Structured Products and Derivatives

GameStop: The Voting Machine Versus The Weighing Machine

Posted on 27 January 2021 by David Merkel

Photo Credits: Seattle Municipal Archives, Luis Anzo, piepjemiffy & Pine Tools || Truth is stranger than fiction, particularly with the behavior of crowds in markets

Before I start writing this evening, I want to say that what I write here is correct in its major findings, but it is quite possible that I got some details wrong. This is complex, and there are a lot of issues involved.

I’ve had four friends ask me about GameStop [GME] over the last few days. Thus I am writing an explanation as to why things are so nuts here.

As a prelude, I want to tell everyone that I have no positions at present in GME, and have no intentions of taking a position in it ever. Mid-decade, I owned GME and lost a little bit on it. I came to the correct conclusion that their business model no longer worked before most of the market gave up on it. If anything, the business model is worse now than when I sold. I think the true value of GME is about $5/share, unless management does something clever with its overvalued stock. Fortunately, I have written a really neat article called How do you Manage a Company when the Stock is Considerably Overvalued? I’ll talk about this more toward the end of this piece.

One more note: I never short because it is very hard to control risk when shorting. When you are short, or levered long, you no longer control your trade in full, and an adverse price move could force you to buy or sell when you don’t want to.

I can imagine working at the hedge fund, and my boss says to me, “What should I do about GME?” My initial answer would be “Nothing, it’s too volatile.” If pressed, I would say, “Gun to the head, it is a short, if you can source the shares, and live with the possibility of being forced by the margin desk to put more capital.”

Now you know my opinion. Let me explain the technicals and the fundamentals here.

The Voting Machine

Ben Graham used to say that the stock market was a voting machine in the short-run, and a weighing machine in the long-run. In a mania, you can get a lot of people chasing the shares of a speculative company like GME, and in the short run, the aggressiveness of the buyers lifting the ask and buying call options can drive the stock higher.

With GME, there is another complicating factor — there are more shares shorted than there are shares issued. This means that some brokerages have been allowing “naked shorting,” i.e., allowing traders to sell short without borrowing shares. This is illegal, and I wouldn’t be surprised to see the SEC pursue a case against some brokers as a result.

When there are a lot of short sellers in a given stock, if buyers can get the price to rise, it can create a temporarily self-reinforcing cycle as shorts are forced by their brokers to put up more capital, or buy in their short position. This is called a “short squeeze.” I’m pretty certain that has been happening with GME.

Now, beyond that there are several other factors:

Longs that are locked because of large positions
Use of call options to magnify gains (and maybe losses)
Co-ordinated buying by small traders.
Possible use of total return swaps
Moving shares to the cash account

I’ll handle these in the above order. There are three entities that own more than 10% of GME. Blackrock, Fidelity, and RC Ventures (the investment vehicle of Ryan Cohen, CEO of Chewy.com). Once you own more than 10% of a company, you can’t sell shares until six months have passed since your last purchase. If you purchase more, you must notify the market within two days. If you finally get to the point where you can sell, you can’t buy again for six months, and if you sell you must notify the market within two days.

RC Ventures, which now has three board seats on the GME board, can’t sell GME shares until mid-June, as they bought their last shares in December. I have no idea when Blackrock and Fidelity last bought GME shares but it six months have passed, I would be bombing the market with shares. Since I haven’t seen a filing by either one, I assume they can’t do it for now.

With call options, when a call is sold, the writer of the option must either:

Bear the risk in full
Buy other call options to hedge, and/or
Buy GME stock to hedge, with the risk that you will have to buy more if the stock goes higher, or sell if the stock goes lower.

Buying call options is a leveraged strategy — you can win or lose a lot — usually it is lose. On net, the market is not affected much — for every buyer there is a seller, and derivative positions like calls net to zero. The only time when that is not true is when prices move so fast that margin desks can’t keep up. At that point, brokers take rare losses.

Co-ordinated trading by small traders, perhaps influenced by wallstreetbets at Reddit is something new-ish, though it is reminiscent of the bull pools that existed in the early 20th century. The main difference is that it is a lot of little guys versus a few big guys. Regulations today call a few big guys trying to manipulate the price of a stock “market manipulation,” which is illegal. That does not apply to little guys talking to each other, most likely.

But there is a greater problem here. Even if you are participating with wallstreetbets, how do you know when others will sell to lock in profits.? It’s not as if anyone is looking at the likely flow of future dividends. The dividend has been suspended. Eventually the willingness of the “bull pools” to extend more liquidity will run out. Then there will be a run for the exits — this is a confidence game. Don’t be a bagholder.

With respect to total return swaps, it is the same issue as call or put options. Someone has to take the other side of the trade, and either bear the risk or hedge the risk. There usually should be no net effect.

Finally, there is moving GME shares to the cash account, which means those shares can’t be borrowed in order to short them. There are two points here:

There is already illegal naked shorting going on here, so moving shares to the cash account may not do much.
If you are a monomaniac, and are pursuing only GME, you might decide to lever your position via margin. At that point it is not possible to move shares to the cash account.

That takes care of the technicals, now on to the fundamentals.

