When you buy a “future,” you’re actually making a third kind of investment that’s neither debt nor equity. That is, nobody owes you money, and you don’t really own anything yet. What you’ve bought is one type of those allegedly supercomplex and supposedly ultradangerous items called derivatives.
You remember how in 1995 a semieducated young wanker in Singapore, fiddling with derivatives, brought England’s noble, ancient Barings Bank to its knees, and now everyone in the House of Lords is selling fish and chips. And you heard how in 1994 the treasurer of Orange County, California, picked up a derivative hitchhiking on Sunset, drove around the corner for a little fiduciary slap and tickle, and the next morning an entire suburb of Los Angeles awoke to find that its streets and sewers had been sold at a bankruptcy auction.
Considering the way things turned out for England, Orange County, and you in the commodities market, derivatives do seem daunting. But, in fact, all that the three of you did was make deals with other people in the market.
A derivative is a deal about buying or selling rather than the buying or selling proper. When you own a derivative, what you own is a bargain that you’ve made. You’ve promised to pay or charge a certain price for a certain thing to be received or delivered at a certain time. Where it gets confusing is that this promise itself can now be bought and sold.
Derivatives are so-called because they “derive” their value from other more straightforward investments, such as just plain owning cows, Orange County, Singapore Slings, or whatever. These things are known as the underlying commodities. The derivative is the deal. The underlying commodity is what the deal’s about.
Derivatives are risky. But risky is the point. Derivatives are a way to buy and sell risk. Big risks mean big rewards. Some people can afford more risk. Some people like more risk. And some people are as chicken as I am.
You’re into derivatives whether you like it or not. Your adjustable-rate mortgage is a derivative: You got a deal on a loan that was cheaper, at that time, than a fixed-rate mortgage. In return, you’re taking a risk. Your risk is that the amount of interest you’ll pay in the future will be derived from a formula involving the prime rate, T-bills, and the chairman of Chase Manhattan’s boxer-shorts-waistband size. In this case, the underlying commodity is banker fat.
Now that we've become experts on every kind of investment, we can figure out what the triumph of free-market capitalism really means. What it means is euphoria and panic. If investments are okey-dokey, we’re all making a fortune selling Pfizer shares to each other. Convenience stores put twenty-dollar bills in the TAKE ONE/LEAVE ONE tray. The World Bank gives toasters to Africa. If investments are not-so-hotso, we throw up our hands and declare bankruptcy. Jobs get so scarce we have to pay to baby-sit for other people’s kids. And the Salvation Army goes up and down the Bowery taking soup back from bums.
The investment business is based on people being able to do what they want with their money. They may want to do some odd things. “People put their money where their thoughts are,” said one investment banker I interviewed. This means that there are a lot of men who are, so to speak, in financial topless bars, sticking millions of dollars into the G-strings of lap-dancing debts and equities. “If a thing can move freely, it can move stupidly,” said another investment banker.
This is how booms and busts develop in the marketplace. And these booms and busts can have larger consequences, such as in 1929 when stocks were crashing, banks were collapsing, and President Hoover was hoovering around. Pretty soon, you could buy the New York Central Railroad for a wooden nickel, except nobody could afford wood. People had to make their own nickels at home out of old socks, which had also been boiled, along with the one remaining family shoe, to make last night’s dinner. So the kids had to walk to school with pots and pans on their feet through miles of deep snow because no one had the money for good weather. My generation has heard about this in great detail from our parents, which is why we put them in nursing homes.
Our own kids will probably be shunting us off to the senior care facility when we start telling them about the Asia crisis. Back in 1997 there’d been a bull market in stocks since the apatosaurus roamed the earth. Inflation scares were limited to newspaper stories about silicone breast implants. The unemployment rate was so low that if your dog wandered into a McDonald’s, it would wander out wearing a TRAINEE badge. And Asian economies were even stronger than ours. They had some kind of “Asian values” thing going on, involving hard work, thrift, respect for the family, and fortune cookies that read, “Confucius say: Do your homework.” Plus, countries in Asia had smart government policies, such as “Export everything.” The world was getting calculators, stereos, and VCRs. Asians were getting rich. Everything was wonderful.
