Derivatives Explained
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This was forwarded to me by a fellow trader. I don’t know where it came from and would gladly give attribution if I did.
Explanation of Derivative MarketsHeidi is the proprietor of a bar in Detroit . She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with a new marketing plan that allows her customers to drink now, but pay later. Heidi keeps track of the drinks consumed on a ledger (thereby granting the customers’ loans). Word gets around about Heidi’s “drink now, pay later” marketing strategy and, as a result, increasing numbers of customers flood into Heidi’s bar. Soon she has the largest sales volume for any bar in Detroit . By providing her customers freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for wine and beer, the most consumed beverages. Consequently, Heidi’s gross sales volume increases massively.
A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi’s borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral. At the bank’s corporate headquarters, expert traders figure a way to make huge commissions, and transform these customer loans into DRINKBONDS, ALKIBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don’t really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation’s leading brokerage houses.
One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi’s bar. He so informs Heidi. Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.
Overnight, DRINKBONDS, ALKIBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.The suppliers of Heidi’s bar had granted her generous payment extensions and had invested their firms’ pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her wine supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations, her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.
Fortunately though, the bank, the brokerage houses and their respective executives are saved and bailed out by a multi-billion dollar no-strings attached cash infusion from their cronies in Government.. The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-drinkers who have never been in Heidi’s bar.
Now do you understand?
Again, if you can provide any evidence of where this originated, I will gladly provide attribution.
Guy Fawkes @ July 3, 2010
Lose The Election, Lose The Pension
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Congress-critters have the best retirement plan in the world. If you ever get elected to Congress, you get the full Congressional retirement package. That holds true whether you serve one term or 25 terms.
I don’t need to say much about how despicable, cynical and disgusting this arrangement is for the reptiles who allegedly “represent” their districts back home. Nor do I need to remind us all that these cretins deserve nothing other than scorn for the destruction they have visited upon this country. And there is certainly no reason to point out how their ridiculous retirement plan should be scrapped.
But since we all know that Congress won’t change that, I have a proposal.
Proposed: Congress people only get their pension IF THEY RETIRE. A congressman who runs but loses his/her election is no longer eligible for a Congressional pension.
The beauty of this plan is that Congressmen get to keep their pensions. But they only get to keep them by leaving willingly.
What do you think? Please vote.
Guy Fawkes @ July 3, 2010
The Sub-Pennying Problem
Posted in: Markets | Comments (2)
Dennis Dick at Trading Defenders has a terrific presentation on the market-destroying fiasco that is known as sub-pennying. If free markets matter, then sub-pennying should be illegal.
Guy Fawkes @ May 18, 2010
Trading in a Rigged Market
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I never doubted that there was manipulation going on in the markets, but I honestly thought it was mostly confined to low-liquidity markets like penny stocks and low volume markets like gold & silver. The Flash Crash of May 6 proved me wrong. The crash and bounce occurred across all sorts of instruments – high volume, low volume, high liquidity, low liquidity, stocks, futures, forex – nothing was immune.
The combination of high-frequency trading, co-located servers, illegal front-running, Federal Reserve money, volume rebates, sub-pennying and moral hazard has turned what used to be a legitimate market into a rigged casino. Frankly, I think my odds in Las Vegas might be better. In Vegas, at least the house is upfront about how the game is tilted in their favor.
With that said, here are my thoughts about how to succeed as a trader in a rigged game:
1. Do not pay any attention to fundamentals. Fundamentals mean nothing in this market. John Paulson was widely praised for making a billion dollars shorting the housing market. His fundamental analysis was spot-on. But we now know that he made a lot of that money because he bought credit default swaps on bonds that he helped Goldman Sachs put together – bonds literally designed to fail. Even with accurate fundamental analysis, he essentially worked with GS to rig the game. The only qualifier I would give to this recommendation is that certain overwhelming trends cannot be manipulated away by the banks and the government. All the new money that the Fed and ECB have pumped into the banks will eventually show up in the economy, and you can be certain that we will eventually have severe inflation. The problem is – as Lord Keynes is reputed to have said – the market can stay irrational a lot longer than you can stay solvent. The Too-Big-To-Fails – banks, insurance companies, car companies – will be bailed out someway, somehow. Even though they are fundamentally insolvent and their stock isn’t worth the paper it is printed on – they will NOT go to zero. Fundamentals mean nothing.
