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Rogue Waves and Standard Deviations - Part 1
(April 26, 2002)
by James J. Puplava / Financial Sense Online
To the ancients, they were known as sea monsters. During the Middle Ages, cartographers drew mystical maps depicting this terror in a "Sea of Darkness." For centuries, grizzly old sea dogs wove unbelievable tales of these "holes in the ocean" over a pint of grog at the local tavern. Of course, knowledge replaced mythology as the age of exploration was birthed. These supposed sea monsters were in reality large waves. Today we refer to them as rogue waves. And yet, to sailors, they are still known as monsters with the power to sink a ship with one mighty blow.
These powerful forces of nature are the result of a series of coincidental wave trains that crest, amplify, and become one large wave. They can appear suddenly, and just as abruptly dissipate, leaving death and destruction in their wake. Their very existence is predictable, a matter of statistical probability. We even know where they are likely to occur. With modern science, we can predict their wave height and times they are likely to appear. We even know their whereabouts. They lurk off the eastern coast of South Africa, the Gulf of Alaska, the Florida coast, the northern Atlantic, and Antarctica. Sailors will tell you that big storms breed big waves. Scientists say those waves are getting bigger and more frequent. Off the shores of Cornwall, they have been measuring the size of these monsters for the last 20 years. Nobody can say why, but these waves keep getting bigger.
Three Factors of Force
The height of a wave is determined by three factors: wind speed, fetch, and duration. These three factors combine to form one of nature's most powerful forces. How big they become is determined by the speed of the wind, the width of the open water or fetch over which the wind blows, and how long the wind has been blowing. Wind is not the only force that can create these sea monsters. Wind speeds of 70 knots can topple waves and hurricane force winds of 100 knots or more can actually flatten them. Another more powerful force, when combined with strong winds, can make these waves formidable. That force is a strong, opposing current in the direction of an oncoming wave. When a strong current suddenly opposes a large wave train driven across a vast open space of ocean, the likely outcome is the formation of a rogue wave of staggering height. The Halloween Storm of 1991 saw the combination of these forces come together producing wave heights as high as 150 feet. The strength of these wave sets was felt as far a way as Florida where 15-foot waves pounded the boardwalks of coastal cities.
The fact that these waves have become predictable, with whereabouts well known, is no consolation to sailors who must remain vigilant for their sudden appearance. These freak waves come out of nowhere and catch sailors off guard. If unprepared, they can flip, roll, or pitch pole a vessel causing it to founder or sink. These breaking waves can exert as much as one ton per square foot of pressure when they hit a vessel. Because of their enormous size, an officer on watch can spot them and take evasive action to mitigate their damage increasing the ship's survival rate. For those who make their living by the sea, they have become one more element of risk to contend with when making ocean passage.
Decades of Our Global Financial System at Risk
While sailors and the shipping industry must contend with this growing risk, this same phenomenon is occurring simultaneously in the world's financial system. Since the early seventies, these storm fronts have been appearing with much greater regularity. They began after President Nixon severed the dollar-gold link in August of 1971 and the world of fixed relationships ended. Fixed currencies, regulated interest rates, and the era of financial stability were dead. No longer anchored by gold, foreign currency risk and interest rate risk were added to business risk as additional elements of risk in the financial system. Since the 1970's, each decade has seen the financial system buffeted by a series of storms of greater magnitude and frequency. In the eighties, it was the recycling of petrol dollars and Latin American loans, the oil patch crisis in Texas, the dollar crisis, and the stock market crashes of 1987 and 1989. The nineties began with the S&L crisis, Barings, Bankers Trust, Metallgesellschaft, Sumitomo Bank, Mexico, Orange County, Asia, Russia, LTCM, and Y2K. The first year of the new century began with Enron and Global Crossing and a plethora of telecom bankruptcies. And we are only into our second year of this new century.
What we are seeing in the financial system is similar to what we are seeing in the natural world, which is the increasing frequency and magnitude of storms. As seen from the above list and frequency of crises, storms continues to grow and raise the possibility of one too many shocks to the system. In last week's Ask The Expert segment of my broadcast, Professor Frank Partnoy said, "It is only a matter of time before we have another Enron. I have been saying this for a long time. They are going to continue to get bigger and more unruly and that is going to continue. Moreover, we just have to hope that it won't hit the point that it causes a systemic breakdown Eventually we are going to get one of these [rogue waves] that we cannot fix Maybe we can live with an Enron. But can we live with two at the same time? What if Enron and LTCM had happened in the same month? Would any one of us be confident of the financial system?" 1 In the words of former Treasury Secretary, Nicholas Brady, "Every time there's been a fire, these guys [derivative traders] have been around it." 2
So far, these financial storms have been contained by oceans of central bank injected liquidity. Like ships on the sea, each storm that has hit the financial system has rolled over and the system has righted itself. What worries regulators is what would happen if a series of these waves hit the system all at one time. In effect, one crisis piles on top of another, becoming a series of crisis trains, with the crest of one crisis superimposing and amplifying the others to form one monster, financial rogue wave. Could the system handle the simultaneous occurrence of an Enron with a Metallgesellschaft, LTCM, Barings, Mexico, or Argentina? The advent of such a shock would cause the world of derivatives and the models that run them to implode. It could take down the global financial system.
What? Me Worry?
