Are we headed for an epic bear market? By Jon Markman

[Rajiv]

Re: Are we headed for an epic bear market? By Jon Markman

The headline doesn't reflect what he really said!

If you read beyond the first paragraph

Greenspan said the impact of the crisis has yet to fully feed through to the world economy and that it has changed the way banks price risk on the assets they trade. Developments in the U.S. housing market will be crucial to determine how long the credit crunch lasts, he said.
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Greenspan also suggested there were signs of improvement in interbank lending rates as well as the market for asset-backed commercial paper, or short-term IOUs secured by home and car loans. While ``we're not through this yet,'' he said later in a speech at the London School of Economics, ``we're creeping closer to normality.''

[Spartacus]

Re: Nasser

I did understand it at one point.

Try this (from faltering memory, so don't take it as an unerring report)

You have a price of a (standard) call where you are not required to buy the underlying, call this price STD

Suppose you DID have to buy the IBM whether the price fell or rose, what would the call's price be? Call this price NOdef

Compare STD to NOdef - is the difference huge?

speaking generally for a moment, Ignoring the expectations of a particular call's final disposition, Saber is claiming the most important factor in setting the call's price is NOT THE RIGHT TO BUY but the right not to buy, ie, the right to default

Sapiens,

that is a great read. Thanks for sharing.

RE: Nasser

"You're long, I'm short. You think that the IBM call you're writing for $5 gives you the right to buy IBM. But, in fact, you're already long in the contract. In paying $5, you are prepaying your potential default. If IBM drops, you don't have to pay the money, even though you are long. Why not? Because you have already paid the so-called premium, which is the cost of the default of the long. That's what a call is."

Does that make ANY sense at all ?

I wont even quote the text on the Put/Call ratio, its pathetic.

Does he write something clever about volatility in falling/rising markets ?

[touchring]

Re: Are we headed for an epic bear market? By Jon Markman

One person must be taking the truth, and the other person is lying?

http://www.bloomberg.com/apps/news?p...d=aNohwpYdqHeo

Greenspan Says World Credit Crisis May Be Almost Over (Update1)
By Gonzalo Vina and Robert Hutton
Oct. 1 (Bloomberg) -- Former Federal Reserve Chairman Alan Greenspan said the worst of the global credit crunch may be almost over after signs that lenders were seeking to buy longer- term assets of lower quality.
``Lenders in recent days have been reaching out for longer- term, lesser quality assets, and that is a good sign,'' Greenspan said in a speech in London today. ``Is this August-September credit crisis about to be over? Possibly.''

[JoeSixpack]

Re: Nasser

Sapiens,

that is a great read. Thanks for sharing.

RE: Nasser

"You're long, I'm short. You think that the IBM call you're writing for $5 gives you the right to buy IBM. But, in fact, you're already long in the contract. In paying $5, you are prepaying your potential default. If IBM drops, you don't have to pay the money, even though you are long. Why not? Because you have already paid the so-called premium, which is the cost of the default of the long. That's what a call is."

Does that make ANY sense at all ?

I wont even quote the text on the Put/Call ratio, its pathetic.

Does he write something clever about volatility in falling/rising markets ?

[Rajiv]

Re: Are we headed for an epic bear market? By Jon Markman

Yes indeed - if you have the cash or asset positions to cover your bets -- as opposed to just a promise of being able to cover your bets when they come due.

e.g. take a simple derivative like buying or selling a index future. If I do not have the cash to buy the stocks in the index, or I do not have possession of the stocks in the index, then I am borrowing the cash or borrowing the stocks -- on the very small collateral that I have deposited with my broker - and as far as my broker is concerned, he/she is making me a loan of those assets!

Thus in my view, most derivatives end up being bets made on borrowed assets. This is why I said that derivatives are useful, but with a limited scope.

[c1ue]

Re: Are we headed for an epic bear market? By Jon Markman

Rajiv,

I see - although it seems you are actually lumping derivatives with borrowed money.

Is it safe to say that derivatives investment without leverage would then be ok?