The Weighing Machine

The fundamentals of GME are lousy. How many of you know their debt ratings? I see one guy in the back raising his hand at half mast. Well, let me tell you that GME has two bonds outstanding:

$216+ million of a secured first-lien note rated B2/B- maturing in 2023 with a 10% coupon trading in the mid-$103 area for a mid-6% yield-to-worst, which GME can’t likely call.
$73+ million of an 6.75% unsecured note rated Caa1/CCC+ maturing in less than two months with a mid-5% yield.

Both of these notes are trading above par, but they still trade as junk. If it were not from the interest of RC Ventures they would trade a lot lower. They did trade much lower before RC Ventures bought their stake — yields for the unsecured debt exceeded 40% annualized.

This is a troubled company that would be teetering on the brink of bankruptcy were it not for the efforts of RC Ventures. As such, I would say that the value of GME is at most the price that RC Ventures is willing to pay for it, and that amount is uncertain. (Did I mention that they are losing money regularly?)

And to the bulls I would add, don’t discount the possibility of a trading suspension where you can’t get out of your positions. I can tell you that if that happens the price of GME will be a LOT lower when trading resumes.

What is not “Advice”

Here is my non-advice for everyone.

For those that own GME, sell now. I said NOW, you waited ten seconds.

For those that are short GME, hold your short to the degree that you can.

To the management of GME, do a PIPE, sell a convertible bond or preferred stock. Buy another company in a stock swap. Do anything you can to monetize the idiocy of the bull pool at wallstreetbets. They are offering you a free lunch. Hey, and as an added incentive, RC Ventures can’t sell right now, but you can. Every bit of monetization that you do will benefit RC Ventures to a degree, and dilute them as well (a plus!).

Take the dopes at wallstreetbets to the cleaners, and show them the power of the primary market as you dilute them. Oh, and while you have the opportunity, pay off your bonds, or at least set the money aside in escrow to redeem them at the call date. That is the rescue strategy for GME: sell stock to the losers who have foolishly bid the price up, and use it to rebuild you business. Even RC Ventures may thank you.

Full disclosure: no positions in GME

The Tail Can’t Wag the Dog

Posted on 27 February 2020 by David Merkel

Photo Credit: theilr || Cute dog, huh?

There are a pair of articles regarding the efforts of a few people posting at Reddit to make money in stocks as part of a perpetual motion machine. The articles are here: Businessweek, Matt Levine.

The idea is for a bunch of people to buy calls in the morning, which forces market makers to hedge by buying the underlying stock, which pushes the price up, giving automatic gains. Now, real hedgers hedge options using options, but the net effect should be the same regardless.

What the speculators mentioned in these articles don’t get is that they are violating rule XXXII:

Dynamic hedging only has the potential of working on deep markets.
Arbitrage pricing can reveal proper prices in smaller less liquid markets if there are larger, more liquid markets to compare against.? The process cannot work in reverse, except by accident.
The Rules, Part XXXII

The quick summary of this is that the tail can’t wag the dog. The amount of money in the options market is far smaller than the money in the stock market. As such, if speculators try to overwhelm the market for a given stock with call purchases, real money sellers will happily oblige them and provide them with stock. They will not win on average.

There are no simple magical money machines in the market. Those that think they have one have deceived themselves.

Avoid Short Volatility Products

Posted on 23 January 2020 by David Merkel

Photo Credit: Niccol? Ubalducci || Tornados are similar to financial events where volatility erupts. You can predict them in aggregate, but not in specific

Remember when I wrote Where Money Goes to Die? Well, short volatility products cratered, but cryptocurrencies treaded water, with a lot of volatility.

I am telling you today to avoid short volatility products again. This seems to be a case where people don’t learn. Why? Because there is seemingly free yield from shorting volatility in the bull phase of the equity market. The opposite side of the trade is a disaster as well…. indicating that timing has to be precise if you are trying to earn money off of rising volatility.

Here is an additional reason to avoid short volatility products: the stock market is priced to produce a return of 2.5%/year over the next 10 years. The only time that has been lower than that is during the dot-com bubble.

In this situation, with valuations so high, it would not take much of a scare to make the market drop sharply, which would make volatility jump. Many short volatility products would be wiped out.

So, if you own short volatility products, sell them now. I am not saying “buy long volatility products” because that is a gambler’s game. It is a time to protect principal, not a time to seek speculative gains.

Avoid Complexity in Limiting Risk

Posted on 19 October 201920 October 2019 by David Merkel

Picture Credit: Olivier ROUX || Simplicity almost always beats complexity.

I’m not a fan of EIAs. I’m not a fan of variable annuities, unless they’re really simple with rock-bottom expenses and no surrender charges. I’m not a fan of ETNs. I hate structured notes. I’m also not a fan of ETFs that are filled with derivatives.

Ten years ago, I wrote a piece called The Good ETF. It is still as valid now as before, along with its companion piece The Good ETF, Part 2 (sort of). And for Commodity ETFs, there was: Fusion Solution: The Stable Value Fund Guide to Commodity ETF Management. If you are rolling futures in an ETF, it had better be done like a short bond ladder.

You can add in the pieces that I wrote before and when the short volatility ETFs imploded. What did it say in The Good ETF?