2. Trade on technical patterns only, but don’t trade them blindly. Most technical patterns are well-known and heavily traded: head & shoulders, double tops, double bottoms, moving average cross-overs. Part of high-frequency trading is technical trading, and those computers can read and react faster than you can. Some of the more well-known patterns have quit working. I’ve only been trading for three years, and in that time, I have discerned at least three different markets, markets that behaved unlike other markets. I started trading the ES in January 2008. From that point till March 2009, the market behaved as I expected it to. From March 2009 till around February this year, the character of the market completely changed, and the indicators I had been using and relying on quit working and others started working. Around February this year, the character of the market changed yet again, and again the patterns I was trusting quit working and others started working. The moral of the story is this: in a technical market, you have to trade on technicals – but always beware that the very nature of the market can change.
3. If you are a program trader, then you must immediately test and implement your self-protection plan for the next occurrence of Flash Crash. The computer programs that generated the crash are still out there, still cranking, still front-running, still sub-pennying and still not smart enough to understand how to react in every situation. I was a programmer for 10 years, and I know from experience there is no way that developers can anticipate and test for every possibility – especially the kind that happened on May 6. You must be prepared to override your programs and protect yourself. When spreads on the ES are 40 times wider than normal, stops get blown, accounts get blown and lives get blown. Protect yourself.
4. If you hold positions overnight, hedge. Just because the Flash Crash happened during American market hours doesn’t mean it could ONLY happen during American market hours. I know some traders who hedge their positions with options. I know others who hedge their positions with correlated instruments, (like hedging the ES with the DAX). Whatever you do, you must protect yourself. It has been demonstrated again and again that the so-called regulators will not punish the major players, so you must assume that the major players will do everything within their power to manipulate whatever market you are in. Protect yourself.
5. Don’t expect justice. When the mafia ran a protection racket in a neighborhood, it didn’t make business impossible, it just made it more expensive and less just. You must have the attitude of a shop owner in a mafia-controlled neighborhood. You know they are going to shake you down eventually; plan and prepare for it now. If you find it impossible to be a businessman in such a neighborhood, then get out now before something violent and ugly happens to your war chest. But if you are able to accept the fact that the crooks run the neighborhood and the cops won’t do anything to stop them, then you must figure out how to do business with the crooks. The metaphor holds: the mafia needed the shopkeepers to keep doing business, otherwise they would have no one to shake down. Just know that they are going to take an unjust, unfair portion of your profits. Another way to express this thought is: bring your expectations in line with reality.
6. Don’t give up. It is still possible to make money trading in a rigged market. You have to be nimble, you have to trade defensively, you have to be humble. Even though this market is rigged, it still speaks and will still tell you what it is going to do – you just have to learn the language. If you have not already made the decision to be a student of your market, you must now decide to be a student, always be a student of the market you trade. If you are not willing to be a life-long student, then find another profession.
Guy Fawkes @ May 18, 2010
Who Owes What
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The NYTimes has a lovely, concise graphical representation of the debt situation in Europe. Note the relative size and importance of Greece to the other PIIGS. Given that French and German banks are owed the most, now you should understand why the ECB agreed to the $1 Trillion bailout: they aren’t saving Greece; they are saving French and German banks that made stupid, high-risk bets.
Does that sound familiar?
Guy Fawkes @ May 14, 2010
Sincere Ignorance and Conscientious Stupidity
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Nothing in all the world is more dangerous than sincere ignorance and conscientious stupidity. -Martin Luther King Jr.
Nobody wants to believe that there are a handful of Wall Street bankers so intractably evil that they would rather destroy the entire world economy than give up their vacation home in the Hamptons. Nobody wants to believe that there are a handful of Washington politicians so intractably evil that they would steal the life savings of millions of people just to preserve their government perks and pensions. Nobody wanted to believe that the Weimar Republic could devolve into National Socialism in only four years – but it did.
I understand why some would think I’m a conspiracy nut. Had I not seen it with my own eyes, heard it with my own ears, touched it with my own hands and lived it every day for the last 25+ months, I would think I was kooky, too. But the facts are right out in the open for anyone who cares to read a balance sheet.
The financial establishment, (which funds Washington through political donations and funds the mainstream financial media through advertising), love to say “nobody saw this coming” but they are either liars or idiots. Lots of people have been warning that the world is heading for a credit crisis for at least the last 3 years. I can name several right off the top of my head: Karl Denninger, Mish Shedlock, Bill Fleckenstein, Reggie Middleton, Peter Schiff, Nouriel Roubini, Gary North and Marc Faber have all written extensively about it for years. Their record is both long and public.
These guys deal in hard facts. Not conjecture, not theories, not “interpretations” – mathematics. And the mathematics were there in the publicly posted balance sheets of every major bank on Wall Street for all to see. The mathematics were there in the balance sheets of Fannie Mae and Freddie Mac, there in the balance sheets of AIG. The balance sheets said these organizations were all doomed when the loans they made to people who couldn’t pay all went bad.