After all, strictly speaking a 1st level derivative is not the same as a derivative of a derivative (2nd level) and so forth.

I do agree there is a bit of a Ponzi nature in at least of the markets, but that is as much a result of herd behavior as it is a specific cash flow pyramid scheme.

[Rajiv]

Re: If you REALLY want to understand derivatives[*]

Nasser Saber's Revolutionary Option Theory

It's not every day somebody comes along claiming that all of options theory is bunk. But that's exactly the idea proposed by Nasser Saber, an adjunct professor at New York University and general partner of Saber Partnership, a trading and risk management firm.

In his latest book, Speculative Capital & Derivatives: The Nature of Risk in Capital Markets (Financial Times/

Prentice Hall, 1999), Saber audaciously declares that, from the earliest days of economic inquiry to the present, every piece of literature and university lecture on options has been flat-out wrong. Oh, and the few times options have been priced correctly in the marketplace are the result of dumb luck.

The General Theory
Is an option really an option?

The classic definition of an option is the right, but not the obligation, to buy (call) or sell (put) an underlying asset for a certain price. But Saber argues that in this definition, the literal meaning of the word option is mistaken for the nature of the beast. In fact, there's no choice involved in the process. "If I sell you an IBM call and IBM goes through the roof, do I have the right not to deliver? Not really. I have to deliver. What happened to my right as the seller?" Options, he says, are always defined from the point of view of the buyer. Why? "There's no answer for it."

Even shifting to the holder's point of view, the absurdity persists: "If you own a call that's out of the money, you're not entitled to anything; if it's in the money, you have to exercise the option. Not to exercise would be like a lottery winner not collecting his prize. It's irrational."

So what is an option? The right to default on a forward. For the long, that right is called a call; for the short, a put. Saber explains. "Take IBM. It's at $120 right now. You think it'll go up; I think it'll come down. That's our bet. You're long, I'm short. You think that the IBM call you're writing for $5 gives you the right to buy IBM. But, in fact, you're already long in the contract. In paying $5, you are prepaying your potential default. If IBM drops, you don't have to pay the money, even though you are long. Why not? Because you have already paid the so-called premium, which is the cost of the default of the long. That's what a call is. Conversely, for the short, it's called a put - the cost of default of a short contract - when it rises in price."

This reading of options, Saber says, dispels all their theoretical and practical inconsistencies and paradoxes. For example, take the contrarian nature of the put/call ratio on stock index options. When the ratio of puts to calls on a stock index increases, the conventional wisdom goes, it should imply a bearish sentiment. It has been generally observed, however, that such an increase is followed by a rise in the market. Because the logic of the change in the ratio is inconsistent with the observed events, it is said to be a contrarian signal.

But the call and put are the prepaid cost of default of longs and shorts in a forward. When the put/call ratio increases, it means that more shorts and fewer longs have prepaid their losses because they anticipate the market rising. In that case, both groups have taken a prudent action: shorts because they have prepaid a loss that could increase with a market rise, and longs because they have not rushed to prepay a potential loss that would decrease with a market rise. The opposite is true when the put/call ratio declines. The actions in markets and the indicator of those actions are logical and consistent. But because options are misunderstood, Saber says, this logical relation is misinterpreted as a contrarian signal.

[Spartacus]

If you REALLY want to understand derivatives[*]

you MUST read Nasser Saber (no links to free PDFs, sorry)

An option is not a right to buy or sell, but a right to default, and Black-Scholes only "works" by accident.

(don't ask for more - I've forgotten all the aguments and nunaces)

[Rajiv]

Re: Are we headed for an epic bear market? By Jon Markman

The core idea of derivatives is that you are making bets with borrowed money, with a very small collateral! Whether they be Futures, options, or other exotic derivatives.

Derivatives in themselves are value neutral, and can be a very useful tool used with a great deal of moderation and to achieve limited and very specific goals. It is when they are used as the primary method to make money(in other words, they are treated as an actual, physical asset), that the problem arises.

When used thusly, they become a gigantic Ponzi scheme, reliant upon an infinite availability of credit -- ultimately somebody is left holding the bag! As can be seen in the current credit crisis.