Then somebody attacked the baht. Currency traders snuck up behind Thailand’s legal tender and stabbed it with a chicken-satay skewer. They hit it so hard, it thought it was a Mexican peso. They tore it into little pieces, wadded them up, and started a huge spitball fight on the Bangkok stock exchange that caused all of Thailand’s stocks to go running home to Mother.
What the traders really did to the baht was sell it. Investors in international currency markets started looking at Thailand’s economy. Maybe the world had as many calculators, stereos, and VCRs as it wanted. But the Thais were borrowing money overseas to produce more—borrowing so much money that Thailand had a balance of payment deficit even though it was exporting everything. Some of those smart government policies turned out to include, “You’d better loan money to a certain general’s son if you’re smart.” Thais couldn’t buy calculators, stereos, and VCRs—they’d all been exported—so Thais bought overpriced real estate and cockeyed stock issues. Thailand had risky debt, bad debt, and worse equities. Maybe owning baht wasn’t such a good idea.
Currency traders sold baht. The government of Thailand bought baht, using the foreign currency it had from exporting calculators, stereos, and VCRs. Thailand did this to keep the baht from being “devalued.” Devaluation simply means admitting that your currency is worth less compared with other currencies, but no government likes to do it. When a currency is devalued, imported raw materials—stereo ore and barrels of unrefined calculator numbers—become more expensive. Inflation rises. Foreign investments—VCR farms—lose value. Stock prices fall. Everything goes in the toilet.
The whole 1970s experience in America was essentially the story of the dollar being devalued. We can’t blame the Thais for wanting to avoid a situation that could lead to disco and Jimmy Carter. Anyway, currency traders were glad to sell baht, so they sold some more. Aggressive currency traders even sold baht they didn’t own. They borrowed baht to sell, hoping to repay the loan later with cheaper baht. (This is called selling short. You can do it with stocks or, for that matter, with the car you borrowed from your neighbors, if you think you can pick up the same Saab for less before they get back from the Bahamas.) Traders figured that eventually the Thai government would run out of foreign currency. The Thai government ran out of foreign currency. Everything went in the toilet.
When the currency traders were done with Thailand, they started looking at other economies in Asia. Maybe owning Indonesian rupiah, Malaysian ringgit, and South Korean won wasn’t such a good idea, either. Malaysian prime minister Mahathir Mohamad blamed the ringgit’s devaluation on “Jewish speculators.” (You may remember how everyone in New York was going around saying, “Oy vey, sell the ringgit.”)
By October 1997, the currency-dumping spree had reached Hong Kong, and, although the Hong Kong dollar wasn’t devalued, the Hong Kong stock market took a TWA Flight 800. The Hang Seng index fell 1,211 points on October 23, with its shares losing $42 billion in value. This scared the pants off the Japanese market. The pantsless Japanese shocked the European markets, which took it out on the markets in Mexico and Brazil (on the theory, I guess, that undercapitalized wogs are undercapitalized wogs no matter where you find them). By Monday, October 27, the terror had reached
the New York Stock Exchange. The Dow Jones Industrial Average went down 554 points because…because everyone else was doing it. It was the largest dollar decline in history and the largest percentage drop in ten years.
Then the market recovered. “Monday was very, very scary,” said David the floor broker. “We were worried about Tuesday. But after the Tuesday rally started, it was all forgotten.”
It turns out that on October 28, the American economy was still there. None of America’s factories or malls had been abducted by space aliens. American workers hadn’t forgotten how to flip burgers during the night. The market soared.
But was this just a “dead-cat bounce”? On Wall Street, they say—“Even a dead cat will bounce once if it drops from high enough.” The market skidded.
But Asian devaluations could be good. Imports will be cheaper. Inflation will stay low. The market jumped.
