Economic Sabotage

[dieseltaylor]

I called the thread economic sabotage because:

1] being legal does not mean it is right or proper

2] citizens have a duty to their society - implicitly

So if I am aware that the market is becoming perilous and has national implications do I:

1] pile in and make as much money as possible

2] withdraw from the market and advising my clients why

3] just withdraw from the market

4] ring the alarum bells loudly and publically

So does a citizen have to support his nation or does he just go along for the ride and benefit by exacerbating an illness in the market. If he believes the second then does the state need to look after his interests or has he placed himself outside the law?

Explaining how derivatives can be good does not trump the fact they have been used for financial disaster - there is no defence.

Paulson employee wrote:

“It is true that the market is not pricing the subprime RMBS wipeout scenario. In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institutional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”

[ASL Veteran]

Sorry, I was away for a few days. Kanonier Reichman is correctly describing what a 'Call Option' is. Keep in mind that a 'Call Option' is just one kind of derivative. There are many derivatives out there and I only used the example of a 'Call Option' to explain what a derivative is. It is also the most simple derivative out there.

Diesel, there is nothing fundamentally good or bad about a derivative. A derivative just exists and has a function that it fulfills for both those who want to use it to reduce risk through hedging and for those who want to gamble a bit through speculating. It's really not that complicated. Saying that a derivative is good or evil is similar to saying that a hammer is good or evil. The thing about my example that seems to be troubling you though is - well there doesn't seem to be any purpose to it other than for wealthy people to make more money. Well, I suppose that's right to some degree except for one thing. By show of hands, does anyone in here have a savings account, own shares in a mutual fund, have a 401k, or have a pension plan? How do you think the value of your savings accounts, mutual funds, and pension funds change? Does anyone in here think that once you deposit your money in a bank savings account that the money just sits in a vault? If that's what happened, then how would a bank be able to pay you interest on your deposit? No, a bank can pay you interest on your savings accounts because the bank does something with your money. The bank either invests it or lends it to someone else. This is probably one of the most common finance mistakes people can make - they assume that money that is being 'saved' is removed from the economy as if it's being stuffed in a huge corporate mattress somewhere. Au Contraire! In fact, stuffing money in your mattress actually causes you to lose money because the value of your dollar is reduced because of inflation.

[dieseltaylor]

ASL - you do not appear to answer my point regarding a duty to society. Is this because I have not explained the concept or that you cannot recognise it.

AS for derivatives being good or bad I agree absolutely that they are not inherently wrong. However rather like a automatic rifle in the wrong hands - and with no constraints they can be misused. Does society need to legislate for power crazed monetary morons - I think so.

Btw as an ex-banker I am very familiar with what banks do. And also that money given to hedge funds is not money that can then be lent to businesses - oops I should have conditioned my remark to say on normal lending multiples. Afterall if GS wants to lend 100 times its actually asset base why of course they in theory could lend to businesses.

I do also have quite a few shares. I understand interest, return, profitability and investment. I also understand gambling as I have had a few flutters in my time. I think I can safely say that derivatives to cover actual real assets is pretty reasonable. Betting that mortgages/crop/raw materials which one does not have a direct interest in is probably not good.

And what is your feeling about the mishap last Thursday. Just the tiniest concern perhaps that a system designed solely for getting a trading edge on each other is perhaps not the most robust. And any forward thinking intelligent person may wonder what deliberate sabotage of these automated trading systems could result in.

Personally I would love to have bought Accenture at 1cent. I wonder what trades happened on the way down. I am not the only one:

Thursday, May 6, 2010 will become a study for every financial college in America. In just 16 minutes, the Dow Jones Industrial Index dropped just under 1,000 points, the largest inter-day drop in history.

At first, a fat-finger trade made by Citigroup was blamed. Now, however, the blame is being laid on automatic triggers in the high-tech trading systems of Wall Street giants, like Goldman Sachs, Citigroup…basically any number of market makers.

But the one question that is not being asked is this:

Why are these high-tech trading systems programmed to panic?

Because that’s exactly what they did, and as I study them, I don’t see how there is any way of avoiding another computer-generated panic sell-off like the one we experienced last Thursday. Institutional investors often use such systems, as well as banks, and the problem with these systems is that while they protect their user’s positions in the Market, they are all using the same algorithms and the same triggers to sell, which leads to…you know…1,000 point drops in the Dow in less than a quarter-hour.

What’s the danger? Well, Thursday is one such danger, for example. Millions of people lost millions of dollars in sixteen minutes.

There’s also the idea that if these trading systems can create a panic sell-off, they can also create a level of control that would allow a less-than-moral trader or Market Maker to cause a panic sell-off for huge financial gain. I’m not saying that’s what happened on Thursday.

I’ll leave you to your own conclusions.

Incidentally what is your position on the Hunt Brothers and their failed attempt to corner the silver market?

Do you worry that as physical delivery of stock rarely takes place that in fact trades are not being settled, and that some trades are in fictitious stock. Automation is a wonderful thing but as there is no money in policing the system you have lots of opportunity for people to screw the system. This is kinda of an important area where it appears to be a problem, Lord knows what less important stocks are suffering:

http://www.sifma.org/capital_markets/docs/Fails-Charge-Trading-Practice.pdf

The Sponsors, together with the Federal Reserve Bank of New York, are recommending this Trading Practice in order to preserve and enhance the efficiency and operational integrity of the marketplace for Treasuries by reducing the incidence of Delivery Failures. Widespread and chronic Delivery Failures impede efficient market clearing and can undermine overall market liquidity by causing market participants to withdraw from the Treasury market. This in turn impairs hedging and market making activity in the cash market, resulting in poorer overall functioning of the Treasury market. Given the benchmark status of the Treasury market, such dysfunction has negative consequences for capital markets more generally

I think there are plenty of things in NY that require some serious thinking. Velocity of trading with millions of spoof trades playing with the price is just bonkers in terms of small gain but potential for danger.

[dieseltaylor]

ASL - just to save you looking:

http://www.stpadvisors.com/working_papers/STP2007_1_Fails_in_Bond_Market.pdf

which indirectly covers the shares market. Given its an official paper you may believe , as I do, that there is a considerable possibility that the report is engaged in diminishing the problem, rather than as an expose of a worrying flaw.

But as the greatest exponent of capitalism the US is a concern:

http://www.articlesbase.com/ethics-articles/the-impact-of-naked-short-selling-and-ftds-on-capital-markets-614775.html

[dieseltaylor]

http://www.bloomberg.com/apps/news?pid=20601109&sid=arFjbsBO7BS8

Very well written piece explaining in laymans language the incentives built into CDO's that meant the managers would gradually make even good stuff rotten over the years. I find it incredible that so much money could be wasted so casually. Admittedly they say some propspectuse went to 1500 pages - however that in some ways makes me think it more likely I would smell a rat. However if it was not my problem to deal with any **** if it went tits up I would accept a fee to be blind .......

Possibly not . Being honest is a nice feeling.