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Highlights from 2021

Highlights from 2021

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A corgi stares glumly at a Christmas tree.

2021 was a tough one for me personally. I burnt out in the early part of the year and got very sick. Then I somehow managed to break my foot in three places and couldn’t walk properly for months. For someone who was looking forward to lots of October and November hikes around Hong Kong, this was a pretty annoying and unexpected development.

On the plus side, 2021 did mark a major return to writing thanks to the launch of the Odd Lots blog. This means I actually have quite a bit of bylined work to highlight here this year (I’ve grouped it below according to theme). Meanwhile, the podcast itself is going from strength the strength and I think some of my favorite episodes were recorded this year. My cohost, Joe Weisenthal, and I are both hugely grateful to all those who are listening to and reading this content.

Speaking of which, we do have some big Odd Lots things planned for 2022, so stay tuned!

Supply chains

What Pandemic Puppies Can Tell Us About Supply Shortages, June 17
This was my first deep-dive into the bullwhip effect as explained through one of my favorite things: puppies. The bullwhip effect is, IMHO, essential to understanding what’s been going on with the economy and inflation. It describes how small changes in consumer demand at one end of the supply chain can end up leading to big swings in production at the other end. Those swings can get bigger and more problematic as demand and supply struggle to reach equilibrium, leading to repeated supply shortages (or gluts) and wild swings in prices.

Introducing the Chokepoint Economy, When Shortages Start to Matter, Aug. 4
I think this was an important change in 2020/201. The dramatic experience of the global pandemic seems to have taught many policymakers that the relative flow of goods and capital can matter more than the absolute levels. That means ‘chokepoints’ rather than Keynesian ideas of abundance may be a more useful framing for the future direction of the world’s biggest economies, with governments increasingly focused on building up strategic capacity in things like food security, transportation/shipping, semiconductors, etc. (Of course, China has been doing this for years).

What the Semiconductor Shortage Has to Do With Corporate Bonds, Sept. 15
Joe made me write this but I actually ended up thinking it’s a decent analogy. At first glance, the business of selling chips doesn’t have much in common with the business of selling the debt of blue-chip companies (ha). But as the piece makes clear, both those industries are dealing with a problem of how to allocate an asset that’s in short supply and they end up doing it in similar ways.

What the Economics of Sawdust Can Tell Us About Supply Shortages, Oct. 22
One of the difficult things about supply chain disruptions is that they can expose unexpected connections and therefore have difficult-to-predict consequences. The story of sawdust in the mid-2000s is a great example of this kind of unexpected connection. I don’t think many people would have expected a housing bust to lead to higher milk prices.

ESG and oil

What’s Wrong With ESG Investing as Explained Through the Medium of Ohio
First, let me say that the volume of gushing ESG press releases and investment guides far outweighs the amount of critical stuff out there. But what criticisms of ESG you do tend to see, often veer into highly abstract and conceptual territory. This story was an attempt to illustrate some of the biggest ESG drawbacks through a single thing: the great state of Ohio.

Get Ready for the Inflationary Pushback to ESG Investing, July 15
This wasn’t a long or very detailed post but it did end up being very prescient. As gas and oil prices soared in the latter half of the year, there was a lot of hand-wringing over whether or not underinvestment in fossil fuels had contributed to the problem. I don’t think you can blame it all on ESG, but there is certainly a capital markets component here (see below).

Why Surging Oil Prices Have a Lot to Do With Capital Markets, Oct. 18
To understand what’s going on with the nodding oil pumps in US shale country, it helps to look to the gleaming skyscrapers of New York. In other words, there’s a perception that as oil prices go up, it will inevitably attract more energy players who will dig more wells and increase supply etc. But that ignores a big structural break in the energy’s relationship with capital markets after the shale oil boost of 2014/2015. Investors don’t want to see energy companies spend all their money on drilling and exploration anymore, instead they’re asking for buybacks and discipline on spending. It’s no longer about aggressively growing production, but more about preserving ROE.

Inflation

We Need to Talk About the Great Mayonnaise Inflation Mystery
Part of the reason Odd Lots episodes have been so fun this year is because supply chain issues have given Joe and I a chance to go very, very micro and examine individual businesses, industries and even products. In that spirit, here is a deep dive into what’s going on with mayonnaise prices and how they’re actually measured in CPI indices. So come for the insights into how mayonnaise is actually made, and stay for the deep dive into index construction.

