Derivatives Trading… the Mother of All Bubbles


On November 27th, a story appeared in the Financial Times telling readers that rich investors were having to resort to ‘underhanded’ means and special favors in order to get into the best hedge funds.

Somewhere in the dark mush of our own brain came a flicker of light… and the ringing of a bell. We recalled how hard it was to get in on the Initial Public Offers of the late ’90s. All a fellow had to do was to put together a plausible story and take it to the financial wizards of Wall Street or the City. A few months later, actual shares of this hypothetical business would hit the streets. And since managers found it convenient for the shares to rise quickly following their release, they were normally priced at a level where they were bound to go up, even though they were already selling for far more than they were worth. This meant that getting in on the early stages of the IPO was almost guaranteed money-in-the-bank. And it is why Barbara Streisand, to cite a famous example, would send tickets to her shows to IPO managers, hoping for more than a round of applause.

Of course, the dot.coms blew up in January 2000… and investment bankers stopped getting the free tickets. Now, they’re going to hedge fund managers.

But the average fund has not been doing well; so far in 2006 you could have done better by accident than by hedge fund. The typical fund is up only about 7%. The FTSE has risen 9% and the Dow is up 15%. This seems only to have made investors desperate to get into the tiny group of funds that are doing well.

Well-established and top performing funds are often ‘closed.’ They already have plenty of money. And smart managers know that they cannot accept more without degrading their returns. When too much money chases a limited number of good investment ideas, investments regress to the mean. Still, “people are quite flabbergasted, especially very wealthy people, when you send their money back,” said the FT source.

Last week, another bit of news reached us: the derivatives trading market, in which hedge funds tend to speculate, has reached a face value of $480 trillion… 30 times the size of the U.S. economy…and 12 times the size of the entire world economy. Derivatives trading has become not merely a huge boom or even a large bubble – but the mother of a whole tribe of bubbles… dripping little big bubbles throughout the entire financial sector.

And now our friend Simon Nixon reports that the hedge fund industry is transforming the “social geography of Britain. Fortunes have been created on a scale and in a timeframe that we have not witnessed for 100 years, if ever before. According to the Daily Telegraph, the average age of buyers of old rectories – those quaint country houses favored by the new-moneyed classes – in Britain has fallen by ten years to people in their early 30s.”

Societies go through major trends and minor ones; small fads and big ones; cute little peccadilloes and major public spectacles. Before the Renaissance, societies were besotted with religion – a passion that burned itself out in the crusades, the wars of religion, and the inquisition. Then, they took up politics – and became so wrapped up in ‘isms’ that, by the 20th century, they were killing each other at the fastest pace in history. More than 100 million people died in the 20th century – victims of bolshevism, national socialism, communism, nationalism or some other excess of political enthusiasm.

And now it is finance that has the world’s attention. China says it is a ‘communist’ country. But it seems not to care. Nor does anyone else care what the Chinese call themselves. The only thing anyone seems to care about is that China is open for business. They could throw vestal virgins into Vesuvius or tear the beating hearts out of their enemies so long as their economy grew at 10% per year. The Chinese are the envy of the entire world. Politics has yielded to money.

The fashion for politics peaked out in the United States during the Kennedy Administration. Kennedy’s inaugural remarks – ‘ask not what your country can do for you…ask what you can do for your country’ – marked the all-time high. That was before the war in Vietnam came a cropper, and before the war on poverty and the war on drugs were launched. People believed in those wars and were sorely disappointed when victories weren’t forthcoming. Now of course, we have a war on terror… but few people talk about it at all… and no thinking-person mentions it without an ironic smirk. In fact, the war on terror is hardly a political war at all – but a campaign designed to protect the flanks of the great financial empire. If it were discovered that it diminished consumer spending or raised mortgage rates, for example, it would be stopped tomorrow.

Now, it is money that counts. And mommas now want their babies to grow up to be hedge fund managers. They know where the money is. There’s no money in religion – unless you’re a TV evangelist… and those slots are hard to get. Besides, they are more business than religion, anyway. A good politician, meanwhile, even if he is slick, can only skim off a certain amount without getting caught with his pants down. The Clintons, for example, were only able to pull off a shady land deal…and operate a penny-ante cattle-trading account – besides the book contracts, of course. It might have been serious money, but it took a whole career of sordid dissembling to pull it off. The Bushes have done better, but it has taken them a couple of generations and a few CIA contracts. And in any case, it is nothing compared to the kind of loot a hedge fund manager takes in while he is still young enough to enjoy it.