Good ETFs are:
* Small compared to the pool that they fish in
* Follow broad themes
* Do not rely on irreplicable assets
* Storable, they do not require a ?roll? or some replication strategy.
* not affected by unexpected credit events.
* Liquid in terms of what they represent, and liquid it what they hold.
The last one is a good summary.? There are many ETFs that are Closed-end funds in disguise.? An ETF with liquid assets, following a theme that many will want to follow will never disappear, and will have a price that tracks its NAV.
The Good ETF

But tonight I have another complex investment to avoid, and a simple one to embrace. First the avoid…

There was a piece at Bloomberg Businessweek called ETFs With Downside Protection? It?s Complicated. These are called defined outcome ETFs. Basically they are a bundle of equity options that cut your losses, while limiting your gains on a given equity index. (Also, you don’t get dividend income, and have to pay manager fees.) In-between the cap on gains, and where losses kick in, your returns should move 1:1 with the index. The same will be true with losses after the first N% get eaten — below N% losses, you begin taking losses.

Illustration of Defined Outcome ETF returns as compared to an index fund using the same index as the Defined Outcome ETF

I wanted to keep the illustration simple. This hypothetical defined outcome ETF caps gains at 10%, and absorbs the first 15% of losses. This example assumes no fees, which would likely be lower on the index fund. This example assumes no dividends, which would get paid to you in the index fund, but not on the defined outcome ETF.

Defined outcome ETFs purchase and sell tailored options that are backed by the central counterparty the Options Clearing Corporation — a very strong, stable institution. Credit risk still exists, but if the OCC goes down, many things will be in trouble. The options exist for one year, after which gains are paid to and losses absorbed by ETF shareholders. The ETF then resets to start another year following the same strategy with slightly different levels because the relative amounts of the cap and the loss buffering rely on where equity volatility is for a given index at the start of the year.

Unlike an index fund, your gains cannot grow tax-deferred, though if you have gains, you can roll them over into the next year.

I’ve read the offering documents, including the sections on risk. My main argument with the product is that you give up too much upside for the downside protection. The really big up years are the places where you make your money. There aren’t so many “average” years. The protection on the downside is something, but in big down years it could be cold comfort.

The second part is the loss of dividends and paying higher fees. Using the S&P 500 as a proxy, a 2% dividend lost and a 0.5% added fee adds up to quite a cost.

There are implementation risks and credit risks but these risks are small. I ran a medium-sized EIA options book for a little more than a year. This is not rocket science. The investor who is comfortable with options could create this on his own. They list more risks in the offering documents, but they are small as well. What gets me are the costs, and the upside/downside tradeoff.

A Better, if Maligned Investment

Recently Bank of America declared ?the end of the 60-40? standard portfolio. I think this was foolish, and maligns one of the best strategies around — the balanced fund.

Yes, interest rates are low. Yields on some stocks are higher than the yields on the Barclays’ Aggregate [bond] Index. But if you only bought those bonds, you would have a rather unbalanced portfolio from a sector standpoint — heavy on utilities and financials. The Barclays’ Aggregate still outyields the S&P 500, if not by much, like 0.8%/yr.

The real reason that you hold bonds and cash equivalents is not the income; it is risk reduction. I’m assuming no one is thinking of buying the TLT ( 20+ Year Treas Bond Ishares ETF), which is more of a speculator’s vehicle, but something more like AGG ( US Aggregate Bond Ishares Core ETF), which yields 0.3% more, but the overall volatility is a lot less.

With AGG, fixed income claims of high investment grade entities will make it through a deflationary crisis. In an inflationary situation like the 70s, the bonds are short enough that over a five year period, you should make money, just not in real terms.

It’s good to think long term, and have a mix of fixed and variable claims. The bonds (fixed claims) lower your volatility so that you don’t get scared out of your stocks (variable claims) in a serious downdraft.

The models I have run have returns max out in an 80/20 balanced fund, and the trade-off of risk for return is pretty good down to a 60/40 balanced fund. In my personal investing, I have always been between 80/20 and 60/40.

As it is, if you are looking the likely returns on the S&P 500 over the next ten years, it’s about the same return available on a A3/A- corporate bond, but with a lot more volatility.

Thus the need for bonds. In a bad scenario, stocks will fall more than bonds, and the balanced fund will buy stocks using proceeds of the bonds that have fallen less to buy stocks more cheaply. And if the stock market rises further, the balanced fund will sell stocks and use the proceeds to bank the gains by buying bonds that will offer future risk reduction, and some income.

As such, consider the humble balanced fund as a long-term investment vehicle that is simple and enduring, even when rates are low. And avoid complexity in your investment dealings. It is almost never rewarded.

What Caused the Financial Crisis?

Posted on 15 September 201816 September 2018 by David Merkel

Photo Credit: Alane Golden || Sad but true — the crisis was all about bad monetary policy, a housing bubble, and poor bank risk management======================

There are a lot of opinions being trotted around ten years after the financial crisis.? A lot of them are self-serving, to deflect blame from areas that they want to protect.? What you are going to read here are my opinions.? You can fault me for this: I will defend my opinions here, which haven?t changed much since the financial crisis.? That said, I will simplify my opinions down to a few categories to make it simpler to remember, because there were a LOT of causes for the crisis.

Thus, here are the causes:

1) The Federal Reserve and the People?s Bank of China

For different reasons, these two central banks kept interest rates too low, touching off a boom in risk assets in the USA.? The Fed kept interest rates too low for too long 2001-2004. The Fed explicitly wanted to juice the economy via the housing sector after the dot-com bust, and the withdrawal of liquidity post-Y2K.? Also, the slow, predictable way that they tightened rates did little to end speculation, because long rates did not rise, and in some cases even fell.