The loans went bad. The money dried up. The banks are technically insolvent. The only reason they haven’t been shuttered is because they own the regulators, they own the Congress, they own the executive branch and they own the Federal Reserve.
Their “profits” are illusions, but the debts are real. There are only two ways to deal with debt: pay it off or default. The banks won’t default, and they can’t pay it off, so here’s what they have done – they stole the money from the US Taxpayer.
How did they do it? Let’s look:
The S&P 500, which is a proxy for the entire market, has been trading at over 140 times earnings since last summer. What that means for you non-financial types is that the price of the stock market is 140 times the value of the profit the combined companies made. (I would post a link to this statistic, but Standard & Poors removed the link from their website in October.) For comparison, the long term, (80+ year) historical average of the S&P 500 is 15 times earnings. In other words, in an economy with “official” unemployment hovering at 10%, “official” underemployment over 20%, a housing market that has crashed, major banks, insurance companies and auto makers that would be bankrupt if not for the injection of literally trillions of dollars in taxpayer money, plummeting tax receipts, states struggling with historic budget deficits and the largest financial bubble in history – the stock market is trading ten times higher than it’s historical average. Is this economy ten times better than average?
How is that possible?
Follow the money:
March 16 2008 – The Fed & Treasury give JPMorgan a $29B gift if they agree to buy Bear Stearns for $2/share. (When the stock closed on Friday, March 14, it was trading at $22/share. The final purchase price was later negotiated to $10/share.)
July 2008 – Congress gives Fannie Mae & Freddie Mac $800B to keep them from bankruptcy.
Early September 2008 – Lehman goes bankrupt. This event triggers the payment of credit default swaps AIG has sold to various banks around the world. They don’t have the money to pay. Congress authorized an $85b payment to AIG, (later increased to $145b), to keep AIG from BKing. Most of the money that goes in the front door of AIG went right out the back door into the pockets of banks such as Goldman, Morgan-Stanley, Deutsche Bank, UBS, Citibank – the usual suspects.
Late September 2008 - The Big Banks are in fact insolvent, so Hank Paulson, (ex-CEO of Goldman Sachs and current SecTreas), goes to Congress and threatens global apocalypse if Congress doesn’t cough up the dough to bail them out. Congress caves. Hundreds of billions are funneled to the banks through the Federal Reserve. Blomberg files a FOIA request with the Fed to see where the money went. The Fed ignores it. Bloomberg takes ‘em to court. The judge rules in Bloomberg’s favor. The Fed ignores them. To date, the Fed still hasn’t turned over the information.
February 2009 – Obama demands another $800b to help goose the economy. Most of it goes to banks.
March 2009 – the S&P500 hits an intraday low of 666, almost a thousand points below the all time high it hit in October 2007.
Since then, unemployment continues to rise, housing defaults rise, commercial real-estate tanks, sovereign debt crises spread around the globe. Where did ALL THAT MONEY we gave to the banks go?
Look at the stock market. We are currently trading right at 1200 on the S&P, a rise of a little less than 100% in a year. Only one sector of the market has profits consistent with a 100% rise in just over 12 months: Financials. One sector of the market has shown the biggest increase in price in the last year: Financials. One sector of the market makes more donations to Washington than any other: Financials. One sector of the market got hundreds of billions in taxpayer dollars: Financials.
Conclusion: The Wall Street banks took the money that they were supposed to be loaning out to Main Street, and used it to drive up the price of their shares.
How’d they do that?
Front-running, co-located servers and high-frequency trading.
Guy Fawkes @ April 30, 2010
Meanwhile…
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US public debt as a percentage of GDP has more than doubled since the banking crisis started. (As far as I am concerned, the only crisis was for the banks’ shareholders, bondholders and executives. Banks for bust all the time. Big, fat, hairy deal.)
Here’s the money quote from today’s article in Yahoo Finance:
Economists note that countries that endure banking crises often end up having debt crises a short time later. That is because governments borrow heavily to prop up their banking systems, which sends their own debt burdens soaring. That debt buildup has occurred in the United States, which has seen its publicly held debt jump from 36 percent of the total economy in 2007, before the crisis hit, to 64 percent this year. That’s the highest level since 1951, when the country was still paying off the debt run up to fight World War II.
Debt levels of all developing countries are rising to levels not seen over the past 60 years, the IMF said in an economic survey released last week. The U.S. government forecasts that its publicly traded debt as a percentage of the total economy will reach 77 percent by 2020. By comparison, Greece’s debt burden exceeds 100 percent.