The financial world and central banks acknowledge such a possibility, but quickly dismiss it. The policymaking arm of the Fed has taken a laissez-faire approach to the derivatives market. Fed Chairman Greenspan continues to marvel at derivatives as a product of financial innovation. Despite efforts to regulate the market in the aftermath of Enron, an army of lobbyists from the brokerage and banking community have defeated every new attempt at regulation. In the financial world, derivatives have become the closest attempt by the financial community to finding the alchemist stone. They have created the ultimate leverage through a fractional reserve investment world that has allowed profits to multiply in a way never thought possible. At its pinnacle of success, LTCM and its small band of traders were making more money than the best run companies in the Dow. A few years later, Enron would top that off by making more money trading derivatives in 2000 than Long Term Management made in its entire history. 3 As Roger Lowenstein wrote in his book, "When Genius Failed: The Rise and Fall of Long-Term Capital Management," the leverage offered through derivatives enabled LTCM to turn nickels on trades into annual returns of forty percent. Why worry when there's profits to be made?
The Day is Coming . . .
The financial world is snugly confident that their computer models will shelter them from these storms. However, there will come a day without warning when the financial world will not behave as predicted. It will be a day when prices either plunge or leap off the charts in a way never seen before. It will be an abnormality, an outlier, on the tail end of the curve a random event that random distribution can't explain. A standard deviation that was predicted but unexpected, small, simple, and considered insignificant when it began, a discontinuous price change on the remote end of the curve that erupts into a crisis. On that one day, and that one day only, the professors will discover an indelible truth. Math cannot make certain what is inherently uncertain. As the crisis unfolds and the turbulence in the markets builds, and when the precision of the models is needed most, it will be at this moment they find their models have failed them. They were designed to protect the user from losses under normal conditions. They do not work when markets prove to be less random or independent.
Random Markets and Unpredictability
In the early 1960's, Eugene Fama, a professor at the University of Chicago, wrote his doctoral thesis, "The Behavior of Stock Market Prices." A simplified version of his thesis, titled "Random Walks in Stock Market Prices," would eventually be published in Institutional Investor. His thesis would shake the investment world. Coining the term "Efficient Capital Markets," Fama argues on average, it is nearly impossible for an individual to consistently beat the stock market as a whole because of the broad availability of public information. Fama would become the father of the Efficient Market Theory, which was behind the growth of index funds in the 1980-90's bull market. 4
However, Fama's own work acknowledged that when it came to the price movement of individual stocks, there were many more days of extreme price movements than would occur in a normal distribution. Looking at a bell shape curve, the expected or average price movement for a security fell within the broad hump of the curve. The problems are located in the tail end. This is where the extreme elements in the market are found. The tail end is where rogue waves that produce discontinuous price movements can destroy capital when they occur. Unfortunately, the models can predict their probability of occurrence, but not their timing.
The problem for investors is that all markets exhibit the extreme price movements of Fama's stocks. This has broad implications for the derivatives market because of constantly changing patterns within markets. The Black-Scholes formula that drive the derivatives markets can predict with certainty what happens within a limited universe. The trouble comes from the incomplete universe used in the model. When it applies to the financial markets, no sample universe is ever complete.
Over time, markets evolve and change. New trends and patterns are formed. This was my thesis behind the "The Next Big Thing." A new pattern of leadership emerges. What was dominant in one particular era is least dominant in the next era. This is reflected over time in the transition from bull to bear markets. A bull market turns into a bear market and a new bull market in another asset class begins. This is what the historical charts show us. Nothing ever remains the same, despite the best efforts of mathematicians to make them constant.
The Six Faces of Risk
Because of LTCM and more recently Enron, derivatives have once again come under a surging storm cloud that hangs over the market. Critics argue that these highly leveraged vehicles now pose the specter of systemic risk to the financial system. Regulators are worried that these sophisticated financial instruments are subject to a multitude of risks. The risks vary from price risk of the loss of the underlying asset values, default risk or counterparty risk, settlement risk where the other party doesn't pay up, liquidity risk otherwise known as funding risk, and operational risk where something goes haywire in the system. The culmination of all of these risks into a much larger risk known as systemic risk. Defenders of the system argue that the case for risk has been vastly exaggerated. They believe that derivative risk has been overstated by referring to their notional principal value, which grossly inflates the actual credit exposure. The use of netting makes this notional value much less than it appears. The actual net credit exposure on swaps amounts to no more than 1% of notional principal. 5
From OCC: Notional Amount: The nominal or face amount that is used to calculate payments made on swaps and other risk management products. This amount generally does not change hands and is thus referred to as "notional." Bilateral Netting: A legally enforceable arrangement between a bank and a counterparty that creates a single legal obligation covering all included individual contracts. This means that a bank's obligation, in the event of the default or insolvency of one of the parties, would be the net sum of all positive and negative fair values of contracts included in the bilateral netting arrangement.
The defenders of derivatives argue, "Because derivatives are equivalent to combinations of already trading securities, they cannot introduce any new, fundamentally different risks into the financial system. What derivatives can and do accomplish, however, is to isolate and concentrate existing risks, thereby allowing for the efficient transfer of such risks among markets participants." 6
Systemic Risk Inherent in Black-Scholes Option Model
What others have argued and shown successfully is that, "...all the conditions sufficient for a repetition of a debt related calamity are in place. These conditions include the complacency of the authorities and the ignorance of the people." 7 I would add one more, which is the conceit and hubris of Wall Street. Trading rooms at investment banks have a blind faith in the "Holy Grail" of the investment world with the Black-Scholes model created in 1973. It is the adulation and blind faith that a mathematical model can create numeric certainty in an uncertain world that makes the market so vulnerable to systemic risk. The key assumption of Black-Scholes is that the volatility of a particular security remains constant. The model imbues prices with an actuarial certainty when none exists. Moreover, the notion that volatility has replaced leverage as the best proxy of risk becomes its Achilles heel. The fact that rogue waves are infrequent doesn't remove the possibility that when they appear, they will sink the ship. As in a storm, leverage amplifies the danger. It becomes excess cargo whose weight makes the ship that more vulnerable.
