2012: A Trader's Odyssey

Submitted by institutional trader Paulo Pereira, currently on sabbatical

Global market Musings: Volatility And The "Backstop"

I recently received the following question from a friend of mine and wanted to share my thoughts with my market pals, and throw this out for feedback.  I would be particularly interested in hearing from my derivatives friends who are much more technically informed than I am on the subject.

“I was looking at something today that I thought you would probably have some comment on:  have you noticed how wide the out months on the VIX are versus the one or two month?  How are you interpreting this?”

From my viewpoint this has been a key debate/driver in the equity derivatives world for a good while now (I started having this discussion in early 2011 with some market pals and the situation has only grown more extreme since then).  One excellent resource on the subject I would encourage everyone to follow is the work done by Artemis Capital, a volatility fund run by a fellow named Chris Cole.  His letters are heavily technical but he does a great job of discussing the volatility landscape and market topology.  I know it's a bit of heavy reading, but if you really want to get to the bottom of this, here is his website link: http://www.artemiscm.com/category/research/ ... Just scroll down the page for the summary of each letter.  Specifically, I would encourage you to read the paper Volatility at World's End from April 2012 (see the chart on page 6 discussing the VIX curve) and the letter Fighting Greek Fire with Fire from Sept 2011 on volatility and correlation.  I particularly like this quote:

"Like terrorism, we've gone from ignoring the left tail to obsessing over it. I'm not saying the world is suddenly a safe place and deflation should be ignored. It is not that I find the fear of deflation misplaced but rather mispriced. Those who defend this cost of insurance will tell you the probability doesn't matter as much as the extremity of the outcome. While there is truth in this rebuttal it still doesn't address what happens to volatility when all these buyers look to cash in on their expensive tail risk insurance all at the same time. The jackpot is a lot smaller when everyone owns a winning lotto ticket. All that expensive protection will likely underperform expectations and in the end you would have done better hedging closer to the odds. It is hard to make money knowing what everyone else already knows.  I'd rather spend my time imagining what unforeseen risks are not priced into the market. Is there something that will be as obvious tomorrow as it is laughable today? I sincerely hope the future vindicates current monetary policy but it is unwise to have blind trust. If global central banks are willing to protect us at all costs against deflation then who will protect us against the central banks?" - Volatility at World's End, page 8

But back to the question – how am I interpreting this?  In my own modest, undereducated opinion, I think the volatility curve reflects two simultaneous dynamics.

The first dynamic is in the long end, in the variance/swap market for longer dated volatility (>1yr) which remains stubbornly elevated in the upper 20s or higher, even though realized vol is nowhere close to this... why?  Yes there are plenty of folks who believe the Great Depression 2 has arrived, but even during the early 1930s, volatility did not realize 30+ except in very short stretches during the decline.  Nobody I know is seriously buying longer dated implied vol in size at such levels, so what gives?  I think the problem is not with demand for long-term protection but with supply, i.e. who would the natural seller of long-dated 30+ vol be.  Buffett?  Insurance companies?  Yale/Harvard?  The reality is nobody in the financial has long-term balance sheet visibility AND security of funding, and I think this is a symptom of how the Fed and govt intervention has farked up everything by preventing the market from clearing through actual price discovery over the past five years.  Few investors fully trust a non-government counterparty to be there to pay out a few years down the road, and private entities struggle to retain the balance sheet funding to commit as a seller of vol and "ride out" the immense carry available (the Harvard endowments should be ALL OVER THIS imho, as you could easily extract double digit returns riding down the vol curve assuming you have the balance sheet to take a MTM hit when "shtuff happens").  Come to think of it, if major technology megacaps can place long term debt at extremely low rates, why not go into the long-term carry finance business by issuing a 10-year 2% coupon and use the proceeds to continuously sell 1-year variance for a low-double digit unlevered return?  I would prefer this to a dilutive acquisition, but I doubt any investors would be pleased!  With capex, staff, and economic outlook being what they are -- what else you gonna do with the money?  Somebody should call Breitburn (Apple's cash manager in Nevada).

The other dynamic is in the short-to-mid market for vol, which remains in severe contango (the premium of VIX futures over spot my friend described).  I chalk this up to the unrelenting efforts over the past three years by policymakers whose third mandate appears to be to stick-save stocks no matter what and “kick the grenade down the road.”  I fear this has conditioned long-biased cash investors that stocks always come back (I have written about the dangers of this psychology in Global Market Musings earlier this year).  But this psychology of "the Big One may come… just not yet" is faced off against the ever present "event risk" – the gap risk that keeps premiums elevated a few months out.  The “system would blow big ...if it does blow...which could be in a few months, but not this week" sort of thinking perhaps?  This has led to an unbelievably profitable "carry" (short gamma) business for derivative dealing desks on the Street these past two years – in fact, of all my market pals, the only ones I know who are having a great time on the sellside are those whose job it is to trade equity derivatives.  They are killing it because ultimately their job comes down to collecting steeply overpriced insurance products…in the short run.  Sure, some buyers of that insurance suffer from what I call the "Paulson factor" (wanting to be the short hero when everyone is long).  Chris Cole's quote earlier about the jackpot being a lot smaller when everyone has a winning lotto ticket is very apropos.  But it also reminds me of a quote I read many years ago: “The moral is clear. When Wall Street appears in genius mode, raking in huge profits on mysterious products and complex trades, the secret isn’t genius at all.  It is that hubris is running wild, and so is risk.  And whether it’s tomorrow or five years hence, risk will jump from the shadows, knife in hand, to cut genius down to size.” (Fortune Magazine, 26 November 2007)

Ultimately what I'm saying here boils down to this: unceasing market intervention has crushed the forward-looking expected returns for pretty much every asset class out there: rates, credit, HY, equities, equity with overlay/protection strategies (calls too cheap), long/short, macro, relative value, you name it.  The Feds have done much more than just peg rates to zero and sit on the yield curve – they have quite literally stripped the investment management industry of most (but not all) alternatives for generating a decent return in the future by convincing the trapezing investment community that there is a safety net.  This belief heuristic pulled investment returns into the present by rallying EVERYTHING.  This is simple math, but hard to stomach for the investor who's career is on the line if he's not “chasing” or “in the game.”

