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Wednesday, May 27, 2009

Confessions of Chinese Derivatives Deals Part 2

(Caijing.com.cn) My understanding of what's wrong with the banking system was clarified recently when I helped a Chinese company extricate itself from a bad deal. I'm an American lawyer who spent several years working in Hong Kong for major investment banks. In that capacity, I read correspondence between the company and its bank. I realized that the system's problems are not just about greedy salespeople, but that investment banks have quite often failed as institutions. My job was to write complicated derivatives often sold to Chinese companies. Today, many companies still don't understand how risky those products are. I fear derivatives contracts could cost these companies a lot of money before they expire. Like the American government, banks have different branches that are supposed to limit the powers of one another. On one side are salespeople and traders. The amount of money they earn depends on how much they generate for the bank. So it's in their interest to sell as many financial products as possible; the more complex and profitable, the better.

On the other side are the overseers -- lawyers, credit analysts and compliance officers. Their job is to protect the firm. An overseer is supposed to block reckless transactions at any bank known for selling dangerous products that could hurt its business. My position was somewhere in the middle: I was a "legal structurer," which means I was a banker with legal training, and I was often enlisted by salespeople to get derivatives approved. I learned the process from the inside. Right around the time banks started selling complicated derivatives in China about five years ago, the financial industry underwent a change that broke down the internal balance of power at banks. Bankers who earned simple fees by helping clients raise capital began working together with other bankers who sold derivatives. The 1999 repeal of the Glass-Steagall Act in the United States and similar liberalization worldwide let banks combine the two groups of bank services under one roof. But previously they had been kept separate – for good reason. This change is easy to understand with an example. Imagine a successful, newly listed Chinese company that needs capital to grow. Its bank first gauges interest among global investors. Let's say the bank decides the company could most efficiently raise money by selling corporate bonds in U.S. dollars. But the company, which earns revenue in yuan, would face the risk of changing currency values that could make debt repayments more difficult. So the bank might propose a hedge to remove this risk from the client, in exchange for some initial profits from the derivative.

All that seems normal; it's just packaging a bond with a hedge. But think about what happened behind the scenes. The arrangers of bonds and the sellers of derivatives got together to concoct a single solution. Even though these two types of bankers are generally allowed to work at the same firm, lawyers and compliance officers would still maintain a clear separation -- the so-called "Chinese wall" -- between them. Why? To prevent insider trading. Traditional bankers who arrange bonds are considered trusted advisers and hold private information about their clients. When derivative salespeople know what bond advisers know, they may be tempted to pursue unfair profits by using information about those clients to their advantage. Bank overseers were well aware of this danger. So they made sure that any salesperson with inside company information could not trade securities in that company, nor could he or she even speak about the company with anyone from the derivatives side of the aisle. Nevertheless, derivatives bankers designed products together with bond arrangers. The potential profits were too attractive not to. And derivatives bankers always had incentives to sell clients these transactions, whether or not bond arrangers thought companies needed them. I no longer work for investment banks, and I recently advised a Chinese manufacturer that was served by a single team of bankers, which included bond arrangers and derivatives experts. The client never knew that these two groups had different motives. Worse, the company signed an agreement that effectively locked it into working with the same bank for both its debt offering and any derivatives. Even after the debt offering fell apart in the global credit meltdown, the company still wound up with a currency swap that now threatens to wipe out its quarterly profits. Clients may have known about these conflicting roles, but such awareness would not have come easily. Contracts were complicated. See if you understand this contract language: The bank "may effect other transactions involving financial instruments related to the bond offering and other transactions contemplated herein." That means the bank might make money off a deal, whether or not its client does. But many Chinese companies didn't understand the implications of that kind of language, whether they read it in Chinese or English. And salespeople certainly didn't go out of their way to enlighten them. This conflict of interest has caught the attention of Chinese regulators. But the issue won't be resolved anytime soon. From now on, Chinese companies, especially those with derivatives already on their books, should watch for what really motivates their bankers.

