Hedging Options

Just google "Buffett on derivatives" to see the latest on the subject from the Sage of Omaha. In theory, derivatives are financial means to manage risk by syndicalizing it. In practice, nobody knows how well they work when large scale panic selling and/or contagion hit the financial markets.

The recent worries about subprime lending in the house market, preceded by the Chinese sell off, has one ponder as whether or not these might be the signs for financial trouble that not only Buffett, but also Greenspan as of late, has been talking about.

If one considers the slowing of the house market together with the drop in durable goods orders (i.e. what goes with/into a new house), one may get a picture that's so much uglier than what one is normally told through the 'official' channels. To get an idea as how far and wide the subprime lending has gotten, consider the range of companies whose executives are called to testify in front of the US Congress: HSBCPlc (HSBA.L), New Century Mortgage Corporation (NEWC.PK), Countrywide Financial Corp. (CFC.N), General Electric Co's (GE.N) WMC Mortgage unit and First Franklin Mortgage (FFHS.O). Subprime lending has made for many a record high bonus on the Wall Street of the 2006's end.

The options for the US government are few and limited. It can raise or lower interest rates. If it lowers them, one side effect could be that houses keep appreciating--one source said that all the subprime lending problem would disappear if house prices went up by 10%. The cost of so doing is increased inflation, which has already been at work. Another casualty could be the mighty dollar itself, including its position for some treasury departments in the developing and oil exporting worlds. Raising rates is a an even less likely option for the current thinking goes that it would send the whole economy down, so it would be considered only if inflation was acknowledged as the bigger problem than the risk of recession. A third option would be to raise taxes. If the Democrats were in power, that would have been the way out of this situation. The Republican executive may decide though to creatively tax the US by going into Iran. Not counting the political evidence supporting a war with Iran, the economic rationale is there. The dollar would improve its safe haven status, the oil would keep transacting mostly in dollars, and a lot of the financial troubles that have been accumulating since Greenspan would be shouldered by us all in the form of war debt, or something along the lines of the war budget (deficit) for Iraq.

Consequently, some options for the individual investor become: defense companies, Swiss Francs, and US Treasuries. Before I forget, let's mention Red 22 in Las Vegas.


fCh said...

So far, the US financial markets have done well--plenty of optimism ahead of the FED meeting on Tuesday and Wednesday. It seems that what appeared like a subprime disaster has been contained. Myself, I am somehow skeptical.

Could it be that Paulson is going to the rescue the subprime just like another Goldman Sachs guy did for LTCM about 10 years ago?

I should probably add that unemployment figures and the immigration reform, Bush talked about in his Latin American trips, are two more options out of the subprime problem.

Anonymous said...

By way of moral hazzard, here's a quote from today's newspaper:

As problems with subprime mortgages have escalated, officials on Wall Street as well as in Washington have urged lenders and the government to step in and cushion the blow to troubled borrowers and find ways to enable them to remain in their homes.

Anonymous said...

Prepare for a Storm
Steve Hanke 04.16.07, 12:00 AM ET

In late February Alan Greenspan warned of the possibility of a recession. The next day the markets took a dive. Since then anxiety has set in and market volatility has increased. Even Panglossian brokerage houses have warned that if a recession occurs, house prices could tumble 10% this year and the stock market could decline by 30%.

We must, of course, add to this noise some nasty facts about subprime lending, which constituted as much as 20% of U.S. mortgage lending in 2006. And that's not all: Another 13% of mortgage lending was to borrowers with only slightly better credit than subprime. There's a tendency for these borrowers, and their lenders, to live in a delusional world in which an inability to service the debt is papered over with refinancings and creative repayment schedules.

With default rates on the rise, mortgage-lending standards being tightened and $500 billion in adjustable-rate mortgages to be reset in 2007, we can expect the return of a half-million houses to a bloated inventory of unsold homes in the next six months. The collateral damage from the housing market is already baked in the cake: Expect a continued slump in residential construction activity and employment, lower house prices that will force more subprime lenders to the wall and put strains on the most leveraged parts of the financial system and a slowdown in consumption expenditures.

These bits and pieces suggest that enough evidence is around to justify preparing for a storm. Based on the recent course of events, one business-cycle scenario that merits consideration was fully developed in the 1930s by Friedrich von Hayek, a Nobelist and leader of the Austrian school of economics. For Hayek and the Austrians, things go wrong when a central bank sets short-term interest rates too low and allows credit to expand artificially. The result is an asset-price boom. Asset-price booms sow the seeds of their own destruction: They end in slumps.

