By Richard Daughty, on February 24th, 2010
People hear my clear, clarion call for them to buy gold, silver and oil as their protection from the monetary and fiscal stupidities which abound – abound! – all around us, and they have questions, such as the one that is burned into my brain from an altercation this morning outside of the hardware store, where I was telling some idiot to buy gold, silver and oil, and which elicited the response, “Why are you yelling at us in such a deafening manner? Can’t you see that we are standing right here, you moron?” which is, if you count, actually TWO questions!
And it gets worse when another popular response is “What about the stock market? Will it go up or down?” and my answer is, being as polite as I can be, always the same: “What is it with you greedy people always asking two questions at once, which only confuses me and makes me angry? Get out of my sight, you silly rude persons, or I will, as was said in ‘Monty Python and the Holy Grail’ and from which I am obviously ripping off this stilted style of dialog because I have no creativity or talent of my own to come up with anything better, taunt you again!”
Actually, I am rude to these people because they are so stupid compared to, apparently, the incandescent brilliance of my Super Mogambo Brain (SMB), which clearly sees nothing but total, unmitigated disaster from the current monetary and fiscal position of the US and the world, and although it seems so blindingly obvious to me, I figure my surprising genius is the result of my (for one thing) living under a yellow sun, here on this planet you call Earth, and which we call Glabbynakker on my home planet, which refers to the shiny excretory pellets, which are little blue, watery balls, of a stupid creature called Glabby (actually the Greater Glabby, versus the Nervous Glabby, which doesn’t stink as much), and if you could see a glabbynakker and the Earth side-by-side, you would see the resemblance and understand why we don’t call it, like I said, Earth, and it has nothing to do with the fact that Earthlings are, apparently, morons, although the analogy of comparing Earthling intelligence to alien poopie is entirely apt, in a kind of rude, crude and inappropriate way that was not intentional at anytime heretofore, up until now, when I just thought of it, so that, from now on, it will be.
But I digress, and more to the point, if these people had been polite to me, I would have told them that they are obviously new around here, because everybody in THIS stinking little one-horse, provincial little nowhere town full of buttheads, already knows EXACTLY how I feel about the Federal Reserve creating so much excess money and credit (inflation in the money supply), especially so that the Congress can deficit-spend it (inflation in the debt), which results in inflation in prices of something, or some things, or most things, or all things, which has, fortuitously, resulted only in inflation in stock prices, inflation in bond prices (thus driving interest rates low), inflation in housing prices, although it has also produced inflation in the size and expense of government, inflation in the percentage of the population living on the government’s handouts, simmering inflation in consumer prices that will soon explode, (making the poor poorer), inflation in wages and – lest we forget! – the literal creation of the derivatives market and its massive subsequent inflations in themselves and Every Freaking Thing (EFT)! Hahahaha! We’re freaking doomed!
But the essential point is not that the idiotic Congress and the Federal Reserve disregarded the Constitution because some stinking, know-nothing lowlife bastards on the Supreme Court in 1934 said, and reaffirmed at every legal challenge since then, that it was OK to have a fiat money instead of gold as money even though the Constitution itself said otherwise, but what happens when you start creating too much money and credit; you get inflation in prices.
And as for the stock markets? They will go up and down, but mostly up, with heart-stopping falls and amazing rises, because there is a constant torrent of government deficit-spending money coming into the economy and it all, every last dime of it, will eventually come finally to rest as a profit in somebody’s pocket, and that person will have to “do something” with it.
And since the stock market will have been going up, up, up due to all the previous trillions of dollars coming into people’s pockets and being “put to work” in the stock market, it is a “natural” place to invest all of this money, as it is one of the few places such immense amounts of money, such mountains of money, such Unbelievable Freaking Scads (UFS) of money, can be conveniently “put to work”, being merely stored on computers.
Then, one day, you’re sitting on the sofa watching TV and listening to your family whining about something, probably about how you watch too much TV and eat like a pig until now you are a fat, stupid slob with stains on the front of my shirt and down the front of my pants and even on my socks (“Mom! Dad spilled food on his socks and now his feet smell even worse!”), which is really getting on my nerves, if you really want to know.
So there you are, not suspecting anything when, suddenly, out of a clear blue sky, one of Taleb’s “Black Swan Events” will come bursting onto the scene and everything will be wiped out, either figuratively (in which case gold, silver and oil should soar in price as inflation in the prices of necessities soar, as indeed the Black Swan Event could be massive inflation in food prices and a bond market collapse), or literally (in which case it won’t matter because we will all be dead).
Hoping for the best, go with gold, silver and oil! It’s not only the smart play, but also easy, as in, “Whee! This investing stuff is easy!”
