Wednesday, October 15, 2014

The Risk That Will Bite You Next Is NOT The One That Bit You Last

Traumatic and painful events burnish their effect upon our brains. This happens profoundly in childhood, as well as in relationships, and most definitely as readers will know,  in the financial markets. As a result, we alter behavior, and do things differently in the future. Tokyo real estate was no longer Japan's risk once it plunged skewering banks and investors in the process. Latin-American debt from the recycling of petrodollars, once a mammoth exposure has been throttled long ago. Asian countries are no longer held hostage by fickle hot-money flows. And it probably won't be large company malfeasance (like Adelphia, MCI, or Enron) drilling holes in investor portfolios that gets one fired for being contrarian. Nor is it probable that dodgy liar-loan mortgages packaged together into dubiously-annointed 'AAA' CDO's will set in motion a catastrophic global unwind. No. Rather, we will (and undoubtedly we already are) well-into the process of doing too much of precisely that thing which we shouldn't. And what ever it is, or will be, it won't be Japanese Real Estate, NT or JDSU or carelessly conjured CDOs, or whatever that thing was that buggered you soooooo much that it still hurts.

This is, in itself, one of the best arguments why Sarbanes-Oxley, and Dodd-Frank, EMIR and AIFMD are such abominable wastes of time, effort and money (for everyone except the lawyers feeding at the trough). Not that the risks they attempt address weren't risks, or that people were harmed by them. They were. It's just highly contentious whether they still are,  or will be in the future and so worthy of the draconian regulatory regime(s) imposed ostensibly to control them. It will be a VERY long time before investors, again, plough double-digit billions into a Madoff-like purported secret money-machine with no transparency and audited by some guy in a 2nd story walk-up named "Dave", or take liquid collateral held against short-duration loans to clients, and shoot-the-moon by swapping it for illiquid long-duration mortgage bonds in a suicidal reach for yield.  The germane observation here is that you cannot legislate against stupidity. And since it is stupidity (generously laced with greed) in the general sense that is at the root of risk, it will undoubtedly surface again in some other market endeavor,  asset class or investment meme,  such as myopic share buy-backs, insurance-linked securities, collectible art, high-end London Real Estate, or over-the-top deal prices with  Frankensteinian capital structures paid for Private Equity investments. Who knows?

Because we know it is more or less deterministic, that bad things ultimately result when greed mates with stupidity, ruminating upon important yet-to-be encountered risks is a worthwhile undertaking, for risk-managers and portfolio managers alike. I would add that their bosses and investors, respectively would also benefit from meditating upon the question of "what risk will bite you in the ass - tomorrow?", but if the past is a guide, its urgency will be lost in the process. So what might be tomorrow's Big Risk? High equity prices? Tight credit spreads? Generalized relative valuation levels of asset classes to historical norms? ZIRP? Exiting ZIRP? Student or auto loan-backed ABS? China growth stall? Threats of War?  Eurozone sovereign debt kerfuffle? Bank capital ratios? Ted Cruz or Nigel Farage? The diminutive age of the average HF analyst? A butterfly somewhere in the highlands of Mexico? The homogeneity of the average Finance MBA, and the curriculum studied? I daresay they are all candidates worthy of consideration…. all potentially destabilizing…but….but….

….But I think that the big risk to be concerned about - the one that sets the present apart from the past,  - is the nature of risk itself. We feel more comfortable than ever in measuring much risk, for we have PhDs with powerful computers and software, all developing unpronounceable but impressive-sounding risk models spawning more acronyms than used by the armed forces. We use our DMAs to link directly to markets, giving the illusion of abundant liquidity that results from framing our references during subdued times, modeling it on observed turnover, bolstered by the presence of HFTs and dark pools. And yet despite these advances, we appear to understand little more than we ever did (or at least ignore it the same as ever). So while everyone does as they did before, they ignore the profound difference in the structure of liquidity,  leverage, and the interplay and consequences upon both of risk-model herding and position crowding, the latter far more subject to the destabilizing whims of short-term agent-shepherds.

Dealers and banks are providing less liquidiity, and warehousing less risk than ever, precisely at a moment in time when the amount of systemic liquidity sloshing about, trading discretionarily on a leveraged basis is highly elevated relative to historical experience. These market-making activities have been meaningfully excised - a casualty of the Volcker rule and other regulatory demands from authorities - replaced by more discerning and more discretionary liquidity providers on the buy-side.  One can argue (perhaps rightly) that both specialists and market-making securities dealers, during times of elevated vol, have always stepped away from making prices. And so they have, or least widened spreads and diminished quote size to the same effect.