During the slumps the economy is vulnerable to what Austrians termed a "secondary deflation," where banks call in loans and are stingy about extending credit. Households produce their own version, liquidating riskier assets (like stock mutual funds) and moving into cash and government bonds. In the economy at large, investment and consumption suffer.

So much for the scenario and theory. Just how can an investor prepare for such a storm? In other words, are there investments that will do well if the economy deteriorates?

Amid the credit-boom phase of the present business cycle, the Japanese yen has been weak across the board, and is 25% undervalued against the dollar. One reason for this is that the Japanese government engaged in massive intervention to push down the value of the yen in late 2003 and early 2004. Investors thought that the government was committed to a weak yen policy. That, and the fact that interest rates in Japan are some of the lowest in the world, meant that investors thought they had a free lunch in the form of the carry trade--borrowing in low-rate yen, investing the proceeds at higher rates in other currencies.

The yen carry trade has become wildly popular, accounting for perhaps $1 trillion of yen-denominated borrowings, traders speculate (no one knows the true figure). The carry traders, of course, immediately sell the borrowed yen to acquire high-yielding assets of the other currencies. All this selling has kept the yen artificially weak.

But that could change very rapidly. Yen carry trades are risky and can reverse very quickly. Then, the yen violently appreciates. Just consider the most recent unwinding. On Feb. 26 the yen was trading at ¥120.50 per dollar. Then a stock market tumble in Shanghai precipitated a worldwide selloff of risky assets. Carry traders undid their positions, buying yen and repaying their loans. By Mar. 5 the yen had spiked up in value to ¥115.15 to the dollar.

In preparing for a coming storm investors should anticipate further unwinding of yen carry trades and a significant appreciation of the yen. One way to play this is to purchase out-of-the-money call options on the yen traded on the Chicago Mercantile Exchange. I recommend a December call at a strike price of 90.

Anticipating an eventual reversal of Swiss franc carry trades, and a sharp appreciation of the Swissie, I recommended (Sept. 4, 2006) selling a Euro/Swiss futures contract. At present the position is losing 2%. Relax and continue to hold it.

Steve H. Hanke is a professor of applied economics at The Johns Hopkins University in Baltimore and a senior fellow at the Cato Institute in Washington, D.C.

Anonymous said...

Shifting Targets
The Administration’s plan for Iran.
by Seymour M. Hersh October 8, 2007

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Iraq War;
Bush, George W. (Pres.) (43rd);
Foreign Policy;
Iranian Operations Group;
Plans, Planning

In a series of public statements in recent months, President Bush and members of his Administration have redefined the war in Iraq, to an increasing degree, as a strategic battle between the United States and Iran. “Shia extremists, backed by Iran, are training Iraqis to carry out attacks on our forces and the Iraqi people,” Bush told the national convention of the American Legion in August. “The attacks on our bases and our troops by Iranian-supplied munitions have increased. . . . The Iranian regime must halt these actions. And, until it does, I will take actions necessary to protect our troops.” He then concluded, to applause, “I have authorized our military commanders in Iraq to confront Tehran’s murderous activities.”

The President’s position, and its corollary—that, if many of America’s problems in Iraq are the responsibility of Tehran, then the solution to them is to confront the Iranians—have taken firm hold in the Administration. This summer, the White House, pushed by the office of Vice-President Dick Cheney, requested that the Joint Chiefs of Staff redraw long-standing plans for a possible attack on Iran, according to former officials and government consultants. The focus of the plans had been a broad bombing attack, with targets including Iran’s known and suspected nuclear facilities and other military and infrastructure sites. Now the emphasis is on “surgical” strikes on Revolutionary Guard Corps facilities in Tehran and elsewhere, which, the Administration claims, have been the source of attacks on Americans in Iraq. What had been presented primarily as a counter-proliferation mission has been reconceived as counterterrorism.

The shift in targeting reflects three developments. First, the President and his senior advisers have concluded that their campaign to convince the American public that Iran poses an imminent nuclear threat has failed (unlike a similar campaign before the Iraq war), and that as a result there is not enough popular support for a major bombing campaign. The second development is that the White House has come to terms, in private, with the general consensus of the American intelligence community that Iran is at least five years away from obtaining a bomb. And, finally, there has been a growing recognition in Washington and throughout the Middle East that Iran is emerging as the geopolitical winner of the war in Iraq.

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