Bankruptcy, The Real Threat Part V Sins

Bankruptcy, The Real Threat Part V Sins 1 & 2

The Sins of the Banks are born upon the Populous.

The First Sin, Unknown Loans
Banks very rarely know the how the loan shall be used. Hedge funds intentionally keep the lending banks in the dark as to how the money shall be used. Therefore the banks don’t really understand the risks they are exposed too.

The hedge fund then goes to another bank and makes derivative contracts on the assets they wish to arbitrage. Since derivatives contracts cost only a fraction of the actual value of the stock or bond, the hedge fund gets a greater gain or loss depending on the price difference.

The affect is that banks do not really have any idea of how stable the loans they give out are. When times are going well banking has never policed itself very well. The flaw of the human condition, it’s hard to argue with success.

The owners of the banks see other banks making money in hedge funds, and not wanting to be left behind, they follow like lemmings. This causes a situation in which many more banks are trying to invest in a limited amount of hedge funds. Hedge funds are in a position to pick and choose which loans it takes from banks and can play banks against each other. Therefore banks are willing to give loans to hedge funds without actually understanding the risks of the loans.

Not only are the loans unknown, but the size of the loans have increased. Therefore the failure of just one hedge fund can bankrupt several banks. When the hedge fund called “Long Term Capital Management” became insolvent during the Russian banking crisis, almost sent some of the biggest banks in the world into bankruptcy at the same time.

The Second Sin, Using Derivatives to Leverage Investments
Hedge funds like to use derivatives because they do not actually own the asset (stock, bond …) they are arbitrating. In essence, they only own the right to bet on the direction the value of the asset. The option is worth only a fraction of what the asset is worth if they were to own it outright.

The major difference between owning stock outright and owning derivatives, is that stocks is actual property. A derivative is more like insurance. So a derivative is only good for up to a certain time in the future. When the time runs out, the value of the derivative is zero. So stocks that losses value still have value. A derivative that losses value against the stock it is tracking has no value. It only has value if it increases in value over time, but no value if it does not.

Let’s look at a simple example.

If a hedge fund had $1,000,000 and wanted to buy a stock worth $100 they could buy 10,000 shares of stock. The same option for a stock would be worth $10. If the hedge fund bought options they could own 100,000 options of the stock. The options have a limited life span. We shall assume six months in this example.

The difference between owning options and the stock itself is that an option is set at a price and has a limited time. So 10,000 shares were obtained they would own these shares like property. If the value of the stock fell, the owner would still retain the value of the stock, just at a loss. If the value of the stock increases they also realize the increased value.

For example if the value of the stock became $120 a share for 10,000 shares owned. The value of the investment would have grown to $1,200,000 from an initial purchase of $1,000,000 for an increased value of $200,000

Now using options, if the value of the stock became $120 per share, the hedge fund owns 100,000 options. The value of the investment would be $2,000,000. Remember, options only track change in value of the stock, no the stock itself. So the gain is determined by taking 100,000 options multiplied by the change in price between $120 and $100.In this case the change is price is $20.

$20 is now multiplied by the number of options owned which is 100,000 which gives a total gain of $2,000,000. The cost of the option is subtracted from the price so you spent $1,000,000 on the option. $2,000,000 minus $1,000,000 equals a net gain of $1,000,000. This is five times more than the $200,000 made by owning the stock outright.

Now let’s take a gloomier picture. Let’s say the stock lost value instead of gained value. So unlike stock, options have a limited life span. In this example we shall assume that the option has a life span of six months.

The stock price starts at $100 per share and as before and the hedge fund buys 10,000 shares of stock. This gives a total investment of $1,000,000. The stock looses value and the value of the stock is now valued at $95 per share. Now the total investment is valued at $950,000 so the investment is down $50,000. The hedge fund can hang onto the shares or sell the shares for a loss.

Using derivatives in the form of options, the hedge fund spends $1,000,000 to buy options priced at $10 per option for the stock priced at $100 per share for six months in the future.

Since the stock has lost value from $100 down to $95 per share. Since the stock has lost value and the option in this example only has value if the stock appreciates, then the value of the investment is $0. Since options have a limited time span the hedge fund cannot hold options and wait for the underlying stock price to increase..

In this example the straight stock investment losses $50,000 while the derivative investment losses $1,000,000. Therefore using derivatives has lost twenty times more money than just owning the stock outright. If the hedge fund just held onto the stock, the stock may increase and no loss may be required.

This situation begs the question, so how do hedge funds “Hedge”?

In the case of stocks and other assets hedge funds make bets using derivatives regardless if the asset goes up or down in value. So a hedge fund will deal in two different types of options on stock. One option called a call makes money if the stock appreciates and losses money if the stock depreciates. The other option called a put makes money if the stock depreciates and losses money if the stock appreciates.

For example, a hedge fund wants to make a hedge against a stock in the form of an arbitrage. The stock is currently worth $100 per share. The hedge fund sells call options (the right to buy a stock for a specified price over a specified amount of time) if the stock price goes above $100 per share then the derivative makes money. The price of the option is $10 per option and is good for six months.

The hedge fund also sells put options (the right to sell a stock for a specified price over a specified amount of time) that make money if the price falls below $100 per share. The price of the option is $9 per option and is good for six months. They sell 50,000 call options for $500,000 and sell 50,000 put options for $450,000.

If the price of the stock goes to $110 per share
(50,000 call options) *($10 price rise) = $500,000
(50,000 put options)*($0 price decline) = $0
Price of the sale ($500,000 call options sale)+($450,000 put option sale)=$950,000
The hedge fund has made $950,000 - $500,000 = $450,000 in the deal

If the value of the stock goes to $120 per share using the same math the hedge fund would lose $50,000

If the stock price goes to $90 per share
(50,000 call options) *($0 price rise) = $0
(50,000 put options)*($10 price decline) = $500,000
Price of the sale ($500,000 call options sale)+($450,000 put option sale)=$950,000
The hedge fund has made $950,000 - $500,000 = $450,000 in the deal

If the value of the stock goes to $80 per share using the same math the hedge fund would lose $50,000

Hedge funds can use very exotic techniques in order to make money. In this case as long as the stock doesn’t move up or down too much the hedge fund makes money. If the stock moves outside of the range, the result can be disastrous.

A hedge fund can also lose money if the stock rises and falls dramatically during the course of the time period. This is referred to as volatility. When this happens then when the buyer is in a position to make money and they do so immediately, without waiting for the option to come close to expiration.

Under this condition, the hedge fund can lose money in both directions during the six months the options are good for.

The Sins to be continued.