While I remain sympathetic to the left tail of deflation as the probable outcome (the risk is real, but yes the risk has been overpriced by protection buyers for some time now, as Chris Cole points out), I have been thinking a lot lately about something else that's bugging me about the right tail.  I recently went back to my notes from late 2007 and found an old rant that I wrote at Citi where I discussed Bill Ackman's Pershing Square presentation on shorting MBIA and Ambac.  Those were his high conviction shorts on account of their overwhelming exposure to junk mortgages – and as it turns out they were some of the “AAA backstop” to the whole shadow banking system when it came to shoddy mortgage securitizations.  Ackman’s view was, even if subprime is only a $100bln problem that is 'contained,' the claims that MBIA and AMBAC might have to pay out were so huge relative to capital cushions that they would quickly overwhelm the balance sheet and send these stocks from $80 to zero, quite literally on a razor's edge (did I mention these were AAA rated!!).

In recalling this recently, it suddenly occurred to me that we are into something comparable but possibly far more serious today.  The idea of how pressure in complex systems builds up over time... that complexity and connectivity magnifies contagion mechanisms both seen and unseen... and yet asset prices no longer reflect much worry for future risks ... why exactly?  Because the Federal Reserve has become the ultimate backstop, just as the fixed income derivatives guys on the trading floor upstairs thought they could rely on Ambac and MBIA.  I hate that this seems to head down the goldbug rabbit hole, but where else does this go?  The real convexity... the real non-linearity payout today... it's in betting on the failure of the optical backstop just like it was back then – the thinly capitalized, AAA-rated guys who are purportedly smarter than everyone and happily set up a business where they guarantee immense risks and collect what they think is a sufficient premium that turns out to be laughably insignificant.  Today MBIA and AMBAC are no longer in business – by this I mean their "guarantee" is not worth much for any future underwriting.  So who took their place, figuratively speaking?  Whose balance sheet is the ultimate backstop to reckless financial speculation?  Who created Too Big To Fail?  Who says "Hey, I have the ultimate liability here, but don't sweat it cuz the worst case scenario is simply impossible"... do you see where I'm going with this? 

Now to be clear, I have owned boatloads of silver for years on a thesis that has nothing to do with currency failure or printing money or all that "goldbug stuff"... but I am starting to grow sympathetic to their arguments.  After all, what would you own when the market decides to test the backstop on an immense amount of risk, and the backstop turns out to be a guarantee from a thinly capitalized entity that loses its sanctified status in the eyes of the market at the worst possible time?  What's the hedge to that?  I can only think of real assets like gold, farmland, etc.  Frankly, for all this talk about owning equities as a defense to a currency or sovereign debt crisis, I'm not entirely sure that owning fractional shares of American businesses is a suitable form of protection in a chaotic environment where interest rates, foreign exchange, and global capital are flying around like "a loose cannon on the deck of the world, amid a tempest-tossed era" (President Herbert Hoover from his memoirs in 1931, as quoted in Charles Kindleberger’s The World In Depression 1929-1939, p. 148).  After all, equities are as dependent on an internal rate of return in determining their value as bonds are – so how are equities a hedge in all this exactly?  People in equities tell me all the time "don’t fight central banks" – but isn’t that like saying Ambac’s insurance is "money good"?  The Fed may be the biggest bank in the world, but they're still just a bank making a promise.

So back to the short-term vol contango issue... are the derivative dealing desks conducting similar MBIA-style activity in the equity markets?  Selling overpriced insurance for a few months' duration has been a great profit center for them and if current conditions persist, good times will abound.  But if the ultimate outcome is one where we wake up one morning and S&P futures are locked limit down with one contract traded at the limit, then yes, derivative dealing desks might just be the new Ambac sellers of protection for equities, figuratively speaking.  Are the Feds going to take on these liabilities as well?  Is that what “Too Big To Fail” has come to?  I am not saying this is going to happen.  But this is why I presented the possibility back in April that at some point in the future we may see equity markets trade like grain futures, gapping around at the limit while attempting to clear.  Yes, yes, I know the Feds would “never allow this.”  But frankly this scenario doesn’t even worry me so much anymore from a systemic point of view, because how often and to what size do stocks turn up as collateral in another obligation?  The Rate & FX derivatives market is measured in hundreds of trillions, whereas the equity derivatives market is measured in trillions.  Maybe equity protection buyers are operating in the wrong market – maybe the convexity and non-linearity of the payout is in the rate and FX market, not the equity market.  Maybe the goldbugs are on the right track.  But my gut tells me the big Paulson trade is not betting on a stock market crash – because even if stocks were to crash, the protection is so expensive that to bank a 25:1 return means 1987 on steroids in terms of outcome.  The asymmetry is to be found in the markets with the “ultimate backstop”…the Federal Reserve.  Somewhere in there is an Ambac trade.

Of course I have to caveat all this by saying if there is one lesson I can take home from the past two years, it’s that the inevitable and the imminent are quite different things.

As always, I would love to hear your thoughts.  With kind regards,

Paulo Pereira