Episodes like LTCM and Enron illustrate the lack of transparency within the financial world. The world of disclosure that has worked so well for so long is breaking down. It is becoming more difficult to judge risk on and off the balance sheet because of obfuscation. Gaping holes remain in the system and are only getting larger. If accountants, analysts, and regulators can't find the risk contained in balance sheets, think of the problem for complacent investors. This complacency has given way to a greater moral hazard, which I believe can be traced directly to the Fed. Investors have been lulled into a false sense of security fostered by a belief that the Fed stands ready as lender of last resort to intervene and bail out the markets.
The Genesis of Derivatives
The use of derivatives is not a unique phenomenon. Evidence of their use goes as far back as the days of Aristotle. The earliest option trade ever recorded was a bet on the expected outcome of the olive crop by Thales of Miletus, which is recounted in Aristotle's Politics. The investment made by Thales was a derivative. It actually was an option on a future. He did not invest in olives as the underlying commodity. Instead, he in effect, bought a call on the olive presses for a fall delivery. Thales was hoping to benefit from a better-than-expected olive crop. Thales put a deposit on every olive press in Miletus hoping to benefit from growing demand. Rather than invest in olive presses directly, he leveraged his bet by controlling the output of all of the presses. This leverage magnified his return. Thales' only risk in the transaction was that he could lose his deposit if demand wasn't as strong as anticipated. In which case, he would have only forfeited his option premium. 8
Since the time of the ancient Greeks, derivatives have been used in one form or another to hedge the risk of uncertainty associated with trade and agriculture. Their original use made them powerful tools for transferring risk to bankers and speculators who hoped to earn a profit by underwriting the risk. They have been used in this way for millenniums. Their importance in our investment world took on new significance because of two key events that took place in the later part of the 20th century. The first was the breakdown of the Bretton Woods System after August of 1971. The end of fixed exchange relationships injected two additional elements of risk into the financial system, which were currency risk and interest rate risk. The other important event was the introduction of the Black-Scholes Option Model. The genesis of the growth in derivatives began because of these two events. At the center of this new financial experiment was the notion that volatility would replace leverage as the new proxy for risk.
As international trade increased through the growth of multinational corporations, the need to finance trade and hedge against the uncertainty of interest rate and currency risk caused the market for derivatives to explode. Today the notional value of derivative contracts worldwide is estimated to be over $100 trillion. This market can be divided between the users of derivatives such as corporations, pension fund managers, financial institutions, governments, government agencies, hedge funds, and high net worth individuals and their manufacturers: investment and money center banks. Their use can be seen in the application of risk transfer as well as speculation as shown below.
USES OF DERIVATIVES
FIVE PRIMARY MARKETS FOR DERIVATIVES
Because each user has different objectives, alternative uses of derivatives are pursued. The user is more concerned with the terminal value of a derivative product. If you are a farmer hedging your crops, you are more concerned with the price you can lock in the futures market that can best guarantee you a profit at harvest time. You are hedging against the risk of lower prices. The manufacturer of a derivative is not concerned with what he owns. He can care less if he owns a put or call. It makes no difference. What matters most is the strike price and the expiration of the option. When option writers or the manufacturers of derivative products see prices move away from the strike price of what it is they own, they are required to protect their position from loss. This is done through the buying or selling of an offsetting amount of whatever is they have written.
To give a better understand of this principle, I must digress and discuss a few basics. The option-pricing model requires several inputs in its pricing mechanism in order to calculate the cost of an option premium. The only fixed feature in the model is the strike price, which remains fixed. The strike price can apply to any derivative product whether it is the price of oil, corn, gold, silver, interest rates, or a foreign currency. Each variable in the option-pricing model changes with fluctuations in the market for the underlying product (oil, gold, corn, silver, etc.) and the passage of time. Each variable in the option pricing formula has its own name collectively referred to as The Greeks. They define how a particular variable changes in relationship to other variables. These variables measure the sensitivity of the option price to changing parameters. The most important of these are listed and described below.
|Delta||Sensitivity of the option price to the change in the underlying asset price.|
|Gamma||Sensitivity of the option delta to the change in the underlying asset price.|
|Vega||Sensitivity of the option price to the change in implied volatility.|
|Theta||Expected change in the option price with the passage of time assuming risk-neutral growth in the asset.|
|Rho||Sensitivity of the option price to interest rates or dividend payout.|
A Matter of Insurance
In effect, the underwriters or manufacturers of a derivative product function in the same role as an insurance company. Just as an insurance company collects a premium from the policyholder in exchange for assuming the risk of whatever is insured (life, property, automobile, or personal valuables), derivative writers collect premiums for the derivatives they underwrite. In the financial world, derivatives are used to cover risks associated with stocks, interest rates, currencies, or a commodity. In the case of manufacturers of derivatives, they must move to protect themselves in the same way an insurer would against a catastrophe. Since the price is fixed on a derivative product, as the price moves a certain amount away from the strike price of a contract, prudence demands that the writer of an option or derivative contract buy or sell an offsetting amount of whatever it is they insuring against to protect themselves from increased risk. This change in increased buying or selling to protect against the delta change in a position is referred to as "delta hedging."