Stock Market Rallies: Nothing Lasts Forever originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today’s markets. Its been called “the most entertaining read of the day.”
By Ajay Shah, on September 4th, 2009
Central counterparty for OTC derivatives
Jayanth Varma is astounded that some corporate treasurers think that their derivatives positions should not be backed by collateral. I am too. On a related track, there is news today that RBI is pushing banks to report interest rate swap transactions through CCIL. This is in the right direction.
The futures clearing corporation as the role model
The role model here is the futures clearing corporation, e.g. NSCC. Futures clearing corporations are designed to enable safe trading between strangers, which makes possible the nice efficiencies of the anonymous electronic market. In doing this, futures clearing corporations demand the identical collateral from all customers. There is no question of NSCC exempting SBI from collateral requirements because SBI is para-statal. It is through such toughness on collateral requirements that NSCC has built up a 13-year track record, of surviving quite some market turbulence, as central counterparty.
More generally, the `recipe’ of how clearing corporations work has fared well in the last 100 years, barring a few failures which are really about operational risk, corporate governance, malpractice etc. If someone is serious about running a clearing corporation properly, it can be made to work. All that one has to do is to ensure sound ownership and governance in the exchange business.
Rule of law
I have a disagreement with the mechanism adopted by RBI, on the issue of rule of law. If the story is accurate, RBI officials met a few banks and asked them to do something different. If we respect the concept of rule of law, then it is better to run through the full set of steps:
- Put out a draft rule change for comments.
- Genuinely, substantively, listen to the commends. Consider it possible you may be mistaken.
- Put out a modified rule on the website, after which everyone should be obeying it regardless of whether there has been a meeting with RBI officials or not.
- Rule changes should be appealable at an SAT.
This is a better process flow, one that expresses the goal of having rule of law. SEBI is the most advanced financial regulator in India today, in having developed the closest approximation to this process.
A real problem with corporations and OTC derivatives in India
I am not a legal expert, but in my understanding, at present, if two corporations enter into an OTC derivative against each other, this is not enforceable. Enforceability is limited to the class of transactions where one of the two counterparties is a bank.
This is reminiscent of 1970s vintage rules of the game in exchanges. Here, exchanges forced the public order flow to only go to market makers. Public orders could not match against each other. Or to say it differently, public orders could not compete with the quotes posted by the market maker. This was a way to rig the rules of the game so as to favour the market makers.
In similar fashion, the existing rules with banks and OTC derivatives in India (if I have understood them correctly) are a way to prop up the profitability of banks at the expense of customers of banks. This is anti-competitive. It helps ensure that the inter-bank OTC market is a rigged game, one that favours banks at the expense of corporate customers. It is one more reason why exchange-traded derivatives are so important in India. It is only on the NSE screen that, for the first time in India’s history, we are getting a genuine, competitive, transparent market for the currency or interest rate futures.
These kinds of efforts at rigging the game, in the context of corporations and OTC derivatives, help increase the chances that India will be a pioneer by world standards on the shift of the currency and bond markets to the exchange platform. In terms of the ratio of the size of the OTC currency forward to the size of the exchange-traded currency futures, India is already one of the remarkable places in the globe.
Where corporations are different
While futures clearing corporations should give no quarter to corporate customers as far as collateral requirements are concerned, I think there is a case for having bigger position limits for corporate hedgers.
There is a genuine tension here. If small position limits are used, this reduces the usefulness of the derivatives market for society, because the most important customers of hedging (corporations) are blocked from using it. If special rules are applied for corporate hedgers, there will inevitably be certain shades of gray on what gets done. Yet, when regulators swing over to the other direction and blindly force tiny position limits, it imposes a cost on society. There is a bias towards such over-reaction given that regulators have a different personal perspective on the risk and return from a rational rule set, when compared with the welfare gains to society.
I think the real answer lies in more principles based regulation. For physically settled contracts, there should be no dislocation in the delivery process and for cash settled contracts there should be no artificial distortion of the market price. An excessive attempt at writing down rules does not get the job done.
By Ajay Shah, on June 29th, 2009
There is a fascinating article in The Economist about how the world of derivatives has shaped up through the crisis.
I often encounter misconceptions about hedging. The one line that summarises the issue is this: The job of a hedging strategy is to combat extraneous economic exposure. Let me focus on currency exposure as an example, though the basic idea works in all aspects of hedging. A good currency hedge is one which neutralises the effect of currency fluctuations on the NPV of profit.
I have seen four major mistakes in the way people think about hedging:
- Hedging seen as a way of eliminating currency risk in the translation of direct import/export proceeds. This is wrong because it’s an incomplete picture of what happens to the profits of a company when the currency moves. A lot of finance practitioners are confused on this subject, particularly in India where RBI rules have had mistakes on these things for decades. (While RBI staff made mistakes, that was no reason for currency hedging consultants and such like to also make the same mistakes).