You have got to remember, that most financial transactions today are based on mathematical (spreadsheet) models. When modeling, many externalities are hypothesized away. The most egregious one that I know (this becomes particularly egregious with derivatives) is that my (small) trade will not MATERIALLY effect the market. This assumption turns out to be false. There is a gigantic ripple effect with each derivatives trade.

Further,the assumption goes that there is enough liquidity in the market to cover my derivatives position -- this too is no longer correct, as the volume of derivatives trading has increased. This in my opinion is why Cramer was going ballistic when requesting that the Fed reduce rates.

Ultimately, taken to its logical extreme you end up floating in an ocean of indebtedness -- with society at large paying the cost through inflation, and individuals enduring financial collapse -- generally through no fault of their own.

See also LTCM

As LTCM's capital base grew, they felt pressed to invest that capital somewhere and had run out of good bond-arbitrage bets. This led LTCM to undertake trading strategies outside their expertise. Although these trading strategies were non-market directional, i.e. they were not dependent on overall interest rates or stock prices going up (or down), they were not convergence trades as such. By 1998, LTCM had extremely large positions in areas such as merger arbitrage and S&P 500 options (net short long-term S&P volatility). In fact, some market participants believed that LTCM had been the primary supplier of S&P 500 gamma, which had been in demand by US insurance companies selling equity indexed annuities products for the prior two years.[citation needed]

Because these differences in value were minute—especially for the convergence trades—the fund needed to take highly-leveraged positions to make a significant profit. At the beginning of 1998, the firm had equity of $4.72 billion and had borrowed over $124.5 billion with assets of around $129 billion. It had off-balance sheet derivative positions amounting to $1.25 trillion, most of which were in interest rate derivatives such as interest rate swaps. The fund also invested in other derivatives such as equity options.
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However, in May and June 1998, net returns from the fund in May and June 1998 fell 6.42% and 10.14% respectively, reducing LTCM's capital by $461 million. This was further aggravated by the exit of Salomon Brothers from the arbitrage business in July 1998. Such losses were accentuated through the Russian Financial Crises in the August and September of 1998, when the Russian Government defaulted on their government bonds. Panicked investors sold Japanese and European bonds to buy U.S. treasury bonds. The profits that were supposed to occur as the value of these bonds converged became huge losses as the value of the bonds diverged. By the end of August, the fund had lost $1.85 billion in capital.

The company, which was providing annual returns of almost 40% up to this point, experienced a Flight-to-Liquidity. In the first three weeks of September, LTCM's equity tumbled from $2.3 billion to $600 million without shrinking the portfolio, leading to a significant elevation of the already high leverage. Goldman Sachs, AIG and Berkshire Hathaway offered then to buy out the fund's partners for $250 million, to inject $4 billion and to operate LTCM within Goldman Sachs's own trading. The offer was rejected and the same day the Federal Reserve Bank of New York organized a bail-out of $3.625 billion by the major creditors to avoid a wider collapse in the financial markets.

[c1ue]

Re: Are we headed for an epic bear market? By Jon Markman

I could find no way to make money with them that I would consider ethical

Rajiv,

Can you explain this statement? I don't understand why derivatives are inherently unethical - unless you are saying the only way to make money is to cheat?

[Rajiv]

Re: Are we headed for an epic bear market? By Jon Markman

I swore off derivatives in 2002 -- after I discovered how they really worked! I could find no way to make money with them that I would consider ethical. In my analysis, the best that could be done was to create a limited hedge to protect the value of some of your assets.

[Sapiens]

http://articles.moneycentral.msn.com....aspx?page=all

Are we headed for an epic bear market?
The credit bubble is just starting to unwind, a credit-derivative insider says. And while U.S. borrowers are being blamed for the mess, they were really just pawns in a global game.

By Jon Markman
Satyajit Das is laughing. It appears I have said something very funny, but I have no idea what it was. My only clue is that the laugh sounds somewhat pitying.

