Derivatives Reform - Where are the Regulators?

There's been a lot of talk lately about taking a more proactive role in regulating derivatives.  Well, I received a brazen email last night which illustrates that such derivatives are still being marketed unabashedly, with no shame and no regulation.

The email was from Harrah's, for their Buffet of Buffets.  Now, obviously, we know what a buffet is - you go and stuff your pie hole until you can't walk, for an affordable price.  A "buffet of buffets," however, is a dangerous derivative, designed to do irreparable harm to society in general, and clearly carries systemic risks.  The buffet of buffets allows the purchaser to gorge himself not just at one buffet, but at ANY of Harrah's 7 buffets at 7 different Vegas Strip properties. "Revel in Las Vegas' world renowned buffets in a whole new way!" The banner touts... Yeah - sure - I remember similar claims about adjustable rate and interest only mortgages, CDOs and CDS... new, "innovative" products that were supposed to be godsends, and turned out to be tools of the devil.

There is brazen fraudulent mistrepresentation in this derivative also:  the terms sheet claims: "unlimited-access buffet passes to any of seven world-class buffets."  However, the list of buffets included is then disclosed:

Caesar's Palace

Paris

Rio

Harrah's

Flamingo

Bally's

Planet Hollywood

Imperial Palace

It's obvious that the structurers of this derivative tried to put in some absolute crap that would under-perform and cause damage to purchasers - as anyone who has done any kind of research would agree that calling the Imperial Palace's buffet "world class" is outright fraud.

Let's get back to the prospectus:

"Loosen your belt and get a "Buffet of Buffets" day pass, then let loose and enjoy all day access to seven of the most spectacular buffets in the city, all for one ridiculously affordable price of $29.99."

Hmmm.. that sounds familiar - oh yes - it reminds me of a pick-a-payment mortgage, as described here by AAMortgage:

"A mortgage that makes home buying more affordable. You can increase your cash flow by selecting a very low payment from the variety of choices available. This flexibility gives you more control over your finances."

The pick-a-payment mortgage was supposed to be a benign way to gain flexability and affordability... Just like the buffet of buffets!  And we know how pick-a-payment worked out - mass carnage!

Reading more of the fine print on the buffet of buffets: "Just charge your buffet to your room, and you're on your way to a once-in-a-lifetime Las Vegas buffet experience."

Hmmm. I am almost certain that this won't be a "once-in-a-lifetime experience."  At the very least, you will revisit the experience the next morning on the crapper, as your body fights the effects of the prior day's binge.   Unfortunately, although you can postpone the economic reality of debt repayment by issuing new debt, you can't postpone the gastrointestinal reality of the buffet of buffets by hitting another buffet.   Let's give them the benefit of the doubt and just say it should be described as at least a "twice in a lifetime experience."

Believe it or not, this seemingly simple derivative buffet of buffets is so complicated that they need a frequently asked questions document for it!  My favorite is this one:

"8. What happens if I am in line to enter a buffet when my all-inclusive citywide buffet pass expires?

A: Unfortunately, once the pass has expired we can not let a customer in with their expired pass. Customers should give themselves plenty of time to gain entry into a buffet should they want to go close to when their current pass will expire."

Well - that should sound alarm bells in the head of any prudent investor - this is the problem Scion Capital's Michael Burry had with his negative carry positions:  his investors didn't want to wait for their seat at the profit table, and chastised Burry for spending money holding the positions, which resulted in him being forced to liquidate earlier than he wanted to.

If you have the buffet of buffets pass, you'll be worried about getting stuck in line and having your pass expire, so you'll have a tendency to hit the buffet at sub-optimal times, earlier than you prefer, and thus you'll be giving up expected value.

Summing up, we can easily see that despite its benign appearance and marketing, the buffet of buffets is a dangerous derivative that bears many common characteristics of products we have already seen fail spectacularly during the financial crisis.  We need less talk about regulation, and more actual regulation, and this is a good time to start. 

-KD