The challenge that the manufacturers of derivative markets face in today's uncertain investment markets is that the more these parameters change (interest rates, volatility, etc.), the greater the need for "dynamic hedging." This prudence requires traders and writers of derivatives to hedge more than just the gamma. To keep risk levels manageable, all derivations and possible permutations must be hedged from changes in underlying asset prices, interest rates, and vega convexity.
The problem for the derivatives market is that derivatives fall into two distinct classes: one complex and the other less so. These two broad categories are linear and nonlinear. A linear derivative is easy to hedge against; whereas a nonlinear derivative is much more complex and more unstable, and requires more dynamic hedging. Nonlinear derivatives are dependent on a second derivative. The important point to understand is that derivatives are not all linear in their reaction to price changes in the underlying asset. They are convex or concave in they way they react to asset price changes.
Linear and Nonlinear Derivatives
As the following diagrams illustrate, a linear derivative behaves in a straight line as shown. An example might be the option price on IBM. Let's say you bought a call on IBM, giving you the right to buy IBM at $90 a share. As the price of IBM moved up, the price of the call option would move up in a linear fashion with the rise in the share price of IBM. A linear derivative will be subject to changes in delta. However, it will not be subject to other Greeks such as gamma, theta, vega or rho. Linear derivatives require very little hedging. Nonlinear derivatives are subject to much greater variation and require greater hedging on part of the holder or writer. The issue gets even more complex when "synthetic securities" are introduced. These are derivatives with linear characteristics dependent on two or more instruments in the market such as interest rates and currencies.
Complexity and Psychology in the Markets
Derivatives can further be classified as to their time-dependent characteristics. I'll discuss these in Rogue Waves & Standard Deviations - Part 2 when I cover interest rate swaps. At this time it is important to interject what you have already by now concluded. Derivatives are very complex instruments. The derivatives market is a lot like the weather. This is why I've used weather analogies in writing about them. Like weather, the financial markets, and in particular derivatives, are very hard to predict for many of the obvious reasons. In both cases, we're dealing with complex, chaotic systems that are incredibly sensitive to changing conditions. Weather forecasters have their jobs cut out for them because weather is the result of the myriad interactions of countless molecules from the air, land and the sea. We would have perfect weather forecasts if we could model and predict the movements and changes in every one of these molecules in a real time mode and instantaneously transmit them to the weather user.
Like weather, the financial markets behave in a similar fashion. On any given day, the closing price in any market is the result of the interaction between buyers and sellers reacting to thousands of financial molecules in the form of company earnings, industry conditions, the economy, domestic politics, or geopolitical events. The result of these interactions will depend on the mindset or the psychology of the markets at any given moment. If the market is in a bullish trend, the reaction might be favorable for radically different market outcomes. If, for example, the market is bullish, they might see a lowering of interest rates as bullish for the markets and stocks go up as result. If the market psychology is bearish, the markets could react negatively to the same lowering of interest rates and stock prices go down. If the markets are bearish, they might view the lowering of interest rates as either inflationary or a sign that the economy is weakening. So unless you have the pulse or can read the minds of the hundreds of millions of traders or investors worldwide -- in real time -- your chances of predicting short-term movements in the markets is a lot like predicting the weather.
Profs, Quants and Traders in La La Land
Talk to the quants (quantitative analysts) and the traders in the derivative markets and you will find they are still searching for the perfect model. The risk of leverage still goes unrecognized. The issue of illiquidity is another problem not faced by most traders or factored into most derivative models by manufacturers. Most derivatives trade in the OTC market, which makes them less liquid than exchange-traded contracts. Given the fact that many of these markets are highly geared, the liquidity issue is more pronounced. When you own the market, you are essentially trading against yourself. This becomes a problem when the unforeseeable event arrives unexpectedly. However, to the professors and traders that ply these seas, "The Perfect Storm" is something that only happens every 100 years. As we've seen in the last decade, these 100-year storms occur more frequently than the professors or traders are willing to admit. From Barings, Bankers Trust, Metallgesellschaft, Sumitomo Bank, Mexico, Orange County, Asia, Russia, LTCM, Enron, and now to Argentina, their appearance is beginning to become a regular feature of the derivative landscape.
Human Emotion and Price Movements
Traders just shrug these events off as bad luck. Those who have been caught in these maelstroms of financial history still see them as anomalies. The frequency of their occurrence suggests that more attention should be paid to the "fat tails" of the curve. Reared on Fama's teachings of efficient markets and the infallibility of their models, the professors, quants, and the traders in the derivatives market believe that prices will go where their models want them to go. In this aspect, they have become like monks with an absolute blind faith based on the teachings of their religion. They ignore one of their chief priest's findings on efficient markets. There are times when their models are not efficient. Fama, who had written his thesis on the price movements of the Dow Industrials, had discovered price anomalies. He discovered that, for every stock, there were times of extreme price movements that would occur in a normal distribution. These extreme movements in price were the result of human behavior. Oftentimes in the market investors and traders do not react the way the models predict. Human emotion takes over. Instead of rational behavior, humans behave irrationally. This translates into extreme price movements in the markets. Repeatedly humans befuddle the models by proving they aren't automatons. They act on gut, instinct, and irrational delusions. When this happens, they cease to act as individuals and become part of the crowd. This is when all reason is lost and they run with the herd and retreat with the horde.
