mfioretti: derivatives*

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  1. Before the global financial crisis, a rise in raw-materials prices used to be bad news for the economy and stocks in general. Since central bank easy-money policies took off, that's become a thing of the past.

    One possible explanation is the level of exposure that banks and investors have to the industry. The 5,000 biggest publicly traded companies tracked by Bloomberg in the iron and steel, metals and mining, and energy sectors have a combined $3.6 trillion in debt, according to their most recent financial reports, double what they had at the end of 2008.
    Gushing IOUs

    Much of the increase is due to money that was borrowed to dig mines and wells whose output, at previous prices, would have easily repaid most maturing bonds and loans. But as commodity prices have tumbled, so has the ability of companies to meet their obligations. The Bloomberg Commodity Index is still only 3.9 percent higher than a 25-year low hit on Jan. 20.

    Five years ago, those companies tracked by Bloomberg had more operating income than debt, on average. Now, it would take them more than eight years' worth of current earnings, without provisioning for interest, taxes, depreciation or amortization, to clear their combined net obligations.

    It's unclear where the other portion of the $3.6 trillion in liabilities lies but probably, most of it is owed to banks. If the remaining $1.5 trillion is indeed on the balance sheets of financial institutions, that would represent about 1.5 percent of the total assets of all the world's publicly traded banks. That doesn't seem very significant, or any cause for concern. But to put it in some context, U.S. subprime mortgages represented less than 1 percent of listed banks' assets at the end of 2007.
    http://www.bloomberg.com/gadfly/artic...ve-built-a-3-6-trillion-debt-mountain
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  2. Quicker than any human seemingly could have done it, someone—or rather something—bought $110,530 worth of cheap options on Altera, a company that makes digital circuits.* Over the next several minutes and until the end of the day, as humans digested Mattioli’s takeover rumor at human speed, Altera’s stock price rose. When all was said and done, those cheap options had resulted in a $2.4 million profit. Speculation immediately centered on the idea that an automated program (a “bot”) had scanned the tweet, interpreted its meaning, and instantly bought those options based on an algorithm. The robot had read the tweet and made a killing on it before anyone knew what was going on.

    On April 6, a Reuters report disproved the initial hypothesis. In fact, Reuters reported, the trade occurred 19 seconds before the tweet, and one second after a headline appeared on the Dow Jones Newswire.

    I know a guy—a human guy—who was on the other side of that trade. And he says this wasn’t the first time it happened to him. He’s convinced someone’s figured out an algorithm that’s faster than anything he’s ever seen before. So fast, he fears, that it might eventually put him out of a job.

    And then on Wednesday, April 1, when the drugmaker Receptos was involved in takeover rumors, it happened again. Shares in Receptos leaped, but not before somebody had already bought a slew of options at lightning speed, banking another tidy sum. (My friend’s firm escaped dramatic damage in these instances, losing less than $30,000 between the two. Others were surely less lucky.) In each of these cases, the buyer appears to have responded within moments to a tweet, or possibly to a phrase posted in some other online venue—nailing down the precise trigger is difficult.

    Could it be a human and not a bot making these trades? My friend doesn’t think so. The complexity of the orders would slow a person down too much to be feasible. “It would be impossible for me to do. By the time you could read the news, process it, and press the ‘buy everything’ button, it would take too long. The speed is unbelievable. They’re buying everything within like 3 seconds of it coming out, which is not possible for a human.”



    If you’ve read the Michael Lewis book Flash Boys, you know about the high-frequency trading wars. But the story here was a little different. Those HFT guys were detecting that someone had interest in buying a stock at $5 a share, and then, using technological hocus-pocus, jumping in to buy it first before immediately reselling it to the person at $5.01 a share—over and over, in tons of different stocks, making tiny gains at massive volume.

    What we’re talking about here are options trades based on breaking rumors. And because options are derivatives—you’re buying the right to buy shares, not the shares themselves—it’s possible to achieve larger wins for a smaller outlay of cash. What makes these particular trades so striking is that they were made at the very tail end of the day, when the bought options were all only minutes from expiring. The odds that any given stock will suddenly rocket in the next few minutes are extremely low, which makes buying expiring options cheap and the bet very lucrative if it pays off. Consider that if the purchaser of those Altera options had taken his $110,530 and simply bought regular stock in Altera with it, he would have cleared about a $34,000 profit by the end of the day. Instead, using options, he made $2.4 million.


