Derivatives…”financial weapons of mass destruction”  This article is a continuation of my remarks and completes the 3 part series.

By way of a brief review, the essential points made last week were:

There are many ways one can be wrong when hedging and that the hedged investment positions can not only fail, but create additional losses (as the trader at JPMorgan Chase discovered.) 

We are experiencing, in the words of PIMCO’s Bill Gross, “A secular delevering” while in the midst of an “authentic debt crisis.” 

Risk control has little to do with investment products and everything to do with the mindset that governs the way the investor operates. 

Earlier I provided a brief history of the evolution of currency, which in turn facilitated the development of modern day commerce and fractional-reserve banking. The establishment of central banks (like the Federal Reserve in the U.S.) was in response to the inherent dangers of fractional-reserve banking. I also explained that it was the innovation of credit that powered the unrivaled economic growth of what were to emerge as the financially advantaged nations over the ensuing 100+ years. I asserted that the financial crisis of 2008 was not a Black Swan as depicted by so many commentators, but rather what Watkins and Bazerman describe as a “predictable surprise.” I concluded by explaining that today’s risk management experts, rather than abandon a risk model that is deeply flawed, simply continue to tinker with it. The following are the concluding paragraphs from last week:

“‘Value at Risk’ (VaR) has emerged as a ‘sophisticated’ enhancement/extension of this flawed risk management framework. VaR purportedly measures aggregate portfolio risk. The VaR hypothesis is that individual risky positions are presumed to offset each other, rendering a potentially high risk portfolio to be safer. If, for example, a portfolio has a $1 million long position in a specific security, and a $1million short position in a similar security, a risk management model like VaR subtracts the short position from the long position. Voilà! – the aggregate risk level is now netted out and it is affirmed to be a safer portfolio.

“Notice VaR assumes future relationships will always resemble the past; that price fluctuations are never synchronized; and that risk is measured by “net” exposures. Also notice that VaR became the Great Enabler of the financial crisis of 2008. As you will see [this] week, in a complex adaptive system that incorporates power laws and scale, the risk elements depicted in a VaR model should be added together, not netted out.”

This week we will begin by defining terms, clarifying the influence of power laws and scale, delve into the peril of inductive reasoning, and take a closer look at derivatives. Even if I am only partially correct, failed theoretical frameworks like today’s modern hedging strategies, the Efficient Market Hypothesis, Modern Portfolio Theory, etc. could precipitate an exceedingly painful redistribution of wealth from ignorant hands to knowledgeable hands.

Complex Adaptive Systems

As Nassim Taleb’s book The Black Swan became increasingly popular, the term “Black Swan” entered into popular lexicon and the term became increasingly abused, misinterpreted and misunderstood. It is now common to hear folks refer to events as “Black Swans” that are nothing of the kind. What I now call the “Black Swan defense” is little more than an abdication of personal responsibility.

It appears the term “Complex Adaptive System” is also gaining ground, and perhaps it too may make it into popular lexicon. While not yet a common term, for the few times I have encountered it I have observed that it is equally misinterpreted and misunderstood.

A defining property of a complex adaptive system is the manner in which it emerges. Complex adaptive systems are not designed from the top down as are most hierarchical organizations. Rather, complex adaptive systems evolve and, in effect, they design themselves in ways that are unpredictable. In other words, one cannot look at the sum of the parts to predict the whole – the whole emerges interactively, rendering a sum of the parts extrapolation largely useless, even in the simplest of complex systems.

For a system to be “complex” the agents must be

  1. Diverse (That is, agents must respond uniquely to the same stimuli.)
  2. Tightly coupled (The agents of tightly coupled systems have prompt and major impacts on each other. If what happens in one part of a system has little impact on another part of the system, or if everything happens slowly, the system is not described as “tightly coupled.” Tight coupling raises the odds that intervention will make things worse, since the true nature of the “problem” is unlikely to be understood correctly.)
  3. Interdependent (The actions of independent agents are mutually influencing.)

When a complex system is additionally described as adaptive it indicates the system incorporates collective learning. Highly adaptive systems imply a facility, and speed, with which collective learning occurs. Adaptability, however, does not necessarily imply a positive outcome for all agents.

Our capital markets are man-made Complex Adaptive Systems. I repeat, our capital markets are man-made Complex Adaptive Systems… and they are typically in a condition referred to as “stable.” Unless a system is in a “critical state” there is no immediate threat. For example, in nature we might see a community of wooden homes (a complex system) in a stable condition and not immediately threatened by the possibility of fire. The same community (system) in a hot, windy, dry summer, punctuated by lightning storms, could be described as “critical.” At some point a catalyst could set the community ablaze. Important note: in a system that has transitioned to a “critical” state, the actual catalyst is irrelevant.