Given the fact that markets aren't perfect and human emotion can run to extremes, it is time to examine the probability of future storm fronts. It is quite possible that a series of these storms will unite to form what may become "The Perfect Financial Storm." Within this storm front, there exists the possibility of the emergence of a rogue wave of such towering height that it becomes "the" wave that eventually topples the financial system. There are three different possibilities that currently exist. Any one of them has the potential of becoming a major storm. Even worse is the possibility that all three could combine and become a series of crisis trains with the crest of each crisis superimposing and amplifying each other to form one monster financial rogue wave.
The Debt Pyramid
From its humble beginning nearly three decades ago, the bond market has become a large ocean upon which the players of the derivatives markets sail. For The Big Boys, the bond market has become the pre-eminent global financial market. Its size is colossal in comparison to other markets. It has become the center of gravity for the world's financial system. This complex market is primarily made up of benchmark government bond issues, money markets, short-term deposits and loans, and sophisticated derivative instruments. Today, the bond market has become a giant leviathan that interprets, reacts, and renders judgment on economic data with unquestionable authority. It is the one force large enough that can discipline or humble governments.
In his book Debt & Delusion, Peter Warburton describes this colossus. "Unofficial estimates of the size of the world bond market at the end-1997 suggests a figure of around $25 trillion [much larger today] roughly equivalent to a year's GDP of the 20 largest developed countries. This staggering total represents a doubling since 1989, and a six-fold increase since 1982. Almost two-thirds of this debt is owed by governments and their agencies, or backed by them. Quite simply, the public sector segment of the debt mountain is the counterpart to almost 25 years of lax fiscal policy, [the result of the severance of the dollar-gold link that ended with the collapse of Bretton Woods] that is, perennial budget deficits. 10
This debt is created as a result of government-run budget deficits. When governments spend more money than they take in from taxes, they tap the capital markets where large institutions provide the necessary capital. Because money is no longer backed by gold or silver, there are no restraints on government fiat-created debt. This explains why credit markets have grown so rapidly these past two decades. Moreover, the transference of credit creation outside the monetary system to the securities markets is the main reason why we have not seen inflation in the economy. The inflation takes place in the markets through the expansion of credit within the financial system.
The whole system is based on confidence. Government-related debt isn't backed by actual physical assets. Instead, the system runs on blind faith and confidence in governments and their central banks. The bond markets are the ultimate confidence game. What lies behind that confidence is the taxing authority of the state and its ability to extract taxes from its citizens in order to meet its debt payments. The pricing mechanism is based on confidence reflected in the interest rate offered on those bonds. The higher the degree of confidence in government, the lower the interest rate and visa versa.
Rules of Play
There are several standard rules of the game that dominate these markets. One is the yield curve play of borrowing short and investing long. The other option is to play the credit spreads between lower quality and higher quality debt. As the bond market has mushroomed in size, the issuance of lower quality debt has grown alongside the issuance of investment-grade debt. The credit spreads, or the difference of yields between the two, can diverge or converge over time. The difference between spreads serves as a barometer of confidence in the financial system. During periods of market stress such as 1994, 1997, and in 1998, spreads widened as fears of default or credit quality grew. It is during these intervals that hedge funds and professional institutions exploit the difference between the higher yields offered on lower quality issues and high quality debt.
LTCM's Italian Bond Play
This was the standard bill-o-faire at Long Term Capital Management. In fact, one of the first major scores at LTCM was made in the Italian bond market. Italian finances were a mess in the early 90's as a result of fiscal policies pursued by Italy's Communist Party. The bond markets feared default, so interest rates rose on Italian bonds. The spread between higher-quality German bonds and Italian bonds rose as high as 8 percent. 11 This differential in credit spreads created the opportunity for LTCM's partners. They were looking to capitalize on by an arbitrage play that would exploit the mispricing of yields. The partners thought the markets had overstated the risk. LTCM's traders moved aggressively, buying the Italian government fixed-rate debt and short-term floating rate paper. The fund tried to hedge part of its portfolio by balancing it's huge long position with a short position. But its hedges were incomplete due to the enormous size of their position. LTCM was fortunate in this play in that their hunch was right. Their long position paid off. LTCM is an example of how a fund, through leveraging a derivative, was able to dominate a particular market. When a market can become dominated by a large derivative position, it has become highly geared. Gearing refers to the power of derivatives to dominate a market for a low or fractional cost of direct ownership.
LTCM's approach to investing was totally mathematical. The firm relied on the precision of its models to exploit historical patterns and anticipate risk. Everyone on Wall Street had similar models to read the markets. The genius in the firm came from the partner's ability to read the models. They did it better than anyone else on The Street. Two questions drove the firm's investment strategy: what was the expected average return of a trade and how much the returns vary from the average in any one year. Essentially, the firm's models were relying on a reversion to the mean. In this case, they were hoping that the divergence in bond yields would eventually converge. Historically, this has been the pattern of the markets.
