my understanding of derivatives

I posted this as well on Winterwatch. I think it illustrates how I think about derivateves.

I recently read Satyajit Das’s book “Traders, Guns, and Mony”. Das is perhaps the world’s foremost expert on derivatives. If I remember correctly, Das says that the typical CDO has the following structure: 1-2% equity tranch (usually held by the issuer), 3-4% mezzanine (all risk with no gain), 95% investment grade.
Incidentally, this is exactly the way the Titannic was built. The ship had 10 bulkheads, to prevent a leak in one from filling up the whole boat. However, the bulkheads only went 90% of the way up to the ceiling. After the first one filled, the water just flowed over into the next. The equity tranches have been sunk by losses, the mezzanine are almost full, and the investment grades are next. See www.Markit.com for their ABX indices. Prices range from 95 for AAA to BBB in the 30’s.

comment I posted on Winterwatch

Winterwatch:

I believe that another way to look at the credit crisis is that buyers of debt are still learning that their paper (ABCP, MBS, CDO, CLO, etc.) is not backed up by sufficient capital, but rather by fictitious capital. They paid for an income stream that may not exist secured by collateral that is insufficient to prevent substantial losses. In every credit cycle, there is a boom in which easy credit supports overpricing of collateral. When the vicious cycle collapses under its own weight, the opposite happens. First, creditors call in loans. Then they stop lending. The terms are tightened, and rates go up. There is a reason why banks preferred to move assets off-balance-sheet and issue ABCP to finance this. I suggest you read Soros “The Alchemy of Finance” for a more complete explanation of what happens. IMHO.

I am very flattered by Russ's reply:

Comments 8, 10 and 13 nail the concept of fictitious capital,
perhaps even better than me.

(my comment was #8)

Hedge Funds!

Next week should be fun for Hedge Fund news! We get to find out how many investors have gotten "redemptions suspended" letters! Should be an interesting week.

just waiting...

There's nothing new with my positions. More bad news on housing. The housing market is now over $2.3 trillion smaller than it was in 2005, down 52% in total sales from $4.5 trillion. The investment banks have had their post scare bounce, and will just slide for a long time. Their earnings will suffer for at least the next year. Not only will they struggle to find new business, but all their comps will come up against all-time earnings highs. Retail will tank just in time for Christmas, as consumers were still getting 6% of their yoy purchasing power from mortgage equity withdrawals until August.

Predictions: We will go into recession (officially) beginning of next year. The dollar will hit new lows. Who will lend to people who don't pay them back? Gold might actually be a good thing to be in if all currencies fall. This could be the case if there are two types of currencies left: debtor countries who won't pay (USA) and bagholders who hold worthless paper (Chindia, OPEC). UK/EU are a bit of both. In this scenario, all currencies might fall against gold. We'll have to wait and see. I'm not ready to just on the train just yet.

thinking about my trading tactics

Satyajit Das says that markets overreact short term and underreact long term. This has happened with homebuilders which plunged when housing sales fell flat and then recovered most of their losses. Since then, homebuilders have gone downhill continuously. Countrywide is another recent example. Countrywide fell 25% in the subprime lender panic at the end of February before recovering 80% of that loss. Now it trades under 50% of the high.

I will try to make this rule my primary trading tactic.

I believe that the reason that this rule stands is because the markets first anticipate changes in the fundamentals and get ahead of them, later they fall behind and lag the fundamentals.

A word from the wise man:

Article by Satyajit Das.

It's Friday!

Well, 'Ol Chopper (Helicopter Ben) really has his work cut out for him now. Commercial paper is still shrinking. His half point cut sent the DOW skyrocketing. Then gold took off. After gold, then the 10 and 30 year bonds. I've seen more headlines about inflation and recession in the past couple of days than during all of August. I think this rally will be short-lived.

The subject of today's ramble will be speculation on the future. Namely, what will happen when hedge funds trying to catch the next bubble and investors/speculators trying not to get left behind inflation get hammered? What is the next bubble after that? Art? That's a bubble too. I remember hearing weekly stories of record art prices in 1998-99, just before the Dot.Com implosion. The stock market? The stock market has already hit its peak in terms of gold or Euros, and probably won't make a new high in dollar terms. Higher long-term rates will kill the market as soon as earnings start to reflect the reality of bad loans on the books. They can sweep the losses under the rug, but they can't get a good return on equity when it's not there. Real estate? In the right locations, it might actually be a sound investment, but probably not in California. It really depends on how long it takes for the commodity/emerging markets bubble to pop. I put commodities and emerging markets in the same bubble because emerging markets are supplying the demand and monetary inflation that are feeding the bubble. Foreign currencies could do very well, especially those that are not dependent on the U. S. market. The Euro comes to mind. How about companies paying dividends in Euros? I'll have to see what's out there.

