I don’t need to do anything to market time by going to cash. Warren Buffett is doing it for me (without an unwanted capital gains tax event) through my large position in BRK.
Also read somewhere that banks still have hundreds of trillions of dollars of derivative contracts on their books. Perhaps that’s why Warren is selling Bank of America?
intercst
Banks had, have, and will continue to have those contracts. That has nothing to do with Buffett sales. While everyone wants these derivative contracts to be eliminated, in reality if the banks do that, the economy cannot handle such a shock. It will dry up lending, the bid-ask spread will be so wide, if risk cannot be hedged, most folks who require risk capital will not be getting it.
That’s the line investment bankers have been feeding us for decades, but it’s just a line.
When risk is hedged, it’s no longer risk. So the one financing this new business is not really putting their money at risk. If the investment goes well, they get a handsome payout. If it doesn’t, they get most of their money back and suffer only a small loss because of the hedging.
That significantly changes the incentive for the one with capital. They no longer care about funding only businesses that have a good potential for the future, they instead want to fund everything they can, screening out only the very worst ideas. When the upside is big and the down side is small, you make as many bets as you can, knowing that it takes only one big winner to make up for dozens of losing bets.
That causes lot of new businesses to get funding which should never be funded. Ultimately, that destroys a lot of capital. Not the hedger’s capital, but the capital of the ones accepting the actual risk in the hedge.
—Peter
Yep. How much of your union pension fund is invested on the “wrong” side of the hedge?
intercst
You could argue the same about insurance companies too. Insurance companies take risk for premium. Now, there are many who think insurance companies are evil and should not exist. But they serve a purpose of mitigating risk, and to mitigate their own risk, they have to write millions of contract.
Likewise a bank when it writes loans, lends money is taking risks. They have to mitigate their own risk to a certain extend, that is where derivatives come in to play. If banks cannot mitigate then they will not take those risks. It is fairly simple. For ex: FED increase the risk weightage for certain kind of instruments in their capital buffer calculation, guess what, banks have reduced those assets. And certain type of loans are more expensive now.
Separately, the bank derivatives are not the reason why Buffett sold.
There are many problems with your statement. Risk is inherent in all things we do. Every time you get into a car there is a risk of accident. All the time accidents take place. Are we going to ban driving? Those folks have no business of getting into the car and driving, and should have stayed in their houses? Are we not transferring their risks to so many people who are safe drivers and never had an accident in their life?
Those who are taking risk for premium do it knowingly. If they take excessive risks or not adequately funded to deal with liabilities or charge too little premium, they pay a price. That is how capital markets work.
But I didn’t make that argument. You’re setting up a straw man.
I didn’t make that argument, either. Another straw man.
I was talking about investment banking, not commercial banking or insurance.
However, I think my argument does apply to commercial lending. If a bank is hedging away all of the risk of their loans, they have no incentive to make loans that will be repaid. If the loan goes bad, that’s the problem of the holder of the hedge, not the bank. It gives the bank incentive to make every loan they can, and charge high fees to do so, making all of their profits up front.
Once again, we end up with loans being made that should not be, ultimately destroying capital, and ruining businesses that might have been able to survive without the loan.
—Peter
That is what I disagree with. No one is in a better position to judge the viability of an equity investment than the one making that investment. When they pass the risk off in a hedge, they often do so to investors who don’t have as much information about the business. Same for hedging (or outright selling) of commercial loans. The end investor does not have access to all the information about the business that the original lender does.
—Peter
If you are making an investment without sufficient information I can understand that. But if you don’t have a model to deal with the lack of information and risk, then you don’t have the business to make such investment. Capital market is not there to protect you from making dump investments. Saying someone might get hurt therefore let no one drive doesn’t make sense.
Investment banking is helping companies go public, raise debt, M&A, and advice. They don’t create these exotic derivatives.
It is the commercial lending that hedges interest rate risk, credit default risk, currency risk etc
No you don’t. Those loans even if they are marketed to individual investors they are collateralized, and many loans are pooled and collateralized, etc.
With due respect, you don’t know what you are talking about.
What I’m describing is exactly what caused the banking crisis in the 2007-2009 time frame. I think I know a bit more than you give me credit for.
—Peter
The GFC crisis origin is not in derivatives and CDS is not purchased by ordinary investors. They are purchased by Pension funds and other sophisticated players. What you described and what happened during GFC are very different.
Even today, Fannie Mae sells MBS. If we stop MBS securities, which are nothing but derivatives, we stop the funding for US housing market or for that matter if auto loan companies cannot issue ABS then most of the auto loan market freezes, the same goes for various other asset backed markets.
I am not sure you understand how the credit market works. I will leave it here.
That is the face value, but the terms are small.
CDS are derivatives.
And a quick history lesson. Credit default swaps were invented in the 1990s. Before then, there were plenty of commercial loans made without these hedges. They are completely unnecessary for a functioning commercial banking system. All they do is insulate bankers from bad lending decisions.
—Peter
Municipal bond insurance, which is a CDS with a different name and it exits from 1970.
You are just hung up on CDS now. BTW, you are creating strawman, after strawman and arguing against it.
The original post mentioned because of the derivatives in the banking system Buffett hence WEB is selling BAC? From there derivatives are bad to latched on CDS now and arbitrarily declared CDS is not required. You don’t understand the instruments, their purpose. Merely thought those are bad and should not exist.
CME, trades risk on everything from interest rate movement to agricultural products to live stock, minerals to oil to stock market. Without that most industries cannot operate normally.
I would encourage you to understand a bit more about banking, Investment banking and why derivatives exist and their use.
No, it’s not. Municipal bond insurance is issued by insurance companies. Insurance companies are specialists in gauging risks, and are regulated. Those regulators limit the amount of risk that an insurer can take on in order to protect all policy holders.
