I was doing well at the firm, the second-in-command of a large bond portfolio and bringing in lots of new business as one of the primary marketers. It wasn't a great time to go. I was sick, with a major case of the flu. But as my training and the song say: "when the going gets tough, the tough get going".
Without knowing it, I was destroying my sleep by taking "non-drowsy" Sudafed to control my nasal leakage (not long after this that they started dividing antihistamines into Daytime and Nightime for this very reason). I was wired into a Wide-Awake! and quasi-dreamlike state for the whole conference. Not sleeping at all, I read thoroughly read the materials that Morgan Stanley had provided. I listened to the presentations. I became more and more dumbfounded. It was incredible what they were trying to sell.
During question and answer session after the final presentation on the last day, I could resist no longer. One blue suit among a sea of blue suits, I put up my hand to ask my only question of the conference. The moderator recognized me and the sea of blue suits swiveled towards me as I sat in in my stay-awake stupor.
Carswell : "So, as I understand it, you can structure an OTC option or an embedded option that structured note gives me a one-time, two year look back call option on any index of my choosing in the world."
Morgan Stanley: "Yes, that would be easy for us to do."
Carswell: "What would be the premium on this type of structure?"
Morgan Stanley: "Approximately sixty percent."
Carswell: "So I pay $100 for something that immediately goes to $40?!"
A bit of mumur from the audience and the Morgan Stanley very quickly and diplomatically changed the subject to something more positive for their sales pitch.
The smart people in the audience knew what I was getting at. The insurance company and public sector pension fund investment managers, looking for a way to place speculative bets outside their investment policies, shook their heads at the "hick from Canada" who obviously didn't get that this was a great way to make awesome money for their portfolios. I went back into my Sudafed induced trance and took the earliest flight back home that I could.
When my boss and the President asked me what I had learned for the firm at the conference, my reply was very succinct: "It was the stupidest @#$$%&*@#$#@#$%$#@$ garbage I have heard in my entire life!"
I was not asked to head up the firm's foray into derivatives. I think that my former firm has only used derivatives for hedging and implementation purposes, not speculation. My boss at the time, a very shrewd bond manager, has not used derivatives or structured notes in his bond portfolios. I have only purchased structured notes twice in my investment career, to hedge the risk of a falling Canadian dollar around the time of the last Quebec referendum. I thought that there was a very high risk that the Yes side might win (it was very close). In that case, the structured note , a cheap "out of the money" put on the Canadian dollar would effectively limit the damage of a plunging Canadian dollar. I thought that fifty basis points (.5%) in yield give-up was an acceptable expense for my clients' portfolios. It cost me some performance, but my clients were the best protected in Canada.
As the likeable but latent "Scarecrow", another military man, implies in F.I.A.S.C.O: "Derivatives don't kill people, people kill people." The use of derivatives, in itself, is not bad. They can be used for very useful and reasonable hedging purposes. Unfortunately, from the picture painted in F.I.A.S.C.O. and what I have seen personally, the typical use of derivatives seems to be pure and unbridled speculation. In the case of the many currently collapsing hedge funds, this has been combined with previously unheard of use of leverage. All the while off balance sheet of the participating financial institutions.
A military officer is trained to serve his or her country and lead into danger or battle, if necessary. Duty and honour are key to the military culture in any country. The motto of West Point (link to Internet site), The United States Military Academy, is "Honour, Duty, Country". The motto of the Royal Military College of Canada, my alma mater, is "Truth, Duty, Valour". I abide by these values and the Code of Conduct and Standards of Practice of The Association for Investment Management and Research (link to Internet site) (AIMR), my professional association. I can honestly look myself in the mirror and know that I have never purposefully taken an action contrary to my clients' interests.
From what I've read of the activities of the ex-military Scarecrow, he didn't ever subscribe to true military values or soon forgot them in his lust for money, power or the sheer thrill of action. He certainly couldn't have been a member of AIMR or soon will have a serious problem with keeping his CFA. The other members of his group, "The traders and salesmen (who) tossed their math journals in the garbage and bought copies of Sun Tzu and other military how-to books", should be worried if they're CFAs as well.
As we're constantly telling you on The Financial Pipeline, there's always someone unscrupulous waiting to relieve you of your money. To quote Frank Partnoy: "I believe derivatives are the most recent example of a basic theme in the history of finance: Wall Street bilks Main Street. Since the introduction of money thousands of years ago, financial intermediaries with more information have been taking advantage of lenders and borrowers with less."
As Frank Partnoy suggests in his book, financial institutions are now seeking out less-sophisticated investors to sell derivatives to. My next-door neighbour is a simple man, financially. Last spring, he showed me his Uncle's monthly statement from a prominent Canadian investment dealer. To my astonishment, his Uncle held a structured note issued by the Canadian Export Development Agency (EDC). It wasn't too bad. While it was a call on some weird financial occurrence, likely to lay off some EDC currency or market risk, it didn't have a lot of downside principal risk. The uncle, like the unsophisticated institutional investors in F.I.A.S.C.O., was somewhat surprised when it lost all of its optionality and dropped $4 in value. He did get the high coupon on Canadian Federal Government Agency bond that his salesman had sold him on. The problem was that his total return was worse than staying in the TBills he had sold out of.
Talking about F.I.A.S.C.O. with a former institutional bond salesperson who, like Scarecrow, is now in private wealth management, he recounted recently going to visit a prospect who had been managing his own account, with some help from a few friendly investment dealers. "You wouldn't believe it" , he said. "All this guy had was structured notes and he had no idea what he was holding. He thought they were government bonds!" Any bets on what retail product line probably has a high retail sales commission?
Long Term Capital Management (LTCM) had huge derivatives positions and was levered 100:1. Its partners and traders, the efficient market theorists who invested, the financial institutions who lent to them, their Wall Street investment bankers and sundry and sordid financial hangers-on are all going to lose big in this one. Rumour has it that Warren Buffet had offered to rescue LTCM but management had turned them down, because Warren wanted to fire them all. Rumour also has it that they paid themselves huge bonuses out of the funds just before the stuff hit the fan. Nice Guys.
They're really fortunate that they were stupid on a large scale. Alan Greenspan finally had to bail them out for fear of what might happen to the money centre banks. I wouldn't want to be Alan when he tries to explain to Congress why he bailed out these Wall Street cronies. The United States certainly has lost any moral authority it once had to convince other countries not to bail out their failed banks and money-losing industries. How could he sell it? "Well, we only believe that American banks are too big to fail!"
The securities of good companies are being sold cheaply because the hedge fund managers, "Masters of the Ludicrous", are panic selling them because their banks have told them to. The current period of financial distress means that I am buying high quality cash flows as cheaply as I ever have. This includes the period in December 1992 when I bought General Motors Acceptance Corporation bonds at 2.75% and Sears Canada bonds at 4.25% over Canada bonds. I am buying corporate bonds, which I think will be the best performing financial asset over the next few years and very cheap Real Estate Investment Trust (REIT) units.
What should you do as an individual investor? As a wise stockbroker once told me, When you have money and everyone else is spending it, save it. When you have money and everyone else has already spent theirs, buy things. This applies to investments.
Forget about derivatives and speculation. Get as close to high quality cashflows as possible and stay there. Do your research and homework and buy the cashflows of good businesses cheaply, whether they're stocks and bonds. Investors with over-levered and speculative positions are selling and liquidating anything that they can. It's a great time to buy.
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