Confessions of Chinese Derivatives Deals, Part 1

By Mushtaq Kapasi

(Caijing.com.cn) Even America's most famous investor, Warren Buffett, admits he got burned by derivatives during the global financial crisis. And if he didn't know what he was doing, imagine what could happen in the future to Chinese companies.

Many Chinese firms had little experience with complicated financial products such as derivatives before they bought billions of dollars worth of these investment products. Many of these investors, especially small to medium-sized companies, could see their profits wiped out, and may face bankruptcy if their investments explode.

Why do I think this? Because I helped create these derivatives. I'm an American from Texas who worked for about a decade for international banks and law firms. Derivatives experts sought me out because I'm a lawyer with a degree in mathematics. I spent thousands of hours in Hong Kong skyscrapers translating the calculations and cash flows into arcane, legal English. And I eventually figured out how the banks -- and, I must admit, myself -- could profit by selling products their customers didn't fully understand. T

The basic concept behind derivatives is simple. They are financial agreements in which one party agrees to pay another party if a market goes up or down. For example, imagine an airline that buys jet fuel. The airline could face trouble if the price of oil shoots up. To protect itself, the airline can buy a derivative -- a hedge -- that will pay money if the price of oil rises. Of course, if the price of oil drops, then the airline would lose money on its hedge. But, on the other hand, it would also pay less for fuel. You could think of this sort of derivative as a type of insurance.

But in China, the profit margins on simple and safe derivatives fell too far for foreign banks. A couple of years ago, after they sold all the derivatives they could to large Chinese banks and state-owned enterprises, investment banks then targeted smaller Chinese firms. These firms had less money, so the only way for the banks to maintain their profit levels was to make derivatives more complex and risky. My job was to write them.

Many small Chinese companies had taken out loans and wanted to protect themselves against changes in interest rates. A simple hedge would have worked fine. Instead, the banks sold complex derivatives called "cost reduction swaps" that were linked to such obscure factors as differences in euro interest rates. When the credit crunch hit Europe, Chinese clients suddenly had to pay millions of dollars to their investment bankers.

Or consider what happened last summer, when the world believed that the yuan would appreciate. Small manufacturers who earned revenue in foreign currencies worried that their yuan expenses would remain constant while the yuan values of their sales would fall. Banks were eager to help these factories hedge their currency risks, but because everybody in the world believed the yuan would appreciate, it was very expensive to hedge.

So the banks created some tricky products. One popular derivative would arrange payments every month between a bank and company. If the yuan had gone up from the start of the trade, the bank would pay the company. If the yuan had gone down, then the company would pay the bank. These monthly payments would continue for five years. But to make monthly payments more favorable for the company at the start, many banks gave themselves the right to terminate the derivatives earlier than scheduled. If the trade was hurting a bank, it could tear up the contract; if the trade was helping the bank, it could continue to profit -- and the company would have no choice but to continue losing money.

China Eastern Airlines is one notorious case of a perilous hedge. Quite sensibly, the airline bought derivatives that would pay if oil became more expensive. But to make the hedge cheaper in the short term, China Eastern agreed that if oil prices dropped past a certain point, then it would have to pay double what the bank would have to pay if the price of oil went up. After the oil bubble burst last year, the company admitted these derivatives cost them 6.2 billion yuan -- and obliterated their profits for 2008. Of course, China Eastern is a huge company with government support. Most small investors are not as lucky.

By most estimates, at least hundreds of these unnecessarily complicated derivatives remain on the books at Chinese companies. Many are linked to markets that could go haywire at any time. Chinese derivative holders would then face enormous costs that many can't afford. I would urge all companies that bought derivatives to pull the contracts from their files and read the fine print now. No one forced companies to buy these derivatives or accept the contracts the banks wrote. But the banks always knew so much more than the companies, and they exploited this advantage. In the end, I decided to leave on my own, to try to make the game fairer and bring derivatives back to their intended purpose. In a future article, I will explain how structural incentives in banks actually encouraged derivatives that were not right for clients. Derivatives in China didn't have to turn out this way.

