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Friday, April 30, 2010

Deriding derivatives

When I was in basic training at Ft. Carson, payday occasioned some marathon crap games for a few days.   I did not play, but the games attracted my interest because of a man in my outfit, who did not play either, but made side bets on the rolls of those who did play,  This man had just graduated from law school, passed a bar exam, and was headed for the adjutant's office as soon as he completed basic.  Because he had an incipient ulcer, he was exempted from some of the more strenuous training.  I noticed him sitting on his bunk for long periods of time shuffling through a set of flashcards.  They were cards that contained the probability formulas for various sequences of dice rolls.  He had these flash card sessions to keep the odds for certain roll sequences at the front of his mind.

After the crap shoots, he always had a huge amount of cash.  I and some of his other friends would accompany him to the secure mail box outside the post office because there were people who knew how much money he was carrying, some of whom were pretty pissed-off because some of it was originally theirs, and would not mind getting it back.  He would mail brown envelopes containing two to three thousand dollars home to his wife.  At that time, buck privates in basic training were paid about $63 a month.

When the SEC announced its suit against Goldman Sachs and the Senate held hearings,  I immediately thought of my old army buddy.  Goldman Sachs was doing essentially what he was doing,  They were making side bets on other peoples' plays in the futures market.  Some people were investing in groups of mortgages.  Then Goldman Sachs would make bets on whether those investors would lose their asses on a bad investment, just as my old army friend would bet on bad crap-shoot bets.  It is gambling no matter what technical sounding names they give it.    And when people know the odds that bets being made by investors--or crap shooters--are pretty sure to lose, they tend to win mightily.

I was a farm and business editor when the Chicago Commodities Exchange started dealing in futures markets.  The idea of a futures contract was that a farmer could buy a contract to deliver his corn harvest at a certain price in October, for example.  The advantage was that he could lock in a price and did not have to worry about the ups-and-downs of the market.  If the market went down in October, he got the price he bargained for, which could be better than the market price at the time.  If the price went up,  he might get less for his corn than the prevailing price on the actual market.  That was the idea on which the futures market was established.

However, very few farmers bought futures contracts.  Most preferred to gamble on the actual market price for their corn, and they would either sell at harvest time or store it to see what the prices would do.  The people who bought and sold futures contracts were mostly speculators, sometimes called day traders, sometimes called gamblers.  They kept track of agricultural  production forecasts, weather trends, and foreign markets, and spent the day buying and selling futures contracts.

Another commodity that was wildly traded was pork belly futures.  At the time that the futures market was established for commodities, the Chicago stockyards were being closed and packing houses were decentralized throughout the country.  The futures contracts provided the packers with a means of scheduling a constant supply of pork at a known price.  Regional livestock auctions took the place of stock buyers at the old stock yards.  One in my region began to get complaints from packers to whom he had scheduled shipments that kept coming in late.  They found that he was buying  futures contracts and then delaying shipments on hogs to the packers.  When the packers reported that their supplies were a bit short, this showed up in the daily livestock reports and the futures traders would take it as a sign of a demand market and offer to buy futures contracts at high rates.  The auction operator would then sell his contracts to them and make a profit.  And then ship the hogs, which would get reported as an abundant market.  These manipulations took only a few days.

When the man's ploy was discovered, new rules were put in place, but he had made quite a bit of money by then.  He was side-betting on other people's hedges or bets and then manipulating the market.  He kept on playing the futures market, but his strategies were no linger as apparent and he continued to make money. 

Derivatives are essentially side bets on someone else's throw of the dice.  It is pure gambling, but some people, like my old army buddy, had developed ways to know the odds on what would fail.   So did that auction-house operator.  One cannot help but wonder if Goldman Sachs also found a way to manipulate the market or tabbed sure losers and bet on them.

This is pure gambling, and when it is referred to as casino banking, the term is right on. 


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Aberdeen, South Dakota, United States