Friday, October 10, 2008

Derivatives:Hantu Was Right

Hantu Laut

On 2nd October I wrote about the state of the American economy and the likely causes of the financial meltdown in America under my posting "American Get Screwed".

One of the reasons leading to the financial crisis was the use of financial derivatives. These are very complex financial instruments that not many investors understand the workings and risk involved.They are supposed to reduce risk but in the wrong hand,greed and overexposure could be disastrous.

There are wide range of derivative contracts traded on the financial markets based on different kind of assets and indexes.You can even have derivatives on the weather.How all these different instruments work you may have to visit the investment gurus on Wall Street(where it was invented) to explain to you.

Below is a paragraph of what I wrote on 2nd October:


"Much of the troubles started from highly innovative and risky financial derivatives, over-extended credit,over-speculation of trading in stocks and bad financial management.Some of the top CEOs in America are undeservedly overpaid with some having pay packages running into hundreds of million.Their over-indulgence in highly speculative financial derivatives were the cause of the meltdown"

Many of you would still remember Baring Bank and its rogue trader Nick Leeson who speculated in derivatives trading that brought the centuries- old bank to its demise.That's what derivatives can do to banks,corporations or anyone who are greedy,careless or have no understanding of the mechanics of these complex instruments.Former Federal Reserve Chairman Alan Greenspan was a great believer and supporter of these beastly business tools.

Lehman Brothers and Merrill Lynch were creators of credit derivatives.These derivatives are the sweethearts of investment banks and brokerage houses by selling them and making huge upfront fees and premium payments.Another victim,AIG jumped on the bandwagon and went overboard in derivatives involving the sub-prime market.

Below is an article on the subject that appeared in the New York Times yesterday, 8th Oct:


Published: October 8, 2008

“Not only have individual financial institutions become less vulnerable to shocks from underlying risk factors, but also the financial system as a whole has become more resilient.” — Alan Greenspan in 2004

George Soros, the prominent financier, avoids using the financial contracts known as derivatives “because we don’t really understand how they work.” Felix G. Rohatyn, the investment banker who saved New York from financial catastrophe in the 1970s, described derivatives as potential “hydrogen bombs.”

And Warren E. Buffett presciently observed five years ago that derivatives were “financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.”

One prominent financial figure, however, has long thought otherwise. And his views held the greatest sway in debates about the regulation and use of derivatives — exotic contracts that promised to protect investors from losses, thereby stimulating riskier practices that led to the financial crisis. For more than a decade, the former Federal Reserve Chairman Alan Greenspan has fiercely objected whenever derivatives have come under scrutiny in Congress or on Wall Street. “What we have found over the years in the marketplace is that derivatives have been an extraordinarily useful vehicle to transfer risk from those who shouldn’t be taking it to those who are willing to and are capable of doing so,” Mr. Greenspan told the Senate Banking Committee in 2003. “We think it would be a mistake” to more deeply regulate the contracts, he added. Read more....

The Asian markets are going to take a big tumble today because of what happened on Wall Street yesterday.The Dow was down 7.3% in yesterday's trading.

The whole world is in financial turmoil.Malaysia is still in a slumber.More concerned with politics than state of the economy.The KLSE is the only exchange that is not in sync with the other markets.Are we fundamentally strong or are we living in a state of denial.Watch the market next week.

Next post:'Where Crude Oil Heading For'

13 comments:

Fazrul Shahril said...

Dear Sir,

Nice article and very informative.

Thank you,

Regards,

Ivan Yong said...

Hi Hantu,

I have a question to ask actually, by generating such huge bailout from a coffer with no cash, it will come to a point whereby the greenback will worth the same as the Banana Dollar during the Japanese time.

What would happen next if the US continues that path?

Hantu Laut said...

fazrul,
Thanks.See you around.

Mat Salo said...

H-L,

Have been busy lurking at the PJ sessions court hanging with geriatric gents like Zorro & Din...

Rightly so, Sir. No one is paying attention to this serious meltdown. The full effects will take some time to fully manifest itself. In the meantime politicians are in denial mode. I'm glad I heard an inner voice that made me pull my money from stocks held by Wachovia. I think from now on everyone will be turn conservative in their investments.

Sir, my latest post is a tribute to 'the old geezers'. And I mean that in a nice way. You were mentioned, of course.

I do believe you are also the proud owner of a D300? I got mine second hand a week before Raya... It's a great camera, Sir. I just need to learn how to work it, that's all. Haha.

kittykat46 said...

Derivatives are not evil in themselves. Its when people use it for greed that it becomes dangerous.
Options to Buy/ Options to Sell all kinds of products and financial instruments are a necessary part of international trading, be it in goods or financing.

