One of the derivatives instruments that LTCM used was total-return swaps, contracts that facilitate 100% leverage in various markets, including stocks. For example, Party A to a contract, usually a bank, puts up all of the money for the purchase of a stock while Party B, without putting up any capital, agrees that at a future date it will receive any gain or pay any loss that the bank realizes.LTCM was Long Term Capital Management, a hedge fund whose collapse was so huge the Fed had to step in with gubment bucks to save the financial system from disaster. You can't tell what a financial institution is actually worth in certain circumstances because its "investments" include financial instruments whose value cannot be determined and whose downside is not comprehensible to the "Oracle of Omaha," the most celebrated investor in the country, the man who steered his company to an increase totaling more than 60% of its value over the past five years. Because of their potential to really screw up the entire financial system, Buffett called derivatives "financial weapons of mass destruction. They're so "toxic" (Buffett's word) his company set about selling off the derivatives-based part of an enormous insurance company that forms part of the Berkshire Hathaway empire. They're so complicated they were still working on the divestment according to his shareholder letter in 2003:
Total-return swaps of this type make a joke of margin requirements. Beyond that, other types of derivatives severely curtail the ability of regulators to curb leverage and generally get their arms around the risk profiles of banks, insurers and other financial institutions. Similarly, even experienced investors and analysts encounter major problems in analyzing the financial condition of firms that are heavily involved with derivatives contracts. When Charlie and I finish reading the long footnotes detailing the derivatives activities of major banks, the only thing we understand is that we don’t understand how much risk the institution is running.
And yet so-called over-the-counter trade in derivatives is largely unregulated by anybody. Hell, it may not be possible to regulate them.
The shrinking of this business has been costly. We’ve had pre-tax losses of $173 million in 2002 and $99 million in 2003. These losses, it should be noted, came from a portfolio of contracts that – in full compliance with GAAP – had been regularly marked-to-market with standard allowances for future credit-loss and administrative costs. Moreover, our liquidation has taken place both in a benign market – we’ve had no credit losses of significance – and in an orderly manner. This is just the opposite of what might be expected if a financial crisis forced a number of derivatives dealers to cease operations simultaneously.
If our derivatives experience – and the Freddie Mac shenanigans of mind-blowing size and audacity that were revealed last year – makes you suspicious of accounting in this arena, consider yourself wised up. No matter how financially sophisticated you are, you can’t possibly learn from reading the disclosure documents of a derivatives-intensive company what risks lurk in its positions. Indeed, the more you know about derivatives, the less you will feel you can learn from the disclosures normally proffered you. In
’s words, “Ignorance more frequently begets confidence than does knowledge.” Darwin
However, look at this from an article by Paul De Grauwe in the Financial Times:
The credit crisis has destroyed the idea that unregulated financial markets always efficiently channel savings to the most promising investment projects. Millions of US citizens took on unsustainable debts, pushed around by bankers and other “debt merchants” who made a quick buck by disregarding risks. While this happened, the
monetary authorities marvelled at the creativity of financial capitalism. When the bust came, a large number of Americans who had been promised a new life in their beautiful homes were told to move out. This boom and bust cycle cannot have been an example of efficient channelling of savings into the most promising investment projects. US
In the current clusterfuck of a financial meltdown, with funds and banks and related industries scrambling to cover their lost billions and the Fed pouring billions into the financial industry to keep things afloat, a litle regulation is going to be necessary. The other day, Bush said the money boys had gotten drunk and now had a hangover. It's time to hire a bartender willing to cut the drunks off when they get sloppy.
There is a second idea that is likely to become the victim of the financial crisis. This is the idea found in macroeconomic models, that individuals are supremely well-informed creatures. In these models that are now being used in central banks and universities, individuals understand the most complex intricacies of the world in which they live and they have no disagreement about this. All these individuals understand the same “truth”.
If we have learnt one thing from the credit crisis it is that individuals did not understand the “truth” and, it must be admitted, neither did economists. Individuals who sold the new financial instruments did not understand the risk embedded in these instruments, nor did the buyers. When the bubble started many interpreted the happy turn of affairs as permanent and took on massive levels of debt that turned out to be unsustainable. When the bubble burst, they did not understand what had happened and nor did most experts. Our world is one of a fundamental lack of understanding of the “truth”.