At the peak of the craziness of the last cycle, banks took to protecting themselves by buying (credit) protection on other banks as a 'hedge' for systemic risk (which instead exacerbated contagion concerns, seemingly missing the facts that their bids drove risk wider, increaing counterparty risks, and that the inevitable collapse required to trigger these trades would also mean the payoffs to the 'hedges' would never be realized). Fast forward 8 years and it appears once again, as Bloomberg reports, that banks are buying (equity) protection in order to hedge the stress-test downside scenarios enforced by The Fed.
For more than a year, dealers in the U.S. equity derivatives market have noted a widening gap in the price of certain options. (chart below shows the absolute premium for downside protection over upside protection)
If you want to buy a put to protect against losses in the Standard & Poor’s 500 Index, often you’ll pay twice as much as you would for a bullish call betting on gains. (chart below shows the relative premium for downside protection over upside protection)
New research suggests the divergence is a consequence of financial institutions hoarding insurance against declines in stocks. As Bloomberg details,
While various explanations exist including simply nervousness following a six-year bull market, Deutsche Bank AG says in a Dec. 6 research report that the likeliest explanation may be that demand is being created for downside protection among banks that are subject to stress test evaluations by federal regulators. In short, financial institutions are either hoarding puts or leaving places for them in their models should markets turn turbulent.
“Since so many banking institutions are facing these stress tests, the types of protection that help banks do well in these scenarios obtain extra value,” said Rocky Fishman, an equity derivatives strategist at Deutsche Bank.
“The way the marketplace has compensated for that is by driving up S&P skew.”
The Federal Reserve’s Comprehensive Capital Analysis & Review, or CCAR, has become one of the most important annual events for the largest banks. It determines whether trading units, including equity derivatives, can handle a market shock and pay out capital to shareholders. In the test, banks must demonstrate that they can weather a crisis and stay above minimum capital ratios even as their amount of equity is reduced by losses and the planned dividends and buybacks.
One aspect of the stress test is gauging how banks respond to what’s the Fed describes as a “severely adverse” scenario. It’s the most extreme of three situations laid out by the central bank during the annual CCAR.
“One of the reasons S&P puts have been so expensive relative to at-the-money options this year is that the severely adverse scenario prescribed by CCAR program implies a very negative shock to the S&P,” said Fishman. “It creates value for the downside options.”
Of course, we have seen this kind of systemic hedging by banks before. When banks bought credit protection against other banks during the last crisis. Still, the Fed stress tests remain the cornerstone of the U.S. central bank’s efforts to prevent a repeat of the 2008 financial crisis and to gauge the ability of banks to withstand economic turmoil. To Dan Deming of KKM Financial LLC, their presence will have a lasting effect on risk tolerance.
“Risk requirements have ramped up to a point where market participants are forced to buy downside puts as an insurance policy against open option positions,” said Deming. “What was perceived as reasonable risk five years ago is no longer seen as reasonable amid all the new requirements.”
But what regulators (since we are sure the banks know) miss in their math is that these so-called hedges only payoff when a systemic collapse happens and, in the case of the last crisis, the actual assumed payoff disappears as counterparty collateral chains dry up, banks implode, and just when you needed the hedge the most... there is no one left to pay you.