Meriwether, LTCM's founder, had cut his teeth at the bond desks at Salomon Brothers. His years of trading the markets had taught him the heart of bond trading which was that bonds traded on their mathematical spreads. Riskier bonds carried a higher yield because of credit concerns over risk-free Treasuries. What Meriwether had learned in his days running Solomon's Arbitrage Group is that over time, credit spreads would eventually narrow. This constant divergence/convergence theme would become the hallmark of LTCM's trading strategy. The trick was to have enough capital to stay the course and allow the divergence/convergence theme to play itself through. Repeatedly, he had seen this pattern play itself out in the credit markets with predictable regularity. This was the one lesson he had learned in his days at Salomon. One lesson not learned at Salomon was that leverage shortened the time horizon. Salomon was well capitalized and would have never allowed a trader to bet the ranch with the firm's capital. At Solomon, traders were supervised and watched over by independent risk managers. Their job was to hold the traders accountable for the actions of their trades.
When Meriwether formed LTCM, he was no longer accountable to a risk management desk. At LTCM, the partners were accountable only to themselves. Another difference at Meriwether's hedge fund is that from its very genesis, Meriwether had decided that his fund would leverage its capital by a factor of 30:1. That is how confident he was in its models and the professors who had created them. Such was the conceit and hubris of the firm's partners. At its peak before its demise, the firm's capital was leveraged by a factor of 55:1.12 The one lesson that Meriwether had not learned in his days at Salomon was that leverage removed the time element from the divergence/convergence game. When you are losing 20 percent of your capital a day, time is not a luxury. The models on which the fund based its investment strategy did not include leverage in their risk calculations. To the professors and partners that ran the fund, volatility in a particular market defined risk. This unlearned lesson would eventually lead to the firm's downfall.
The bond market is made up of a vast matrix of yields and credit spreads on various debt instruments. This matrix is the nucleus of the international debt markets, which are exploited through arbitrage by hedge funds, large banks, and sophisticated investors. These large players have become the support mechanism on which the bond markets rest. Without these players, bond yields would be much higher and asset prices lower, reflecting the true credit risks of the market. The bond market is one of the most highly geared markets in the financial system whereby a small amount of capital, in relation to the underlying assets, controls the market. The gearing of the bond market is done with derivatives, which have become the standard tools of the trade in the speculative community. This is where LTCM plied its trade.
Harder to Find "The Edge"
The divergence/convergence game had narrowed over the years because many firms were using the same models to take advantage of irregularities in the system. Because of arbitrage [exploiting the anomalies in the market], the yields and spreads on bonds were grossly inflated. This was due to the demand created through leverage, which kept bond yields lower and prices higher than would normally be the case. To make up for this razor-thin margin between high and low-quality debt, firms employed leverage to increase their returns. This leveraging enabled hedge funds like LTCM to turn a 1% return into a 59% return. Because everybody played the convergence/divergence game, it became increasingly difficult for firms such as LTCM to exploit the differences in credit spreads due to arbitrage. In other words, if everyone spots the same trend and jumps in, the advantage of arbitrage is lost. Advancements in communication made it more difficult to gain advantage over competitors. When everyone's plasma screen is interconnected around the globe, a million eyes are watching the same thing. This forces firms to make more speculative and leveraged plays in order to produce the higher returns expected from their wealthy clientele.
A Lesson from 1997: Working Both Ends for The Middle
In the end, LTCM would fall victim to a game it had mastered. Because of leverage, the firm didn't have the staying power to ride out the storm of the turbulent Asian and Russian debt crises. Beginning in 1997, credit spreads began to widen again. Volatility levels were rising and signaled an opportunity to be exploited. If volatility levels rise, a trader has to make a judgment on whether the markets are right or wrong. In 1997, stock market volatility levels began to rise. LTCM believed that the market was wrong, so it began to sell volatility by shorting options on the S&P 500 Index and other major exchanges in Europe. They were working both sides of the market by selling options against a sharp rise and a sharp fall in the market. The firm was pocketing the premiums from selling options because premium levels had risen as a result of volatility. The partners believed this to be an abnormality -- a divergence that would correct by converging over time. This is eventually what happened. By late fall of 1997, the IMF bailed out Korea and the markets around the globe began to settle down. Volatility levels had fallen and the wealth of LTCM had multiplied. The divergence/convergence theme had worked once again.
The firm's models were predicting only a small loss exposure in its position. It was inconsequential given the LTCM's trading capital. The models showed that it would take a ten-sigma event, a statistical freak or rogue wave, before the firm would lose all of its capital. The Fed and other central banks and international agencies had given the markets a reprieve by injecting plenty of liquidity into the financial system. This liquidity found its way back into the stock market giving stock prices a major boost. Volatility levels came down and the firm made a small fortune. The firms' partners were now worth hundreds of millions. One partner, Hilibrand, was worth half a billion. Instead of counting its profits, the firm began to make even riskier bets into Brazilian and Russian bonds and Danish mortgages. The fund saw very limited opportunities for investment. Instead of resting on their capital to wait for another opportunity, they felt the compunction to put their money to work somewhere. It is the same fatal mistake made by many traders.
May 1998: LTCM's Ten-Sigma Event
This drive to invest would mark the beginning of the end of LTCM. The ten-sigma event, that the models showed unlikely, eventually happened. Credit spreads widened as Wall Street traders began to unwind their riskier, less liquid bond positions. The result was by May of 1998 credit spreads began to widen. The bond arbs began to lose money and LTCM was among the largest on The Street. The firm's model had predicted a narrowing of credit spreads. Instead, spreads widened. As more firms liquidated their riskier positions, volatility increased, thereby widening spreads even further. A dark hole of liquidity had been created in the markets. As this chart shows, credit spreads between investment grade bonds and high yield bonds began to widen again. Credit spreads began to diverge instead of converge as predicted by LTCM's models; while volatility levels went off the charts.
