Be sure and check out this article from the Wall Street Journal.? Derivatives being private contracts between two parties, they can’t easily be traded.? To eliminate a position prior to maturity, one can do three things:
- Sell it back to the party you bought it from.
- Sell an equivalent contract to a third party.
- Sell your interest in the contract to a third party.
In situation 1, the exposure goes away, but the negotiation can be tough because they know they are the only ones that can eliminate the exposure in entire.? In situation 2, the exposure goes away, but one still has counterparty risk, in that they have bought and sold the same item to two different parties.? If one party defaults while owing money, the other obligation does not go away.
In situation 3, the exposure goes away if it can be done.? Sometimes the derivatives prohibit such a trade, because they don’t want the possibility of diminished creditworthiness.
So, as the WSJ points out: derivatives, even crdit and equity derivatives can’t be traded like stocks.
Thanks for shining a light on this issue David. It is complete fantansy to believe that the traders at JPM and other mega derivatives factories are assigning values to these products that are anywhere near their liquid value…even without a multi-standard deviation event. I enjoyed your work on the accounting of financials, but it seems to me that this single issue makes all that work border-line fruitless, as who knows what the REAL carrying book value is at many of these firms. I would venture to guess that when the history books are written about this era of “record high profit margins”, a lot of the “record” will be phantom in nature. Though GAAP allows all of this and it may not be illegal, what happens when a 2 or 3+ standard deviation event does occur and some of these institutions have to write down book value by massive amounts? So much for those record high margins!
James, I agree, and this is just another place where Buffett has it right. Derivative books are easy to mis-mark, and the multifactor pricing assumptions look nice on paper, but presume too much on liquidity. In a crisis, there will be a lot of illiquid derivatives holders seeking cash.
Thanks for the reply David. Since you agree and an investor really cannot quantify the risks with any level of real certainty, doesn’t this place most major financial stocks in the speculative column rather than potential investment? Also, do you have any sense of the scale of foreign currency positions in carry trade currencies (yen and swiss franc) by corporate american? Fannie Mae recently reported significant gains due to yen positions – obviously a core part of their business!
Fannie does have some yen debt outstanding. Maybe they were “lifting the leg” on a hedge. 😉
With financials, I am long two foreign banks, one mortgage REIT, and one insurer. I would be long more insurers, but I have trading restrictions. I would avoid money center and investment banks in countries that are capital importers. When the tide goes out, their liquidity will be pinched.