Why We Should All Start Talking About ‘Whackflation’
I still think this is probably the best way to look at inflation right now. This is the monetary equivalent of the bullwhip effect described above. It means that prices can be prone to inflationary booms but also deflationary busts if demand suddenly evaporates, or if it becomes clear that businesses have over-ordered. You can see the whackflation idea clearly in lumber prices, which have already gone through a few mini cycles of booms and busts as the market struggles to reach equilibrium.

Lumber prices have been moving through mini cycles of booms and busts

Capital Markets

No, the U.S. Isn’t Being Overrun by Zombie Companies, June 23
Every time the Fed lowers interest rates someone ends up complaining about how the central bank is creating zombie companies, or businesses that aren’t economically viable but are being kept artificially alive. But the idea of zombie companies running amok in the U.S. economy isn’t born out in anecdotes (see for instance, Hertz’s big comeback after filing for bankruptcy last year) or in the numbers (most companies took advantage of ultra-low interest rates to refinance and term out their debt, meaning they’re actually less indebted than they were before 2020) I do think there are important tradeoffs and risks to think about when it comes to central bank stimulus, but keeping zombie companies alive after the worst global pandemic in more than a century isn’t one of them.

One Sign That the Fed Changed Everything in Corporate Bonds, Sept. 13
Following on from the above, it’s important to realize that something big and important did happen in credit markets in 2020. The Fed for the first time effectively backstopped the entire corporate bond market (even without having to actually buy that much of the debt). The downside of this is that market participants rarely forget a new central bank backstop, and there are signs that corporate bond investors have permanently priced this new reaction function in.

When Everything Is a Growth Stock And All Money Is Venture Funds, Dec. 3
What do you get a credit market that has everything? How about billions of dollars of loans at ultra-low interest rates to companies with no income? This is a deep dive into recurring revenue loans, which are based on expected revenue from a company’s service contracts or subscriptions due (aka annualized recurring revenue). One way of thinking about these is that they’re the credit market equivalent of what’s going on in equity markets, where lofty stock valuations are often justified by wildly optimistic earnings forecasts (see also the below piece on the slaughter in growth stocks).

In the Tarantino Market, the Hottest Stocks Are Getting Quietly Killed, Dec. 3
November was a really weird month for equities. On the one hand, the S&P 500 was basically flat. But on the other hand, some stocks were getting absolutely slaughtered. What’s interesting about this under-the-surface selloff was that it hit all the hottest stocks with seemingly little catalyst. Nothing much happened other than retail investors and hedge funds took a breath and decided that those super-hyped growth narratives maybe looked a little far-fetched.

Treasuries

A $21 Trillion Treasuries Mystery Is Bedeviling Global Markets, March 3
Another year, another bout of weird price action in the $21 trillion U.S. Treasury market that forms the bedrock of financial markets and the benchmark risk-free rate. This year, the gap between bid and offer prices for the 30-year hit its widest since the panic of March 2020 (when the Treasury market was also roiled by leveraged players). It was yet another strange move in a market that really isn’t supposed to have this many strange moves.

Treasuries Acting Like Meme Stocks Helps Explain Low Bond Yields, Oct. 14
The other big mystery in the U.S. Treasury market has been the persistent bid for U.S. debt despite all those worries over inflation and looming rate hikes. One possible explanation is that there are just a lot of buyers for USTs right now who aren’t all that price-sensitive. Buyers like big U.S. banks need Treasuries to satisfy regulatory requirements and so on. Another way to think of it, is that the way a financial asset behaves can change depending on who’s holding it.

Accounting

What One of China’s Biggest Developers Can Tell Us About Debt, Sept. 29
“If you want to avoid being seen to cross any red lines, you could simply go dark” is the opening line of this piece on how one Chinese property developer seems to have responded to the country’s recent crackdown on real estate leverage. It pretty much sums it up.

What the Heck Is a ‘Reverse Repo Note’ and What Happened to All of Tether’s?, Dec. 9
Tether’s financial accounts use some odd nomenclature to describe the financial assets that are supposed to be backing their stable coins, including something called a “reverse repo note.” This shouldn’t be confused with a basic “reverse repo,” which is a normal and well-known term in financial markets. No one in the repo market seems to have ever heard of ‘reverse repo notes’ before though.

Arbitrage

There’s a Massive Arbitrage Opportunity in the Plastics Market, July 13
Do you know what a nurdle is? After reading this post about plastic markets you will. The story centres around a potential arbitrage opportunity in the plastics, with polyethelene in the U.S. and Europe trading at a massive premium to prices in China, but it’s mostly about the compounding effect of supply chain disruptions as shortages in one area (shipping containers, refining capacity) end up adding to scarcity of something else (plastics elsewhere in the world). 

