Derivatives - What Are They, What Do They Do - Open Discussion

The following is from Warren Buffett letters to shareholders all the way back in 2002.

http://www.berkshirehathaway.com/letters/2002pdf.pdf

Imagine the foresight it took to write this, back then!

I particularly like this quote! “Mark-to-market” then turned out to be truly “mark-to-myth.”

This subject is regarding derivatives.

Marshall


From page 13:

Each contract had a plus or minus value derived from one or more reference items, including some of mind-boggling complexity. Valuing a portfolio like that, expert auditors could easily and honestly have widely varying opinions. The valuation problem is far from academic: In recent years, some huge-scale frauds and near-frauds have been facilitated by derivatives trades. In the energy and electric utility sectors, for example, companies used derivatives and trading activities to report great “earnings” – until the roof fell in when they actually tried to convert the derivatives-related receivables on their balance sheets into cash. “Mark-to-market” then turned out to be truly “mark-to-myth.”

I can assure you that the marking errors in the derivatives business have not been symmetrical. Almost invariably, they have favored either the trader who was eyeing a multi-million dollar bonus or the CEO who wanted to report impressive “earnings” (or both). The bonuses were paid, and the CEO profited from his options. Only much later did shareholders learn that the reported earnings were a sham. Another problem about derivatives is that they can exacerbate trouble that a corporation has run into for completely unrelated reasons. This pile-on effect occurs because many derivatives contracts require that a company suffering a credit downgrade immediately supply collateral to counterparties. Imagine, then, that a company is downgraded because of general adversity and that its derivatives instantly kick in with their requirement, imposing an unexpected and enormous demand for cash collateral on the company. The need to meet this demand can then throw the company into a liquidity crisis that may, in some cases, trigger still more downgrades. It all becomes a spiral that can lead to a corporate meltdown.

Derivatives also create a daisy-chain risk that is akin to the risk run by insurers or reinsurers that lay off much of their business with others. In both cases, huge receivables from many counterparties tend to build up over time. (At Gen Re Securities, we still have $6.5 billion of receivables, though we’ve been in a liquidation mode for nearly a year.) A participant may see himself as prudent, believing his large credit exposures to be diversified and therefore not dangerous. Under certain circumstances, though, an exogenous event that causes the receivable from Company A to go bad will also affect those from Companies B through Z. History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times.

I was skeptical that this would be worth my time to watch, but it is very good at showing how it all ties together (even though I knew all of this):

http://vimeo.com/3261363?pg=embed&sec=&hd=1

Email sent to:

Brooksley Born,

I know your fought for the regulation of OTC derivatives:

http://www.marketoracle.co.uk/Article14485.html

I am for the most scientifically efficient regulation.

In 1988, Larry Summers wrote a critical research paper which implied that for the fiat (money=debt, fractional reserve, i.e. ponzi) financial system to be able to escape return to an intrinsic value of zero (as fiat systems have done in every example in history of man), that this most efficient regulator had to be suppressed:

http://www.gata.org/files/gibson.pdf
http://news.goldseek.com/GoldSeek/1247554800.php

What Summers discovered was that gold is the regulator of real interest rates. The people vote and the market corrects itself. If interest rates are lower than the inflation rate, gold ALWAYS increases in fiat price (because gold pays no interest). Interest rates are the regulator of all financial activity. I want you to think outside the small box of incidences of "fraud" and think about the larger containing box of "opportunity cost". Interest rates regulate humanity's opportunity cost. If interest rates are not regulated by the market feedback mechanism (the mother of all fraud), then regulation of individual incidences "fraud" is analogous to putting a bandaid on cancer sores.

But gold failed to regulate from at least 1992 (especially 1996) forward. Why? Because CPI statistics were increasingly lies to make it appear that real interest rates were positive:

http://www.shadowstats.com/alternate_data/inflation-charts

And because Central Banks were leasing their gold to suppress the gold price. And because as the BIS confirms, up to 100 times more derivative silver (and gold) promises (effectively naked shorts) were sold than exists physical metal (more supply of "metal" means lower price):

http://silverstockreport.com/2009/OTC-silver-fraud.html

Greenspan misapplied the freemarket theory, because there is no way that markets can self-regulate if the feedback mechanism for interest rates is suppressed. I have a hard time believing that Greenspan did not know gold was being suppressed, since he stated, "central banks stand ready to sell unlimited quantities of gold".

Had your regulation of OTC derivatives pushed through, you would likely have revealed the interest rate manipulation, and caused the fiat system to self-correct earlier, which would have caused a massive recession if not depression and a skyrocketing gold and silver price.

Instead the boys kicked the can down the road, and what is coming now is horrific beyond description. What we are likely to get now is a backlash of socialism so severe (because decades of mis-allocation due to incorrect opportunity costs), that the freemarket will be crushed for decades. For example, even now the freemarket can not buy gold and vote, because mathemetically gold can only keep pace with inflation, and yet gold is taxed at 28% (and probably higher soon), so thus anyone who buys gold is going to lose at least 28% in terms of purchasing power (although this will be better than what is coming for people who don't buy gold).

Macro-economics trumps micro-management. Socialism is central decision making and freemarket is individual decision making. Capital is not money, and when money has incorrect oppportunity cost, then capital is destroyed (for a looong time). The freemarket did not fail, Summers and the boys suppressed the feedback mechanism that allows individuals to vote and regulate. The fraud was at the very top, at the macro-economic level. It was 100% socialistic (central management).

And now we are going to pay for it with horrific hyper-inflationary, greatest depression since Rome.

An interesting confirmation is the mathematical fact that when gold is money, savers gain 33,900% greater return per century:

http://www.marketoracle.co.uk/Article16212.html

God bless,
Shelby...