Power Law and Scale 

In the most simplistic terms, power laws describe the phenomena whereby the magnitude of an event increases proportionally to the nature of the stimulus. Power laws describe a condition in which extreme events occur with greater frequency, and/or magnitude, than assumed (or implied, by a bell shaped curve – the bell shaped curve being but one class of event distribution.) Unlike the bell shaped curve, the primacy of statistical outliers is integrated into power law distributions. An example of a power law is the Pareto principle, more commonly referred to as the 80/20 rule. The Pareto principle states that, for many events, roughly 80% of the effects result from 20% of the causes. For example, the 1992 United Nations Development Program Report states the richest 20% of the world’s population controlled 82.7% of the world’s income. 

Scale is another feature of complex adaptive systems which follow power laws. Scale, in nature, is regarded as having a finite limit. If a community of wooden homes finds itself ablaze the practical maximum amount of damage is constrained by the size of the community, or some logical subset of the community. Such a blaze will not engulf the entire state. In man-made complex systems, scale may approach infinite. Think of a rogue country or terrorist organization in possession of nuclear weapons. The degree of destruction and devastation potentially perpetrated by a rogue terrorist group is as unthinkable as it is extreme. This is why countries like North Korea and Iran pose such an extreme threat.

Here’s my point. The normal bell shaped distribution of events is a grossly mistaken governing assumption of capital markets. In the investment milieu, risk follows a power law distribution characterized by fat tails. An alternative way to express all this is to say that the probability of encountering an extreme event is small, but it does happen. And when it does happen it creates, what Charlie Munger calls, “a lollapalooza effect.” Please reread this paragraph.

Derivatives 

Unlike stocks, that directly represent fractional ownership interests in real companies that produce tangible goods and services, derivatives are little more than a wager, backed by a promise to settle accounts at a future date. While buyers now require collateral to be posted by the seller, a sudden and contagious series of defaults could easily render these contracts, collectively, under-collateralized because it is not possible to mark-to-market in a chaotic, rapidly falling, tightly coupled, market. For example, as the market became increasingly chaotic during the 2007-08 collapse of subprime mortgage backed securities, liquidity effectively evaporated to zero and valuations were reduced to a guesstimate. With this as a framework, consider the following.

The global market for derivative products is massive and opaque. As of 30 June 2011 the Bank for International Settlements reported that the estimated total notional amounts outstanding of OTC derivatives stood at approximately $707.6 trillion. The aggregate capitalization of the world’s stock and bond markets is about $150 trillion. At $707.6 trillion, the total notional amounts of OTC derivative products is more than 4.5 times greater than the capitalization of the world’s stock and bond markets taken together; and this $707.6 trillion is approximately ten times greater than global GDP.

I do not believe there is a person on this green earth who knows how this financial detritus is likely to ultimately impact the world economic stage. Notwithstanding, the Wall Street math wizards – the same folks who brought us the housing bubble – continue to disregard the obvious inadequacies of their failed risk management models and continue to promote the application of derivative products. (Undoubtedly, self-interest contributes to the persistence of these mostly senseless but profitable products.)

To better illustrate my growing apprehension (and I am not alone), I will now focus on a specific subset of the derivatives market: the Credit Default Swap (CDS) which represent approximately $32.4 trillion of the $707.6 trillion total.

In simplest terms, a CDS is a financial agreement whereby the seller of the CDS contracts to compensate the buyer in the event of a loan default – in effect, a CDS is an insurance contract. Anyone may purchase a CDS, even buyers who do not hold the loan instrument and who have no “insurable interest” in the loan. When there is no insurable interest in a CDS contract, these contracts are referred to as “naked.” Critics assert that naked CDSs should be banned, comparing them to buying life insurance on your neighbor over whom you have no insurable interest. (Consider the moral hazard of life insurance sans an insurable interest: buy a policy on your neighbor, bump him off, and then collect on the policy. Talk about an antisocial incentive. While the definition of insurable interest varies from state to state, I do not believe there is an insurance company in the world that would write a life insurance contract without an insurable interest. But I digress.)

A naked CDS is a wager; and with the ability to short a CDS, the CDS market has been elevated to casino status. Moreover, because naked credit default swaps are synthetic, there is no limit to how many can be created. Furthermore, CDSs are not traded on any exchange nor are there reporting requirements of transactions; cowboy capitalism at its finest. (It is my understanding that most, if not all, OTC derivatives are bereft of reporting requirements. They are simply private contracts between the parties.)