A Huge Arbitrage Opportunity Has Just Opened Up in Crypto, Nov. 24
There was a moment this year where you could buy Bitcoin at a double-digit discount to prevailing market prices so long as you purchased from certain Indian crypto exchanges. Of course, the whole incident was pretty short-lived but it does illustrate a wider point about ostensibly decentralized money — it’s really not that decentralized depending on the exchanges and regulations involved (i.e. you can’t necessarily port money from India to elsewhere that easily).

Scoops

Goldman Bankers Beg to Work Only 80-Hour Weeks in Stinging Deck, March 18
In spring of this year, a group of first-year bankers at Goldman Sachs conducted an anonymous survey, formatted the responses into a slide deck (obviously) and then sent it to on to higher-ups. The deck contained a litany of grievances including long working hours, unrealistic deadlines and an overall pattern of declining mental health as first-years grappled with pandemic-related isolation combined with a bumper year for deals. The deck kicked off something of a reckoning on Wall Street as investment banks started competing with each other to better compensate their burnt-out junior bankers, with higher pay, somewhat restricted hours and even Pelotons.

Billions in Secret Derivatives at Center of Archegos Blowup, March 29
This was the first story to draw attention to the type of financial instruments Bill Hwang had been using at Archegos, the $20 billion fund which went spectacularly belly-up in the space of a few days in March. As noted in the piece, Hwang’s use of swaps meant that he could amass big positions in stocks without actually owning the underlying securities. He also didn’t have to provide as much margin to his prime brokers. Since this piece was published, the SEC has proposed new rules that would require more disclosures for swaps and limit how much hedge funds can use them.

Morgan Stanley to Repay Hong Kong Staff $5,100 for Quarantine, Nov. 24
Morgan Stanley was the first investment bank in Hong Kong to announce that it would reimburse staff for quarantine costs, a story which also kicked off a round of competitive offerings from investment banks. The issue of quarantine reimbursement is probably of limited interest to anyone outside of Hong Kong, but it’s certainly been a big topic in a city where it’s now prohibitively difficult and expensive to travel. Hong Kong’s extreme quarantine requirements have very much altered its attractiveness for expat financial workers and fundamentally changed the value proposition of being based the city (by way of personal example, I haven’t traveled outside the territory for more than two years now).

Misc.

Bonds of Power – Lecture for Investor Amnesia’s Imperial Finance: A History of Empires
Putting this lecture together for Jamie Catherwood’s Investor Amnesia series was a lot of work but it also ended up being surprisingly fun. It’s a deep dive into one of my favorite topics — the nature and moral obligations of debt — as explored through the prism of defaulted Russian imperial debt and imperial Chinese bonds. One thing it illustrates perfectly is that because bonds are so often tied up in stories of who owes what to whom, they can end up being surprisingly powerful political tools. (You should also check out some of the other great lectures by Marc Andreessen, Niall Ferguson and Kim Oosterlinck, who has also done some sterling work on the topic of morality and bonds).

The year in credit (2019)

The year in credit (2019)

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I’m a little late to this annual tradition but here it is — highlights from 2019’s collection of credit-related stories. This is by no means a full list of my work this year, but these are the things that I’m thinking about as we enter the new decade.

Did Fed Know What Credit Markets Didn’t? Loan Bankers Get Strict, February 7
It’s easy to forget this now, but in early 2019 the market was all-aflutter over the Federal Reserve’s Senior Loan Officers Survey, which showed banks tightened lending standards over the last three months at the fastest rate since the middle of 2016. The furor died down as banks began easing standards again (though tightening for C&I loans has since resumed) and the Fed lowered rates, but it hints at the amount of concern out there about overheating in the credit market.

Hot Rally Raises Questions of What’s Really Cooking in Credit, March 22
The almost complete recovery in credit markets since the sell-off in late 2018 plus a dovish Federal Reserve helped refocus attention this year on the multiyear boom in corporate debt. That boom means investors are arguably accepting worse deals for less return. For Deutsche Bank analysts, the dynamic has shades of a previous Wall Street boom.

CLOs Are Starting to Look More Alike, Stirring Uneasy Memories, June 11
Another entry for the ‘history doesn’t repeat, but it does rhyme’ category. Rampant demand for leveraged loans has outpaced supply in recent years, leaving CLO managers with a more limited pool of loans from which to create their deals. That means the chance of two CLOs holding the same underlying debt increases so a single soured loan could wind up hitting multiple investors.

