Doctored Up

10/21/2022

When I was growing up, food was not wasted. If food was on your plate, you were told, “you better clean your plate.” Any food that was prepared but not served was kept as “leftovers.” My mother was a master at reworking leftovers into a different meal the next night. My father described a meal that had gone through my mother’s process of transformation as “Doctored Up.’ He would often ask her what she was going to add to make the new dish as tasty, if not tastier, the second time around.

We have recently seen unusual securities put enormous pressure on the global financial markets. If my father was still around, he might be asking what had been done to ‘Doctor Up’ these securities to create such a market shock.

We are familiar with investing in traditional investments like stocks and bonds. The ‘investment engineers’ in financial centers around the world have also developed a variety of other investment products that are known as financial derivatives. These products tend to be complex. Investment in them can be very risky, especially if the investor does not fully understand all the risks involved. 

Derivatives are securities that my father would describe as ‘Doctored Up’ to look and taste better to an investor. For example, by adding additional leverage and multiple layers of options to traditional investments, the end product is made to appear more attractive to an investor. However, such a product will usually carry new and greater risks.

The major instability which occurred in the UK markets recently was a direct result of some ‘Doctored Up’ bonds in which UK pension funds had invested. Known as Liability Driven Investments (LDI), these products had been designed to help match the assets and liabilities of the pension funds, so there was no risk of a shortfall in the money needed to pay pensioners. As interest rates rose, pension funds holding LDIs had to post collateral as the LDIs lost value. The pension funds struggled to find the cash, so were forced to sell their UK gilts (the equivalent of our Treasuries). This put significant downward pressure on the bond market, and panic ensued. The panic not only roiled the markets, but indirectly led to the recently selected Prime Minister losing her job.

The events in the UK are a timely reminder of the pervasive use of derivatives in the global markets. When markets turn, these securities, with their complicated and often poorly understood risks, can shock market participants. The derivatives market is huge. One global bank with a balance sheet of over $3 trillion of traditional assets has also facilitated derivative transactions on behalf of its clients to the tune of over $15 trillion. Those assets are carried as off-balance sheet items.

I am not sure anyone truly understands the complexity of the ‘Doctored Up’ risks in the derivatives market. I recall, though, that while most of my mother’s ‘Doctored Up’ dishes were wonderful, a few were just plain awful.

Carl Gambrell