POOR RICHARDS REPORT
Chapter 13
DERIVATIVES: A WITCHES BREW
Way back when, in the 1990’s, a leading financial paper of the salmon color discussed the pros and cons of a new financial instrument: Derivatives.
There were five articles on the subject. Two were favorable and two unfavorable. To my suspicious mind the cons outweighed the pros.
The fifth article had an editorial bent in which they flatly stated that the reason it was approved was because everyone was going to make money except the buyer. Caveat Emptor! True enough, at every tumble in securities there usually was a derivative involved.
My definition of a Derivative (DD-Dirty Diaper) is that one takes an unmarketable security and meshes it with a good one. My definition of an unmarketable security is one with questionable long term strength and few shares or debt outstanding. They usually sell at a huge discount to the market because of the risk involved.
The issuer of the DD’s can express high optimism in their creation because the unmarketable has been marked up to par. Dear reader, there are monstrous commissions involved here. Just look at the quarterly earnings of the major banks. Obscene!
That is why major institutions keep calling for TRANSPARENCY. They want to know how much credit (sloth) is involved. In other words, they want to know how bad they are being taken.
When Bill Gross left Pimco to be with Janus Corp it is a fact that billions of bond transactions were done at Pimco as investors wanted out since Mr Gross left. It is rumored that Pimco is left with many bonds that have a DD attached to them and Mr. Market does not want to pay a “fair” price for them.
The “professionals” are finding all kinds of way to keep their filthy ball rolling. This, I believe, will lead to many bond defaults. George Soros, leading hedge fund manager, has already visited the President of Argentina because they are about to default on his holdings. That is when we will perhaps hear a “big bang” ! When one country gets away with it, so will the others. Debt obligations used to be far and few between. The amount of AAA credit can be counted on one hand. Over twenty years ago one needed hands, feet, and an half an extra person to count AAA credits.
The partial answer to stopping these defaults is to ban DD’s completely and let one’s outstanding debts mature when due.
Short Sales
Short sales used to be and can be a very dangerous trade, because ones losses were unlimited on the upside. Basically one is selling high and hoping to buy back at a lower price. Before the rule was changed one had to find a stock in the firm’s back office that was available for a short sale. The seller had to wait for an uptick in the same security before doing the transaction. All this was done on margin- which is also using other people’s money. When one buys a stock for cash all one can lose is the cash. If one sold short a $10 stock and it goes to $150 one has lost $140 if one did not buy back the stock before that. If the stock declared a dividend then the short seller must pay the dividend to the owner of the stock one sold short.
Joseph P Kennedy , JFK’s father, was the first Chairman of the SEC (Securities Exchange Commission) and the first rule he passed was the short sale rule. The market then calmed down and order was restored.
I believe the hedge funds and the “banks” are responsible for the demise of the short sale rule. It allows them to sell short and deliver later. The reminds me of the “bear raids” of the 1920’s before the crash of 1929.
It is purported in certain respected newsletters and established business papers that JP Morgan was short so many silver contracts on the COMEX (Commodities exchange) that under their rules it would have taken them over 100 days to cover (buy back) their short sales.
Since they have knocked the price way down what they purported to do was buy the depressed silver from the Exchange traded funds (in the US) and deliver that silver to the COMEX. Highly unethical and illegal, but then they swamp the under staff legal division with all kinds of legal arguments for which they have paid a battery of legal eagles (lawyers).
The hedge funders and “Banks” will argue that they are providing liquidity to the market place with HFT’s, derivatives and short sales. This is true on a short term basis, but when the bell rings and the trumpets sound and us little guys want out and we force the bank to send us our dough. This forces them to sell and if they sense a “big bang” then they will find no chairs when the music stops.
Then there will be no liquidity, high volume on the downside, and instead of a rebound, one will find quicksand because there are no rules left.
Panic starts when billionaires become millionaires for a short period of time before they become one of us.
Remember it is not how rich one is, but how one makes their money.