Convexity Hedging Beast’ Blamed for Lower Bond Yields, August 19
This isn’t strictly a credit-related piece, but I include it as an example of the reflexivity of markets. It’s very possible that the yield curve inversion we were all worrying about this year was the result of technical forces (convexity hedging), or at least exacerbated by it. That sort of begs the question of whether this kind of technical activity can end up worsening, or event creating, trouble in markets. See also, the VIX exchange-traded product blow-up of early 2018 or the occasional rumblings of a similar dynamic in credit derivatives and the cash market.

Repo Fragility Exacerbated by a Hot New Corner of Funding Market
JPMorgan Warns U.S. Money-Market Stress to Get Much Worse
Odd Lots: Why the Repo Market Went Crazy
Repo Oracle Zoltan Pozsar Expects Even More Turmoil
Repo! A blow-up in the repo market happened this year! Again, this is not strictly credit-related, but turmoil in this crucial short-term lending market can end up impacting dealers’ risk appetite and therefore wider markets. Of particular interest is the role of sponsored repo outlined in the first piece. This is something the Bank for International Settlements ended up singling out as a key catalyst for the troubles.

Goodbye Bond King, we hardly knew ye

Goodbye Bond King, we hardly knew ye

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Bill Gross, the erstwhile ‘Bond King,’ has announced his retirement. Over the course of four decades, Gross made his name actively trading bonds and started doing that before those bonds were really even considered things that were actively traded. He co-founded Pimco, then moved to Janus in late 2014 in an abrupt and somewhat drama-filled chapter of market history.

While buckets of ink have been spilt on Gross’s career and legacy, I want to point out two things. The first is that, as the title suggests, there’s still a lot we don’t know about the Bond King’s strategy. While investing in bonds might seem like a straightforward activity, it’s no secret that Pimco augmented its performance with a host of derivatives and ‘overlays.’

See for instance, Zoltan Pozsar’s work on the topic in early 2015, which I wrote up in a column for the Financial Times around the same time:

Reach for returns takes funds into the shadows

… The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.

This shadow banking system has long been described as a network of non-bank financial intermediaries, but it is perhaps better characterised as a reference to a particular set of financial activities.

Classic examples of such activities include financial institutions borrowing money by pawning their assets through ‘repo’ agreements or securities lending transactions, as well as using derivatives.

Traditional notions of shadow banking usually centre on the idea of repo being used to fund the balance sheets of broker-dealers and banks. When entities like Lehman Brothers and Bear Stearns became locked out of the repo market in 2008 they suddenly found themselves starved of financing, triggering an avalanche of stress across the financial system.

Regulators have spent the years since the financial crisis trying to clamp down on shadow banking as they attempt to improve the overall safety of the financial system. Since such activities are rarely associated with traditional mutual funds that invest in bonds and other assets on behalf of large investors such as pension funds and insurers, such funds have rarely been mentioned in conjunction with shadow banking.

Mr Pozsar’s research suggests that is a mistake. For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.

Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.


Gross was also famously vocal when it came to espousing a short-volatility strategy in mid-2014. Doing so wasn’t necessarily wrong, as Gross noted it was “part and parcel” of an overall investment strategy that rested on sluggish U.S. growth and low interest rates, but it nevertheless raised eyebrows among his peers and competitors who viewed the new crop of buy-side volatility-sellers as tourists in a somewhat dangerous market.

The second point is that the sheer size of Gross’s creation — Pimco — has at times had massive effects on the wider market. “Big West Coast player” means just one thing for many in fixed income, and Pimco was said by plenty of observers to have frequently thrown around its gorilla-esque weight to get favourable pricing and allocation on new bond deals. Conversely, however, the sheer size of the Total Return Fund (which from memory peaked at almost $300 billion), was also said by market participants to pose challenges for its managers, the idea being the fund had grown so large it effectively struggled to beat its benchmarks.

That size could also have more deleterious effects. Few people seem to remember now, for instance, that when Gross left Pimco, it coincided with a noticeable sell-off in inflation-linked bonds and junk-rated paper. Or that the flash crash in U.S. Treasuries in October 2014 was rumoured to have been sparked by a sudden liquidation of interest rate positions favoured by Gross. There are still so many interesting open-ended questions posited by Bill Gross’s adventures in Bond Land, and from that perspective I’m somewhat sorry to see him go.