Mushtaq Kapasi is president of Octagon Pacific, a structured finance consultancy.

Monday, May 25, 2009

Watch Out For Contango: Looking For The Best Long Term Oil Fund: USO, OIL, USL or DBO

By Perry H. Rod, Published: March 6th, 2009 8:48 PM PST

It's really very simple.

Go to any stock comparison chart today and compare the popular United States Oil Fund (USO), Barclay's iPath S&P GSCI Crude Oil Fund (OIL), or PowerShares Crude Oil Double Long and compare these to The United States 12 Month Oil Fund (USL) or PowerShares DB Oil Fund. You will find that USL and DBO outperform the rest in all long term charts - 3 months, 6 months, 1 year.

That's because of contango, the term used for the strategy of buying the front-month futures contract and rolling it forward, which is what all the major funds have to do in order to try and keep in line with current crude oil future contract trading.

Remember, oil contracts priced in the future are currently more expensive than current prices. As long as that is the case, when the current month's futures contract expires, these funds are forced to 'roll over' and pay a higher price for the next month's contract. Who pays for the difference? The long term investor of these funds who don't know any better. What makes it more extreme (and unusual) is that a major chunk of the futures contract volume is actually driven by the fund that's trying to follow the contract prices.

Did you get that? It's pretty ridiculous when you think about it: the index supposed to follow current crude oil prices actually drives the current price.

Assuming that all this is true, it is actually the longer term contracts that provide a more meaningful look into the value of oil. The current contracts go all the way to the year 2017, where traders currently predict that the price of oil will be $74 (that's, of course, laughable to those who believe we are hitting a period of peak oil around the world, even with the economy causing a drop in short term demand).

In any case, there are two oil funds that are superior in that they have already proven not to lose as much unnecessary dollars when rolling from one futures contract to the next, and yet they still follow the current price of crude: USL and DBO.

USL buys 12 months worth of contracts and rolls over all of them, which spreads out the contango and minimizes the effect of the price differential roll over between the current month and the next. DBO, on the other hand, uses management discretion, meaning they can basically buy and do whatever they want depending on what the current futures contract situation looks like. It has worked so far, as they are performing in line with USL, suggesting that they are also likely spreading their bets and buying 12 months worth of contracts.

I'm still waiting on a fund that focuses more on late date futures contracts only, but right now USL and DBO are the best available. In 3 months, 6 months and 1 year, USL and DBO have outperformed OIL and USO by around 10-20%. That's the price you pay when you buy USO or OIL.

Oil ETFs Like The United States Oil Fund: A Short Hedge Against The Market?

By Reggie Abaca, Published: 02/19/09 at 4:19 PM PST

With fewer people working in the United States, fewer people have been driving. It had been assumed that this would cause a new trend of falling consumption of oil, as was the case in the early 1980's. But hold on there. Oil prices shot up on Thursday after government data showed that oil inventories unexpectedly fell and consumption may be on the rise again.

This came right on the heels of unrelated reports that the religious right wing Of Israel will likely take control of Israel's government and Benjamin Netanyahu's Likud party will actually be the "moderate" wing of the newly formed hard-line government of Israel. That will be bad news for Iran and their government's ambitions, as there is now yet another report from the United Nations stating that Iran likely has enough uranium to form a single nuclear bomb. Israeli leaders have repeatedly stated that capability to be unacceptable. In fact, Mr. Netanyahu has stated that the Iranian issue is, for him, more important than the world's financial crisis.

Iran's main defense and threat against an Israeli attack would be oil disruptions through the Persian Gulf and beyond.