In this late, degenerate imperial age, no one gets richer faster than hedge fund managers. Last year, Edward Lampert, of ESL Investments (a hedge fund business), set the pace with $1.02 billion in compensation. Compared to him, James Simons of Renaissance Technologies Corp. must have felt like a charity case, with only a bit more than $600 million in take-home. But he still did better than Bruce Kovner, at Caxton Associates, who earned $550 million.

The New York Times provides a list: Steven Cohen of SAC Capital Advisors, $450 million; David Tepper of Appaloosa Management, $420 million; George Soros of Soros Fund Management, $305 million (Soros was number one in 2003, with $750 million); Paul Tudor Jones II of Tudor Investment Corp., $300 million; Kenneth Griffin of Citadel Investment Group, $240 million; Raymond Dalio of Bridgewater Associates, $225 million; and Israel Englander of Millennium Partners, $205 million. Poor Richard Fuld; the man earned only a paltry $35,257,099 for his work running Lehman Brothers. And E. Stanley O’Neal, at Merrill Lynch got even less: a miserly $32,134,673.

We do not report those figures out of jealousy, but simply puzzlement and amusement. Every penny had to come from somewhere. And every penny had to come from clients’ money. Investors in leading hedge funds must be among the richest, smartest people in the world. Still, with no gun to their heads, they turned over billions of dollars’ worth of earnings to slick hedge fund promoters.

What do you need to do to get that kind of work? Well, it helps to be good with complicated math. Then, you can join other hedge fund managers who trade derivative contracts that the clients cannot understand, such as the recently launched CPDO, the Constant Proportion Debt Obligation. According to Grant’s Interest Rate Observer, the CPDO may be an innovation, but it is hardly a new idea. It is remarkably similar to the CPPI, or Constant Proportion Portfolio Insurance, which made its debut 20 years earlier.

The CPDO is meant to protect investors against the risk of investment-grade credit defaults. CPPI was meant to protect investors from a stock market crash, using a complex formula that clients also couldn’t quite understand. Then in 1987, only about a year after the CPPI was introduced, the stock market crashed and investors finally figured out how they worked. Sifting through the debris, analysts determined that CPPI had not protected investors; instead its fancy programmed trading features actually magnified the losses.

We don’t know how the CPDO will hold up under pressure, but we can barely wait to find out. Whenever the higher math and the greater greed come together, there are bound to be thrills.

The twitty quants at big investment firms invent the complex derivative contracts… give them a jolt of juice…and then the abominations spring to life. The next thing you know, the hedge fund whizzes are building big houses in Greenwich, Connecticut – and there are billions of dollars… no trillions… in CPDO and other contracts, in the hands of buyers who don’t quite understand the elaborate equations behind the contract… and (here we are just guessing) who will be surprised when they find out.

If you are good with figures, you can at least partially protect your own investments. But it usually means taking a position on the opposite side of the great weight of investment capital. You can also find ways to make more money than your slower-moving peers, again, by doing things a bit differently. But neither financial wizardry… nor any complex instrument… can protect a whole market. The whole market can’t protect itself from itself. The more people climb onto an investment platform – whether it is derivatives trading, dot.coms, dollars or dirigibles – the more it creaks and cracks, and the more damage it does when it finally gives way.

But buyers of CME (the Chicago Mercantile Exchange) don’t seem to notice. Google (NASDAQ: GOOG), the newest, hottest technology stock of late 2006, trades at a forward P/E of 36… CME trades at an astounding 51. CME is where futures and derivatives trade. The stock came out three years ago at $39. Since then it’s gone up 14 times, to more than $550. In New York, meanwhile, the NYSE gets half its daily volume from hedge fund trading. Its stock too, has been on a roll, now trading at 10 times sales, 119 times trailing earnings, and 46 times forward earnings.

If you want to profit from hedge funds, the best way is to become a hedge fund manager. Or, if you want really want to get into hedge funds, but wish to retain your dignity, you could consider investing in a hedge fund company. At least two hedge fund companies have sold shares to the public on the London market.