Anyway, for those interested in mulling these questions more, here’s some previous work — much of it done with the FT’s fantastic Mike Mackenzie:

Gross exit from Pimco tests bond market – September, 2014
Pimco upheaval rattles bond market – September, 2014
Wall St sheds light on Bill Gross reign after Pimco departure – October, 2014
Bonds: Anatomy of a market meltdown – November 2014
Caught on the wrong side of the ‘vol’ trade – December, 2014
Reach for returns takes funds into the shadows – February, 2015

Where Leverage Lives

Where Leverage Lives

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I was thinking about the recent volpocalypse and some of the action we’ve since seen in the credit market, where February’s big market ructions played out in credit derivatives as opposed to the cash corporate bond market. That’s not entirely surprising given that the cash market has long been said to be less liquid than its synthetic counterpart, but what is rather concerning is these are largely derivatives tied to credit indices and there’s the potential for a self-fulfilling feedback loop similar to what we arguably saw in VIX-related products and the Volatility Index itself. Overall, there are huge pockets of leverage in the system, from run-of-the-mill equity options used to eke out excess returns, to more esoteric credit derivatives like CDX options.

Anyway, it put me in mind of the below piece from a couple years ago.

—-

This Is How Leverage in the Financial System Lives On

By Tracy Alloway

(Bloomberg) — Rumors of leverage’s death have been greatly exaggerated.

In the aftermath of the 2008 financial crisis an abundance of leverage — borrowed money used to amplify returns — was blamed for exacerbating losses on subprime mortgages and contaminating the banking system with catastrophic results. Since then a host of new rules have been enacted to reduce financial leverage, including penalizing certain derivatives positions, such as the credit default swaps (CDS) villainized in the crisis, as well as outright curbing the amount of borrowing allowed at big banks.

While such efforts have made substantial steps in derisking the financial system — especially at large lenders — they’ve also encouraged the creation of new types of leverage and its migration to different players. Today, much leverage appears to sit on the balance sheets of large and small investors, often fueled by the need to generate returns amidst ultra-low interest rates and high correlations that see asset classes move together and make it more difficult to produce outperformance, known as ‘alpha.’

Leveraged strategies may include selling volatility or dabbling in derivatives tied to interest rates or corporate credit. While few are suggesting that the leverage deployed via such tactics could cause a crisis on the scale of 2008, it can create unexpected consequences ranging from a ‘flash crash’ in one of the world’s most liquid markets to constraints on the Federal Reserve’s ability to change monetary policy, as highlighted by a new paper from visiting professors at the Bank for International Settlements.

Moreover, they underscore the risks facing the market as investors continue to divide themselves between those eschewing the chance to earn a steady stream of returns by betting big — and those willing to risk the chance of outsized losses in the event of a significant change in markets.The latter group found a posterchild in the way of Bill Gross, the former co-chief investment officer of Pacific Investment Management Co. (Pimco) and erstwhile ‘Bond King’ who spoke publicly about his use of derivatives to increase returns in the “new neutral” era of ultra-low interest rates, shortly before departing the company in late 2014.

Pimco’s flagship bond fund, the Total Return Fund (TRF), sold $94 billion worth of put and call options on floating to fixed income swaps, or 41 percent of the fund’s net asset value, according to BIS data. Known as selling or shorting volatility, the strategy allowed Pimco to collect insurance-like premiums as long as interest rates stayed low.Similarly, Pimco deployed eurodollar futures, a type of derivative that locks-in interest rates for investors, with long eurodollar contracts at the Total Return Fund (TRF) jumping from 250,000 in March 2013 to almost 1.2 million as of June 2014.

While Pimco noted at the time that such long eurodollar futures contracts were “used to manage exposures at the short end of the yield curve and express PIMCO’s expectations for short-term rates,” they also come with the benefit of added leverage, in effect boosting returns so long as rates remained low.

Gross’s departure from the fund in September 2014 sent the TRF’s managers scrambling to liquidate the eurodollar contracts as investors redeemed their money. The liquidation may have exacerbated the flash rally in U.S. Treasuries that took place shortly after, when the yield on the benchmark 10-year note seesawed wildly in the space of a few minutes, the BIS paper said.