- Hedging seen as a profit centre. This is wrong because the job of hedging is to eliminate exposure of the NPV of profit, not to make money. Suppose a company embarks on a currency hedging program. Half the time (ex-post) the hedge will appear to have made money and half the time (ex-post) the hedge will appear to have lost money.
For a company which has very big currency exposure, ex-post, half the time there will be massive cash losses on the currency hedge. If top managers, directors or regulators do not understand this correctly, it’s easy to jump into complaints about `massive losses on derivatives trading’. This emphasises the importance of seeing a hedging strategy and the economic exposure in an encompassing way. A person who closes out one element of an overall hedging strategy because that’s generated a lot of cash outflow in recent days is, well, wrong.
- Hedging away the core sources of profit. A refinery is a bet on the `crack spread’, the gap between the price of crude oil and the price of petroleum products. The shareholder and owners of a refinery are inexorably speculators on the crack spread. If you don’t believe that this spread will do well, don’t build a refinery. For a refinery, this is core business risk, this is the source of profit. It is not an extraneous economic exposure. To try to hedge away this exposure is not correct.
- Insecurities about imperfect hedges. Every now and then, a bright person complains that a proposed hedge has a substantial basis risk. The only perfect hedge is found in a Japanese garden. All realworld hedges are imperfect. The useful question is: Is an imperfect hedge better than no hedging?
The Economist article points out that with the upsurge in volatility, demand for derivatives has gone up, not down. Once most large firms of the world start doing balance-sheet scale hedging, derivatives positions will be much larger than they are today. The world needs bigger, not smaller, derivatives markets. We stumbled on our way to that world, and now have to figure out once again how we are going to get there.
In the world of OTC derivatives, firms face credit risk owing to contracts with banks and banks face credit risk owing to contracts with firms. In the good old days, these risks were mostly ignored, and OTC derivatives looked more attractive than exchange-traded derivatives (where posting collateral is unavoidable). Now, both sides are getting wary about what this involves. Banks have started charging higher prices for bearing this risk (either though a bigger price or through collateral requirement), and banks have started refusing to have exposures against certain firms. Both these phenomena should enlarge the footprint of exchange traded derivatives. All this flows logically but it was interesting seeing descriptions in the article about things actually shaping up this way.
By Trace Mayer, on May 14th, 2009
The inherently unstable, fundamentally unsound and immoral worldwide financial system organized out of intrinsically worthless debt has exploded into derivatives and imploded into a greater depression. Several of the stronger voices in the financial press evade the D word which hangs over the world economy like the Sword of Damocles.
But Yahoo Finance! reports, “The Obama administration is asking Congress to extend its oversight of the financial system to include the shadowy market of derivatives, the kind of complex financial instruments that helped bring down the giant insurer AIG. … The global business world holds a staggering $600 trillion of these [over-the-counter] contracts.”
 The Obama administration is already doing everything they possibly can to intentionally exacerbate the greater depression. The use of political debt-based currency is destined to either implode in a deflationary depression or explode in hyperinflation. As the Treasury bubble predictably bursts interest rates will rise. The bond market is trembling as recognition that a 30-year bull market is coming to an end.
DERIVATIVES
Wikipedia gives a fairly clear definition of a derivative. ”Derivatives are financial contracts, or financial instruments, whose values are derived from the value of something else. … Because the value of a derivative is contingent on the value of the underlying, the notional value of derivatives is recorded off the balance sheet of an institution, although the market value of derivatives is recorded on the balance sheet.”
Wealth can be either a tangible or financial asset. Tangible assets have intrinsic value and can never become worthless while financial assets can. Often times financial assets are subject to counter-party risk. Counter-party risk is the risk of loss due to a counter-party’s non-performance and is contingent upon their financial ability to pay.
In the shadowy world of derivatives there are many counter-parties potentially liable for hundreds of trillions of dollars. These derivative assets infect the balance sheets of many public and private corporations, local and state governments and other institutions. Through the use of fair-value lying the value of the derivative assets is hugely overstated while the value of the derivative liabilities is hugely understated. Even worse is that the contingent liabilities have no basis in reality because they are based on nominal market value and not notional value.
Credit default swaps insure against a counter-party failing to make their payment. Currently premiums for credit default swaps are twice as high on British sovereign debt as Cadbury. In other words, a company that makes chocolate eggs is a better credit risk than a major western government.
APPLICATION TO PENSIONS
A good example of a derivative is a pension. For example, an individual works for Chrysler for 40 years and retires. Chrysler agrees to pay $2,000 per month for the rest of the retiree’s life. The value of the pension is derived from the value of the underlying (Chrysler).
