Let me deal with the Warren Buffet / General Re item first.
General Re had a reputation in the derivatives business for writing derivatives other players would not touch - 14 year bets on interest rates, etc. They also seemed not to sell or buy offsetting products as much as they should. No one else wrote derivaties as long as GenRe.
GenRe wasn't a little worse, they were a lot worse.
You know the saying Buffet has about poker games - that if you sit in a game, and you don't spot who the sucker is, then it's you ? Evidently GenRe never heard this...
Warren bought a very cheap insurance company. When he got into the derivatives book, he realized he got what he paid for....
The custom derivatives business can be good money maker - IF:
1) You control the risk - offset the deals, don't over leverage, test against a wide selection of possible events, qualify your counterparties, etc.
3) You price product right - which means that there will be times, maybe 2-6 months when you will not sell xyz product because the price is too low. This is a hard discipline to learn, but otherwise you don't make your cost of capital.
So Buffet's view of the derivaties biz reflects his experience - basically, he screwed up (or was intentionally decieved) part of the due diligence.
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Why do I believe about 90 cents on the dollar for custom derivatives ?
Because I expect that is what they will sell for if there are multiple bidders - say 7-12 bidders who would have a real interest and ability to buy on margin.
Now GS, for example, is prime broker for a wide variety of large hedge funds.
As prime broker, GS sees all the books of these funds.
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Let's say REFCO has a contract where REFCO makes money if Copper goes OVER $1.70 a pound. Let's say the contract is for 10 million pounds.
GS can find funds that have contracts where they make money if Copper is UNDER $1.90 a pound. Maybe one fund has 4 million pounds, one 3 million, and one 2 million.
These funds will be interested in buying parts of the REFCO contract, since this will not just take them flat on copper exposure, but give them a larger payoff if copper stays between
$1.70 and $1.90.
So the hedge fund buys enough to cover their 4 million pounds.
This not only locks in their profit, but it will effectively free up margin money - money the fund can use to make a bet on nickle or natural gas or the Canadian dollar.
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Okay, a couple of objections to this -
1) Won't most hedge funds be on the same side of the deal as REFCO, since most funds have a heard instinct ?
2) Will this really reduce the funds risk and allow more margin ?
1) Good point. However, GS deals with a HUGE number of hedge funds - much more than REFCO. So chances are good GS can find someone on the other side.
2) As the prime broker, GS gets to make the risk calculations and loan the margin money. They get to play the game AND be score keeper.
Isn't self regulation wonderful ? ;-)
So this is why Refco will realize about 90 cents on the dollar (minus transaction fees for GS) for most (not all) of their custom derivatives.
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By the way, outside of listed options, I don't play in the derivatives business. It makes my head hurt, and it is far too much like real work. To win, you need to be in New York or London, not Ohmaha or Silicon Valley. |