“The irony is that a more measured pace of liquidation would have allowed the fund to profit from the bond market ‘flash rally’ of October 15, 2014,” visiting BIS professors Lawrence Kreicher and Robert McCauley wrote in the paper. “In any case, it appears that a huge long eurodollar position could be and was liquidated in a fortnight. By contrast, [the TRF’s] liquidation of its ‘short volatility’ position may have contributed to the ‘flash rally,'” by setting off a wave of hedging amongst dealers who scrambled to absorb Pimco’s short position.

The use of eurodollar futures has not been confined to the world’s erstwhile biggest bond fund, with the BIS paper noting that while asset managers play a diminished role in day-to-day trading, they “generally hold the largest eurodollar positions among buy-side participants.” Their “dominance in positioning establishes them as gatekeepers for the Fed’s forward guidance” limiting the U.S. central bank’s ability to change monetary policy if asset managers are not positioned accordingly — as seen in the 2013 taper tantrum.

Investors seeking to boost returns at a time of abundant liquidity and unconventional mo

netary policy have also applied leverage to corporate credit, a market which has exploded in size thanks to low interest rates and yield-hungry investors who have enabled companies to sell more of their debt. While the use of single-name CDSs that offer insurance-like payouts to a single security, company, or government, has diminished in the wake of the financial crisis, trading tied to indexes comprised of multiple entities has jumped.

With corporate default rates at historic lows and with stimulus increasing correlation between asset classes, use of so-called CDS indexes has boomed as both a trading and hedging tool, allowing investors to create an “overlay” on their portfolios to protect against a systemic rise in defaults at a time when liquidity is said to have deteriorated.

Further complicating matters is the explosion in alternative derivatives or ‘derivatives of derivatives,’ with investors now served an expansive menu of exotic synthetic credit products including options on total return swaps (TRS), options on CDS indexes, and a suite of other bespoke offerings.

Such ‘swaptions,’ as they’re sometimes known, give investors the right to buy or sell the index at a particular date and for a certain price, and are said to have surged in popularity in recent years. Analysts at Citigroup Inc. estimated that about $24 billion of CDS index options traded in 2005, rising to $1.4 trillion in 2014 — a more than a 5,000 percent jump in activity in just under a decade.

Strategists at Barclays Plc have expressed concerns that the rapid rise in CDS index option volume was impacting the underlying index, while a senior credit trader at one of the biggest banks told Bloomberg earlier this year that the notional volume of credit index options traded has on some days surpassed the volume of trades in the referenced index. A more recent survey by Citigroup Inc. analysts earlier this year showed 72.6 percent of investors expressed concerned over how “investors are taking more leveraged risk using derivatives.”

In the equity market, a jump in the number and amount of products tied to the Chicago Board Options Exchange’s Volatility Index, the VIX, are sometimes said to be impacting the index itself. While the VIX, which is based on options contracts tied to the S&P 500, remains far below its financial crisis highs, volatility of the index itself last year reached an all-time record.

This is how leverage in the financial system lives on – Bloomberg, August 2016
Market selloff played out in the most hidden corners of credit – Bloomberg, February 2018

A quick thing on the long-awaited, entirely predictable ‘Volpocalypse’

A quick thing on the long-awaited, entirely predictable ‘Volpocalypse’

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How many warnings did buyers of XIV, the volatility-linked exchange-traded note (ETN) note that went bust last week get? A lot.

First there was the prospectus itself, which spelled out wipe-out risk fairly clearly. Then, there were multiple articles from multiple financial news and analysis outlets, myself included.

There were also tweets!

Like, lots of them!

The below tweet was from Jan. 31st — about five days before the actual blow-up! The only response I got to this at the time was from a guy complaining that he couldn’t see the x-axis so the chart was meaningless. That wasn’t the point! And if you don’t understand what a change in the shape of the VIX futures curve might mean for volatility-linked products, then you probably shouldn’t be trading them!

I tried to sum up just how telegraphed this was in a short note for our markets morning newsletter, which you can sign up for (for free) here.

I don’t mean this to sound callous to those who lost their shirts on this product, but neither do I want this to be spun as a failure on the part of forecasters and journalists etc. This was a well-telegraphed event that people saw a mile coming. That doesn’t mean there wasn’t failure somewhere. The fact that some retail investors seem to have been taken completely by surprise in the recent turn of events suggests they probably shouldn’t have been in these products in the first place. Whether that’s a failure on the part of the regulator, the ETN-issuer, the brokerages that enabled trading in the products, or some other party, I leave that to others to decide.

Did someone say something about synthetics?

Did someone say something about synthetics?

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Two words excite me like no others.