    There have also been reports about hedge funds that trade based on sentiments expressed in tweets. In the case of the Altera incident, though, a bot appeared to read a rumor, understand it, and instantly execute an options strategy based on it. And for my friend—at least in his corner of the business, a corner he’s worked in for seven years—this felt like something radically new. “It used to feel like a race that we could win or lose,” he says. “But whatever algorithm they’ve developed, we are now completely helpless. Sitting ducks. This is by far the most advanced version of this we’ve ever seen. It’s at a totally different level.”
    http://www.slate.com/articles/busines...r_meet_the_guy_it_cost_a_fortune.html
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  3. The story shows a not-surprising backstory: bankers were actively soliciting the Chicago Public Schools with proposals involving auction-rate securities, the hot product of the day. CPS hired a politically connected former banker to evaluate the deals. Any regular reader of this site no doubt has figured out that it takes a high level of expertise to evaluate derivatives, and that’s well beyond the skill level of most “bankers”. The open question here. Even so, in this case the analysis was so slipshod that it raises the question of whether the advisor ever intended to do anything more than provide a paper trial supporting going ahead with the deal.
    http://www.nakedcapitalism.com/2014/1...onstrates-high-cost-high-finance.html
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  4. raising interest rates could implode the monster derivatives scheme. Michael Snyder observes that the biggest banks have written over $400 trillion in interest rate derivatives contracts, betting that interest rates will not shoot up. If they do, it will be the equivalent of an insurance company writing trillions of dollars in life insurance contracts and having all the insureds die at once. The banks would quickly become insolvent. And it will be our deposits that get confiscated to recapitalize them, under the new “bail in” scheme approved by Janet Yellen as one of the Fed’s more promising tools (called “resolution planning” in Fed-speak).

    As Max Keiser observes, “You can’t taper a Ponzi scheme.” You can only turn off the tap and let it collapse, or watch the parasite consume its food source and perish of its own accord.

    Collapse or Metamorphosis?

    The question being hotly debated in the blogosphere is, “What then?” Will economies collapse globally? Will life as we know it be a thing of the past?

    Not likely, argues John Michael Greer in a March 2014 article called “American Delusionalism, or Why History Matters.” If history is any indication, governments will simply, once again, change the rules.

    In fact, the rules of money and banking have changed every 20 or 30 years for the past three centuries, in an ongoing trial-and-error experiment in evolving a financial system, and an ongoing battle over whose interests it will serve. To present that timeline in full will take another article, but in a nutshell we have gone from precious metal coins, to government-issued paper scrip, to privately-issued banknotes, to checkbook money, to gold-backed Federal Reserve Notes, to unbacked Federal Reserve Notes, to the “near money” created by the shadow banking system. Money has evolved from being “stored” in the form of a physical commodity, to paper representations of value, to computer bits storing information about credits and debits.

    The rules have been changed before and can be changed again. Depressions, credit crises and financial collapse are not acts of God but are induced by mechanical flaws or corruption in the financial system. Credit may stop flowing, but the workers, materials and markets are still there. The system just needs a reboot.
    http://ellenbrown.com/2014/07/25/you-...t-taper-a-ponzi-scheme-time-to-reboot
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  5. The FE can be loosely described as ‘making money out of money’ as opposed to making money out of something; or ‘profiting without producing’ 1 » . Its primacy derives largely from two sources – the ability of the commercial banks to create credit out of thin air and then lend it and charge and retain interest; and their ability to direct the first use of capital created in this fashion to friends of the casino as opposed to investing it in real economy (RE) businesses. So the FE has the ability to create money and direct where it is used. Given those powers it is perhaps unsurprising that it chooses to feed itself before it feeds the RE. The FE’s key legitimate roles – in insurance and banking services – have morphed into a self-serving parasite. The tail is wagging the dog.

    The FE’s power over the allocation of capital has been re-exposed, for those who were perhaps unaware of it, as we see the massive liquidity injected by the central banks via QE disappearing into the depths of bank balance sheets and inflated asset values leaving mid/small RE businesses gasping for liquidity.

    By giving preferential access to any capital allocated to the RE to its big business buddies the FE enables those companies to take out better run smaller competitors via leveraged buy outs. By ‘investing’ in regulators and politicians via revolving doors and backhanders, it captures the legislative process and effectively writes its own rule book.

    Five years after the 2008 crisis hit, as carefully catalogued by FinanceWatch 2 » , economies are more financialised than ever. If the politicians and regulators ever had any balls they have been amputated by the casino managers, under the anaesthesis of perceived self-interest. They have become the casino eunuchs. An apparent early consensus on the systemic problems of over financialisation has melted away into a misconceived search for ‘business as usual’.
    http://www.feasta.org/2014/01/15/over-financialisation-the-casino-metaphor
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  6. To begin with, in Islamic finance, one must work for profits, and simply lending money to someone who needs it does not count as work. Under Islamic law, money must not be allowed to create more money. Instead, a bank must provide some service to “earn” its profits.