As Long Term began to lose big money, it didn't pare back its positions to bring them in line with its rapidly diminishing capital reserves. As assets declined, the firm's leverage increased as a result of the loss in the firm's equity base. Then a series of events unfolded, that when added up, turned into a giant rogue wave. One crisis after another combined and hit the market at the same time. The ten-sigma event had arrived in the form of a combination of financial, political, and geopolitical events. It began with rumors of a pending Chinese currency devaluation, which triggered weakness in the Asian markets, which was followed by Russia's debt default. On the political side, Iraq refused to allow weapons inspections, and in Washington, the nation was introduced to an intern by named Monica. These compounding events forced a flight to quality as investors bailed out of Russian and Asian markets and piled into Treasuries. The yields on Treasuries fell sharply to new lows as shown in the graph above. The consequence caused credit spreads to keep widening. Capital was fleeing from bond arbitrage plays in search of a safe haven afforded by Treasuries.
By late August, the firm was losing millions each day. In five short weeks, LTCM's entire capital base would be wiped out. It had gone from an equity base of $4.67 billion at the beginning of the year to a negative equity by the time of its demise. It reminds me of the movie "Gone in 60 Seconds." In its final days, the fund was losing money in every market with losses from every corner. The fund succumbed to a risk its models hadn't predicted. Its nemesis, leverage, rose to 100:1 by September 21st. That was the day the hedge fund lost $553 million in a single session. When you're heavily leveraged, losses multiply rapidly. This is what the models had left out with their singular focus on volatility. When losses mount, leveraged investors are forced to sell. Since much of the firm's portfolio was illiquid, they were forced to sell into a market without buyers. By doing so, they were running prices down and creating standard deviations that spread to the tail end of the bell curve. In the end, the Fed, led by Mr. Fixit, Peter Fisher, engineered a government-backed bailout with the help of sixteen investment banks. The banks would kick in $250 million each to build up enough equity to keep the fund's portfolio from attack. Interestingly, many of these banks were deep into Long Term having advanced the fund billions in trading capital.
We Never Knew How Bad it Was
What the public never knew is how close the financial system came to imploding. Robert Rubin, President Clinton's Secretary of the Treasury at the time, thought the crisis was the worst he had seen in half a century. All the public knew was that the Fed lowered interest rates and quickly liquefied the financial system. The only thing the public saw, besides a brief spasm in the markets, was that stock prices took off as a result of the crisis. Therefore, investors had learned a new lesson. Crisis breeds lower interest rates, which in turn, translates into higher stock prices. It had happened in 1997 as a result of the Asian crisis. It happened again in 1998 as a result of Russia and LTCM. And it would happened again in the following year with Y2K. Fed-injected liquidity can be seen in the money supply reflected by M3 and in the rise in the stock market reflected in the Nasdaq and the S&P 500.
Reinforcing The Moral Hazard
Since the demise of LTCM in the fall of 1998, the markets returned to normal. In fact, the best year for the market was directly ahead. The returns for the market in 1999 bordered on the miraculous as heavy injections of liquidity by the Federal Reserve ahead of Y2K fed into the stock market. The returns in the Nasdaq were 85.59%. The S&P 500 rose 19.53% and the Dow gained 25.22%. The bond market grew in size, and along with it, the market in derivatives. The bond market was becoming more highly geared and derivatives at money center banks were growing at double-digit rates. The bailout of LTCM by an agency of the government only helped to reinforce the moral hazard. The Fed's intervention sent the markets a message that speculation would be rewarded instead of disciplined by failure. The Fed took on a role of laissez-faire, preferring intervention to prevention.
A few years later, the markets would face another crisis in derivatives with Enron. The press has portrayed Enron as an energy story gone astray by management corruption. In fact, it is a derivative story. As pointed out in his January testimony to the Governmental Affairs Committee, Professor Frank Partnoy told Senators,
"According to Enron's most recent annual report, the firm made more money trading derivatives in the year 2000 alone than Long-Term Capital Management made in its entire history. Long-Term Capital Management generated losses of a few billion dollars; by contrast, Enron not only wiped out $70 billion of shareholder value, but also defaulted on tens of billions of dollars of debts. Long-Term Capital Management employed only 200 people worldwide, many of whom simply started a new hedge fund after the bailout, while Enron employed 20,000 people, more than 4,000 of whom have been fired, and many more of whom lost their life savings as Enron's stock plummeted last fall."
In short, Enron makes Long-Term Capital Management look like a lemonade stand. It will surprise many investors to learn that Enron was, at its core, a derivatives trading firm. Nothing made this more clear than the layout of Enron's extravagant new building still not completed today, but mostly occupied where the top executives' offices on the seventh floor were designed to overlook the crown jewel of Enron's empire: a cavernous derivatives trading pit on the sixth floor.
I believe there are two answers to the question of why Enron collapsed, and both involve derivatives. One relates to the use of derivatives "outside" Enron, in transactions with some now-infamous special purpose entities. The other which has not been publicized at all relates to the use of derivatives "inside" Enron.
Derivatives are complex financial instruments whose value is based on one or more underlying variables, such as the price of a stock or the cost of natural gas. Derivatives can be traded in two ways: on regulated exchanges or in unregulated over-the-counter (OTC) markets. My testimony and Enron's activities involve the OTC derivatives markets.
