By Doug Noland
February 6 – Wall Street Journal (Spencer Jakab): “Only very rarely has a trade gone from being so good to being so bad so quickly. Among the most profitable trades during the bull market has been to short volatility, essentially betting the market would get calmer and stay calm. An exchange-traded instrument, the VelocityShares Daily Inverse VIX Short-Term exchange-traded note, grew to $2 billion by harnessing futures on the Cboe Volatility Index. The note, with the symbol XIV, had a 46% compound annual return from its inception in 2010 to two weeks ago. Late on Monday, though, the combined value of the note fell 95% to less than $15 million as trading was halted early Tuesday… The product contained the seeds of its own destruction. By selling short futures on the Cboe Volatility Index, or VIX, it profited in two ways in the recent market calm. It took advantage of the typical ‘contango’ present in the market—longer-dated futures tended to be higher-priced than VIX itself and fall in value. Constantly rolling over the position to sell more distant futures was a moneymaker. Another was simply profiting from volatility falling to near record lows.”
The collapse of two Bear Stearns structured Credit funds in July 2007 marked a critical (mortgage finance) Bubble inflection point. These funds were highly leveraged in (mainly “AAA”) collateralized debt obligations (CDOs), as well as being enterprising operators in Credit default swaps (CDS). It was essentially a leveraged play on the relatively stable spread between subprime mortgage yields and market funding costs. It all worked splendidly, so long as stability was maintained in the subprime mortgage marketplace. This strategy blew up spectacularly when confidence in subprime began to wane (rising delinquencies) and lenders to Bear Stearns (and others) turned skittish. Liquidity in subprime-related securities evaporated almost overnight.
About everyone downplayed the relevance of subprime. It was a “small” insignificant market. U.S. economic fundamentals were robust, while cracks had yet to become visible in prime mortgages or U.S. housing more generally. Indeed, the decline in market yields heading into 2008 worked for a while to support home and asset prices, including an equities market rally and a new record high for the S&P500 in October 2007.
Missing in the analysis was the critical role structured finance had assumed throughout the mortgage marketplace, especially late in the cycle. CBBs during the mortgage financial Bubble period focused often on “The Moneyness of Credit” and “Wall Street Alchemy.” Literally Trillions of risky mortgages were being transformed into perceived safe and liquid “AAA” securities. Sophisticated risk intermediation fundamentally altered demand dynamics for high-risk loans.
Perceived money-like subprime securities enjoyed virtually insatiable demand in the marketplace, providing prized high-yield fodder for a late-cycle manic episode of leveraged speculation. And so long as sophisticated risk intermediation was running hot, there remained readily available inexpensive mortgage Credit to sustain home price inflation and system liquidity more generally. It became of case of the greater the quantity of risky loans intermediated through Wall Street’s sophisticated structures – the lower the cost and the greater the liquidity in the booming market for mortgage risk “insurance”. With readily available cheap insurance, why not aggressively speculate and leverage?
Finance flooded into structured products, with 2006 seeing a staggering $1.0 TN of subprime-related CDO issuance. The insatiable demand for these higher-yielding instruments ensured even the weakest Credits (devoid of down-payments) would bid up home prices across the country. And years of housing inflation ensured risk model forecasts of minimal future loan losses – and “AAA” ratings galore. In a critical Bubble “Terminal Phase” dynamic, Credit Availability loosened dramatically as borrowing costs declined – ensuring final precarious “blow-offs” in Credit, home inflation and asset prices more generally. In the end, the parabolic expansion of systemic risk created untenable demands on the financial system and risk intermediation, in particular.
Underpinning mortgage finance Bubble Dynamics was the deeply held market view that Washington (the Fed, Treasury, GSEs and Congress) would never tolerate a housing bust. This perception ensured the GSEs would continue to insure mortgages and borrow at risk-free rates despite the reality that they were effectively insolvent. It was this deeply embedded perception and the booming prime mortgage marketplace that over time cultivated all the nonsense that unfolded in subprime structured finance. The Washington backstop ensured that unlimited cheap Credit remained readily available even after years of mounting excess. The resulting “Moneyness of Credit” nurtured major pricing distortions in Trillions of securities.
