Guest Post: Black Swan Cottage Industry And Other Tales Of 12y88y Swaps


Black Swan Cottage Industry and Other Tales of 12y88y Swaps

Imagine an investing job where returns are not the issue.  The objective instead is to think about what can go wrong with a portfolio.  Even better, you aren’t really held responsible for small everyday losses, but the headline-grabbing losses that use impressive words like “multi-sigma” and make money managers scramble for excuses. 

Welcome to the Black Swan cottage industry.

It all seems a bit like the IT “stress-proofers” I saw running around in late 1999, testing and proofing and making sure of things.  And then they were gone.  The Black Swan industry is even better.  The best part of the industry is you get paid to structure protection for events that a probabilist like Emile Borel would say will never happen.  That is not to say it will never happen of course, but that the likelihood of ever having to stress-test your ideas are small.  There is no benchmark for comparison.  I suppose there is no real P&L evaluation, rather you need to minimize the carry cost to a portfolio you are attached to.  A black swan hedge is like a pimple on an ass.

I know there is something deep in our psychology to which Black Swan hedges appeal.  It seduces me too.  A part of brains are wired to fear the unknown, when they part dominates our rational thinking, we process facts in a fearful way.  There is another part that embraces complexity, uncertainty, and conflict.  This part most people need to nurture.  Why?  Because fear on an applied level equals conservatism:  when one conserves, there is no expansion, no newness.  Instead there is theory and dogma and ritual tinged with worry and despair.

A trader snorting coke off a luscious Ukrainian tummy needs the opposite.  Says the Preacher:  “There is a time to embrace, and a time to refrain from embracing.”  I think this wise rabbi means this:  learn to trust yourself, trust in your ability to rebuild and be awesome.  But don’t bet the whole megillah on how big you think your dick is.

You can make your own future by taking control of the now.  It’s is never too late.  Have hope.  We are not the Borg and resistance is never, ever futile.  
The fear creates opportunities for the Black Swan trade.  For example, a man (who loves his grandfather) and innovates brilliantly, trusts his instincts, and pushes his personal universe to the breaking point can gain big, bigger, even biggest of all.  Only to fall into a negative bubble of losses that wipes it all out.  This can leave scars, or rather, scar future investors from giving you their money.  So smart guys create black swan insurance to make reticence vanish and increase AUM.  While they are at it, they can reduce the negative carry by pimping the trades out to institutional investors. 

Black Swan trades prey on our fears, and as a result they focus on things that we really can’t get our hands around.  They are specific and systemic at the same time, using words like “counterparty risk”, and are short on effective hedging.  They neglect considering the more difficult to pin down but hugely  more realistic issues like liquidity.

Let’s say you take a view that Bank of America is a terrific investment so you go all in.  Long equity, full basis trade, the works.  And you are wrong in your view.  Sure something as big as BofA is going to impact the financial system, so your black swan hedge will pick up some bps.  But do the basis point cover the cost of the “hedge” over the time you rolled all those puts or whatever?  Black Swan hedge or not, the BofA trade screwed you over because you are at the rapier point of losses.  Perhaps a long on Goldman Sachs (who has been dialing down VaR for months because they front-run life, the universe, and everything) and no black swan hedge at all would have been a better trade.  Or you are long Kazakhstan debt when it melted down.  It’s at a “bounce” you want to exit on, but it turns out you can’t unwind the position at the quote.  You are stuck with it on the slow grind down.

It’s not that the universe was stacked against you, as opposed to everyone else.  Your view sucked.  Your view may have been terrific, but you can’t execute it like you thought.  At these times in your trading life, you sucked.  Everybody sucks sometimes in some way.     

The following is the epitome of stupid loose, people.  There are literally people buying and selling 100Y CDS (actually it looks like 88 years, like a 12y88y structure, but you know what I mean).  Correct me if I’m wrong, but this can only make sense in the Black Swan cottage industry. 

Looking at some reasonably liquid alternatives one sees no appreciable difference in how risk moves in credit and equity.  How is anchoring a hedge at long durations going to help when the counterparty risk on the entire financial system dwarfs the credit risk on a name?  Even SwapClear has non-trivial credit risk looking a century ahead.

I have such a better alternative to black swan hedges that seldom flies:  Buy cheap.  Sell Rich.  Cut your losses.  Learn from your mistakes.  Respect that part of your brain called “conservative” and dial down risk when you hate to do it.  Alternatively, tongue-kiss as everyone else stands there slack-jawed.

I just know the Black Swan Cottage industry offers imaginative, low-risk jobs.  When I’m done pissing around at it, I’ll teach other people how to not make money and manage risk.  I’ll write a book and send tweets.  Maybe I should buy a Ouija board, channel the spirit of Paul Levy and Kolomogorov, and start dictation.