Derivatives

  • 07 Feb 2013 at 7:13 PM

If You Tax Derivatives, Only Derivatives Will Pay Taxes

In general when something is headlined “A Sensible Change in Taxing Derivatives,” or “A Sensible Anything,” that’s a good sign that it’s not; things that are sensible don’t have to advertise. Also: ooh derivatives are evil ooh, so the odds are even worse. But this particular sensible change – a Victor Fleischer DealBook column about a Republican House proposal to tax derivatives on a mark-to-market rather than “open transaction” basis – is more sensible than you might initially expect; it’s mostly plausible and inoffensive and non-pitchforky.1 (The idea is straightforward: if you own a derivative, and it went up in value this year, you pay taxes on the increase in value. Unlike with, say, stock, where you only pay taxes on the increase in value when you sell the stock.)

One way to tell it’s not too bad is that various reports suggest that the Wall Street reaction so far has been “meh?” or “huh?”; this is presumably in part because it’s not clear how real this is and in part because it’s not clear how bad it’d be if it was real. Wall Street, in the sense of derivatives dealers, already pay taxes on their derivatives inventory on a mark-to-market basis, so the dealers’ dog in this fight is not their own taxes but rather the marketability of various products, from boring ETNs to lovely variable share forwards, to customers focused on tax efficiency.

Nonetheless! There are two ways to think of derivatives. One is they are a specific class of evil things, often involving acronyms, designed to let banksters get up to dirty tricks. This line of thinking goes along with words like “complex” and “opaque” – “derivatives are complex instruments …” etc.

The other way to think of the term is as a catch-all for any sort of contract whose value is determined in part by something in the world. Read more »

Every financial contract is subject to a bunch of risks, and in some sense each of those risks affects its value. There’s some chance that an asteroid will crash into the earth next year, rendering your 30-year interest rate swap considerably less valuable, and if you’re so inclined you can discount its value for that possibility.

One nice thing to imagine is that your financial contract is, like, one contract, and all the risks are spelled out in that contract, and you can figure out the value of the contract based on real or market-implied probabilities of all the risks happening etc., and you add them all up and you conclude “the market value of this contract today is 12!” or whatever and you go on your merry way. But that doesn’t need to be true. Some of your risks live in the contract and are part of the contract; some live in the counterparty and have to do with the counterparty’s riskiness; some live in whatever collateral arrangements you have with the counterparty and have to do with the mechanics of your collateral; some are asteroids.1

Anyway, remember the Deutsche Bank whistleblower story? I said last week that the question of whether DB’s actions constituted accounting fraud was not a particularly interesting question, but that is all relative and you’d be surprised what I find interesting. One thing I find interesting: those Deutsche Bank trades! And umm their accounting.

So, some background. As far as I can tell, DB sold a bunch of credit protection in sort of normal ways, CDX and stuff. And it bought a bunch of protection in leveraged super senior tranches. A super senior tranche, classically, is:

  • You have a pool of reference assets,
  • You pay some spread to a protection writer,
  • If defaults wipe out more than some unlikely-seeming percentage – 15%, say – of those assets, then the protection writer gives you money, more or less 1% of notional for every 1% of losses over that threshold,
  • So for instance if there are 40% losses you get paid 25%.
  • The protection writer is like a big bank or monoline or whatever and, in 2005, is either AAA/AA or is posting mark-to-market collateral or both.

So there’s your trade. A leveraged super senior is the same thing, except replace that last bullet point with:

  • The protection writer posts a bunch of collateral – 10% of max exposure, say – day one.
  • The protection writer is a Canadian asset-backed commercial paper conduit or some other non-credit party.2
  • If certain bad things happen that make you worry that you don’t have enough collateral, you can ask the protection writer to post more collateral, but (1) they don’t have to, (2) they don’t want to, and (3) they can’t.3

Read more »

Oh man, what is going on in this FT article? Here is the bottom line:

In a series of complaints to US regulators, two risk managers and one trader have told officials that Deutsche had in effect hidden billions of dollars of losses.

“By doing so, the bank was able to maintain its carefully crafted image that it was weathering the crisis better than its competitors, many of which required government bailouts and experienced significant deterioration in their stock prices,” says Jordan Thomas, a former US Securities and Exchange Commission enforcement lawyer, who represents Eric Ben-Artzi, one of the complainants.

The “in effect” does a lot of work there; Deutsche Bank “in effect” hid billions of dollars of losses because there were no losses. Other than that!

