Sunday, May 09, 2010

Derivatives of Mass Destruction: From "Fat Man" to "Fat Finger"

I know not with what weapons World War III will be fought, but World War IV will be fought with sticks and stones. Albert Einstein

Deputy National Security Adviser John Brennan said Sunday that the White House does not believe Thursday's Wall Street nosedive was the result of a cyberattack. The Hill

Had Mr. Einstein lived long enough he would not have been ignorant of WWIII's weapons- they are financial in nature, and, instead of "Fat Man" and "Little Boy", modern WMDs are called Credit Default Swaps (CDS) and are ignited by a "Fat Finger".

The need to hedge derivative portfolio "delta" (sometimes in amounts far exceeding the underlying security's total value and often "computer driven") makes financial markets very vulnerable to "Fat Finger" problems (or any multi-standard deviation price changes). It's a WMD (not confined to CDS, hedging is common to all derivatives) waiting for a trigger.

We need to dismantle these WMD, instead of focusing all effort on stamping out the next lit fuse

Unconvinced?  Think I'm (falsely) "shouting fire in a crowded theater"?

Read on.

In theory, CDS provide securities' owners a means to cheaply insure against their default. By paying a (or series of) small premium(s) (usually far smaller than the security's yield) the risk of default is swapped to the CDS seller.

In theory, as with all derivatives (in a former life I used to trade these things), sellers can instantaneously hedge (for instance, by selling the security issuer's stock, bond, or currency) the assumed risks, deriving (sellers hope) profit from the received premiums less any hedging costs.

In practice, (as I learned, painfully) trying to maintain hedges in fast markets (and I traded foreign exchange- a pretty liquid arena) can be impossible. Worse, as price deviation from last hedged position grows, the amounts to hedge grow as well. A .5% move in the underlying might call for a 10% hedge, while a 2% move might call for 35% and so on.

Adding insult to injury, all those hedges may have to be unwound if prices come back to "normal". Among traders, market chasing as described above is called hedging "bad gamma" (which is about as fun as having "bad karma").

In practice, CDS are not primarily used as insurance. They are, more often, purchased "naked", not to hedge against a default, but to bet on it, and perhaps, as you'll see, to actually accelerate it, particularly if one could, through naked purchases in greater amounts than existing underlying securities, force hedgers into selling over-drive.

I suspect events like last week's panic in equity markets will become far more frequent so long as CDS (in particular) use, and thus necessity of hedging thereof, continues to grow.

Warren Buffett, before a Galileo-like recantation and rebaptism in the church of TBTF finance, was a pioneer in recognizing derivatives as financial weapons of mass destruction. Like the nuclear weapons of WWII, modern WMD are examples of tremendous leverage- tiny amounts of fissile material or premium, respectively, explode with enormous yield, wrecking horrific damage.

Unlike atomic weapons, whose direct effects are limited to a blast and radiation radius, modern WMD, like CDS use high speed connectivity and computer driven hedging as transmission mechanisms. The "Fat Finger" ignites a "critical price deviation" forcing hedgers of naked CDS to (try to) sell what might be many multiples of available securities.

Thursday's market action might in the future be seen as the Trinity test of the financial Manhattan Project, broadcast live to anyone in the world with an internet connection.

Fortunately, just as atomic weapons require radioactive cores, so too do our CDS WMD. In the latter case, the underlying core (financial entity) must be highly leveraged. Instability, either at an atomic or financial level, is key to explosive yield. Trying to force default in an unleveraged, highly solvent financial entity would be about as fun as using carbon-12 instead of uranium-235 in an atomic bomb.

In other words, while real world WMD deterrence might require a missile shield, financial WMD deterrence might require a solvency shield. The more solvent, and less leveraged a company becomes, the less it needs to respond to the whims of the markets.  It can just go about its business.

Highly leveraged financial companies like Lehman and Bear Stearns were prime "fissile" material- so unstable they needed daily financial stabilization. Unfortunately, there seems to me to be far more financially unstable material laying around than fissile isotopes- Wall Street finance being far more effective than, say, Iranian centrifuges.

On the bright side, fears of "Fat Fingers" igniting naked CDS into financial WMD might someday be seen in the same light as plans for mutually assured destruction (MAD)- as signs of the need to dismantle armaments. Perhaps Homeland Security should audit the Fed, and dismantle the highly leveraged and unstable financial cores we've strategically placed around the nation.

Either that or people of the future might visit New York as they now visit Hiroshima and Nagasaki- looking at a plaque commemorating the destruction caused by a "Fat Finger" instead of a "Fat Man" or a "Little Boy".

Who knows, maybe in addition to Arms Control, Capital Control will be a national security matter.