Outside Economics

Recently, I came across a great explanation/story about how bonds worked and I added an element that explained how derivatives worked.  I have never had a drink, I think the story is rather funny simply because I have over the years been to many business parties where the booze flowed rather freely and I could imagine this sort of thing happening.

Bond and Derivative Market

An Easily Understandable Explanation of Bond Markets

Heidi is the proprietor of a bar in Detroit. She realizes that virtually all of her customers are unemployed alcoholics and, as such, can no longer afford to patronize her bar. To solve this problem, she comes up with new marketing plan that allows her customers to drink now, but pay later. She keeps track of the drinks consumed on a ledger (thereby granting the customers loans).

Word gets around about Heidi's "drink now pay later" marketing strategy and, as a result, increasing numbers of customers flood into Heidi's bar. Soon she has the largest sales volume for any bar in Detroit.

By providing her customers' freedom from immediate payment demands, Heidi gets no resistance when, at regular intervals, she substantially increases her prices for whiskey and beer, the most consumed beverages. Consequently, Heidi's gross sales volume increases massively.

A young and dynamic vice-president at the local bank recognizes that these customer debts constitute valuable future assets and increases Heidi's borrowing limit. He sees no reason for any undue concern, since he has the debts of the unemployed alcoholics as collateral.

At the bank's corporate headquarters, expert traders transform these customer loans into DRINKBONDS, ALCOBONDS and PUKEBONDS. These securities are then bundled and traded on international security markets. Naive investors don't really understand that the securities being sold to them as AAA secured bonds are really the debts of unemployed alcoholics. Nevertheless, the bond prices continuously climb, and the securities soon become the hottest-selling items for some of the nation's leading brokerage houses.

Enter the derivatives… a derivative is basically an insurance policy on the bonds that buyers get to help insure that the bonds will one day pay off. These policies are traded too on the securities markets, however they are completely unregulated. Because the policy insures the bond it helps strengthen the bonds’ rating. The unregulated nature of the derivatives allows for the issuing company to extend its self beyond what typical capital requirements of other financial institutions, making these financial instruments extremely risky. (The greater the risk, the greater the reward; natural risk and return economics.)

For example a bank typically has a leverage ratio of 8-10 percent capital so for every $1,000.00 they lend they keep $80-100 or a ratio of 10:1 or 12:1 in what is called tier-one capital. However some of the derivatives were written by institutions whose capital level was extended to as much as 40:1 on up to 100:1; so they were keeping as little as $10.00 for each $1,000.00 they insured. Derivatives are not offered by your typical insurance companies.

Now for the rest of the story…

One day, even though the bond prices are still climbing, a risk manager at the original local bank decides that the time has come to demand payment on the debts incurred by the drinkers at Heidi's bar. He so informs Heidi.

Heidi then demands payment from her alcoholic patrons, but being unemployed alcoholics they cannot pay back their drinking debts. Since, Heidi cannot fulfill her loan obligations she is forced into bankruptcy. The bar closes and the eleven employees lose their jobs.

Overnight, DRINKBONDS, ALCOBONDS and PUKEBONDS drop in price by 90%. The collapsed bond asset value destroys the banks' liquidity and prevents it from issuing new loans, thus freezing credit and economic activity in the community.

The suppliers of Heidi's bar had granted her generous payment extensions and had invested their firms' pension funds in the various BOND securities. They find they are now faced with having to write off her bad debt and with losing over 90% of the presumed value of the bonds. Her whiskey supplier also claims bankruptcy, closing the doors on a family business that had endured for three generations. Her beer supplier is taken over by a competitor, who immediately closes the local plant and lays off 150 workers.

The size of the world derivative market, as of December 2013, is $710.182 Trillion; The world economy is $72-85 Trillion, the US economy is only $17.02 Trillion, it is an extremely big market!

The investors turn to the insurance companies who insured the bonds and demand that they too pay up, however because they did not keep enough capital to cover such large losses they implode and seek a bail out to keep from laying off thousands of employees and to keep the world markets open. After all without insurance on the bonds, no one would buy the bonds in the first place (even government bonds) and thus capital flows would completely stop. Totally crippling not just Heidi’s community of Detroit, but the world as we know it!

Fortunately though, the bank, the brokerage houses, insurance companies and their respective executives are saved and bailed out by a multi-billion dollar cash infusion from the Federal Reserve Bank and the Government.

The funds required for this bailout are obtained by new taxes levied on employed, middle-class, non-alcoholics.

If you want check if your portfolio holds derivatives let us know by clicking here.

Note: I could not find the original author of the story about Heidi's Bar to give proper credit; I added several paragraphs because the original story did not actually talk about derivatives - just bonds.