But hedge funds are supposed to be able to produce superior returns for both investors and managers. If they could do so, why would they wish to trade their shares for cash? What will they do with the money; invest it in someone else’s hedge fund? But with returns falling…and customers beginning to ask questions… more hedge fund impresarios are likely to want to get out while the getting is good. As the funds become less profitable, in other words, more will probably be sold to strangers who don’t know any better.

And then, someday – perhaps someday soon – a peak in the credit cycle will come. The mother of all bubbles will finally pop and then the ‘little big bubbles’ in the financial industry will pop. The Dow will come down – the dollar too. Junk bonds will sink. Builders in Greenwich will notice that their phones aren’t ringing as often. NYX and CME will crash. And 5,000 hedge fund managers will be on the streets… looking for the next big thing. When will it happen? How? We don’t know. But our guess is that when the history of this bubble cycle is finally written, derivatives will get a special ‘tipping point’ place… like the Hindenburg in the history of the Zeppelin business… or the Little Big Horn in the life of George Armstrong Custer.

Bill Bonner
The Daily Reckoning

Bill Bonner

Bill Bonner

Best-selling investment author Bill Bonner is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter companies. Owner of both Fleet Street Publications and MoneyWeek magazine in the UK, he is also author of the free daily e-mail The Daily Reckoning.
Bill Bonner

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  1. The best commentary on derivatives I’ve read. Makes it all seem so simple -because it is is simple common sense.

    Aline Stewart
    August 14, 2008
  2. I think I heard a “POP”. This article should be sent to U.S. congress. Bernake and Paulson don’t want to tell them where the $700 billion is going and It sure as hell is not to cover mortgage losses.

    Lauchlin Rozier
    September 25, 2008
  3. Well my mum told me there are no shortcuts of making money but there are smart people who do make them at cost of others and they themselves have spent on things which no longer stay with them (their mercedes big mansion etc)

    WELL ITS again lesson time I GUESSS

  4. I am trying to find out exactly when Derivatives became legal — I thought I had read a date – 1999 — but cannot verify it. Can anyone help?

    Sara Porter
    May 30, 2010
  5. Sara, 20th September 1931. That was the day the Bank of England defaulted on it obligations.

  6. I am trying to find out exactly when Derivatives became legal — I thought I had read a date – 1999 — but cannot verify it. Can anyone help?

    The first exchange for trading derivatives appeared to be the Royal Exchange in London, which permitted forward contracting. The celebrated Dutch Tulip bulb mania, which you can read about in Extraordinary Popular Delusions and the Madness of Crowds by Charles Mackay, published 1841 but still in print, was characterized by forward contracting on tulip bulbs around 1637. The first “futures” contracts are generally traced to the Yodoya rice market in Osaka, Japan around 1650. These were evidently standardized contracts, which made them much like today’s futures, although it is not known if the contracts were marked to market daily and/or had credit guarantees.

    Probably the next major event, and the most significant as far as the history of U. S. futures markets, was the creation of the Chicago Board of Trade in 1848. Due to its prime location on Lake Michigan, Chicago was developing as a major center for the storage, sale, and distribution of Midwestern grain. Due to the seasonality of grain, however, Chicago’s storage facilities were unable to accommodate the enormous increase in supply that occurred following the harvest. Similarly, its facilities were underutilized in the spring. Chicago spot prices rose and fell drastically. A group of grain traders created the “to-arrive” contract, which permitted farmers to lock in the price and deliver the grain later. This allowed the farmer to store the grain either on the farm or at a storage facility nearby and deliver it to Chicago months later. These to-arrive contracts proved useful as a device for hedging and speculating on price changes. Farmers and traders soon realized

    that the sale and delivery of the grain itself was not nearly as important as the ability to transfer the price risk associated with the grain. The grain could always be sold and delivered anywhere else at any time. These contracts were eventually standardized around 1865, and in 1925 the first futures clearinghouse was formed. From that point on, futures contracts were pretty much of the form we know them today.

    In the mid 1800s, famed New York financier Russell Sage began creating synthetic loans using the principle of put-call parity. Sage would buy the stock and a put from his customer and sell the customer a call. By fixing the put, call, and strike prices, Sage was creating a synthetic loan with an interest rate significantly higher than usury laws allowed.

