Wednesday, March 25, 2009

Diamonds Are No Longer Forever

Responding to the global recession in late February, De Beers’ once mighty diamond cartel closed down about half its global production, including Orapa Number 1 in Botswana, the world’s biggest diamond mine. The immediate problem was a nearly 25 percent drop in prices in December. But De Beers’ fear is not just that retail prices will continue to decline - it has managed that problem before - but that the public will begin to sell its hoard of diamonds, or what is called at De Beers "the overhang."
At the heart of this concern is the reality that, except for those few stones that have been permanently lost, every diamond that has been found and cut into a gem since the beginning of time still exists today. This enormous inventory, which overhangs the market, is literally in - or on - the public's hands. Some hundred million women wear diamonds, while millions of other people keep them in safe deposit boxes as family heirlooms.
De Beers executives estimate that the public holds more than 500 million carats of gem diamonds, which is more than 50 times the number of gem diamonds produced by the diamond cartel in any given year. The moment a significant portion of the public begins selling diamonds from this prodigious inventory, the cartel would be unable to sustain the price of diamonds, or maintain the illusion that they are such a rare stone that their value is, as the ad slogan claims, "forever."As Harry Oppenheimer, who headed the cartel for more than a quarter of a century, pointed out, "wide fluctuations in price, which have, rightly or wrongly, been accepted as normal in the case of most raw materials, would be destructive of public confidence in the case of a pure luxury such as gem diamonds, of which large stocks are held in the form of jewelry by the general public."The genius of the cartel was creating this "confidence" in the myth that the value of diamonds was eternal. In developing a strategy for De Beers in 1952, the advertising agency N.W. Ayer noted in a report to De Beers: "Diamonds do not wear out and are not consumed. New diamonds add to the existing supply in trade channels and in the possession of the public. In our opinion old diamonds are in 'safe hands' only when widely dispersed and held by individuals as cherished possessions valued far above their market price."In other words, for the diamond illusion to survive, the public must be psychologically inhibited from ever parting with their diamonds. The advertising agency's basic assignment was to make women value diamonds as permanent possessions, not for their actual worth on the market. It set out to accomplish this task by attempting through subtly designed advertisements to foster a sentimental attachment to diamonds that would make it difficult for a woman to give them up. Women were induced to think of diamonds as their "best friends."This conditioning could not be attained solely by magazine advertisements. The diamond-holding public, which included individuals who inherited diamonds, had to remain convinced that the gems retained their monetary value. If they attempted to take advantage of changing prices, the retail market would be chaotic.
Even during the Great Depression of the 1930s, there was only a limited overhang, since the mass-marketing of diamonds had begun only a single generation before the crash. So even though demand for diamonds almost completely abated, De Beers, by shuttering all its mines and borrowing money to buy up the production of the small number of independent mines that still existed, was able to weather the crisis.Today, however, with many generations of the diamonds it mass-marketed overhanging the market, and most of global diamond production in independent hands, it no longer is in a position to bring supply and demand into balance. Adding to this precarious situation, diamond cutters, manufacturers and dealers, have, as of Feb. 15, an estimated $40 to $50 billion worth of diamonds in mines in the pipeline that will intensify the downward spiral when the gems reach the market later this year.If the current recession so deepens that the desperate need for money trumps the tenacious grip of sentiment, and the public begins selling even part of its hoard, it could finally shatter the brilliantly nurtured illusion that the value of the glittering stones kept on fingers, in jewel boxes, and in vaults is eternal. As the overhang came pouring into the maket, De Beer's nightmare could become a reality.