With bonds yielding almost nothing and stocks looking fully valued by most measures, investors need more choices. Fortunately, they’re out there. For decades, the biggest institutional investors have used alternative investment strategies to generate higher returns, with less risk, than standard portfolios.  Today, most of these strategies and asset types are available to Main Street, often through ETF’s or mutual funds or similar investor-friendly formats. But, like any investment, you need to inform yourself.

Master Limited Partnerships

MLPs (master limited partnerships) are a type of limited partnership that is publicly traded. There are two types of partners in this type of partnership: The limited partner is the person or group that provides the capital to the MLP and receives periodic income distributions from the MLP's cash flow, whereas the general partner is the party responsible for managing the MLP's affairs and receives compensation that is linked to the performance of the venture.

One of the most crucial criteria that must be met in order for a partnership to be legally classified as an MLP is that the partnership must derive most (~90%) of its cash flows from real estate, natural resources and commodities.  Congress established these special vehicles in the '80s to spur investment in energy infrastructure, and that’s just what this rapidly expanding industry needs today: money for drills, pipelines, and storage, etc. The advantage of an MLP is that it combines the tax benefits of a limited partnership (the partnership does not pay taxes on the profits - the money is only taxed when unit-holders receive distributions) with the liquidity of a publicly traded company.

Long/Short Funds

Long/short funds are the mutual fund industry's attempt to bring some of the advantages of a hedge fund to the common investor. Most long/short funds feature higher liquidity than hedge funds, no lock-in period and lower fees. However, they still have higher fees and less liquidity than most mutual funds. Unlike most mutual funds, long/short funds often require a minimum investment of more than $1,000.

Long/short funds aren't allowed to use as many derivative and short positions nor as much leverage as hedge funds, but they do provide some diversification to the average investor in down markets. Today, several high-quality mutual funds offer access to this strategy but still provide all the usual mutual fund benefits, including daily valuation and liquidity. While these funds won’t keep up with the market during big bull runs, they should significantly outperform it on the downside.

Private Equity

Private equity has been the top performing asset class for big investors for a long time, but it has been a tough area for regular investors to participate in. That’s changing. Private equity consists of investors and funds that make investments directly into private companies or conduct buyouts of public companies that result in a de-listing of a publicly traded entity. Capital for private equity is raised from retail and institutional investors, and can be used to fund new technologies, expand working capital within an owned company, make acquisitions, or to strengthen a balance sheet.

The majority of private equity consists of institutional investors and accredited investors who can commit large sums of money for long periods of time. Private equity investments often demand long holding periods to allow for a turnaround of a distressed company or a liquidity event such as an IPO or sale to a public company.

Collectibles

Most collectible assets classes -- memorabilia, jewelry, cars -- should be looked at as hobbies with an upside. These can be fun to get into, but they’re really not suitable for people just looking for returns. This type of investing requires an extremely deep understanding of the particular collectible, the market and the capital. This can be a very illiquid area of investing. I knew a fellow early in my career, who had an amazing collection of over 500 Lugar Pistols, many had been owned by famous people, but he couldn’t sell the collection. A nearly $500,000 investment with no way to convert it to cash.

Art may be an exception. Art has been recognized as a store of value for centuries in almost every civilization, and there are several high quality funds that specialize in this (some even lend out its art to its investors). The trick is to invest behind someone who is both a true expert and an experienced, trusted fiduciary.

Angel Investing

An angel investor or angel (also known as a business angel or informal investor) is an affluent individual who provides capital for a business start-up, usually in exchange for convertible debt or ownership equity. A small but increasing number of angel investors organize themselves into angel groups or angel networks to share research and pool their investment capital, as well as to provide advice to their portfolio companies.

Angel investing is exciting but risky. Most angel investors will tell you they expect a return ratio of one third, one third, one third. One third of his/her investments make money, one third go bust, one third plod along. But stats indicate that serious angels can achieve internal rate of return of well over 20%, which is obviously very attractive. Probably the best way into the field for new investors is to join a professional angel group.  To find a group to join, you can go through the Angel Capital Association.

If you’re going it alone, make sure a start-up can clearly explain the problem they’re solving, the solution they propose, why their team can handle it, the size of the market, and what the competition looks like. Two more tips: the first money into a start-up should be from a small “friends and family” round (not from you!). And the second is to be sure to keep more money ready for the next round, because the start-up will need it and you may want to invest more.

Like any investment, it is important that you know exactly what you are getting involved in and it is critical to clearly understand the exit strategy – how do you get out of the investment? Or how do you cash out? This and the time commitment are very important, are you committing your money for 3 years, 5 years, or 10 years, the longer the commitment period the greater the return should be. You will want to counsel with an experienced financial consultant who is experienced in the type of investment you are pursuing.