The Chinese Central Bank had a different agenda.? It wanted to keep the Yuan cheap to continue growing via exporting to the US.? In order to do that, it needed to buy US assets, typically US Treasuries, which balanced the books ? trading US bonds for Chinese goods ? and kept longer US interest rates lower.

Both of these supported the:

2) Housing Bubble

This is the place where there are many culprits.? You needed lower mortgage underwriting standards. This happened through many routes:

US policy pushing home ownership at all costs, including tax-deductibility of mortgage interest.
GSEs guaranteeing increasingly marginal loans, and buying lower-rated tranches of subprime RMBS. They ran on such a thin capital base that it was astounding.? Don?t forget the FHLBs as well.
Politicians and regulators refused to rein in banks when they had the power and tools to do so.
Securitization of private loans separated origination from risk-bearing, allowing underwriting standards to deteriorate. Volume was rewarded, not quality.
Mortgage insurers and home equity loans allow people to borrow a far greater percentage of the value of the home than before, for conforming loans.
Appraisers went along with the game, as did regulators, which could have stopped the banks from lowering credit standards. Part of the fault for the regulatory mess was due to the Bush Administration downplaying financial regulation.
The Rating Agencies gave far too favorable ratings to untried asset classes, like ABS and private RMBS securitizations. This is for two reasons: financial regulators required that the companies they oversaw must use ratings for assessing capital needed to cover credit risk, and did not rule out asset classes that were unproven, as prior regulators had done.? Second, CDOs and similar structures needed the assets they bought to have ratings for the same reason.
There was a bid for yieldy assets on the part of US Hedge funds and foreign financial firms. Without the yield hogs who bid for CDO paper, and other yieldy assets, the bubble would not have grown so big.
Financial guarantors insured mortgage paper without having good models to understand the real risk.
People were stupid enough to borrow too much, assuming that somehow they would be able to handle it.? As with most bubbles, there were stupid writers pushing the idea that investing in housing was “free money.”

3) Bank Asset-liability management [ALM] for large commercial and investment banks was deeply flawed. ?It resulted in liquid liabilities funding illiquid assets.? The difference in liquidity was twofold: duration and credit.? As for duration, the assets purchased were longer than the bank?s funding structures.? Some of that was hidden in repo transactions, where long assets were financed overnight, and it was counted as a short-term asset, rather than a short-term loan collateralized by a long-term asset.

Also, portfolio margining was another weak spot, because as derivative positions moved against the banks, some banks did not have enough free assets to cover the demands for security on the loans extended.

As for credit, many of the assets were not easily saleable, because of the degree of research needed to understand them.? They may have possessed investment grade credit ratings, but that was not enough; it was impossible to tell if they were ?money good.?? Would the principal and interest eventually be paid in full?

The regulatory standards let the banks take too much credit risk, and ignored the possibility that short-term lending, like repos and portfolio margining could lead to a ?run on the bank.?

4) Accounting standards were not adequate to show the risks of repo lending, securitizations, or derivatives.? Auditors signed off on statements that they did not understand.

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That?s all, I wanted to keep this simple.? I do want to say that Money Market Funds were not a major cause of the crisis.? The reaction to the failure of Reserve Primary was overdone.? Because of how short the loans in money market funds are, the losses from money market funds as a whole would have been less than two cents on the dollar, and probably a lot smaller.

Also, bailing out the banks sent the wrong message, which will lead to more risk later.? No bailouts were needed.? Deposits were protected, and there is no reason to protect bank stock or bondholders.? As it was, the bailouts were the worst possible, protecting the assets of the rich, while not protecting the poor, who still needed to pay on their loans.? Better that the bailouts should have gone to reduce the principal of loans of those less-well-off, rather than protect the rich.? It is no surprise that we have the politics? we have today as a result.? Fairness is more important than aggregate prosperity.

PS — the worst of all worlds is where the government regulates and gives you the illusion of protecting you when it does not protect you much at all.? That tricks people into taking risks that they should not take, and leaves individuals to hold the bag when bad economic and regulatory policies fail.

The Balance: Considering Event-Driven Investing

Posted on 1 September 2018 by David Merkel

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I published another article at The Balance:?Considering Event-Driven Investing.? This is one place where writing in the third person leaves a lot out.? I’ve done a lot with some types of event-driven investing.

Speculating on hurricanes — I did that successfully at the hedge fund 2004, 2005 and 2006.? 2006 because I thought the risk of another strong hurricane year was overplayed.? 2004 and 2005 because I had a good idea of who was underreporting claims after disasters.? That was the only time in my life that I went from long a company to short without stopping, and I covered on the day the CEO resigned, and caught the bottom tick.
Bond deal arbitrage — well, sort of.? I would buy target company bonds and sell the bonds of the parent.? I had to be certain that the deal would go through, but it was a tremendous yield enhancement is the right situations.
From the prior article, speculating on Lula’s non-impact on Brazil qualifies as event-driven.
Stock arbitrage — did a lot with it when I was younger.? Didn’t do so well.
Index arbitrage — did a neutral trade where we shorted one company out of the Russell 2000, and bought another one in.? Made no money on the trade.? We had a good fundamental justification for the trade, but it just goes to show you that this isn’t as easy as it looks.
I buy a decent number of spinoffs.? Most succeeded as investments for me.