But Asian devaluations could be bad. Exports will cost more. Trade will suffer. The market plummeted.
What if Japan gets dragged down? The market plunged some more.
Who cares? All we sell Japan are Seinfeld reruns. The market leaped.
What about China? The market slid.
What about my beach house? The market bounced back.
“We’re rich!” I told my wife. “Get a Range Rover and a pasta machine!”
“We’re poor!” I yelled. “Sell the dog.”
“We’re rich again!”
“We’re poor.”
“We’re really poor.”
“Rich! Rich!”
“Poor! Poor!”
And on like that for several weeks, until my wife pointed out that our entire investment portfolio consists of ten shares of Eastern Airlines inherited from my uncle Mel.
The investment industry creates euphoria and panic. It moves astonishing amounts of cash around the world at startling speed with shocking results. Then it pays itself fantastic amounts of money. Companies registered with the United States Securities and Exchange Commission charged their customers $27.8 billion in brokerage fees in 1996. They made $30.7 billion trading for their own accounts, $12.6 billion underwriting stock issues, $10 billion selling mutual fund shares, and $84.3 billion doing things classified as, to use a technical SEC term, “other.” People on Wall Street don’t consider themselves seriously employed unless they’re “making a phone number.” Kids fresh out of business school are building indoor golf courses and dating Anna Nicole Smith. There’s an old stock-market joke about your investments: “The broker made money. The firm made money. Two out of three’s not bad.”
Is the investment industry just a bunch of pirates in neckties?
“Most of them are,” said a sales representative for a brokerage house.
“What makes you think they’re not?” said a financial analyst.
“I wish,” said a man who manages $2 billion of other people’s money. He was staring morosely at the yard-high stacks of annual reports and research materials on the credenza next to his desk. “I was out of town for two days,” he explained. “My secretary FedEx’ed me some other stuff.”
“The work hours are horrible,” explained the Irish specialist broker.
“Tons of hours. It takes speed, concentration. There’s a big burnout factor. A lot of ‘I want a life.’”
But the same can be said of delivering Domino’s pizzas. The professionals in the world of money seem to make so much of that money themselves. How can anybody justify the size of the paychecks?
“I don’t,” said the $2 billion money manager.
“I can’t defend it,” said David the floor broker.
“They shouldn’t be making it,” said the specialist.
Why do we put up with this? The whole business of international finance is dumbfounding. These damn business cycles—we don’t know whether to lie around the Riviera, clipping the coupons on bonds, or sit around the kitchen table, clipping the coupons in newspapers. Investments cause us to act silly. One minute we’re loading our possessions on top of the Ford and fleeing the dust bowl. The next minute we’re buying dust futures on the Chicago Commodity Exchange.
This shit-shower of money flying around the world…This fiscal El Niño blowing certificate-of-deposit droughts to one place and no-load mutual fund floods to someplace else…These cash storms lofting Hindenburg high-techs into the sky…These speculatory lightning strikes sending transportation and utilities down in flames. What’s in it for us?
We ordinary toilers at the cubicle farm: Why don’t we rise up? Why don’t we get rid of the capitalist system and replace it with something that’s nicer and more predictable, and gives everybody an even break? “What,” I asked all the Wall Street people I interviewed, “does the investment industry give to society?”
But this time they had an answer.
“Liquidity,” said the $2 billion money manager.
“Liquidity,” said the investment banker who’d described how men’s thoughts were on pecuniary B-girls.
“Liquidity,” said the other investment banker who’d told me things could move stupidly.
“Liquidity,” said the Irish specialist broker.
“It provides liquidity,” said David.
Liquidity is the Wall Street word for having things you can do with your money and being able to do them. Liquidity is the essence of the free market. Men with more time to explain themselves might have said something like, “We hold these truths to be self-evident, that all men are created equal, that they are endowed by their Creator with certain unalienable Rights, that among these are Life, Liberty, and Ka-ching!, Ka-ching!, Ka-ching!”