Here’s a synopsis of what seems to have been going on:

  • Starting in 2005, Deutsche did some credit trades where they bought protection from some Canadian pension funds and sold protection to hedge funds, etc.
  • The bought and sold protection were not identical, with various technical bits of non-overlap that you can read about at your leisure down below.1
  • A credit crisis occurred, changing the risks involved in those non-overlapping bits from silly, abstract, purely theoretical risks into significantly more alarming and more-likely-to-occur but still purely theoretical risks.2
  • Deutsche’s people sort of ran around dopily trying to figure out what to do about it. Here’s a condensed version of the running around they did about the main risk, the “gap option” that DB was short in its leveraged super senior trades:

Read more »

How can you not love listening to Lloyd Blankfein? He spoke at this Merrill conference this morning and here are the slides, whatever; he is not a PowerPoint presenter, he is a philosopher. Let’s talk Philosophy of Lloyd.1

Lloyd and I share a number of passions, I assert without evidence, but a quirky one is that we both enjoy idly speculating about conservation laws in finance. In the Q&A Lloyd was asked about the clearing of derivatives and their movement to central counterparties, in which instead of banks trading opaque over-the-counter products with each other and their clients directly, taking client and fellow-bank counterparty risks, derivatives will increasingly trade in standardized cleared form with public pricing and central clearinghouse credit risk. Lloyd began by hypothesizing a “physical law of conservation of risk,” noting that “the things you do to reduce the risk of a 20-year-storm” – like reducing credit exposure to a bunch of different shaky counterparties in derivatives markets – “might make worse the risk of a 50-year storm,” like the credit exposure to one central counterparty whose failure could bring everyone down. I’m with you Lloyd: endorsed; narrow the distribution and fatten the tails etc.

The other concern about the move to clearing is that lots of people expect standardization and clearing will reduce the spreads that banks can charge on cleared things (mostly interest-rate swaps, some miscellany). Coincidentally a while back I speculated about a sort of law of conservation of abstraction, in which the abstract fantasies of our global financial system are built on the mucky underpinnings of a basement at DTCC full of damp stock certificates. That was … that was dumb, I don’t know what I was thinking.2 It’s obviously false. It’s the other way around actually: the more the inputs of the financial services industry abstract away from human activity, the more the outputs can move even higher up the abstraction chain. You see this with DTCC itself, which was seeking efficiency by dematerializing stock certificates even before a hurricane did that job for it, or in that Journal article last week about how Belgium is dematerializing its stock certificates and everyone’s all sad about it but the march of progress waits for no paper-hoarding Belgian.

You can see it especially Lloyd’s take on whether increased clearing of interest-rate swaps, etc., will help or hurt Goldman Sachs’s business. Read more »

If I were the sort of guy who could come in to a company, yell at them a bunch, and get them to sell themselves to someone else at a premium, I would:

  • do that often!, and
  • buy lots of call options on the stock before doing it.

Right? If I bought the call options for, I dunno, $23 an option, and they had a strike price of $36 per option, let’s say, and I bought 5 million of them, and the company eventually sold itself for like $80, then I’d be stumping up like $115 million initially and getting back $220 million for a profit of $105 million, or ~91% of my original investment, and that would be sweet. If instead I boringly bought shares at, say, $59 per share, and it eventually sold for $80, then I’d be putting down ~$295 million to get back ~$400mm for only a ~36% profit. More importantly if somehow I failed to convince this company to sell itself, or even worse if I failed to convince others to buy it, the stock might go lower – maybe really low. If the stock went to $20, I’d lose my entire $115mm option premium, but that’s better than losing $195mm if I’d gone and bought the stock.

In other words, putting a company into play increases its volatility. Options gain value with volatility. Buying an option and then making it more valuable through your own actions – going out and making volatility happen – is a good strategy. So good it’s basically magic.

So good it’s impossible! Because: what kind of idiot would sell you that option?

Let’s ask Carl Icahn. Today he announced a just-under-10% position in Netflix this afternoon. The stock closed up ~14% (after being up ~21% earlier) on the news. And as it happens, Icahn’s Netflix position was almost entirely in the form of call options, so he just made a bajillionty dollars on paper.

Here is what Icahn says about those arrangements:1 Read more »

A core belief here at Dealbreaker HQ is that we’d be really good rich people.1 No conservative 401(k)s and unborn-children-college-funds for us; we’d dedicate ourselves to lives of sybaritic excess. For me, that means that if someone wants to die and leave me an oil fortune, I’ll be putting Morandis on the wall, DRCs in the cellar, and variable prepaid forwards in the trust fund. Everyone needs a little beauty in their life, and also in their trust fund.