One of the world's leading experts on credit derivatives, Das is the author of a 4,200-page reference work on the subject, among a half-dozen other tomes. As a developer and marketer of the exotic instruments himself over the past 30 years, he seemed like the ideal industry insider to help us get to the bottom of the recent debt crunch -- and I expected him to defend and explain the practice.

I started by asking the Calcutta-born Australian whether the credit crisis was in what Americans would call the "third inning." This was pretty amusing, it seemed, judging from the laughter. So I tried again. "Second inning?" More laughter. "First?"

Still too optimistic. Das, who knows as much about global money flows as anyone in the world, stopped chuckling long enough to suggest that we're actually still in the middle of the national anthem before a game destined to go into extra innings. And it won't end well for the global economy.

An epic bear market
Das is pretty droll for a math whiz, but his message is dead serious. He thinks we're on the verge of a bear market of epic proportions.

The cause: Massive levels of debt underlying the world economy system are about to unwind in a profound and persistent way.

He's not sure if it will play out like the 13-year decline of 90% in Japan from 1990 to 2003 that followed the bursting of a credit bubble there, or like the 15-year flat spot in the U.S. market from 1960 to 1975. But either way, he foresees hard times as an optimistic era of too much liquidity, too much leverage and too much financial engineering slowly and inevitably deflates.

Like an ex-mobster turning state's witness, Das has turned his back on his old pals in the derivatives biz to warn anyone who will listen -- mostly banks and hedge funds that pay him consulting fees -- that the jig is up.

Rather than joining the crowd that blames the mess on American slobs who took on more mortgage debt than they could afford and have endangered the world by stiffing lenders, he points a finger at three parties: regulators who stood by as U.S. banks developed ingenious but dangerous ways of shifting trillions of dollars of credit risk off their balance sheets and into the hands of unsophisticated foreign investors; hedge and pension fund managers who gorged on high-yield debt instruments they didn't understand; and financial engineers who built towers of "securitized" debt with math models that were fundamentally flawed.

"Defaulting middle-class U.S. homeowners are blamed, but they are merely a pawn in the game," he says. "Those loans were invented so that hedge funds would have high-yield debt to buy."

The liquidity factory
Das' view sounds cynical, but it makes sense if you stop thinking about mortgages as a way for people to finance houses and think about them instead as a way for lenders to generate cash flow and create collateral during an era of a flat interest-rate curve.Although subprime U.S. loans seem like small change in the context of the multitrillion-dollar debt market, it turns out these high-yield instruments were an important part of the machine that Das calls the global "liquidity factory." Just like a small amount of gasoline can power an entire truck given the right combination of spark plugs, pistons and transmission, subprime loans became the fuel that underlays derivative securities many, many times their size.

Continued: How it worked

Here's how it worked: In olden days, like 10 years ago, banks wrote and funded their own loans. In the new game, Das points out, banks "originate" loans, "warehouse" them on their balance sheet for a brief time, then "distribute" them to investors by packaging them into derivatives called collateralized debt obligations, or CDOs, and similar instruments. In this scheme, banks don't need to tie up as much capital, so they can put more money out on loan.

The more loans that were sold, the more they could use as collateral for more loans, so credit standards were lowered to get more paper out the door -- a task that was accelerated in recent years via fly-by-night brokers now accused of predatory lending practices.

Buyers of these credit risks in CDO form were insurance companies, pension funds and hedge-fund managers from Bonn to Beijing. Because money was readily available at low interest rates in Japan and the United States, these managers leveraged up their bets by buying the CDOs with borrowed funds.

So if you follow the bouncing ball, borrowed money bought borrowed money. And then because they had the blessing of credit-ratings agencies relying on mathematical models suggesting that they would rarely default, these CDOs were in turn used as collateral to do more borrowing.

In this way, Das points out, credit risk moved from banks, where it was regulated and observable, to places where it was less regulated and difficult to identify.

Turning $1 into $20
The liquidity factory was self-perpetuating and seemingly unstoppable. As assets bought with borrowed money rose in value, players could borrow more money against them, and it thus seemed logical to borrow even more to increase returns. Bankers figured out how to strip money out of existing assets to do so, much as a homeowner might strip equity from his house to buy another house.