    Thus, instead of traditional accounts with given interest rates, Islamic banks provide accounts which offer profit/loss. The bank in turn purchases assets with your money, which generate returns for the bank. In particular, charging high interest rates to someone in need is considered unscrupulous, leaving no space for business models like Wonga.com’s.

    Second, high degrees of uncertainty or gharar are not allowed. All possible risks must be identified to investors, and all relevant information disclosed. Islamic finance prohibits the selling of something one does not own, since that introduces the risk of its unavailability later on.

    This rules out investments in conventional derivatives, which require speculation about the future subject to excessive risks. This is also the key reason why Islamic banks survived 2007 unscathed (caveat: while no exposure to derivatives saved them initially, weak risk controls meant that they were left exposed to declines in real asset prices as the real economy went into recession).

    Third, Islamic finance requires you only invest in ethical causes or projects. Anything unethical or socially irresponsible, from weapons to gambling or adult entertainment cannot be invested in. This produces a very strong alignment between Islamic investments and socially responsible funds.

    With their emphasis on equity and investment in the real economy, the principles of Islamic finance provide a stable and productive banking sector. Rather than providing a lucrative financial alternative to investing in the real economy, Islamic banking complements and strengthens the latter. It ensures that financial capital does not lead to artificially bloated asset prices. Instead, it is made to work in the real economy, on real projects.
    http://theconversation.com/explainer-...onversationedu+%28The+Conversation%29
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  7. The entrance of Monsanto into the weather risk market represents the growing interest in these products outside of the energy sector – in this case agriculture. The combination of increasing amounts of freely available and re-usable weather data, the development of more advanced big data analysis techniques, the growing global demand for a variety of weather products, and the development of simple online self-service portals for buyers all suggest that the exploitation of unstable weather systems is still in its early days.
    Big players, big risks

    Crucially, these developments expand the range of players with a financial interest in continuing climate instability. Whilst the claim is often made that weather derivatives and similar products balance out the financial impact of weather on affected businesses, thus smoothing adaptation to climate change, serious political-economic questions do arise about who actually benefits from these financial products.

    The model of paying out based upon observed weather means, in effect, placing bets on future weather conditions – rather than a business insuring itself against a specific loss. Clearly, during a time of instability in global weather, there is a lot of potential profit to be generated from such financial products. The emergence of this developing data-driven weather derivatives and risk market is, therefore, troubling.
    http://theconversation.com/big-data-l...onversationedu+%28The+Conversation%29
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  8. The United States could soon become a large-scale Spain or Greece, teetering on the edge of financial ruin.

    That’s according to Donald Trump, who painted a very ugly picture of where this country is headed. Trump made the comments during a recent appearance on Fox News’ “On the Record with Greta Van Susteren.”

    According to Trump, the United States is no longer a rich country. “When you’re not rich, you have to go out and borrow money. We’re borrowing from the Chinese and others. We’re up to $16 trillion in debt.”

    He goes on to point out that the downgrade of U.S. debt is inevitable.

    “We are going up to $16 trillion in debt » very soon, and it’s going to be a lot higher than that before he gets finished. When you have debt » in the $21-$22 trillion, you are talking about a downgrade no matter how you cut it.”
    http://www.moneynews.com/Archives/Tru...12/11/06/id/462985?PROMO_CODE=103FC-1
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  9. Fannie Mae issued a report that encapsulated the financial system’s biggest problem. The mortgage-finance company, which was wobbling on account of rising defaults, tried to reassure investors that it had $47 billion in capital, which was considerably more than the $30 million required by law. At the time, the report’s authors seemed to fear that some investors might think Fannie was too cautious. In any event, a month later, that protection seemed like a joke. Fannie may have conformed to the rules, but the rules didn’t conform to reality. The lender and its brother company, Freddie Mac, were declared insolvent and handed over to the U.S. government.
    Enlarge This Image
    Illustration by Jasper Rietman

    Deep thoughts this week:

    1. Five years later, we haven’t made the financial system much safer.

    2. But the solution might not be complicated.

    3. And that’s the problem.
    It’s the Economy

    Adam Davidson translates often confusing and sometimes terrifying economic and financial news.

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    Remarkably, five years after the crisis, the health of the financial industry is just as hard to determine. A major bank or financial institution could meet every single regulatory requirement yet still be at risk of collapse, and few of us would even know it. Despite endless calls for change, many of the economists I’ve spoken with have lamented that the reports that banks issue about their finances remain all but useless.
    http://www.nytimes.com/2013/08/11/mag...cial-crisis.html?pagewanted=all&_r=1&
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  10. An infographic that shows what banks have the biggest Derivative Exposures and what scandals they've been lately involved in.
    http://demonocracy.info/infographics/usa/derivatives/bank_exposure.html
    Tags: , , , , , by M. Fioretti (2012-06-24)
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