Every now and then, you get a reader response that deserves to be published.? Such was this response to my piece, “If Hedge Funds, Then Investment Banks.”? I have redacted it to hide his identity.
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I read your latest blog entry with interest because I have worked in the derivatives business and as a part of that helped to set up General Re’s financial subsidiary in 19XX – General Re Financial Products (GRFP). I was one of XX people that started that business from the ground up. I left shortly XXX Buffett arrived on the scene but I still knew a large number of people that remained and I have very good information about what happened there. I may be a bit biased so you should consider where I am coming from as you continue to read.
To be short about it, what happened at GRFP after Buffett took over was a complete mess. I can give you more information on that if you like but I will simply say that what Buffett writes about GRFP, has spin on it. Let me give you a somewhat quick example. Of that $104 million loss he refers to, how much of that could be attributed to salaries and operating expenses? How much of it was due to the forced unwinding of trades on the wrong side of the market? We know that there are high operational costs (these people are paid very well with nice offices, technology, etc.) and that one would expect to pay to get out of these transactions even if they are being marked perfectly correctly. It SHOULD cost money to unwind these trades. So why doesn’t Buffett, who normally gives us so much information, tell us how much of the loss was due to mismarking and how much was due to expected costs? I’ll let you guess at that answer. There’s a lot more to this story but let’s move on…
I am sure you felt safe quoting someone like Buffett – meaning he is likely to get things right almost every time, but even Buffett is not perfect and he has his blind spots. I believe that derivatives may be such a blind spot. I could go into detail about where I see holes in Buffett’s arguments however the bottom line is that I believe the vast majority of transactions done in the derivatives market are plain vanilla transactions that are extremely easy to mark. Did you know that the US Treasury market is now quoted as a spread off of swaps? That is how liquid the plain vanilla instrument is these days. These transactions will certainly not have two traders both booking a profit even though they are on opposite sides of a transaction. Bid/ask spreads in the plain vanilla market are less than 1 basis point per year in yield. I am certain there are exotic transactions that are mismarked for all the reasons that Buffett mentions but how many of these are really out there? My suspicion is that the total number is small enough to not be of any huge concern from a systematic standpoint.
Here is something interesting to consider. Why would the leader of a AAA-rated institution (a financial Fort Knox) that competes in many ways with other large financial institutions wish to lead people to believe that those other institutions may be engaged in a business that is particularly risky?
Just thought I would add my two cents (looks more like 25 cents now).
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For the record, both he and I are admirers of Buffett, but not uncritical admirers.? The initiator of a trade usually has to offer a concession to the party facilitating the trade.? Forced sellers or impatient buyers typically don’t get the best execution.? What my correspondent suggests here is at least part of the total picture in the liquidation of GRFP.? All that said, I still think there are deadweight losses hiding inside that swap books of the major investment banks.
I would certainly not pretend to know more about the derivatives markets than David or his obviously well versed reader. However, I think his reader misses one point. While the lack of liquidity for more esoteric derivatives is likely a problem that few if any have an real grasp on, the real problem with derivatives is the sheer amount created over the past 5-10 years. The derivatives markets dwarf the cash markets at present. While they can transfer risks the do not eliminate them. The explosion in outstanding contracts adds massive systemic risks due to the inherent risks associated with increased leverage.
Even if most contracts are correctly priced, that does not address the increased risks of leverage. Added leverage increases risks which can create situations of forced selling. Forced selling causes normally legitimate models to break down (see LTCM) which can cause more forced selling.
This is how I view derivatives as potential “financial weapons of mass destruction”. If esoteric versions are more predominant, then that just adds gasoline to an already raging fire.
I think you’re getting close, but might be watching the wrong movie. Consider the following-
Assume the indivdual traders at the IBs (not to exclude other players) are all fine traders doing well making their markets in FX/Rates/Credit/Oil/Commodities/Equities et al and managing thier risk with a relatively well matched book. Not an untrivial task given the levels of volatility recently, but let’s give them the benefit of the doubt.
Here’s the problem. If any of their counterparties go toes up then their previously well-matched book is now potentially seriously unbalanced. Not good given volatility moves.
What makes us think the IBs are better at allocating credit than the Banks? (or others). Not to mention the obivous conflicts of interest in that decision due to client relationships or hope of future business.
Do the math conservatively – $680+ trillion( Morgan Stanley est.) derivatives outstanding x 2%-3% counterparty defaults x 5%-20% move in the underlying asset (you pick) = way more than combined maket caps. No matched book. Granted, out of sheer luck some end up on the good side of this (GS?) but overall looks like Muy Malo.
That last comment is interesting about counterparties going belly up on the positions. While this risk is relevant many of the IB and Commercial banks have some kind of credit mitigant in place that helps to absorb these issues. Included among this is the amount of collateral posted on derivatives. I believe the latest amount is about 1.5 trillion. The banks also have very active credit desks that are hedging away the risk. In addition, going in to a trade, if the counterparty is considered risky, a higher credit charge should be assessed.