Chrysler will use actuarial methods under GAAP, which can now be based on fair-value lying, to calculate the estimated pension liability. We will assume it is exactly 15 years or $360,000 which would then be adjusted to the net present value which we will assume is $150,000. This nominal market value would then be carried on Chrysler’s balance sheet as a liability.
On the other hand, the individual uses their own method of fair-value lying to calculate the value of the pension. They may be optimistic and overstate their expected remaining life span at 40 years and use a more friendly discount rate to arrive at a net present value of $450,000, or three times as much as Chrysler’s valuation.
Viewing the balance sheets systemically there is an asset of $450,000 with a corresponding liability of $150,000. But the value of that $450,000 asset is also contingent upon Chrysler’s ability to pay and therefore subject to counter-party risk.
If Chrysler goes bankrupt then there is potentially at least $300,000 of illusory capital in the financial system that evaporates. Of course, some creative investment bank who has loaned currency to Chrysler may actually profit from their bankruptcy and the greater the disparity of illusory capital and real capital then the greater their profit.
GOVERNMENT HELPLESSNESS
During the great inflationary credit expansion the use of illusions, irredeemable government or central bank tickets, as currency in ordinary daily transactions has become universal. Their legal tender status, which is in complete conflict with the United States Constitution, is massive government regulation and the chief cause of all the current financial problems. By violating the supreme law of the land Congress has created this massive mess.
 Now the Obama administration wants Congress to engage in more regulation and intervention. But why would these costumed officials be able to fix the problem they created? Indeed, the only real tools they have are either their little intrinsically worthless tickets, which function like their common stock, or their guns.
Indeed, if the Obama administration sincerely wanted to fix this mess then they would remove the 28% tax on gold and then repeal the legal tender status of the FRN$.
The common stock of America’s owner has recently declined to around 82 and is looking increasingly unattractive. As Vladimir Putin observed “The only problem: your results were poor and this will always be the case because the work you do is unfair and immoral. In the long run immoral policies always lose.”
But the truth of the matter is that the little tickets are subject to an incredible amount of counter-party risk. Federal government liabilities are estimated to be around $100T. When the tax eaters and soldiers no longer get paid with currency that will purchase anything and the purchasing power in their pensions are gone then things will get particularly interesting.
CONCLUSION
The golden Sword of Damocles has begun moving because the great deflationary credit contraction has begun. As the common stock of nations continues evaporating civil unrest will increase. The greater depression will make servicing debt increasingly difficult and many derivatives will continue to trigger and decimate entities during this deflationary crash. Confidence, already slightly eroded, will be completely destroyed as counter-party risk continues materializing. Corporations and governments will DEFAULT resulting in complete worthlessness of those assets. But who needs the dangerous costumed Washington clowns anyway?
Through all of this chaos and change there will be at least one brilliant asset. At all times and in all circumstances gold is money. Gold is the only major currency not subject to counter-party risk. Gold cannot default. Therefore, during deflation if the like-cash FRN$ is king then the real form of cash, gold, is emperor.
Disclosures: Long physical gold and silver with no position in TLT.
By Ajay Shah, on May 12th, 2009
I happened to glance at the top 10 underlyings in derivatives trading at NSE and saw this:
I remember not so long ago, when the only thing that traders in India could think about was individual stocks. At the time, it was extremely difficult to get them interested in macro underlyings.
I find it quite striking that now, the top underlyings are Nifty (i.e. Indian macro), the INR/USD (i.e. Indian macro), mini Nifty (also Indian macro) and Bank Nifty (an industry and not an individual security). I find the sophistication of industry analysis that’s now found in India to be a big step away from the way things were a few years ago, when there was only security analysis and no industry analysis.
The biggest things in modern finance are macro underlyings and not individual companies or commodities. I feel that while this transformation has taken place in trading, there is still some distance to cover in terms of bringing macroeconomic thinking into the hands of the people trading Nifty. People who trade currencies and interest rates explicitly think macro, but most of the people who trade Nifty don’t seem to do this explicitly.
I remember a long time ago, when equity derivatives were still something to argue about in Indian public policy debates, I used to have a vivid sense that individual stock futures would readily tap into the capability for leveraged trading on individual stocks that existed because of `badla‘. But shifting from that to index derivatives was going to require new ways of thinking. You might find this article of mine, from 1997, to be mildly amusing. Today it’s all obvious, but back then it was not.
Market microstructure theory has some important messages about why macro underlyings become more liquid than securities issued by firms. With firms, there is always more asymmetric information, which leads to bigger spreads (or bigger impact cost). With macro underlyings, informational asymmetries are smaller, which gives better liquidity.
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