This is not a “free markets” issue or a “liberty” issue, this is a moral issue. I will be developing this theme in days to come.
Guy Fawkes @ April 29, 2010
Why Greece Matters to You-the American Taxpayer
Posted in: Liberty, Markets | Comments (1)
First, Bear Stearns made a bunch of stupid bets on sub-prime mortgages, and you – the American Taxpayer – bailed them out to the tune of $29 billion in guarantees to JPMorgan, (who bought Bear Stearns only on the condition that the government assume that debt.)
Then, Fannie Mae & Freddie Mac made a bunch of stupid bets on subprime mortgages and you – the American Taxpayer – bailed them out to the tune of $800 billion.
The Lehman Brothers went belly up, which forced AIG to pay billions of dollars in claims on credit default swaps – claims they were unable to pay, so you – the American Taxpayer – bailed out AIG to the tune of $145 billion.
Then the Big Wall Street Banks went kablooie, because they made stupid bets and you – The American Taxpayer – bailed them out with $800 billion in loans. (No, you will not see any return on that “investment”, other than the comfort of watching Goldman Sachs give out $14 billion in bonuses last year.)
Then, Chrysler and GM both came to Washington with their hands out because they made stupid agreements with the UAW and stupid inverstment decisions, and you – the American Taxpayer – bailed them out with “only” about $20 billion.
What have you – the American Taxpayer – received for all this largess doled into the laps of these idiot gamblers? You have the worst economy since the great depression. You have over 22% of the population “under-employed”. You have plummeting home values. You have more tax. You have known tax cheats heading Treasury and the IRS.
Now Greece is going to go bankrupt, and guess who is going to bailout that government? The IMF gives money to Greece. 20% of the IMF’s funding comes from the US Taxpayer, so you – the American Taxpayer – are now sending $7 billion to the Greek government so it can pay its bills.
Spain, Portugal, Ireland, Italy, France and the UK are in line for the same thing.
What can you do about it?
You could start by re-reading the US Declaration of Independence and contemplating this phrase:
We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable rights, that among these are life, liberty and the pursuit of happiness. That to secure these rights, governments are instituted among men, deriving their just powers from the consent of the governed. That whenever any form of government becomes destructive to these ends, it is the right of the people to alter or to abolish it, and to institute new government, laying its foundation on such principles and organizing its powers in such form, as to them shall seem most likely to effect their safety and happiness.
When the colonists determined that the government of Great Britain – their government – had become destructive to the very people it was supposed to protect, they moved to “alter or abolish” that government and establish a new one that would be most likely to secure their life, liberty and happiness.
Guy Fawkes @ April 28, 2010
A Loving Ode to Mother Earth on Her Special Day
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Earth Day. Bleh.
I’m convinced Earth Day was conceived by tea-sipping western European elites who live in mild climates where nature is a devoted, loving and fertile servant to man. I know better. I spent my childhood in Oklahoma and half my adult life in Texas.
Oklahoma springtime meant tornadoes, thunderstorms, wicked unexpected heatwaves, late snowstorms and crop-crushing hail storms. Summer brought drought, searing heat, blowing dust and energy-sapping humidity. Fall was an explosion of allergens to make up for the relatively mild weather. Winter was tree-crushing ice storms. The ground was 90% limestone, so growing anything required dedication, hard work, sweat, perseverance and more than a bit of luck. We had poisonous snakes and venomous and/or biting bugs. In one 18 month stretch, my hometown of 35000 people suffered a devastating direct hit by a tornado and two “100 Year” floods. In other words, “Mother Nature” was mean, nasty, ill-tempered and downright murderous most all the time.
Texas was like Oklahoma only more so. Literally everything in nature was trying to kill you. The weather was tornadoes, hailstorms, thunderstorms, lightning storms, floods, droughts, high winds, searing heat, deadly cold, wicked temperature changes, (I clearly remember a day that had an early afternoon high in the 80s and a late afternoon reading in the 30s), and suffocating humidity. The ground was either caliche clay, which is impossible to till, or rocks. The array of venomous reptiles and bugs, dangerous animals and poisonous plants was exceeded only by the variety of airborne allergens. Literally everything about Mother Nature in Texas was hostile to human life. She was not man’s willing servant; she was a rabid, foam-mouthed, blood-toothed, sharp-clawed maniacal destroyer.
I lived in London for 15 months in 2001-2002. No bugs to speak of. No venomous critters. No poisonous plants. Mild weather year-round, (with a few exceptions). The ground is so fertile it is ridiculous. You could spit a watermelon seed out the back door and be harvesting watermelons 2 months later. Mother Nature, in SW England, was a compliant, willing and fecund servant to mankind. I understand most of France is the same way or better.
