Thursday, April 22, 2010

I never liked calculus

Alan Blinder usually has a balanced and useful perspective on political/regulatory issues.  I remember being impressed by his speech at last year's Minsky conference -- it kinda made me think of what I imagine Paul Volcker is like when there's no TV cameras (Volcker having become the administration's thick-browed-big-stick-wielding-bank-basher for the moment).  From today's Journal:

Derivatives dealers have already shed crocodile tears over the alleged benefits of customization to end users. After all, how else could, say, an airline swap February euros for May jet fuel? Well, I've got an answer. It could sell standardized February euro contracts (for cash) and buy standardized May jet fuel contracts (with cash), on organized exchanges, paying vastly smaller fees to dealers in the process.

Yes, there are unusual cases in which customization is important. But let's not deceive ourselves: The primary beneficiaries of customization are the dealers, not the customers. In the U.S., that basically means five big Wall Street firms—each of which has an enormous stake in the outcome. If they can stave off standardization and exchange trading, comparison shopping will remain very difficult and profit margins will remain sky high. But if reform makes standardized, exchange-traded products dominant, competition will squeeze profit margins to the bone. Here we have what may be the clearest divergence between the interests of Wall Street and Main Street.

I liked this point.  Even though I rarely have much to do with Goldman or Morgan's three-card-monte divisions, every 10-K has disclosures about a company's derivatives position, so I do get a first hand view of this industry (if such a term can be used in reference to footnote 945697/b).  And I rarely see any fancy stuff.  People hedge currencies,interest rates, and maybe the price of one or two major commodities, that's about it.  I don't feel like looking up the statistics, but I would guess that accounts for 90% of the derivatives that Main Street uses.  Yeah, occasionally people fashion crazy custom weapons of mass destruction (as Buffet calls them).  I remember having the guys in a big bank's leveraged loan division explain to us (6 times) how one company had directly pledged a percentage ownership of their natural gas fired power generation assets as collateral for one leg of a complicated a spark spread hedge.  The basic idea was that as gas got more expensive the price of electricity went up, so despite the fact that gas was the major cost they were trying to hedge, the company's assets were more valuable.  Instead of putting up more cash collateral  to cover the hedge, they simply has someone agree to own more of a now more profitable generation asset.  Or something like that.  I don't remember the other legs of the trade, and yes, the company had recently emerged from bankruptcy and was already flirting with it again, why do you ask?

My point being that I have also understood the whingeing about higher collateral requirements to be coming mostly from the banks, and not from the corporate end-users of these things.  These contracts should by and large be transparent, plain vanilla, adequately collateralized in cash, and traded on exchanges.  If you want a custom derivative, by all means, go to Vegas baby!  And if you truly don't have the capital to put up for a real hedge, do what anybody with a solid idea and a decent reputation does -- borrow it.  I don't think the banks have a leg to stand on here.  They are just resisting their clubby high cost barter system being turned into the ultimate commodity: money.  Not that I blame them really.  Resisting commoditization is every businessman's first priority, unless of course you build your business on inducing it.

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