Now, all that said, most areas where there are simple arbitrages typically boil down to a simple credit risk: will the deal get completed? Will the company not take an action that changes its capital structure in a way that hurts me?

Since these are relatively simple trades, the returns are relatively low like that on a short-term junk bond — at present, like the yield on T-bills plus 2-3%.? It’s not very compelling given the risks involved.? Most of the mutual funds that do that type of arbitrage have not done so well.

Thus, aside from spinoffs, at present, I don’t do that much with event-driven investing.? Many of the forms of it are too crowded, and I prefer simplicity in investing.

The Rules, Part LXIV

Posted on 6 February 2018 by David Merkel

Photo Credit: Steve Rotman || Markets are not magic; government economic stimulus is useless with debt so high

Weird begets weird

I said in an earlier piece on this topic:

I use [the phrase] during periods in the markets where normal relationships seem to hold no longer. It is usually a sign that something greater is happening that is ill-understood. ?In the financial crisis, what was not understood was that multiple areas of the financial economy were simultaneously overleveraged.

So what’s weird now?

Most major government running deficits, and racking up huge debts, adding to overall liability promises from entitlements.
Most central banks creating credit in a closed loop that benefits the governments, but few others directly.
Banks mostly in decent shape, but nonfinancial corporations borrowing too much.
Students and middle-to-lower classes borrowing too much (autos, credit cards)
Interest rates and goods and services price inflation stay low in the face of this.
Low volatility (until now)
Much speculative activity in cryptocurrencies (large percentage on a low base) and risk assets like stocks?(smaller percentage on a big base)
Low credit spreads

No one should be surprised by the current market action.? It wasn’t an “if,” but a “when.”? I’m not saying that this is going to spiral out of control, but everyone should understand that?The Little Market that Could?was a weird situation.? Markets are not supposed to go up so steadily, which means something weird was fueling the move.

Lack of volatility gives way to a surfeit of volatility eventually.? It’s like macroeconomic volatility “calmed” by loose monetary and fiscal policy.? It allows people to take too many bad chances, bid up assets, build up leverage, and then “BAM!” — possibility of debt deflation because there is not enough cash flow to service the incurred debts.

Now, we’re not back in 2007-9.? This is different, and likely to be more mild.? The banks are in decent shape.? The dominoes are NOT set up for a major disaster.? Risky asset prices are too high, yes.? There is significant speculation in areas?Where Money Goes to Die.? So long as the banking/debt complex is not threatened, the worst you get is something like the deflation of the dot-com bubble, and at present, I don’t see what it threatened by that aside from cryptocurrencies and the short volatility trade.? Growth stocks may get whacked — they certainly deserve it from a valuation standpoint, but that would merely be a normal bear market, not a cousin of the Great Depression, like 2007-9.

Could this be “the pause that refreshes?”? Yes, after enough pain is delivered to the weak hands that have been chasing the market in search of easy profits quickly.? The lure of free money brings out the worst in many.

You have to wonder when margin debt is high — short-term investors chasing the market, and Warren Buffett, Seth Klarman, and other valuation-sensitive investors with long horizons sitting on piles of cash.? That’s the grand asset-liability mismatch.? Long-term investors sitting on cash, and short-term investors fully invested if not leveraged… a recipe for trouble.? Have you considered these concepts:

Preservation of capital
Dry powder
Not finding opportunities
Momentum gives way to negative arbitrages.
Greater fool theory — “hey, who has slack capital to buy what I own if I need liquidity?”

Going back to where money goes to die, from the less mentioned portion on the short volatility trade:

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default ? this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a ?failure cycle? tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

So as volatility has spiked, perhaps the free money has proven to be the bait of a mousetrap.? Do you have the flexibility to buy in at better levels?? Should you even touch it if it is like a knockout option?

There are no free lunches.? Get used to that idea.? If a trade looks riskless, beware, the risk may only be building up, and not be nonexistent.

Thus when markets are “weird” and too bullish or bearish, look for the reasons that may be unduly sustaining the situation.? Where is debt building up?? Are there unusual derivative positions building up?? What sort of parties are chasing prices?? Who is resisting the trend?

And, when markets are falling hard, remember that they go down double-speed.? If it’s a lot faster than that, the market is more likely to bounce.? (That might be the case now.)? Slower, and it might keep going.? Fast moves tend to mean-revert, slow moves tend to persist.? Real bear markets have duration and humiliate, making weak holders conclude that will never touch stocks again.

And once they have sold, the panic will end, and growth will begin again when everyone is scared.

That’s the perversity of markets.? They are far more volatile than the economy as a whole, and in the end don’t deliver any more than the economy as a whole, but sucker people into thinking the markets are magical money machines, until what is weird (too good) becomes weird (too bad).

Don’t let this situation be “too bad” for you.? If you are looking at the current situation, and think that you have too much in risk assets for the long-term, sell some down.? Preserving capital is not imprudent, even if the market bounces.

In that vein, my final point is this: size your position in risk assets to the level where you can live with it under bad conditions, and be happy with it under good conditions.? Then when markets get weird, you can smile and bear it.? The most important thing is to stay in the game, not giving in to panic or greed when things get “weird.”