Just to share with you a personal experience.
I used to work for a multinational company which, overall worldwide, was a major industrial buyer of gold. As you probably know, the price of gold can jump around all over the place all the time. Gold is popularly sought after as an investment, for jewelery and for speculation.

For the company, that was a problem because gold is just another raw material for use in manufacturing, and we needed some stability in the price.

So as a corporation we hedged about 50% of our gold purchases. The corporate traders made contract options to buy X amount of gold at Y price in 3 months time. Obviously, this sort of hedging requires a derivatives trader on the other side willing to sell the option. It is a derivative, because it is a contract to deliver on the FUTURE, not present price of gold.

There is a risk to either side, depending on how the actual price of gold moves in 3 months time, but it helps share the risk, and for an industrial purchaser, it helps stabilise the cost of manufacturing.

The company had very strict rules that we only hedged based on our worldwide manufacturing needs and absolutely no speculation allowed - the people involved had the rules made very clear to them.


On the subject of crude oil - months ago I wrote that the price of oil, in the short and medium term is not some perpetually increasing number. Like any other commodity, it is subject to Demand/Supply pricing. Unfortunately, the surest way for demand to fall, and the price to fall accordingly, would be a global recession, which is now becoming a reality.

In the long run, of course, oil is going to be an increasingly short commodity, and the price will go up. Alternative energy, and also conservation are really important projects for every country in the world.

Jed Yoong said...

Greedy investment bankers "robbing" old people's savings...Hey that's America, the Land of Brave, Home of the Free...Now everyone is trapped in debt, very brave but not so free?

Hantu Laut said...

Ivan,
The US currency will still be in great demand.The world trades are dominated by US Dollar.The foreign reserves of almost all countries are in the US Currency.

To raise more money the US government will continue to issue short and long term government bonds they called Treasury Bills Big corporations and other investors will buy them. Other countries will have to buy these bonds to save themselves.They must keep the US Dollar alive otherwise if the currency become much devalued they all be fucked.

You see the USA is the biggest conman.If they go down the whole world go down with them.

So, the rest of the world have no choice but to save the US of America.

Hantu Laut said...

Hi Mat Salo,
I didn't get to meet up with Bernard and his gang as I was busy bonding with the grandchildren and than went out station.Will meet up with him on my next trip.

There will be a change of PM or a change of government, hard to say what's going to happen.Whether Najib can bring some sense of soberness and good governance to the country is yet to be seen.He certainly has better personality but whether that would translate into good leadership we would have to wait and see.

The world finances and economy are in dire straits and it's going to get worse before it gets better.The question now is how long would the recession last or would it turn to depression as in the 1930s.

Thanks for the mention.We old geezers have nothing better to do but have to 'kacau' the world to keep our sanity.Writing is very therapeutic and keep our degenerating brain cells from dying on us.

The D300 is a very good camera and just like you I am still learning its many function.The good thing is it can accept old manual focus lenses.I have some very old Nikon long focal length lenses of 300mm and 500mm which I can use with the camera if I switch to manual mode.
One thing I find,like all users manual,reading the manual is boring.Somebody should learn to write manuals like a story book,which is exactly what I found on my visit to KL.

If you are in KL the next time, go to Kinokuniya at KLCC.They have a speciality floor dedicated to photography,architecture and interior decoration.There are few books written on the D300.It's worth getting one of them,it makes reading not a chore.

Must meet up with you one day.Selamat Hari Raya to you and family.

Hantu Laut said...

Mat Salo,
Correction!Kepala pusing!

Para 2... some sense of sobriety and good governance...

Hantu Laut said...

kittykat46,
Nothing is evil in this world except human.We are both the producers and consumers.

Your ex-company was doing proper hedging.Even in proper hedging you still can lose,maybe not physically but in opportunity,depending which way the market moves.If you are a manufacturer and the commodity is your raw material and the price moved below your hedged price than you have lost the opportunity of lowering your manufacturing costs.Hedging is only good for you from incurring physical losses on future uncertainties.

Hantu Laut said...

Daer Jed,

If it is any consolation, the US will not die economically and would continue to rule the whole world either with their money or their guns.

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Ivan Yong Wei Kit said...

Hi Hantu,

Thanks for your comment. I agree.

Everyone is screwed together with the US. However, the Chinese is a different story. For China, I believe US will never allow them to come in aggressively and buy up their banks and financial systems. Nor the Russians.

But this time, things is really different. China,India and Russia will gain the upper hand.

Now the question is what should we as lay man do.This is not only a economy recession but also a credit problem. Many banks will pull back their credit line. Not only mortage owners will have problem even companies will have problem with their cash flow.

In the past, only startups and small companies worry about cash flow. Now the big guys will too but a tad too late. Too much leveraging.

The way, I see it huge retrenchment is on its way. It just doesn't make sense continuing with that sort of cost.