Sometimes OTC derivatives can seem too esoteric to be relevant to average investors. Even the well-publicized OTC derivatives fiascos of a few years ago Procter & Gamble or Orange County, for example seem ages away. But the OTC derivatives markets are too important to ignore, and are critical to understanding Enron. The size of derivatives markets typically is measured in terms of the notional values of contracts. Recent estimates of the size of the exchange-traded derivatives market, which includes all contracts traded on the major options and futures exchanges, are in the range of $13 to $14 trillion in notional amount. By contrast, the estimated notional amount of outstanding OTC derivatives as of year-end 2000 was $95.2 trillion. And that estimate most likely is an understatement.
In other words, OTC derivatives markets, which for the most part did not exist twenty (or, in some cases, even ten) years ago, now comprise about 90 percent of the aggregate derivatives market, with trillions of dollars at risk every day. By those measures, OTC derivatives markets are bigger than the markets for U.S. stocks. Enron may have been just an energy company when it was created in 1985, but by the end it had become a full-blown OTC derivatives trading firm. Its OTC derivatives-related assets and liabilities increased more than five-fold during 2000 alone.
And, let me repeat, the OTC derivatives markets are largely unregulated. Enron's trading operations were not regulated, or even recently audited, by U.S. securities regulators, and the OTC derivatives it traded are not deemed securities. OTC derivatives trading is beyond the purview of organized, regulated exchanges. Thus, Enron like many firms that trade OTC derivatives fell into a regulatory black hole. [sounds to me like the old sea dog's "holes in the oceans"]
After 360 customers lost $11.4 billion on derivatives during the decade ending in March 1997, the Commodity Futures Trading Commission began considering whether to regulate OTC derivatives. But its proposals were rejected, and in December 2000 Congress made the deregulated status of derivatives clear when it passed the Commodity Futures Modernization Act. As a result, the OTC derivatives markets have become a ticking time bomb, which Congress thus far has chosen not to defuse.
Many parties are to blame for Enron's collapse. But as this Committee and others take a hard look at Enron and its officers, directors, accountants, lawyers, bankers, and analysts, Congress also should take a hard look at the current state of OTC derivatives regulation. (In the remainder of this testimony, when I refer generally to "derivatives," I am referring to these OTC derivatives markets.) [Emphasis added.] 13
We Still Haven't Learned
So once again, another monster has appeared in the form of a derivative storm. The markets, the regulators, the speculative community, and the investment public haven't learned the lesson. The amount of leverage in the system has been amplified. The degree of speculation has multiplied and volatility levels remain low as shown in the VIX.
Complacency is everywhere, reflected in investor optimism and the bullish sentiment of investor advisors. The markets have been lulled into a peaceful slumber.
The only sign of trouble on the horizon is rising gold prices and widening credit spreads. Short-term Treasury yields have fallen because of 11 Fed interest rate cuts. Default rates are at near-record levels and they are working to widen credit spreads between high-quality bonds and lower-quality debt as shown this chart. The stock market has remained on a downward trajectory, confined to a narrow trading range, and propped up by government intervention in the markets. The Plunge Protection Committee is hard at work.
On the horizon several storm fronts are visible. Any one or more of them could combine into a rogue wave to hit the financial markets, creating "The Perfect Financial Storm." We now have the possibility of another ten-sigma event. Oil prices have jumped with the conflict in the Middle East, the U.S. is at war against terrorism, default risk is increasing which is widening credit spreads, and the rise in gold prices is signaling there is more trouble ahead. It is only a matter of time before we face another LTCM or Enron or the simultaneous occurrence of multiple LTCMs and Enrons hitting the markets at the same time. The question now is who is on the wrong side of a trade. Below the surface, rumors are flying that someone big on The Street is in trouble with their derivative book. The question is not if, but when and who.
of the complexities involved in the derivative markets, I've just
scratched the surface of possible problems. Suffice to say we
are now living in a target-rich environment with multiple possibilities
for error. For this reason, I will continue this discussion in
Rogue Waves & Standard Deviations - Part 2. I'll cover three
other problem areas in the derivative markets which are credit
spreads, contamination, and gearing of the gold and silver markets.
1 Partnoy, Dr. Frank, Financial
Sense Newshour Ask The Expert Interview, April 20, 2002.
2 Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, 2000, p.105.
3 Partnoy, Dr. Frank, The Unregulated Status of Derivatives & Enron, Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002
4 Fama, Eugene, Behavior of Stock Market Prices, The Journal of Business of the University of Chicago, p. 38, No. 1, January 1965.
5 Schwartz, Robert, Derivatives Handbook: Risk Management and Control, John Wiley & Sons, 1997, p. 3.
6 Ibid., p. 4-5.
7 Warburton, Peter, Debt & Delusion, Trafalgar Square, 1999, p. 246.
8 Taleb, Nassim, Dynamic Hedging: Managing Vanilla and Exotic Options, John Wiley & Sons, p. 13.
9 Taylor, Francesca, Mastering Derivatives Markets, Second Edition, Prentiss Hall, 2000, p. 16.
10 Warburton, Peter, Debt & Delusion, Trafalgar Square, 1999, p. 144.
11 Lowenstein, Roger, When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House, 2000, p.57.
12 Ibid., p. 162.
13 Partnoy, Dr. Frank, The Unregulated Status of Derivatives & Enron, Hearings before the United States Senate Committee on Governmental Affairs, January 24, 2002
Quarterly Derivatives Fact Sheet - OCC
by James J. Puplava
April 26, 2002
Storm Watch Index
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