Classic: Wrecking Ball Looms for Big Housing Spec

Posted on 8 December 2017 by David Merkel

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I thought this old post from RealMoney.com was lost, never to be found again.? This was the important post made on November 22, 2006 that forecast some of the troubles in the subprime residential mortgage backed securities market.? I favored the idea that there there would be a crash in residential housing prices, and the best way to play it would be to pick up the pieces after the crash, because of the difficulties of being able to be right on the timing of shorting could be problematic.? In that trade, too early would mean wrong if you had to lose out the trade because of margin issues.

With that, here is the article:

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I have tried to make the following topic simple, but what I am about to say is complex, because it deals with the derivative markets. It is doubly or triply complex, because this situation has many layers to unravel. I write about this for two reasons. First, since residential housing is a large part of the US economy, understanding what is going on beneath the surface of housing finance can be valuable. Second, anytime financial markets are highly levered, there is a higher probability that there could be a dislocation. When dislocations happen, it is unwise for investors to try to average down or up. Rather, the best strategy is to wait for the trend to overshoot, and take a contrary position.

There are a lot of players trotting out the bear case for residential housing and mortgages. I’m one of them, but I don’t want overstate my case, having commented a few weeks ago on derivatives in the home equity loan asset-backed securities market. This arcane-sounding market is no small potatoes; it actually comprises several billions of dollars’ worth of bets by aggressive hedge funds — the same type of big bettors who blew up so memorably earlier this year, Amaranth and Motherrock.

A shift of just 10% up or down in residential housing prices might touch off just such another cataclysm, so it’s worth understanding just how this “arcane-sounding” market works.

I said I might expand on that post, but the need for comment and explanation of this market just got more pressing: To my surprise, one of my Googlebots dragged in a Reuters article and a blog post on the topic. I’ve seen other writeups on this as well, notably in Grant’s Interest Rate Observer (a fine publication) and The Wall Street Journal.

How a Securitization Works (Basically)

It’s difficult to short residential housing directly, so a market has grown up around the asset-backed securities market, in which bulls and bears can make bets on the performance of home equity loans. How do they do this?

First, mortgage originators originate home equity loans, Alt-A loans and subprime loans. They bring these loans to Wall Street, where the originator sells the loans to an investment bank, which dumps the loans into a trust. The investment bank then sells participation interests (“certificates”) in the trust.

There are different classes of certificates that have varying degrees of credit risk. The riskier classes receive higher interest rates. Typically the originator holds the juniormost class, the equity, and funds an overcollateralization account to give some security to the next most junior class.

Principal payments get allocated to the seniormost class. Once a class gets its full share of principal paid (or cancelled), it receives no more payments. Interest gets allocated in order of seniority. If, after paying interest to all classes, there is excess interest, that excess gets allocated to the overcollateralization account, until the account is full — that is, has reached a value equal to the value of the second most junior class of trust certificates — and then the excess goes to the equity class. If there’s not enough interest to pay all classes, they get paid in order of seniority.

If there are loan losses from nonpayment of the mortgages or home equity loans, the losses get funded by the overcollateralization account. If the overcollateralization account gets exhausted, losses reduce the principal balances of the juniormost certificates — those usually held by the originator — until they get exhausted, and then the next most junior gets the losses. There’s a little more to it than this (the prospectuses are often a half-inch thick on thin paper), but this is basically how a securitization works.

From Hedging to Speculation

The top class of certificates gets rated AAA, and typically the lowest class before the equity gets rated BBB-, though sometimes junk-rated certificates get issued. Most of the speculation occurs in securities rated BBB+ to BBB-.

The second phase of this trade involves credit default swaps (CDS). A credit default swap is an agreement where one party agrees to make a payment to another party when a default takes place, in exchange for regular compensation until the agreement terminates or a default happens. This began with corporate bonds and loans, but now has expanded to mortgage- and asset-backed securities.

Unlike shorting stocks, where the amount of shorting is generally limited by the float of the common stock, there can be more credit default swaps than bonds and loans. What began as a market to allow for hedging has become a market to encourage speculation.

With CDS on corporate debt, it took eight years for the notional size (amount to pay if everyone defaulted) of the CDS market to become 4 times the size of the corporate bond market. With CDS on home equity asset-backed securities, it took less than 18 months to get to the same point.

The payment received for insuring the risk is loosely related to the credit spread on the debt that is protected. Given that the CDS can serve as a hedge for the debt, one might think that the two should be equal. There are a couple reasons that isn’t so.

First, when a default happens, the bond that is the cheapest to deliver gets delivered. That option helps to make CDS trade cheap relative to credit spreads. But a bigger factor is who wants to do the CDS trading more. Is it those who want to receive payment in a default, or those who want to pay when a default occurs?

How It Impacts Housing

With CDS on asset-backed securities, the party writing protection makes a payment when losses get allocated to the tranche in question. Most protection gets written on tranches rated BBB+ to BBB-.

This is where shorting residential housing comes into the picture. There is more interest in shorting the residential housing market through buying protection on BBB-rated home equity asset-backed securities than there are players wanting to take on that risk at the spreads offered in the asset-backed market at present. So, those who want to short the market through CDS asset-backed securities have to pay more to do the trade than those in the cash asset-backed securities market receive as a lending spread.