For nine long years now, CBB analysis has posited “the global government finance Bubble,” “The Moneyness of Risk Assets” and the “Granddaddy of all Bubbles” theses. I believe the Bubble has likely been pierced. The spectacular blowup of all these “short vol” products is a replay of subprime in the summer of 2007 – just so much bigger and consequential. The “insurance” marketplace has badly dislocated, concluding for now the environment of readily available cheap market protection.
Structured finance was instrumental in ensuring the marginal subprime buyer could access the means to keep the Bubble inflating, even in the face of inflated home prices increasingly beyond affordability. These days, all these structured volatility products have been key to enormous pools of “money” chasing inflated securities prices increasingly detached from reality.
A Paradox of Dysfunctional Contemporary Finance: The higher home prices inflated (and the greater systemic risk) the cheaper it became to “insure” mortgage Credit risk. More recently, the higher stock prices have inflated (and the greater systemic risk), the cheaper it has been to “insure” equities market risk. These highly distorted “insurance” markets became instrumental in attracting the marginal source of finance fueling late-stage “Terminal Excess” throughout the risk markets.
Variations of these “short vol” strategies have essentially been writing flood insurance during a prolonged drought. Key to it all, global central bankers for the past nine years have been intently controlling the weather.
In the mortgage finance Bubble post-mortem, the Fed convinced itself that bad bankers and weak regulation of mortgage lending were the villains. In reality, the overarching issue was found within the financial markets: confidence that policymakers were backstopping the markets fomented price distortions, self-reinforcing speculative excess and untenable leverage. Failing to learn this critical lesson from the Bubble period, radical post-crisis monetary policymaking fostered the perception that equities and corporate Credit were safe and liquid money-like instruments (“Moneyness of Risk Assets”), in the process profoundly transforming market demand, price and speculative dynamics.
Importantly, activist reflationary policymaking ensures that speculative leveraging becomes a prevailing source of liquidity throughout the markets and in the overall economy. When de-risking/de-leveraging dynamics took hold in 2008, a deeply maladjusted system immediately became starved of liquidity. Dislocation (spike in pricing and illiquidity) in the “insurance” markets – subprime in 2007 and equities in early-2018 – marked a critical juncture in risk-taking, leveraging and overall system liquidity.
February 7 – Bloomberg (Dani Burger): “For a fledgling asset class whose idiosyncrasies are understood by few, there sure is a lot of money swirling around in volatility trades. Investment strategies and products married to market swings were thrust front and center by the worst market meltdown in seven years, in which the Cboe Volatility Index surged to its highest level since 2015. VIX-related securities were halted, volatility-targeting quants blamed, and options trading in benchmarks for turbulence ballooned. Too big to ignore, it’s an asset class in its own right, with the might to push around the broader market. Getting a grip on it has confounded strategists and managers alike… There are two categories of securities linked to price turbulence, roughly speaking: ones tied to the VIX directly, and others that take their cue from the volatility of individual stocks. Altogether, estimates for the space are anywhere from $1.5 trillion to $2 trillion. Beyond that is the options market, which itself is an implicit bet on swings in shares.”
Things turn crazy near the end of major Bubbles – and The Bigger the Crazier: One Trillion of subprime CDO issuance (2006) and today’s “anywhere from $1.5 trillion to $2 trillion” of volatility trades is some real financial insanity. The Fed’s strategy has been to aggressively reflate and entrust “macro-prudential” regulation for safeguarding financial stability. Why has there been zero effort to regulate the proliferation of highly leveraged “short vol” products?
It was an extraordinary week that offered overwhelming support for the Bubble thesis. In particular, the risk market “insurance” marketplace was in fact an accident waiting to happen. Moreover, today’s Bubble is very much a global phenomenon.
The S&P500 sank 5.2% this week. Yet this pales in comparison to the Shanghai Composite’s 9.6% drubbing. Hong Kong’s Hang Seng Index fell 9.5%, with the Hang Seng Financials down 12.3%. Equities were bloodied throughout Asia. Japan’s Nikkei 225 index sank 8.1%. Stocks were down 7.8% in Taiwan and 6.4% in South Korea. European equities were under pressure as well. Germany’s DAX dropped 5.3%, France’s CAC 40 5.3%, Spain’s IBEX 5.6%, and Italy’s MIB 4.5%. In Latin American equities, Brazil fell 3.7%, Mexico 5.2%, Argentina 7.6% and Chile 4.8%.
