28 August 2008

Securities Trading: The Wild West

The recent world of Securities Trading is a very dangerous place; a modern day equivalent of the wild west, very limited law and enforcement.

Everyone wants to 'hedge their risks' with securities. Banks, ibanks, hedgefunds, and companies themselves are choosing to insure in a more sophisticated and inexpensive way than the traditional insurance provider. Why pay the premium?

Every company has risk. For example, Delta Air Lines will lose profitability when oil prices rise.
Delta could take out an insurance policy that says
"in the case that oil goes up at least $4/barrel, I want to be covered for $10M."
A traditional insurance company would say "sure, let's calculate what that would cost."
If the acknowledge probability that oil will go up $4/barrel is 20%, then we expect that will cost us $2M.
Plus, we charge a standard 6% premium, so that insurance policy will cost 2x1.06=$2.12M

Or, Delta could insure through selling securities: derivatives of its stock.
If oil does not go up, Delta expects its stock to sell at $10/share.
If oil does go up, then Delta expects its stock to sell at $9/share.
Given the 20% chance of oil going up, you would expect Delta shares to be selling today for $9.80

To insure through securities, Delta could sell it's stock today with the condition that

if oil does not go up, they will buy it back from you for $10.20
and if it does go up, then they will buy it back from you for $8.

If Delta can sell 10 million of those derivatives, it gets the same insurance as the policy offered for 0 premium, saving $120K.

Even if Delta sold the security that

If oil does not go up, they will buy it back from you for $10.21

And if it does go up, they will buy it back from you for $8

And they sold 10 million of those, they are getting the same insurance policy for $2.1M and saving $20k.

Everybody except the insurance company wins. If you buy that security, you expect a 5% return on average, and Delta saves $20k.

Delta can actually do even better.

If an oil company happened to come around, then Delta might even get the insurance for a negative premium.

Since, if oil goes up, oil companies do better and if oil goes down, they do worse, Delta and the oil company happen to compatible conditions to mutually insure.

If oil goes up, Delta doesn't do well but the oil companies do.

If oil doesn't go up, oil companies don't do well, but Delta does.

Thus, the two companies could work out an arrangement to ensure that they both get insured at a 0% premium.

It's not always easy to find just the right company or combination of companies that would provide your mutual insurance. Then, you go to a bank, ibank, or hedgefund. They'll provide the service for you for a small cut. And the same idea goes for virtually every market, not just oil.

Consider a Countrywide selling mortgages for an interest rate. There's a good chance that the home-buyer will default, in which case Countrywide will not be profitable. Let's not insure against that risk for a 6% premium, let's sell a derivative of our stock through a hedgefund who can find a buyer with mutual insuring conditions.

So, what's the problem? As a libertarian I'm sorry to say, the problem is inadequate legislation.

These "securities" are really very risky assets. Yes, they act as insurance for the selling company by securing a less volatile financial future, but for the buyer, they are risky. People and companies buy $millions worth of these risky assets, and sometimes the buyer's losing side materializes. Many times, people can't cover their losses. They had bought more risk than they could afford and have to file bankruptcy. In this case, everybody loses. The gambling buyer is bankrupt, and they company who wanted insurance, is no unable to get paid. Sorry.

The problem really is as simple as this. Sure, the situations aren't usually just two cases and therefore the probabilities and prices aren't always easy to figure out, but people do (this is the heavy math of financial engineering). I remember reading a while back that Tim Geithner, president of the New York Federal Reserve Board, was fighting for a piece of legislation to get more accurate auditing of financial portfolios and prohibit the purchase of assets that the buyer would be unable to cover in some case.

The volume of derivatives traded is enormous and the turnover is very fast. Consider what happened to Delta. They had a good size of securities for the case of an increase in oil. They buyer resold the asset and the same thing again. When it was time to collect, it was found that the company now holding the derivatives was bankrupt and could not be collected from. Delta had counted on that insurance, and eventually had to file bankruptcy themselves. An unfortunate domino effect with negative implications for our economy, all of which could have been prevented with a simple piece of legislation authorizing more accurate portfolio audits and prohibiting the purchase of excess risk.

There is actually a second problem with securities trading, but I'll save that for another post.

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