Don’t Get Duped by Derivatives

Article of the Week from Money Morning

by Martin Hutchinson, Global Investing Strategist, Money Morning

It recently came out that a $1.2 billion derivatives portfolio that Goldman Sachs Group Inc. (NYSE: GS) managed for the Libyan government lost 98.5% of its value between 2004 and June 2010.  If a firm like Goldman will sit idly by while a client eats about $1 billion on a single investment, where do you think you and your portfolio land on Wall Street’s list of priorities?

The message here is simple: You can’t trust Wall Street – not with a $10,000 investment, a $100,000 investment, a $1 million investment, and especially not with $1 billion investment.  Goldman Sachs claims that the Libyans were picking the derivatives trades themselves. But that’s exactly what they would say.After all, if it got around that Goldman’s ace traders were capable of losing virtually all of their clients’ money, bonuses would fly out of the window along with most of the business. I’m sure the Libyan government would have offered a rebuttal if it weren’t being toppled in a civil war.

The Libyans no doubt did much of the investment decision-making themselves, but the real problem is that there was no basis of comparison for the prices of the derivatives products they were being given.

And that’s where there’s a lesson to be learned. As a retail investor, you have to be able to determine a two-way price quote for whatever investment you buy.

The investment landscape is littered with the wreckage of failed structured investments.  Between 2008 and 2010 already-strapped cities and states had to pay Wall Street $4 billion in termination fees to get out of various interest rate products that had gone wrong.

For example, there’s the exciting 2007 “Abacus” deal by Goldman Sachs trader “Fabulous Fab” Tourre, which lost European banks a total of $1 billion.  The investors in Fabulous Fab’s Abacus deal had no independent means of assessing the value of the subprime mortgages in the pool. These were large, “sophisticated” banks, but they deluded themselves with the risk/reward tradeoff they were taking on.

Losses are not confined to the notoriously murky derivatives investments, either. I would bet that the special Goldman clients who earlier this year bought privately offered shares of Facebook Inc. at a $60 billion valuation will end up losing big on their investment as well.

As investors, most of us are not rich enough to get Wall Street’s attention, but we should stay informed about how these firms are luring their clients into spectacularly bad deals.

That way we’ll all know what to avoid.

How to Avoid Becoming Wall Street’s Next Victim

The key to combating Wall Street’s bad deals is price transparency.

It’s no accident that Wall Street’s most profitable products are various types of derivatives, which are not traded over an exchange and whose prices appear only on traders’ screens. Complex structured products are even more profitable since no price at all appears in these.

Additionally, as we saw with Facebook, private companies do not have to give full financial information, and there are no comparables on which their pricing can be based.

So, generally speaking, you should stick mostly to publicly traded stocks.

Short-dated stock options are okay. They have a broad price spread, but that spread is quoted on many financial Websites. So is the “open interest,” which gives you an idea of how many buyers there will be for the option when you want to sell.

When it comes to longer-dated options, stick to those on a highly liquid index, such as the Standard and Poor’s 500 Index. Prices for many of these options are quoted out to December 2013 on the Chicago Board Options Exchange Website.

Bonds pose an even higher level of difficulty because bond price comparisons are harder to find. Still, if you stick to regular investment grade (BBB-rated and better) bonds of large corporations you can’t go too far wrong. But remember, the rating agencies are not very good at rating governments, and many highly rated governments (such as our own) have gone mad with borrowing in this recession, so it’s better to avoid government paper.

As for junk bonds or emerging market bonds, you are already in a realm where price information is hard to come by, and Wall Street brokers know far more than you do about what’s going on.

Of course, “structured products” are the broker-sold investments that you should avoid at all costs. These deals give you part of the upside on a stock portfolio, but no downside except when the market falls more than, say, 50%. These instruments are always designed to be super-profitable for the brokers, making them above-normal commissions.

You don’t have to be a fanatic believer in efficient markets (I’m not) to realize that if the commissions and profits for Wall Street are extra-large, then the deal for you as investor is extra-lousy. So tell the broker to get lost.

As retail investors, we are the least important people in Wall Street brokers’ lives. So ripping us off is highly attractive, provided it doesn’t land them in jail. Of course, if a dopey billion-dollar Libyan fund comes by, that may be easier pickings.

Be warned!

News and Related Story Links at Money Morning:

It’s Time to Bail on Bank Stocks

Rogue Trader Costs Societe Generale $7.2 Billion

Inside Wall Street: The Real Reasons the U.S. Banking System Lost its Way

The Only Way to Solve the European Sovereign Debt Crisis

How to Protect Yourself From the Collapse of Treasury Bonds

Related Article at GEI

The Alchemy of Securitization by John Lounsbury