Buffett Weighs In

Expressed within the framework of complex adaptive systems, the tightly coupled worldwide capital markets are in a state that I would characterize as “critical.” If a worldwide contraction is in our future, derivative products could easily emerge as the catalyst. It was this recognition that prompted Warren Buffet, in Berkshire Hathaway’s 2002 annual report to shareholders, to describe derivatives as “financial weapons of mass destruction…”

Buffett provided additional humorous insight, “… before a contract is settled, the counterparties record profits and losses – often huge in amount – in their current earnings statements without so much as a penny changing hands. The range of derivatives contracts is limited only by the imagination of man (or sometimes, so it seems, madmen.)”

“In a nutshell,” explains James Rickards, “Complex systems arise spontaneously, behave unpredictably, exhaust resources and collapse catastrophically.”

In Conclusion

I have a tendency to be appropriately apprehensive, but usually way too early. With this in mind, it is my assertion that the worldwide financial system is unlikely to resolve its difficulties with a fairytale ending.

Notwithstanding, no matter how painful a systemic failure we might experience, life will not end. So the question becomes, “How can we control our exposure to an end game, the conclusion of which is impossible to predict in character, magnitude or duration?” The answer begins, of course, by not trying to predict the unpredictable. Our inability to forecast the unpredictable does not mean, however, we throw in the towel and declare defeat.

Money and financial institutions provide only the lubricant that facilitates trade and commerce – they are not trade and commerce. This is an easily overlooked distinction. I repeat: money and financial institutions provide only the lubricant that facilitates trade and commerce – they are not trade and commerce. When financial institutions or companies fail – particularly the ones that should have been permitted to fail in the first place – new financial intermediaries and commercial enterprises arise from their ashes. This is the way of Complex Adaptive Systems.

It is my assertion that those who continue to either invest recklessly, or adhere to failed investment models such as the Efficient Market Hypothesis, Modern Portfolio Theory, etc., or participate in the derivatives market – including flawed risk management and hedging strategies – that these folks will likely experience an ill-fated personal financial conclusion.

If what I am describing comes to pass in some form, we can anticipate that the turmoil will cause the prices of all marketable securities to decline – perhaps dramatically. I repeat: if what I am describing comes to pass in some form, we can anticipate that the prices of all marketable securities will decline – perhaps dramatically. Notice I said, “If this comes to pass…” Clearly, it may not. But hope is not a strategy. Furthermore, the timing, magnitude, and duration of a market rout are equally unknowable.

What we can expect is the predictable behavior of the vast majority of investors. The multitudes will panic and begin selling without regard for value. In their scramble to exit whatever positions they hold (perhaps to raise cash for living expenses, or from shear fright) we can anticipate a powerful negative feedback loop that will relentlessly push down prices. 2008 may have been a sneak preview of what the future may hold.

I want to be clear: I am not predicting a financial Armageddon that will end the world. A disruption, no matter how severe, does not portend the end of the world. I also want to be clear that I do not relish the possibility of a worldwide economic tsunami and the misery it will inflict, no matter how profitable such a scenario might ultimately become for us. Our task is to make sure we are not victimized by the foolish behavior of others. In so doing, we are improving the likelihood that we will experience a favorable outcome.

Notwithstanding the perceptions of some who read my missives, I am an unabashed, eternal optimist. I am confident if we are buying high quality assets at significant discounts to enterprise value, carry little or no debt, and most underappreciated, have abundant liquidity (I champion five years) we will have positioned ourselves to profit from folly rather than be victimized by it.

At the risk of repeating myself, I am not insensitive to the pain that such a dislocation could inflict. The point I am trying to underscore is that even in a worst case scenario – e.g. a major economic disruption characterized by global bankruptcies – the only thing that fundamentally changes is ownership: the plant and equipment do not disappear. The ownership of the valuable assets will change and the marginal enterprises will simply fade away.

Almost by definition, the remaining enterprises will be those with viable products and services, the soundest capital structures, and the least burdened by debt. These are the enterprises that will survive and prosper during the recovery. Our job is to be cognizant of the abysmal state of the world economy and the possible ramifications – no matter how remote – so we will not panic; to ensure we are able to survive adversity and ultimately prosper.

We will continue to subscribe to an investment discipline where price is our guide. If an attractive business is safe and cheap – absolutely cheap, not relatively cheap – it will be acquired, irrespective of our perceptions of the future. We worry on a macro level but we invest on a discrete individual security level – assembling a portfolio of 50 cent dollars. In so doing we will be favored by the capriciousness of events, rather than be victimized by them. I hope you are as confident and enthusiastic about our financial future as I am.

To learn more about Marshall Serwitz view his Paladin Registry profile.