I came away from my sojourn in England convinced that the “Save the Earth” people had never lived in Texas or Oklahoma. I knew from experience that Mother Earth didn’t need to be cared for; she needed to be tamed, broken, collared and caged. She is a saber-toothed tiger, eager to shed man’s blood and blissfully indifferent to the consequences of her actions.
I’m nearly certain that the “Earth-First-ers” never spent weeks on end digging ton after ton of limestone from their vegetable garden. I’m pretty sure they never cowered in a “fraidy hole” hoping the tornado blowing over didn’t kill them. I’ll bet they never spent miserable weeks covered in Calomine lotion because they got a rash from poison oak, poison ivy or poison sumac all up and down their arms, legs, trunk and face. I’ll bet they never itched a night away because they were covered in chigger bites or fire ant bites from walking through the grass. I’ll bet they never had a pasture ruined and livestock killed by an invasion of fire ants. I’ll bet they never suffered through a drought that was broken by a flood, or an unrelenting rainy season broken by a drought. I’ll bet they never sat in the emergency room with a friend whose four-year-old son suffered a rattlesnake bite and prayed he wouldn’t lose his leg. I’ll bet they never dreaded fall and spring knowing that the effluvium from all the budding Texas junipers was going to make them sick for weeks. I’ll bet they never struggled season after season to get something – anything – besides weeds to grow in the dreadful soil. I’ll bet they never worried being bitten by a water moccassin while swimming in a local pond. I’ll bet they never chopped their beloved prize pecan trees into firewood because an ice storm had sheared off it’s 100-year-old limbs. I’ll bet they never tried to scrub the iron stains from their clothes – iron stains that came from the red dirt which wouldn’t grow anything useful.
From the time I started school until I was in college, Time Magazine ran cover story after cover story warning the world of an impending Global Ice Age. “The first Earth Day was celebrated on April 22, 1970, amidst a building alarm about the dangers of a new ice age.” All the scientists agreed; it was coming and it was going to be bad. Then sometime in the 80′s “they” decided that Global Warming was the threat du jour. Recently, that has been changed yet again to “Global Climate Change”, (does that phrase have any meaning at all?) In my lifetime, the experts have wrongly predicted every sort of change possible to the environment. Forgive me for being skeptical now.
The “global warming/climate change” scientists have proven to be liars and frauds. Most so-called green technology actually consumes as much fossil fuel and/or creates as much pollution as the technology it is supposed to replace. Recycling waste is an expensive fools’ errand.
My experience is that nature is a rampaging killer, beating on the barricaded doors, jiggling the latches of the windows and probing every crack and crevice of the walls we have built to keep her out and keep us safe. The bulk of my life has been spent battling nature, not caring for it. The logical, natural extension of the philosophy espoused by the “Save the Earth” crowd is that man is a blight on nature and the best thing we could do for Mother Earth is to commit mass suicide.
Earth Day is a sad, sick, stupid joke played on the gullible, the forgetful and the guilt-ravaged. It helps nothing, it wastes time and it diverts our attention from real, solvable problems – like artificial turf and the designated hitter rule. (I contend that the world started going to hell with the advent of both.)
Guy Fawkes @ April 22, 2010
Precious Metals Manipulators and Assassins
Posted in: Liberty, Markets | Comments (1)
This sounds like the script for the next Jason Bourne movie, but it is real and it is happening right now.
The players:
- JPMorgan Chase – allegedly some of The Smartest Guys in the Room
- a London trader named Andrew McGuire – trades precious metals on the commodities markets
- the Commodity Futures Trading Commission (CFTC)- The US Government agency responsible for regulating the futures markets
- the Gold Anti-Trust Action committee (GATA) – a private organization committed to exposing fraud in the Gold Futures markets
Late last fall, Andrew McGuire received first-hand information that JPMorgan Chase actively and intentionally manipulated the price of silver in the futures market. By “first-hand”, I mean that JPM traders bragged to him about what they did and how they did it. Later, McGuire provided the CFTC with specific forecasts as to what was going to happen in the silver markets and when. He was completely accurate, which gave credence to his assertion that the market was manipulated. The CFTC apparently did nothing with the information, since they’ve had it since November. Last week, McGuire contacted GATA director Adrian Douglas with the information. Douglas was scheduled to testify to the CFTC and he used that testimony as an opportunity to expose the scam.
The next day, McGuire and his family were injured when their car was T-boned by a hit-and-run driver in London.
A word to the wise…
Guy Fawkes @ March 30, 2010