The combination of oil consumption not falling as much as expected and the prospect of a major war directly involving oil, is a potential recipe for a dramatic reversal of oil prices. Even the prospect of these combined possibilities is probably good news for crude oil futures traders and investors of exchange traded funds like The United States Oil Fund and Barclay's IPATH ETN. But what does it mean for the world markets overall?

Today's financial crisis and lack of investor confidence is so deep that there is widespread speculation that Bank of America and Citigroup are the "next" victims. But that might even be the tip of the iceberg. For several months, the only glimmer of hope has been cheaper energy prices. However, oil producing nations are actively trying to raise prices, and if oil were to significantly rise once more, could the world economy even sustain it without another dramatic leg down?

Forget shorting the exchanges. Many have forgotten that high oil prices seemed to have triggered the current global financial collapse in the first place. If it were to happen again, wouldn't our problems be multiplied? Many "peak oil" devotees even suggest that the issue could be much more pressing now, with new reports suggesting that Russian oil production - the second largest in the world - has fallen unexpectedly in 2008, possibly leaving Saudi Arabia with an increased future production burden for the world.

Just as it was in 2008, if 2009 is going to get any worse, you can bet that oil prices probably had something to with it

The Inevitable Future: Peak Oil and Socialism

By Reggie Abaca, Published: April 21st, 2009 1:13 AM PDT

The current economic malaise was triggered by falling home prices and aggressive lending practices, they say.

The other part of the story – where oil (OIL, USO, USL) prices shot up to $150 a barrel - has been largely ignored, for now.

But it happened.

Worldwide peak oil is not a theory. It has already occurred and the 2008 oil price shock represented the first real test of what can happen. The after effect of the sudden oil price rise was so devastating that it temporarily crippled the entire world and was the primary trigger to what would become a financial meltdown.

When oil shot up to $150 a barrel, producers had an amazing incentive to significantly increase production. But before they had the opportunity, the world economies fell, and oil consumption dropped. Crude oil prices fell to as low as one fifth of their peak price.

It may take some time for oil consumption to completely recover, but when it does, look out. This time around, financial companies were battered to a point where over three quarters of the industry’s value vanished. So what will be the next victim?

Today’s observer might say that the process of a changing world as a result of expensive energy is already well under way. When the middle class gets squeezed, they naturally turn to government officials who make the most promises. The United States is now led by a popular liberal president along with liberal representatives in the nation’s House and Senate. It is no accident and conservative critics may not be exaggerating when complaining about a move toward socialism.

Somebody needs to tell conservatives, however, that the move toward socialism is now inevitable. Just imagine today’s oil prices doubling or tripling on top of our current economic problems. The result would be rapid inflation and a people who are only more desperate, naturally turning to government officials who make the most promises. Those who make the most promises are those who will naturally ignore long term economic ramifications.

The result is not just a move toward socialism. It is a loss of opportunity for those who are not already wealthy. It is a different kind of America.

Texas energy specialist Matthew Simmons, has predicted that Saudi Arabia, which is by far the number one oil supplier to the world, is already experiencing peak oil production while Saudi officials mask the truth. Recent 2008 production numbers have suggested that Russia, the number two oil producer in the world, has just hit its peak. The question remains, how long will it take for the world’s oil consumption appetite to rise back up, putting pressure on oil suppliers to keep their promises that they can meet demand? Unlike the early 1980’s, when consumption did not pick up for several years, China, India and emerging markets have been experiencing a robust and renewed industrial revolution of their own, fueled by population growth and improved technology. You can see the result in the air quality of those respective nations.

If a dramatic rising price of oil is indeed inevitable, as evidence suggests, the greatest victim may be the United States middle class, who for so long have enjoyed a special status in the world. The cruel reality is that the precious American dream will likely really just be a dream sometime in the future. If oil were at $150 barrel today in this environment, it would already be a dream.

But let’s hope those Saudi monarchs are honest thoughtful individuals who are telling us the truth about their oil production capabilities.

But don’t get your hopes up.