They are synthetic securitisation (or, for the truly old-school, they are three words: regulatory capital trades). These deals usually involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches, and selling the exposure to a non-bank entity like an insurer, hedge fund, or asset manager through the use of credit derivatives.

In many respects, they hark back to the early days of securitisation, when JPMorgan first put together its BISTRO trades, otherwise known as the first synthetic CDOs. Banks may be genuinely offloading risk here, and the deals were called reg-cap trades precisely because they offered capital relief that’s so far been genuinely sanctioned by regulators. On the other hand, they seem to speak to some of the worst of the current environment: a pervasive search-for-yield that may see investors put their money in silly things at silly prices (for this reason, you will sometimes hear reg-cap specialists – usually hedge funds – gripe about the non-expertise of new entrants and the need to price the deals perfectly), as well as nagging concern that in fortifying the banking system post the financial crisis, we’ve simply offloaded a bunch of balance sheet risks onto other entities in a classic case of regulatory arbitrage.

In any case, I bring it up because in less than a week we’ve seen two stories published on the market, now said to be booming, first in the Financial Times and then in the Wall Street Journal. Both detail the rise of the market, with issuance described as having jumped by anywhere from 5.6 percent in the first quarter to at least 33 percent so far this year.

Those looking for a graphical representation of the recent rise of synthetic CDOs, could do worse than this chart from Deutsche Bank. It shows European deals only, but the direction of the trajectory is pretty obvious. The WSJ story also references some interesting figures from consultancy Coalition, pointing out that structured credit revenues at the top 12 investment banks more than doubled year-on-year to $1.5 billion the first quarter of 2017, exceeding the growth rate in more conventional trading businesses in the same period.

Growth in the business is not exactly a surprise, though.

More than five years ago I wrote in the FT about some of the bigger banks working hard to get the business going as a way of securing some new fees at a time when many of their other revenue streams were sluggish. In retrospect, that story’s now looking pretty prescient.

Big banks seek regulatory capital trades

 

Big banks are aiming to help smaller lenders cut the amount of regulatory capital they need to hold against loans in an attempt to make money from deals similar to those first created in the early days of securitisation more than a decade ago.

The big banks want to create so-called regulatory capital trades for smaller lenders as they expect demand for these kind of securitisation structures will rise ahead of regulations designed to provide more stability in the financial system.

Such trades, also known as synthetic securitisations, involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches.

The bank typically then buys protection on the riskiest or mid-level tranche from an outside investor such as a hedge fund, insurance company or private equity firm.

Doing so allows a bank to reduce the amount of regulatory capital it has to hold against the loans – a tempting prospect as banking groups are forced to hold more capital ahead of new regulation such as the forthcoming Basel III rules.

Some of the biggest global and European banks, including Barclays and Standard Chartered, are known to have recently built and used the structures to reduce the amount of capital they need to hold against corporate or trade finance loans.

But some large banks are now hoping to sell their structuring expertise and help distribute the resulting trades to buyers, investors in the trades say.

“The holy grail for some of the investment banks is to try to get some of the second and third tier banks involved, to get structuring fees,” said one investor. The trades hark back to the early days of securitisation in the late 1990s, which helped fuel the financial crisis.

“It’s almost as if you’re seeing the start of the securitisation market coming back in a very modest way,” said Walter Gontarek, chief executive of Channel Advisors, which operates Channel Capital Plc, a vehicle with $10bn in portfolio credit transactions with banks and has started a new fund dedicated to these structures.

Investors such as Channel Advisors say the yields on the deals are attractive compared with other debt securities on offer, and they are able to gain exposure to a specific portion of a bank’s balance sheet rather than invest in the entire thing. The insurers, hedge funds or private equity firms are not bound by the same, relatively onerous capital regulations as the banks. That makes it easier for them to write protection on the underlying loans in a classic case of regulatory arbitrage.”

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Some more early coverage below, for those interested.

Synthetic tranches anyone? – FT Alphaville
Anti-Abacus, anti-BISTRO and anti-balance sheet synthetic securitisation – FT Alphaville
Big banks seek regulatory capital trades – FT, April 2012
Banks share risk with investors – FT, September 2011
Balance sheet optimisation – BOOM! – FT Alphaville, 2010

It’s not just about the VIX

It’s not just about the VIX

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There’s so much talk about volatility right now — and specifically the stubbornly low behaviour of the VIX  — that I thought I’d do a round-up of some of my previous pieces on it.