    One of the first examples of financial engineering was by none other than the beleaguered government of the Confederate States of America, which is sued a dual currency optionable bond. This permitted the Confederate States to borrow money in sterling with an option to pay back in French francs. The holder of the bond had the option to convert the claim into cotton, the south’s primary cash crop.

    Interestingly, futures/options/derivatives trading was banned numerous times in Europe and Japan and even in the United States in the state of Illinois in 1867 though the law was quickly repealed. In 1874 the Chicago Mercantile Exchange’s predecessor, the Chicago Produce Exchange, was formed. It became the modern day Merc in 1919.

    The 1950s marked the era of two significant events in the futures markets. In 1955 the Supreme Court ruled in the case of Corn Products Refining Company that profits from hedging are treated as ordinary income. This ruling stood until it was challenged by the 1988 ruling in the Arkansas Best case. The Best decision denied the deductibility of capital losses against ordinary income and effectively gave hedging a tax disadvantage. Fortunately, this interpretation was overturned in 1993.

    Another significant event of the 1950s was the ban on onion futures. Onion futures do not seem particularly important, though that is probably because they were banned, and we do not hear much about them. But the significance is that a group of Michigan onion farmers, reportedly enlisting the aid of their congressman, a young Gerald Ford, succeeded in banning a specific commodity from futures trading. To this day, the law in effect says, “you can create futures contracts on anything but onions.”

    In 1972 the Chicago Mercantile Exchange, responding to the now-freely floating international currencies, created the International Monetary Market, which allowed trading in currency futures. These were the first futures contracts that were not on physical commodities. In 1975 the Chicago Board of Trade created the first interest rate futures contract, one based on Ginnie Mae (GNMA) mortgages. While the contract met with initial success, it eventually died. The CBOT resuscitated it several times, changing its structure, but it never became viable. In 1975 the Merc responded with the Treasury bill futures contract. This contract was the first successful pure interest rate futures. It was held up as an example, either good or bad depending on your perspective, of the enormous leverage in futures. For only about $1,000, and now less than that, you controlled $1 million of T -bills. In 1977, the CBOT created the T -bond futures contract, which went on to be the highest volume contract. In 1982 the CME created the Eurodollar contract, which has now surpassed the T -bond contract to become the most actively traded of all futures contracts. In 1982, the Kansas City Board of Trade launched the first stock index futures, a contract on the Value Line Index. The Chicago Mercantile Exchange quickly followed with their highly successful contract on the S&P 500 index.

    1973 marked the creation of both the Chicago Board Options Exchange and the publication of perhaps the most famous formula in finance, the option pricing model of Fischer Black and Myron Scholes. These events revolutionized the investment world in ways no one could imagine at that time. The Black-Scholes model, as it came to be known, set up a mathematical framework that formed the basis for an explosive revolution in the use of derivatives. In 1983, the Chicago Board Options Exchange decided to create an option on an index of stocks. Though originally known as the CBOE 100 Index, it was soon turned over to Standard and Poor’s and became known as the S&P 100, which remains the most actively traded exchange-listed option.

    The 1980s marked the beginning of the era of swaps and other over-the-counter derivatives. Although over-the-counter options and forwards had previously existed, the generation of corporate financial managers of that decade was the first to come out of business schools with exposure to derivatives. Soon virtually every large corporation, and even some that were not so large, were using derivatives to hedge, and in some cases, speculate on interest rate, exchange rate and commodity risk. New products were rapidly created to hedge the now-recognized wide varieties of risks. As the problems became more complex, Wall Street turned increasingly to the talents of mathematicians and physicists, offering them new and quite different career paths and unheard-of money. The instruments became more complex and were sometimes even referred to as “exotic.”

    In 1994 the derivatives world was hit with a series of large losses on derivatives trading announced by some well-known and highly experienced firms, such as Procter and Gamble and Metallgesellschaft. One of America’s wealthiest localities, Orange County, California, declared bankruptcy, allegedly due to derivatives trading, but more accurately, due to the use of leverage in a portfolio of short- term Treasury securities. England’s venerable Barings Bank declared bankruptcy due to speculative trading in futures contracts by a 28- year old clerk in its Singapore office.

    Don Chance professor of finance at LouisianaStateUniversity.


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