on, could be badly priced securities. One crack in the wall, could be start off an avalanche.
Banking secrets: Off-Balance sheet securities
If the badly priced securities are not the only problem, the bigger problem is that nobody knows who owns how much of these. Thanks the innovativeness of engineers, we are now able to take huge amounts or risk and completely parcel them out to a different non-related entity with no recourse to the parent company. The parent company thus has incentive to take most of the risks and enjoy the rewards. If and when things go wrong, the parent company just switches off the connection and the counterparties for the trade are done for. The cascading impact can be felt everywhere. The unrelated companies will be hit will with huge bills because of these failures. The scenario though is being played out practically everywhere.
The financial institutions and banks not wanting to miss out on the high-yielding securities like Asset backed securities, collateralized debt obligations; structured investment vehicle used various off-balance sheet transactions.
The beauty of OBS is that it does not trigger any capitalization requirements from the banks hence an easy route to make money. But, in events unforeseen by the bankers, the sharp drop in the prices and drying up of the liquidity has ensured that these securities are virtually written-off. These losses have to be borne by the bank as the sole enabler of the equity of the transactions.
With the sharp drop in these asset prices of these securities, the institutions are faced with losses mounting to billions. With these OBS transactions incurring significant losses, the institutions have to two options, one is to close out the positions and book the losses or bring them on to the balance-sheets, either way the balance sheets are going to face enormous pressure of equity capitalization. It is estimated that about $1trillion would flow into banks’ balance-sheets.
The real impact of these is yet to be seen. The unwinding of these trades on the global scale will create chaos of greatest magnitude.
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