These triple-borrowed assets were then in turn increasingly used as collateral for commercial paper -- the short-term borrowings of banks and corporations -- which was purchased by supposedly low-risk money market funds.

According to Das' figures, up to 53% of the $2.2 trillion commercial paper in the U.S. market is now asset-backed, with about 50% of that in mortgages.

When you add it all up, according to Das' research, a single dollar of "real" capital supports $20 to $30 of loans. This spiral of borrowing on an increasingly thin base of real assets, writ large and in nearly infinite variety, ultimately created a world in which derivatives outstanding earlier this year stood at $485 trillion -- or eight times total global gross domestic product of $60 trillion.

Without a central governmental authority keeping tabs on these cross-border flows and ensuring a standard of record-keeping and quality, investors increasingly didn't know what they were buying or what any given security was really worth.

A painful unwinding
Now here is where the U.S. mortgage holder shows up again. As subprime loan default rates doubled, in contravention of what the models forecast, the CDOs those mortgages backed began to collapse. Because they were so hard to value, banks and funds started looking at all CDOs and other paper backed by mortgages with suspicion, and refused to accept them as collateral for the sort of short-term borrowing that underpins today's money markets.

Through late last month, according to Das, as much as $300 billion in leveraged finance loans had been "orphaned," which means that they can't be sold off or used as collateral.

One of the wonders of leverage is that it amplifies losses on the way down just as it amplifies gains on the way up. The more an asset that is bought with borrowed money falls in value, the more you have to sell other stuff to fulfill the loan-to-value covenants. It's a vicious cycle. In this context, banks' objective was to prevent customers from selling their derivates at a discount because they would then have to mark down the value of all the other assets in the debt chain, an event that would lead to the need to make margin calls on customers already thin on cash.

Now it may seem hard to believe, but much of the past few years' advance in the stock market was underwritten by CDO-type instruments which go under the heading of "structured finance." I'm talking about private-equity takeovers, leveraged buyouts and corporate stock buybacks -- the works.

So to the extent that the structured finance market is coming undone, not only will those pillars of strength for equities be knocked away, but many recent deals that were predicated on the easy availability of money will likely also go bust, Das says.

That is why he considers the current market volatility much more profound than a simple "correction" in prices. He sees it as a gigantic liquidity bubble unwinding -- a process that can take a long, long time.

While you might think that the U.S. Federal Reserve can help prevent disaster by lowering interest rates dramatically, as they did Wednesday, the evidence is not at all clear.

The problem, after all, is not the amount of money in the system but the fact that buyers are in the process of rejecting the entire new risk-transfer model and its associated leverage and counterparty risks.

Lower rates will not help that. "At best," Das says, "they help smooth the transition."

The fine print
Das notes that Japan in the 1990s lowered interest rates to zero and the country still suffered through a prolonged recession. His timetable for the start of the next serious phase of the unwinding is later this year or early 2008. . . . Das' most readable book for laypeople is "Traders, Guns & Money," an amusing exposé of high finance, published last year. Das occasionally writes a blog at his publisher's Web site. Also available are a boxed set of his reference books on derivatives and his book specifically on CDOs. . . .

Perhaps the oddest line on the subject by a world leader was uttered by Luiz Inacio Lula da Silva, the president of Brazil. Asked if he was worried about the effects of the credit crunch in his country, he dismissively called it "an eminently American crisis" caused by people trying to make a lot of "third-class money." . . . CDOs were first widely used back in the late 1980s by Drexel Burnham Lambert junk-bond king Michael Milken to sell off damaged and previously unsellable debt in a way that was more palatable to customers.

I am glad the truth is coming out. I found iTulip while doing research into the securization of sub-primed loans. I could not understand how the alchemy of turning sub-prime loans into AAA securities worked, therefore I refused to gamble with them.

P.S. if you didn't understand the quote at the end by Pres. da Silva, here is a link http://www.moneymorning.com/2007/08/...s-third-class/