Central Banks

What does the Federal Reserve do? What is it's business, and how does it make money?

Well, if you take a dollar bill out of your wallet, you will read "Federal Reserve Note." That's what the Fed does. It prints money. That is the be all and end all of its existence. It prints money. Then it either buys Treasury Bonds from the U.S. Treasury or from the banks.

I need to return to my successful strategy from last year's practice account. I need to buy something with a 6 month strategy and they take profits on any big gain between now and then. This works especially well with options.

Ouch!

Well, ‘ol Ben sure set me up today. I feel like a four-year-old coming out of the men’s room at a NAMBLA (Newly Assured Mortgage Backed Loan Asset) convention.
Maybe the central bankers are really scared. Either that or they were just setting up shorts and prudents for losses. I think the latter is unlikely. They aren’t stupid. But I think that’s just what they did. I think they must be really scared. First the BofE eats its words two days after talking tough. I think that this gave Bernanke the cover he wanted to slash rates. He’s not alone now. He’s got ‘ol Mervyn to look even worse. They’re just praying for the problems to go away. I don’t think they will that easily. (but then again, I couldn’t have been more wrong today.)

Well, I think that I'll just have to sit on everything for another week. August existing home sales come are announced next week, along with housing starts. I wait for the numbers to come in and then take some profits on ITB, and maybe KBH and TOL. After that, I'll have to try to look 6 months out again. My focus in the past couple of months has been lost, and most of my trades in August were horrible. If we are going into recession, I will try to short Mastercard (MA). They're hardly down at all, while consumer debt is at an all-time high.

news and random thoughts...

News from Realtytrac. This article has the following gem:

But the best foreclosure bargains for most of 2006 were not found in Los Angeles, Las Vegas, Miami or other previously hot markets, according to
RealtyTrac’s survey of foreclosure sales in 2006. The survey shows foreclosure buyers in Las Vegas, Miami and Los Angeles on average saved less than 15 percent off full market value in 2006, while foreclosure buyers nationwide saved nearly 25 percent on average. Foreclosures discounts were biggest in several Midwestern states such as Ohio, where foreclosure buyers saved an average of nearly 40 percent, and Indiana, where foreclosure buyers saved more than 35 percent.

This gives us a good idea about what a foreclosure rate of 2% plus local economic weakness (manufacturing) means in terms of prices. They are 25-40% too high.

The next article predicts 2 million foreclosures by the end of the year.

I came up with these thoughts about banks and the banking industry. Part of this comes from reading Keynes, which makes almost no sense to me. Banks make money by borrowing short and lending long. In order to keep longer rates higher, they need expectations of inflation. For inflation, they need to collude with government. The argument could be that banks lose just as much to inflation as they make. That is true. But they always make money on their deals NOW. This is the insidious and devious nature of banking and all usury. However, they want inflation to be stable. That's where the problem comes in.
Another thought about CB's. The reason that CB's should print money in a crisis is to punish hoarders of cash by devaluing their hoards. This will encourage consumption and spending in the face of deflation.

haven't posted in a while...

So I thought I would critique my performance so far. The numbers speak for themselves: 3% through September 14th. Mediocre. I've done a good job of pickeing where the market is, and where it's going. However, my timing on trades has been terrible. I realize that I haven't been taking market sentiment into account. I must remember to be more patient. Several terrible and stupid losses I have taken, I shouldn't have. I need to have more fun, and not follow the market too much.

My goal is to earn 20% by the end of the year.

playing devil's advocate...

Gold goes up either way.

If CB's get tough like BofE today, then berserkers, hedge funds and pig men need to move assets over to the only bubble left (gold and commodities). There easily could be more than enough FC to run up gold even if cheap credit continues to take a beating.

If CB's wimp out and print money, then gold us up, up, and away.

it's eery....

Strange things are happening.





Investors in Canada might lose $35 Billion in ABCP. Need I say more. The asset holders are still being forced to sell. Why? Because credit is still being called.



Nickel has fallen 54%. See six-month chart.

How is this collapse even possible? Three months ago, I was reading stories about nickel inventories being down to a 5-day supply. Turns out that "off-inventory warehouses" had hidden supplies.

Elsewhere, speculators (until today) are jumping into the only bubble left: emerging market commodity stocks.

My strategy: wait. The recession is inevitable at this point. I think I can still get 20% out of this year.