U.S. equities mounted a decent Friday afternoon rally, with the S&P500 (reversing an almost 2% inter-day decline) ending the session with a gain of 1.5%. Perhaps the U.S. market recovery will spark a Monday reversal in Asia and Europe. With option expiration next Friday, it would not be uncharacteristic for a market rally to pressure recent buyers of put protection into expiration. It also wouldn’t be all too surprising to see some players ready to sell an elevated VIX with the first semblance of stability. It’s worked so many times in the past.
It was an extraordinary week in several respects: the VIX traded as high as 50, intense selling of equities across the globe and a meaningful widening of high-yield corporate Credit spreads. Considering the spike in equities volatility, the corporate debt market held together reasonably well (certainly bolstered by ongoing large ETF inflows). Investment-grade CDS did jump to five-month highs. Junk bond funds suffered outflows of $2.743 billion, helping along with the VIX spike to spark the biggest jump in high-yield CDS in about a year. Global bank CDS moved higher this week (from compressed levels), led not surprisingly by Deutsche Bank and some of the other major European lenders. The GSCI Commodities index sank 6.1%, with crude down $6.25, silver falling 3.4% and copper sinking 4.8%.
Curiously, the Treasury market is struggling to live up to its safe haven billing. Notably, in all the market mayhem, 10-year Treasury yields actually added a basis point to 2.85% (up 45bps y-t-d). Long-bond yields rose seven bps to 3.16%. German bund yields gave up only two bps this week, with yields still up 32 bps y-t-d. So not only did the cost of market “insurance” hedges spike higher, Treasury holdings this week did not provide their traditional hedging benefit. This made it an especially rough week for “risk parity” and other leveraged strategies that have relied on a Treasury allocation to help mitigate portfolio risk.
The risk versus reward calculus has rather quickly deteriorated for risk-taking and leveraging. Markets have turned much more volatile and uncertain – equities, fixed-income, currencies and commodities. The cost of market “insurance” has spiked, the Treasury market safe haven attribute has been diminished and various market correlations have increased, certainly including global equities markets. “Risk Off” has made a rather dramatic reappearance. How much leverage is lurking out there in global securities and derivatives markets?
Next week is tricky. I would generally expect at least an attempt at a decent rally prior to options expiration. But at the same time, my sense is that market players are especially poorly positioned for the unfolding “Risk Off” backdrop. A break of this week’s trading lows would likely see another leg down in the unfolding bear market. And with derivatives markets already stressed, major outflows from the ETF complex would be challenging for less than liquid markets to accommodate.
It took about 15 months from the collapse of the Bear Stearns structured Credit funds in 2007 to the market crisis in the fall of 2008. Many still believe that crisis was completely avoidable had the Fed intervened to save Lehman. Yet it was much more of an issue of Trillions of dollars of mispriced securities, dysfunctional risk intermediation, enormous accumulated financial and economic risks, and the inevitability of the financial system’s inability to sustain the necessary quantities of new Credit to keep the Bubble inflating (following parabolic “terminal” excesses).
Similar issues overhang financial systems and economies today, but on an unprecedented global scale. The Treasury market is a glaring difference between 2018 and 2007. After trading as high as 5.30% in June 2007, 10-year Treasury yields sank to 3.84% by November. Fed funds were at 5.25% throughout the summer of 2007, with the Fed slashing rates 50 bps on September 18th and another 50 bps before year-end. I would posit that it stretched out five quarters from “inflection point” to crisis because the Fed back in 2007 still had significant room to push bond and MBS yields lower (prices higher). The Bernanke Fed enjoyed flexibility that the Powell Fed does not. The Treasury ran a $161 billion deficit in fiscal-year 2007.
Things Just Got Too Crazy – completely out of hand. The equities melt-up, the crypto currencies, the technology/biotech mania, M&A, leveraged loans, the return of booming structured finance and the collapse in risk premiums throughout global Credit markets. The Dow is going to a million – along with Bitcoin. Trillions of unending ETF flows. The VIX down to 8.56. Caution to the wind – epically. China Credit.
With another $2.7 TN of QE in 2017, central bankers pushed the envelope too far. And, importantly, Washington (and governments around the world) just went nuts with the view that spending is wonderful and deficits don’t matter. Too many years of central bank-induced over-liquefied markets incentivized excess, from Wall Street to Silicon Valley to Washington to Beijing to Tokyo and Frankfurt. Markets at home and abroad completely failed as mechanisms to discipline, to self-adjust and to correct.
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