One final layer of complexity is that there are standardized indices (ABX) for home equity loan asset-backed securities. CDS exists not only for the individual asset-backed securities deals, but also on the ABX indices as well. Those not wanting to do the credit work on a specific deal can act on a general opinion by buying or selling protection on an ABX index as a whole. The indices go down in quality from AAA to BBB-, and aggregate similar tranches of the individual deals. Those buying protection receive pro-rata payments when losses get allocated to the tranches in their index.

So, who’s playing this game? On the side of falling housing prices and rising default rates are predominantly multi-strategy and mortgage debt hedge funds. They are paying the other side of the trade around 2.5% per year for each dollar of home equity asset-backed securities protection bought. (Deals typically last four years or so.) The market players receiving the 2.5% per year payment are typically hedge and other investment funds running collateralized debt obligations. They keep the equity piece, which further levers up their returns. They are fairly yield-hungry, so from what I’ve heard, they’re none too picky about the risks that they take down.

Who wins and who loses? This is tricky, but if residential real estate prices fall by more than 10%, the buyers of asset-backed securities protection will probably win. If less, the sellers of protection probably win. This may be a bit of a sideshow in our overly leveraged financial markets, but the bets being placed here exceed ten billion dollars of total exposure. Aggressive investors are on both sides of this trade. Only one set of them will end up happy.

But how can you win here? I believe the safest way for retail investors to make money here is to play the reaction, should a panic occur. If housing prices drop severely, and home equity loan defaults occur, and you hear of hedge fund failures resulting, don?t act immediately. Wait. Watch for momentum to bottom out, or at least slow, and then buy the equities of financially strong homebuilders and mortgage lenders, those that will certainly survive the downturn.

If housing prices rise in the short run (unlikely in my opinion), and you hear about the liquidations of bearish hedge funds, then the best way to make money is to wait. Wait and let the homebuilders and mortgage finance companies run up, and then when momentum fails, short a basket of the stocks with weak balance sheets.

Why play the bounce, rather than try to bet on the success of either side? The wait could be quite long before either side loses? Do you have enough wherewithal to stay in the trade? Most players don?t; that?s why I think that waiting for one side or the other to prevail is the right course. Because both sides are levered up, there will be an overshoot. Just be there when the momentum fails, and play the opposite side. Personally, I?ll be ready with a list of homebuilders and mortgage lenders with strong balance sheets. Though prospects are not bright today, the best will prosper once the crisis is past.

Where Money Goes to Die

Posted on 5 September 2017 by David Merkel

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It is often a wise thing to look around and see where people are doing that is nuts. ?Often it is obvious in advance. ?In the past, the two most obvious were the dot-com bubble and the housing bubble. ?Today, we have two unrelated pockets of nuttiness, neither of which is as big: cryptocurrencies and shorting volatility.

I have often said that that lure of free money brings out the worst economic behavior in people. ?That goes double when people see others who they deem less competent than themselves seemingly making lots of money when they are not.

I’ve written about Bitcoin before. ?It has three main weaknesses:

No intrinsic value –?can?t be used of themselves to produce something else.
Cannot be used to settle all debts, public and private
Less secure than insured bank deposits

In an economic world where everything is relative in a sense — things only have value because people want them, some might argue that cryptocurrencies have value because some people want them. ?That’s fine, sort of. ?But how many people, and are there alternative uses that transcend exchange? ?Even in exchange, how legally broad is the economic net for required exchangability? ?Only legal tender satisfies that.

That there may be some scarcity value for some cryptocurrencies puts them in the same class as some Beanie Babies. ?At least the Beanie Babies have the alternative use for kids to play with, even though it ruins the collectibility. ?(We actually had a moderately rare one, but didn’t know it and our kids happily played with it. ?Isn’t that wonderful? ?How much is the happiness of a kid worth?)

I commented in my Bitcoin article that it was like Penny Stocks, and that’s even more true with all of the promoters touting their own little cryptocurrencies. ?The promoters get the benefit, and those who speculate early in the boom, and the losers are those fools who get there late.

There’s a decent public policy argument for delisting penny stocks with no real business behind them; things that are worth nothing are the easiest things to spin tales about. ?Remember that absurd is like infinity. ?If any positive value is absurd, so is the value at two, five, ten, and one hundred times that level.

The same idea applies to cryptocurrencies; a good argument could be made that they all should be made illegal. ?(Give China a little credit for starting to limit them.) ?It’s almost like we let any promoter set up his own Madoff-like scheme, and sell them to speculators. ?Remember, Madoff never raked off that much… but it was a negative-sum game. ?Those that exited early did well at the expense of those that bought in later.

Ultimately, most of the cryptocurrencies will go out at zero. ?Don’t say I didn’t warn you.

Shorting Volatility

This one is not as bad, at least if you don’t apply leverage. ?Many people don’t get volatility, both applied and actual. ?It spikes during panics, and reverts to a low level when things are calm. ?It seems to mean-revert, but the mean is unknown, and varies considerably across different time periods.

It is like the credit cycle in many ways. ?There are two ways to get killed playing credit. ?One is to speculate that defaults are going to happen and overdo going short credit during the bull phase. ?The other is to be a foolish yield-seeker going into the bear phase.

So it is for people waiting for volatility to spike — they die the death of one thousand cuts. ?Then there are those that are short volatility because it pays off when volatility is low. ?When the spike happens, many will skinned; most won’t recover what they put in.

