Remember that old line our parents used to throw at us before we engaged in a little beer drinking? The concept certainly applies to the financial markets when the subject becomes losing more money than one can afford to lose. When looking at the recent history of derivatives trading, even some of the more “exotic” contracts served a worthwhile purpose when used properly and responsibly. Get familiar today with the word “hedging”.
This concept deals with having a mechanism in place that would offset a drop or rise in a particular credit instrument (mortgage pool), interest rate, currency or commodity. The financial companies love to call these strategies “insurance”, but I assure you derivatives are not regulated by any state or federal insurance commission. One of our biggest problems has been their lack of regulation, period.
When one enters into an OTC (private) derivatives contract that goes beyond the need to hedge against an unwanted price movement in an owned asset, that trade becomes pure speculation. Why? No underlying owned asset exists to validate a hedge being the goal. So we often wind up speculating on whether or not someone else’s asset will fail or whether or not a major price change in other assets will take place.
Author Michael Lewis did a great job in “The Big Short” showcasing the history of how the speculation for/ against the failure of mortgage pools brought some of our global financial household names to their respective knees. The leverage in these speculative contracts could be exponential. An eight percent default rate on the underlying mortgages in a mortgage pool, for example, could render the accompanying derivative, sold against the failure of the pool, worthless. Lehman Brothers had been around since 1850. The bulk of Maria Bartiromo’s book, “The Weekend That Changed Wall Street”, dealt with Lehman’s competitors trying to come to its rescue in its final hours. Number crunching like no one had ever seen before kept CEOs and treasurers awake for days. Alas, no one could justify a purchase, and Lehman was “allowed” to fail. Interestingly enough, commentary among those competitors in the book tell us that they realized how close they were to “the brink” as well.
The whole premise of not risking more than one is able to lose should apply to institutions as well as individuals. Lehman was highly leveraged. One account I read put that leverage at thirty times equity. Speculation in the global financial community was/remains rampant and often was accomplished under an FDIC umbrella. Taxpayers are now on the hook for some of those institutional speculations gone awry. More later.