If we’re going to have freedom and the money to enjoy it, we have to put up with the stuff in this chapter. At least that’s what the people who run the stuff in this chapter say. Which brings me to the only reason anybody ever reads a chapter like this: What should you do with your money?
And I actually happen to know. In the course of researching the investment industry, I had drinks with Myron S. Scholes and Robert C. Merton, who had just won the 1997 Nobel Prize in economics. They won the Nobel by creating a mathematical formula for pricing derivatives.* They’ve made a pile of money Sir Edmund Hillary couldn’t climb. And they are two of the smartest people in the world—the Nobel committee says so. I asked them what you should do with your money. (Actually, I asked them, “What I should do with my money” but…) They said the same thing: “Asymmetrical information.”
You should trade on asymmetrical information. The commodities-selling ranchers counting their calves, the Burger King executives calculating their burgers—these are examples of asymmetrical information. When somebody in a market has (or thinks he has) information that the rest of the people in the market don’t have, that’s asymmetrical.
There wouldn’t be much of a market otherwise. If everybody believed what everybody else believed, everybody would set the same price on everything. The middle-aged men on the stock-exchange floor could quit hollering and go have lunch. The Wall Street Journal would become The Wall Street Shopping Mall Giveaway.
Asymmetrical information shouldn’t be confused with “inside information” because it’s exactly the same thing. Inside information is just the part of asymmetrical information that it happens to be illegal to use. If you’re a highly placed executive at Seagram and know about the upcoming Disney takeover and the new Scotch-and-Water Park, you can’t buy Disney stock in anticipation of the premium that Seagram is going to pay for Disney shares. But if you’re the janitor who empties the highly placed executive’s wastepaper basket, and you know that scotch tastes terrible with inner tubes in it and that drunk people in mouse suits are not to be trusted, you can do anything you want.
The problem is, you aren’t either of those people. And neither am I. This is why we shouldn’t be investing in stocks. We should invest in mutual funds. Mutual funds have multitudes of ex-indie-filmmaker M.B.A.s searching out asymmetrical information.
The problem is, there are too man
y M.B.A.s discovering the same asymmetrical information, which makes the information all symmetrical again. This is why we should invest in index funds.
The problem is, index funds contain the same stocks that make up the Dow Jones Industrial Average or the like. Index funds will go where the stock market goes. And where the hell is that?
This information is so asymmetrical, nobody knows it.
(What you should really do with your money is watch me. That is, watch what the baby boom does. We baby boomers have caused everything since 1946. We’ll keep buying stocks until we retire. But when we hit sixty-five, we’re going to sell stocks. And the stock market is going to go down. And we’re going to wet ourselves. The math is simple: 1946 + 65 = 2011. Buy stocks until 2011, and then buy Depends.)
There are alternatives to the free market. Congress could pass stricter investment-industry regulations, more orders and directives like the New York Stock Exchange’s rule against running. Investment-industry professionals probably hate all those limitations. Except they don’t. “I think the mix is perfect,” said David. “The rules are rigid and strict.”
“There are things you take for granted in our market—rule of law,” said the B-girl investment banker.
“It’s mostly disclosure rather than regulation per se,” said the move-stupidly investment banker.
SEC requirements and NYSE bylaws are there to make sure that investment trading is fast and confident and the O. J. jury doesn’t have to be brought in every time somebody says “at” instead of “for.” These kinds of restrictions aren’t concerned with how much money goes to which place, just with how it gets there.
On the other hand, we could have the government take over the investment industry. The government would consider what’s best for us all. If Americans wanted to buy stock, the government might, for example, look at the Coca-Cola Company. Coca-Cola was selling for $1.54 a share in 1982, and, as of mid-1998, it went for $78. That would have been a good buy. But Coca-Cola is not a product that provides social benefits. It causes cavities, is a factor in the increasingly dangerous nationwide obesity health threat, and contains caffeine, which harms fetal development in unwed mothers. The government would buy shares in the Studebaker corporation instead.
Eat the Rich: A Treatise on Economics Page 5