Please note, I’m in an anti-paragraph, anti-proofreading kind of mood today. So typos and big blocks of text are ahead.

1. On the VIX 

Let’s start with this one, from September 2013, about a new index trying to challenge the VIX, the index that most people associate with ‘volatility.’ For more than two decades, the VIX index run by the Chicago Board Options Exchange has been the financial industry’s go-to method for measuring expectations of volatility in the wider marketplace, with the CBOE turning the index into something of a cash cow thanks to the launch of futures tied to the gauge. VIX-related futures have in turn allowed a plethora of VIX-based exchange-traded products (ETPs) to also launch. With all that money benchmarked to the VIX, it’s no surprise that we have occasionally seen upstarts attempt to challenge it.

2. Selling volatility

Now let’s go here to this story from December 2014. About six years on from the financial crisis and deep in the era of monetary stimulus, investors are struggling to make returns and seize upon the realisation that selling volatility — whether that be through shorting the VIX or some other derivative-based method — can be a lucrative (if risky) strategy. This was the big shift in the volatility market. Instead of having a bunch of banks or hedge funds (or de facto, GSEs) sell volatility, you suddenly have a bunch of buy-side funds and retail investors who are interested and able to do so, the latter largely thanks to the explosion in VIX-related products. The big question, per the piece, is whether these new sellers of volatility are more likely to behave differently than traditional vol-sellers. Are they more or less likely to react to abrupt shifts in volatility?

3. Self-reflexive VIX

By September 2015, the VIX is again in the headlines after the unexpected devaluation of the Chinese yuan spooked markets. While the VIX did jump on this news, it was the VVIX (in effect, volatility of volatility) that reached an all-time record. Here’s my article about that: “When there’s a sudden spike in volatility, as occurred last month, the price of near-term VIX futures rises. Meanwhile, volatility players — notably hedge funds and CTAs — scramble to buy protection as they seek either to hedge or cover short positions, causing a feedback loop that encourages near-term futures to rise even further.” CFTC positioning data at the time did suggest a classic short squeeze as investors closed out their short vol positions post the spike. In effect there were said to be two major forces impacting the VIX, systematic volatility sellers as well as VIX-related ETPs that have to buy or sell futures to rebalance. This rebalancing act makes the VIX curve important, a point picked up on by Chris Cole of Artemis Capital in a story I wrote about a month later: “VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn’t handle it,” he said. The concern is that the explosion in volatility-trading means more demand to buy or sell futures to rebalance, which could impact the shape of the curve itself.

4. VIX and beyond!

The proliferation of ETPs tied to the VIX is a concern insofar as it affects the volatility landscape, but it’s not the whole story. To explain, let’s go to Bill Gross, who became the poster child for volatility-sellers after publicly saying in June 2014 — while still at Pimco — that the company was selling “insurance, basically, against price movements” to juice returns in an era of low interest rates. Not once did he mention the VIX. It wasn’t until October 2014, after Gross’s abrupt departure from Pimco, that we got a better sense of what that insurance-selling strategy might mean when the U.S. Treasury market experienced a sudden melt-up, of sorts. At the time, there was plenty of talk that Pimco was liquidating some derivatives positions, which ended up having an outsized effect on the underlying cash market. The U.S. government’s report on the episode later mentioned that: “In particular, anecdotal commentary suggested that some dealers had absorbed a portion of the sizable ‘short volatility’ position believed to have been previously maintained by large asset managers. As volatility spiked on October 15, those positions would have prompted some dealers to dynamically hedge this exposure, exacerbating the downward move in yields.” Then, in August of last year, the BIS published a paper on asset managers dabbling in eurodollars including the example of Pimco in 2014, which I wrote up in a piece called “This is where leverage lives in the system.” That article contained a laundry list of potentially risky strategies across rates (viz eurodollars, futures, forwards), credit (using swaptions and swaps) as well as equities (options, VIX ETPs, etc.). What’s my point? I don’t mean to underplay what’s happening with the VIX, but my concern is that if we’re looking for potential flash points in the financial system then we may want to broaden our horizons.

The year in credit

The year in credit

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Credit markets, I wrote a lot about them this year. One day some other asset class will grab my attention but for the time being it’s this. Sorry.

Here’s what I wrote about the market in 2015 – or at least, since starting the new gig over at Bloomberg in April. I may have missed a few here and there (and included some fixed income posts that I think are related to over-arching credit themes), but I think this is pretty much covers it.

Happy holidays, and may 2016 be filled with just the right amount of yield.

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