A CDS is entered into much like an option contract - the counter parties need no special knowledge and are unregulated. They only need the financial ability to pay on the contract if required.
A CDS was originally used solely by banks to hedge their risk in making loans. As I’ve mentioned already, that divorces banks from responsibility for making bad loans. The CDS counterparty takes on the risk and needs no special knowledge to do so.
But CDS markets have taken on a life of their own. Anyone can buy or sell a CDS without any connection to the underlying security. That’s much like the option market, where parties who do not own stocks can make bets on the direction of stocks without actually owning the stocks. To the extent both of those markets are participated in by people with no connection to the underlying security, it is a zero sum game - one party’s win is another party’s loss. (Technically, less than zero, since brokers and market makers take their own cut along the way. They are guaranteed winners, while all of the gamblers taken in total are guaranteed net losers.)
The vast majority of current CDS contracts are of the gambling variety, with gamblers making bets on the direction of corporate debts.
I’m focused in on your response to that original post, as copied below:
You claimed that risk hedging was required otherwise lending and capital investment would dry up. I’m merely pointing out the error of that statement. Lending and other forms of risk capital were available long before risk hedging existed. Would there be less lending without hedging? Probably. But in the big picture and over time, that would be better for the economy. Getting there would not be easy, but necessary to reform the banking system.
–Peter
So you have arbitrarily determined it is okay for municipal bond investors to have protection against default, but not others. Why? Because you think CDS is bad?
Municipal insurance companies are smart, sophisticated, but the big wall street firms that sell CDS are dumb stupid? If the CDS writers are dumb, then people will not be buying those insurance. Because they want the writer to be solvent if and when they require.
Whatever you think is not true. It is not the just banks, but the bond investors who buy bonds bought these for the protection of their bond portfolio. You are repeatedly getting basic facts wrong.
What is your problem? I see there is a possibility of a company going bankrupt or not able to make their bond payment and I want to bet. Why is it so wrong?
If this is wrong all the agriculture, live stock future markets should be banned. One of the party may or may not be either producer or consumer.
The more people bring price discovery. Have you ever heard of that term?
You have no basis for that statement it is merely your wish. It is like saying, if we can eliminate automobiles overtime we will be more efficient and will figure out to improve local economy.
The banking industry has sufficient regulations. The last major bank failure SVB is not because of any derivatives but because of Federal reserve artificially keeping interest rates low for too long and then raising it very rapidly. Should we eliminate Federal reserve?
You have emotional views on CDS or derivatives and often get basic facts incorrect. Those who write CDS contracts and those who are buying it are big institutional players. They were big pants and manage billions and they should be able to deal with any failures.
That’s not correct. You said that Municipal bond insurance is the same as a CDS. They are not the same. There are significant differences as I have pointed out already.
I have no particular problem with an insurance company writing a policy similar to Municipal bond insurance for various bank loans. As I’ve already said, the insurance companies are reasonably well regulated for financial stability and have professionals in risk assessment and management to assist with the pricing of their policies. Anyone with enough money can sell a CDS. But unlike insurance, CDS sellers are not necessarily regulated (although many are subject to some regulation).
Another difference I haven’t noted before is that muni bond insurance is typically paid for by the municipality - the party borrowing money. CDSs are bought and paid for by the lender. With insurance, underwriters get the opportunity to thoroughly go over the borrower’s finances and can impose conditions and restrictions on the borrower. With a CDS, the one “insuring” is not a party to the loan and has no ability to examine the borrower’s financial condition. They only have information about the borrower that is publicly available and that the lender acquired during the lending process and is able to disclose to a CDS seller.
So these are very different kinds of financial instruments, although at the surface level they look the same.
I was talking about their original use, not the wide variety of current uses.
Frankly, I think that is another line sold to the general public. Do more people really bring better price discovery? Or does it just invite people with no idea of a reasonable price range to the table to screw up price discovery? Personally, I think 15 - 20 knowledgeable parties, split between buyers and sellers, is plenty to get prices into a sufficiently tight range to discover fair prices. If you then add 100 people who have no idea what is a reasonable price making their own offers, you are going to end up with a wider variety of prices that distort rather than refine the current fair price.
We’re getting way off topic, but I can’t stand to let lies about history go. SVB failed because the bank management made too many loans to risky borrowers, then lied to themselves and regulators about their finances. The increase in the Fed rate merely exposed this problem, it didn’t cause it.
You keep saying this. But it’s just not true. My university degrees included some considerable education in finances. But it’s been a while. So before I write any response to you, I make sure that my recollections from those days long ago are correct and still apply. And I have learned a couple of things along the way - not from your attempts to twist facts, but from my reading before I respond to you.
Do I think CDSs are bad instruments? Yes, I do. Not because lenders might want some form of insurance, but because a CDS only looks like insurance when its not. But most importantly, they can easily be used (and almost certainly HAVE been used) by lenders to divorce themselves from the consequences of their lending decisions.
–Peter
I said they both provide insurance against credit, didn’t say same. Provide similar functions.
That’s not a virtue, it just allows Muni’s to borrow at lower rate. If investors feel less risky because the bonds are insured and accept lower coupon. Likewise, investor take some of their coupon and buy protection via CDS.
Whatever you think is not true.
For someone who seems to have very little understanding you are calling others no idea is pretty rich.
You have zero idea about what you are talking. SVB tried to rebalance its balance sheet and in that process took some loss. Their deposits are from Silicon valley companies and VC’s. They started pulling the money and a classical bank run ensued.
It is not risky loans. You have no idea about any of the things you are talking. Your ignorance doesn’t make others are lying.
Goodbye.