Friday, March 20, 2009

Sympathy For The Devil: Why AIG Had No Choice But To Pay

If you want to understand why AIG awarded derivative traders in its Financial Products Group $165 million in bonuses, don’t be distracted by the on-going morality play staged by politicians about the misuse of Federal funds, the blame-shifting game played by AIG executives, or even the disingenuous hand-wringing about the sanctity of contracts. The real decider here is money, specifically, $1.6 trillion worth of volatile derivative contracts. This portfolio, managed by some 400 people in a London-based subsidiary , mainly consists of credit default swaps, interest rate swaps, and other exotic hedging swaps that have the potential of inflicting hundreds of billions of dollars of losses on AIG– and, its de facto partner, the US tax payer.
How did the world’s largest insurer become a hostage to its subsidiary? In 1998, this tiny group got into the newly-created credit default swap business when JP Morgan Chase came to it with a proposition to transform debt on its books into security packages that could be sold off its books. To make these bank debt packages salable to other institution, they needed credible insurance against default to get Triple-A rating. So the AIG financial product group, seeing no risk of default, sold it in the form of credit default swaps. Soon afterwards, with the support of Treasury Secretary Lawrence Summers (now President’s Obama’s economic advisor), the Commodity Futures Modernization Act was passed, which excluded credit default swaps from being considered a "security" under the jurisdiction of the SEC or any other government agency. This act allowed these swaps to be deployed on a massive scale to convert all kinds of debt, including even subprime mortgages and car loans, into triple A securities and turned AIG’s arm, now headed by Joseph J. Cassano, an aggressive Brooklyn-born alumni of Drexel’s back office operations, into a multi-billion dollar profit center for the insurance behemoth. Even though the unit’s 400-odd man group constituted less than one-third of one percent of AIG’s total employees, it produced close to twenty percent of its total operating profits. While Cassano kept the list of his counterparties in the credit default swaps a closely held secret, he bragged at a conference in 2007 that they included a global swath of "investment banks, pension funds, endowments, foundations, insurance companies, hedge funds, money managers, high-net-worth individuals, municipalities and sovereigns and supranationals." One of his more complicated operations involved using a subsidiary called Banque AIG to provide the largest banks in France with custom-tailored swaps that effectively allowed them to evade regulatory capital requirements on hundreds of billions of debt on their books. By 2006, his group was raking in nearly $4 billion in profits, and, as is the tradition in the derivative game, he and his traders got a rich cut of the loot, which on average amounted to roughly $440 million (or about $1.1 million per employee)..
With the collapse in 2008 of the debt AIG was insuring, came such massive losses that Cassano resigned, and AIG, unable to post collateral, faced bankruptcy. At this point in September 2008, the US government rescued AIG, pouring in $173 billion of tax payers’ money. Even so, there remained a $1.6 trillion in potential liabilities that could be triggered by thousands of the credit default and other derivative contracts. To prevent hundreds of billions of losses, these custom-designed contracts, , many of which would not expire until 2012, had to be continually watched, and, if necessary hedged, by traders who understood each one’s particular vulnerability.
. To perform this critical task, key people in the group wanted the same sort of guaranteed compensation in the form of retention bonuses as had in their previous two year contracts. The situation for AIG, and the US government that now owned 77 percent of it, was not unlike the one in Mario Puzo’s Godfather in which an offer is made that cannot be refused. In this case, even without a bloody horse head under the blankets, AIG and its federal overseers could not risk falling into a $1.6 trillion black hole by turning down the demands of those in the financial product group. It was not that they had such unique skills in derivative contracts that they could not be replaced by other people since the managing of these contracts is not overly complex. It is that they knew a proprietary secret, to wit, AIG’s secret book, which included the identities of all the counterparties to the credit default swaps and the unhedged parts of the positions vulnerable to price fluctuations. In addition, replacing some of these operatives in the complex of arcane subsidiaries it had set up technically constituted a change of control and could trigger defaults. For example, as it explained in a secret memo to the staff at the U.S. Treasury in February 2009, just the resignation of two of its Banque AIG executives, Mauro Gabriele and James Shephard, could set in motion renegotiations, and possible defaults in $234 billion in its European derivative contracts with banks. So even key people who had resigned, such as Cassano, were kept on as consultants at fees of up to $1 million a month. The implicit threat was that, if they were simply let go, not only would it cause havoc with the status of the derivative contracts but that traders would be in a position to use the secrets to which they were privy to trade for others against AIG as it attempted to protect the positions in its $1.6 trillion dollar portfolio. Under these circumstances, rather than risking immense losses from having its secret book compromised, AIG paid to keep the key members of the group from defecting. Their compensation, when approved by the Fed and Treasury, would amount to about $500,000 per person a year ( less than half what they had been getting in 2008.) The staff at the NY Fed, while Timothy Geithner was still its head, in fact helped negotiate the terms for these retention bonuses. When Geithner moved on to become Treasury Secretary in January 2009, he presumably understood how financially dangerous it could be to do otherwise, since he intervened with the Senate Banking Committee Chairman in February to get a provision dropped from a bill that would have prevented AIG (and other recipients of federal money) from paying such huge bonuses. In fairness to Geithner, the alternative to making these pay-offs might have proven a thousand times more costly to AIG, and its defacto owner, the US Government. Washington, after all, is ruled by pragmatism, and what difference is there between AIG paying $165 million to the derivative traders who caused the havoc, and the Fed rewarding the rating services that made possible the proliferation of trillions of dollar of toxic debt with $1.2 billion in fees to rate the new debt under its TALP plan to restore the credit markets damaged by its old Triple A rated toxic debt?

Sunday, March 01, 2009

Buffet Versus The Hedge Funds

Warren Buffet’s holding company, Berkshire-Hathaway, finally released its numbers on Saturday (February 28, 2009) which showed that it had the largest decline in its book value in its history. But even before this bad news was announced, hedge funds were massively shorting not Berkshire Hathaway itself but the publicly-traded companies in its $50 billion portfolio. Their bet was that Buffet would be forced to dump the stock of these companies was based largely on his vulnerability to massive losses on derivative contracts, including credit default swaps. It turns out that even while Buffet was denouncing derivative contracts as "financial weapons of mass destruction" and " time bombs", he was amassing one of the world’s largest position in them. For example, he sold derivative contracts on four stock market indexes– the S&P 500 in America, the FTSE 100 in the U.K., the Dow Jones Euro Stats 50 index in Europe and the Nikkei 225 Stock Average in Japan– for $4.9 billion that expose his company to over $35 billion in losses. In 2008 alone these contracts had lost on paper nearly $10 billion and with the market in free fall in 2009, they lost another $3 billion. Indeed, each percent these indexes decrease adds another $350 million to the loss Berkshire Hathaway is liable for. He also sold more than $2/4 billion worth of the infamous credit default swaps, not unlike the ones that brought AIG down once it lost its triple A rating. Such contracts insure that companies will not default on their debt. In addition, Berkshire Hathaway subsidiaries sold derivative contracts on energy for "operational purposes."
Although even the multi-billion dollar paper losses on these derivatives don’t require Berkshire Hathaway to put up money to guarantee payment to its counterparts, they weaken its balance sheet. And since Buffet prides himself on maintaining a "Gibraltar-like financial position," the hedge funds are gambling Buffet will protect Berkshire Hathaway balance sheet– and its triple A rating– by selling part of Berkshire Hathaway’s portfolio. If that happens, they expect to profit in their short sales from the plummeting prices. Whether or not their play succeeds against Buffet, remains to be seen.