Posts tagged ‘put’
Making Safer Asbestos: Einhorn on CDS
David Einhorn, founding hedge fund manager of Greenlight Capital, exploited Credit Default Swaps (CDS) derivative contracts to their fullest in the midst of the financial crisis and now he says any effort to keep them in existence is like making “safer asbestos.” Hypocritical?
As toxic debt devices that profit from credit default triggers, CDSs have created “large correlated and asymmetrical risks,” which have “scared authorities into spending hundreds of billions of taxpayer money to prevent speculators who made bad bets from having to pay,” according to Einhorn.
The abolishment of the CDS market would have no impact on me (I have never traded a CDS in my life), but in principle Einhorn has no leg to stand on. Just because these unregulated insurance contracts were not properly disclosed or collateralized by American International Group, Inc. (AIG) does not mean a transparent, properly collateralized, central clearing exchange could not be created to efficiently meet the needs of counterparties.
Derivatives Description
Conceptually, a CDS is no different than a derivatives option contract. Take for example a put contract. Like a CDS, a put contract can be purchased as insurance (hedging against price declines on a current holding) or it can be purchased for speculative purposes (profit from future potential price declines if there is no underlying ownership position). All derivatives are structured for hedging or speculation, whether you are talking about options, futures, swaps, or other exotic forms of derivatives (i.e., swaptions). CDSs are no different.
Einhorn is not the first person to disingenuously speak about derivatives. The “do as I say, not as I do” principle holds true for Warren Buffett too. Buffett blasted derivatives as “weapons of mass destruction,” yet he has made billions of dollars (read about Buffett on derivatives) in premiums from writing (selling) multi-year options on various indexes.
Derivatives History
Derivative trading goes as far back as Roman and Greek history when similar contracts were used for crop insurance and shipping purposes. After the Great Depression, the Investment Act of 1934 legitimized options under the watchful eye of the Securities and Exchange Commission (SEC). Subsequently, the Chicago Board Options Exchange (CBOE) began trading listed options in 1973. Since then, the investment banks and other financial players have created derivative products making up many different flavors.
The Solution
How does Einhorn feel about central clearing exchanges?
“The reform proposal to create a CDS clearing house does nothing more than maintain private profits and socialised risk by moving the counterparty risk from the private sector to a newly created too big to fail entity.”
Oh really? If the utility of hedging contracts has been documented for hundreds of years, then why wouldn’t we create a standardized, transparent, adequately capitalized central clearing house for these tools? Whether Einhorn is asking for the eradication of all derivatives, I cannot be sure. If his extermination comments apply equally to all derivatives, then I guess we’ll just have to shutter entities like the CBOE, which handled 1.19 billion options contracts last year alone. If eliminating speculation was the focal point of Einhorn’s argument, then perhaps regulators could simply raise the reserve requirements for those merely gambling on price declines or default triggers.
In the end, if what Einhorn recommended came to fruition, he would only be throwing the baby out with the bathwater. CDSs, and other derivatives, serve a healthy and useful purpose towards the aim of creating more efficient financial markets. I agree that the AIG flavor of CDSs were like lethal asbestos, so let’s see if we can now replace it with some safer insulation protection.
Read Financial Times Editorial on David Einhorn
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management (SCM) or its clients owns certain exchange traded funds, but currently has no direct position in AIG, or BRKA/BRKB. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
Buffett Sells Insurance: Weapons of ANTI-Destruction
Writing Options is the Opposite of Mass Destruction
Those same “Weapons of Mass Destruction” that Warren Buffett so ardently warned investors against are the same derivatives that catapulted Berkshire Hathaways (BRKA) Q2 earnings performance. Chris McKhann at OptionMonster summarized Buffet’s moves:
Buffett has sold a large number of puts on four major indexes starting in 2007: the S&P 500, the FTSE 100, the Euro Stoxx 50, and the Nikkei 225. He took in $4.9 billion, with a potential loss of more than $35 billion–but only if all four indexes were at zero come the expiration date (at which point we would be worrying about other things).
Derivatives are like a gun, if used responsibly for gaming or for self-defense, then they can be a useful tool. Unfortunately, like guns, these derivatives are used irresponsibly in many instances. This point is especially true in areas like Credit Default Swaps where there were inadequate regulations and capital requirements to prevent disastrous outcomes (e.g., AIG’s collapse). With proper transparency, capital requirements, and proper regulation, derivatives can be used to manage risk rather than create additional risk.
Although I wouldn’t categorize myself as a value investor like Warren, I would prefer to call myself a growth investor with a value conscience. With that said, if you incorporate valuation within your investment discipline, I believe writing (selling) options is a brilliant idea. I can make this assertion because I’ve used this strategy for myself and my hedge fund. Volatility has a direct impact on the amount of premiums collected; therefore the trading levels of the CBOE Volatility Index (VIX) will have a directly correlated impact on option writing profitability. For example, if I’m selling flood insurance, I’m going to collect much higher rates in the period right after Katrina occurred.
If you are willing to accept free money from speculators betting on short-term swings in prices (Warren sold long-term, multi-year options), while being forced to sell/buy stock at price levels you like, then why not?! However, buying and selling puts and calls is a different game in my book, and one I personally do NOT excel at. I’ll keep to utilizing “Weapons of Anti-Destruction” and collect premiums up-front, like Warren, from speculators and leave the rest of the options strategies to others.
Wade W. Slome, CFA, CFP®
Plan. Invest. Prosper.
DISCLOSURE: Sidoxia Capital Management and client accounts do not have direct positions in AIG or BRKA/B at the time the article was published. Sidoxia Capital Management and its clients do have long exposure to TIP shares. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC “Contact” page.
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