It is tough to time the market, whether it is equity, equity volatility, or credit. ?Doesn’t matter much if you are a professional or amateur. ?That said, it is far better to play with simpler and cleaner investments, and adjust your risk posture between 0-100% equities, rather than cross-hedge with equity volatility products.

Again, this is one where people are very used to selling every spike in volatility. ?It has been a winning strategy so far. ?Remember that when enough people do that, the system changes, and it means in a real crisis, volatility will go higher than ever before, and stay higher longer. ?The markets abhor free riders, and disasters tend to occur in such a way that the most dumb money gets gored.

Again, when the big volatility spike hits, remember, I warned you. ?Also, for those playing long on volatility and buying protection on credit default — this has been a long credit cycle, and may go longer. ?Do you have enough wherewithal to survive a longer bull phase?

To all, I wish you well in investing. ?Just remember that new asset classes that have never been through a “failure cycle” tend to produce the greatest amounts of panic when they finally fail. ?And, all asset classes eventually go through failure.

The Crisis at the Tipping Point

Posted on 9 August 20179 August 2017 by David Merkel

Photo Credit: Fabio Tinelli Roncalli || Alas, there were so many signs that the avalanche was coming…

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Ten years ago, things were mostly quiet. ?The crisis was staring us in the face, with a little more than a year before the effects of growing leverage and sloppy credit underwriting would hit in full. ?But when there is a boom, almost no one wants to spoil the party. ?Yes a few bears and financial writers may do so, but they get ignored by the broader media, the politicians, the regulators, the bulls, etc.

It’s not as if there weren’t some hints before this. ?There were losses from subprime mortgages at HSBC. ?New Century was bankrupt. ?Two hedge funds at Bear Stearns, filled with some of the worst exposures to CDOs and subprime lending were wiped out.

And, for those watching the subprime lending markets the losses had been rising since late 2006. ?I was following it for a firm that was considering doing the “big short” but could not figure out an effective way to do it in a way consistent with the culture and personnel of the firm. ?We had discussions with a number of investment banks, and it seemed obvious that those on the short side of the trade would eventually win. ?I even wrote an article on it at RealMoney in November 2006, but it is lost in the bowels of theStreet.com’s file system.

Some of the building blocks of the crisis were evident then:

European banks in search of any AAA-rated structured product bonds that had spreads over LIBOR. ?They were even engaged in a variety of leverage schemes including leveraged AAA CMBS, and CPDOs. ?When you don’t have to put up any capital against AAA assets, it is astounding the lengths that market players will go through to create and swallow such assets. ?The European bank yield hogs were a main facilitator of the crisis that was to come, followed by the investment banks, and bullish mortgage hedge funds. ?As Gary Gorton would later point out, real disasters happen when safe assets fail.
Speculation was rampant almost everywhere. (not just subprime)
Regulators were unwilling to clamp down on bad underwriting, and they had the power to do so, but were unwilling, as banks could choose their regulators, and the Fed didn’t care, and may have actively inhibited scrutiny.
Not only were subprime loans low in credit quality, but they had a second embedded risk in them, as they had a reset date where the interest rate would rise dramatically, that made the loans far shorter than the houses that they financed, meaning that the loans would disproportionately default near their reset dates.
The illiquidity of the securitized Subprime Residential Mortgage ABS highlighted the slowness of pricing signals, as matrix pricing was slow to pick up the decay in value, given the sparseness of trades.
By August 2007, it was obvious that residential real estate prices were falling across the US. ?(I flagged the peak at RealMoney in October 2005, but this also is lost…)
Amid all of this, the “big short” was not a sure thing as those that entered into it had to feed the trade before it succeeded. ?For many, if the crisis had delayed one more year, many taking on the “big short” would have lost.
A variety of levered market-neutral equity hedge funds were running into trouble in August 2007 as they all pursued similar Value plus Momentum strategies, and as some fund liquidated, a self reinforcing panic ensued.
Fannie and Freddie were too levered, and could not survive a continued fall in housing prices. ?Same for AIG, and most investment banks.
Jumbo lending, Alt-A lending and traditional mortgage lending had the same problems as subprime, just in a smaller way — but there was so much more of them.
Oh, and don’t forget hidden leverage at the banks through ABCP conduits that were off balance sheet.
Dare we mention the Fed inverting the yield curve?

So by the time that BNP Paribas announced that three of their funds that bought?Subprime Residential Mortgage ABS had pricing issues, and briefly closed off redemptions, and Countrywide announced that it had to “shore up its funding,” there were many things in play that would eventually lead to the crisis that happened.

Some of us saw it in part, and hoped that things would be better. ?Fewer of us saw a lot of it, and took modest actions for protection. ?I was in that bucket; I never thought it would be as large as it turned out. ?Almost no one saw the whole thing coming, and those that did could not dream of the response of the central banks that would take much of the losses out of the pockets of savers, leaving bad lending institutions intact.

All in all, the crisis had a lot of red lights flashing in advance of its occurrence. ?Though many things have been repaired, there are a lot of people whose lives were practically ruined by their own greed, and the greed of others. ?It’s a sad story, but one that will hopefully make us more careful in the future when private leverage rises, creating an asset bubble.

But if I know mankind, the lesson will not be learned.

PS — this is what I wrote one decade ago. ?You can see what I knew at the time — a lot of the above, but could not see how bad it would be.