That must have been what motivated JPMorgan to pitch Skelly oil heiress and “acute stress syndrome” sufferer2 Ann Fletcher to enter into variable prepaid forwards on the Exxon Mobil stock in her trust. That or:

The value of the Trust prior to entering into the May 2000 VPF was $14,392,000. As of June 30, 2003, the sum of the Trust’s repayment obligations under the three VPFs had grown to $10,336,050. The value of the Trust at the time the Bank resigned as co-trustee [in March 2006] was $12,515,085.57. The Trust’s associated decline in principal was $1.88 million.

The Bank produced emails and spreadsheets to show that the Bank earned $1,127,189 from the VPFs. Expert testimony indicates that the Bank earned as much as $2,000,000 in profit.

So, I dunno, I feel like 7.8% in profits over 6 years is a not bad result on a pretty vanilla equity financing trade?

You can read the opinion, some of which strikes me as being pretty clearly wrong but hey I am not an Oklahoma trusts lawyer,3 here. Baaaaaasically there was a trust, and it had stock, and the idea was to pay the dividends of the stock to Fletcher during her lifetime and then, when she died, to give half the stock to her children and the other half to charity. At some point someone – JPMorgan? Fletcher? – conceived the idea that Fletcher should get much more money during her lifetime, basically by selling stock and pocketing the proceeds, leaving of course much less stock for the children and charity. So that happened. Read more »

Soon it will be time for Congress to shout at bankers about derivatives again and that’s fine, but allow me to indulge a bit in mourning for a derivative that Basel III killed today. That being of course SunTrust’s postpaid bifurcated collateralized variable share forward on its Coca-Cola stake:

SunTrust Bank’s third quarter is about to be a bit of a kitchen sink report, and that includes tossing out its old stash of Coca-Cola. … Included in the asset shuffle will be the sale of 60 million shares of Coca-Cola Co. that the bank has held for nearly 100 years, a sale that will lead to a $1.9 billion pre-tax gain in the quarter.

SunTrust had in 2008 entered into two contracts to sell its Coke shares in 2014 and 2015. But after reviewing its position in light of new global capital regulations known as Basel III, SunTrust realized holding onto its Coke shares would punish its capital standing and decided to move forward the sales. The bank also said owning the shares hurt its stress-test results.

Probably nobody cares about this but me, but the derivative in question is among the works of art in the financial world so I want to share it with you.* Basically what happened is (all numbers rounded and split-adjusted): Read more »

I very much enjoyed this Morgan Stanley electric shenanigans case that settled yesterday. According to the complaint, this happened:

  • KeySpan, an electric generator, realized that prices for electric generation would be going down as more capacity came online.
  • It decided to keep up prices by cutting back its own generation.
  • But that’s dumb, because then it wouldn’t be able to sell much electricity at the high prices, which would mainly benefit its competitors.
  • So it decided to buy its main competitor, cut back generation, but still sell plenty of electricity at high prices.
  • But it “concluded that its acquisition of its largest competitor would raise serious market power issues” and so would raise problems with antitrust and electric grid regulators.
  • So it said “aha, a swap!”
  • And it synthetically acquired the capacity of its largest competitor (Astoria Generating) by entering into a swap with Morgan Stanley where it effectively bought that capacity at $7.57 a kilowatt-month.
  • And Morgan Stanley hedged that trade by entering into a swap where it effectively bought the capacity from Astoria at $7.07 a kilowatt-month.
  • Attentive readers will note that that’s a $0.50 difference, so Morgan Stanley made $0.50 per kW-month for about three years, for total revenue of around $21.6mm.*

So what do you make of it? The complaint sounds terrible, but then it would, and Morgan Stanley isn’t talking (and not admitting or denying etc. etc.), so we’ve only got one side of the story and maybe it’s exaggerated. But if you believe the complaint then everyone at KeySpan and Morgan Stanley knew that they were structuring this deal to get around antitrust requirements that they knew would make it impossible for KeySpan to buy Astoria directly. That’s certainly one possibility – everyone was as criminal as criminal can be – and, yeah, sure, probably, though the relatively low-dollar-value settlement might suggest otherwise.

But I like imagining the other possibilities in which someone was taking advantage of someone else’s naïveté. Read more »