But going back fifteen years to LTCM, what one saw "under the hood" was that the entire Street generally acted as a counter-trend buffer with vast liquidity-providing positions contra the flow. They were not stupid positions but attractive, positive-carry relative-value inventory accumulation. The reason they [street creditors] jointly "administered" LTCM into a managed unwind was precisely NOT to have these liquidated into an open market where they were themselves "full-up". Imagine the carnage and dislocation in their absence. The important distinction here is that the street were principals with permanent capital - NOT agents. While they may withhold the both quantity and levels at which they supply, they were, in practice, their own masters. Outsourcing the liquidity provision to HFs, or other agents raises the question - like in 2008 - whether even those that are dedicated to such opportunistic pursuits, as agents, will be in the position to what they may wish to do. With ultimate investors - whether individual, institutional or otherwise - being behaviorally hard-wired towards gamma-negative tendency, one would be challenged to imagine anything other than the classical response of pulling in one's proverbial horns, and redeeming, or putting in protective redemption notices given the lengthy notification requirements. One can imagine the destabilizing demands upon liquidity, in the absence of decisive principal capital to take the other side. I think this will translate into fatter highly-kurtotic left-tailed returns at the mere hint of serious demand flow.

But that is only part of the story. Coincidentally, we now have near-uniformity in model risk in the name of VAR, and an increasing deployment of risk-parity approaches. Both of these are profoundly gamma-negative. Volatility, suppressed by abundant liquidity, infers diminished risk as measured by VAR, encouraging a complacent accumulation of risk using available leverage. Risk-parity often results in a similar rear-view risk-assessment, and acquisition of leverage. Faced with a spike in volatility accompanying almost any potential event (exogenous or endogenous), The Market's aggregate positioning and leverage will deterministically trigger demands for liquidity, most likely in the same direction as the shock, into a veritable vacuum, replete with classical feedback loops. This is before considering the large increase in mimetic trend-following, momentum and CTA strategies' relative size and importance within market ecosystems, and the large army of discretionary day-traders waiting for set-ups and breakouts. These are unmitigated amplifiers of already-gamma-negative feedback loops. The paradoxical result, in a world with more risk-managers than ever, using better measurement and technology, with more position limitations, thresholds, and more-than-abundant capital is a market that is likely to prove more brittle than ever before. For not only will the modern liquidity providers intent on avoiding costly adverse selection step out of the way, they too will turn and trade in the direction of the impulse. LOR's Portfolio Insurance, will, by contrast, appear benign.

To most fundamental equity, fixed-income, FX, and commodity traders, the Quant Wreck of 2007 hardly registered.  To those running systematic model-driven equity long/short strategies, recalling these mid-summer events is likely to trigger PTSD-like responses. But the lessons they burnished, worth heeding in regards to today's broader systemic structure are clear. Everything's fine until its not. Models, while useful, are always flawed. Participants habituate behavior basis the recent past - and are not forward-looking.  Leverage is poison. Participants caught in risk/margin/redemption crosscurrents cannot discriminate and can only unwind their positions. Gamma-negative behavior outweighs gamma-positive behavior by a large margin. The exit is always smaller than perceived in aggregate before the theatre fills with smoke. Feedback loops cause dramatic overshoot.  Out of the wreckage arises amazing opportunity. Dry powder is essential for credit is often impossible to obtain when the opportunities are the juiciest.


Anonymous said...

Great reminder, thx.

Eric said...

Can you explain "gamma-negative" and "gamma-positive" for us non-finance geeks?

David Merkel said...

You wrote a lot more than me on this, and more eloquently, but once more we are on the same page.

We both mentioned 2007, and noted the crowding of hot money in what will prove to be less liquid than imagined.

Good job.

"Cassandra" said...

David, I was channelling YOU on this one, but thanks.


Gamma-positive/negative (semi-technical description) refers to the option-hedging measure describing the change in the exposure of an option, relative to the change in the price of the underlying.
Arbitrageurs who sell options, for example, will hedge their exposure (delta or prob) of having someone claim on the insurance they sold. If they sold an option the market will go up, they will buy more as the price goes up. This is (gamma negative), or pro-cyclical behavior. Gamma negative is counter-cyclical behavior, and stabilizing because the hedger is doing the opposite of the direction of price movement (selling when it goes or buying when it goes down). Momentum or trend followers are pro-cyclical: they respond to movements by trading in the direction of the movement. My observation is that the increasing amount of pro-cyclical catalysts are more destabilizing in the absence of counter-cyclical forces (like the presence of liquidity-providing market-makers who are principals).

Polemic said...

Core beliefs that many of us wish to have been trying to express in the hope that the world should understand but I don't think anyone has presented them in such an erudite and comprehensive way. Congratulations

This should be compulsory reading and appear testable in any SEC/FCA/CFA (you name it) exams.

D Volatility said...


Anonymous said...

Great insights. I'd say July 17 (VIX daily change + ~45%) is equivalent to Feb. 27, 2007 (VIX + ~80%), which was the opening gun in the runup to Lehman. Last few days, as you imply, seem analogous to Aug. 2007. As coworker pointed out to me this afternoon, vol suppression has lessened the need for hedging, while encouraging leveraged increases in position sizes. End of QE must cause one time shift in hedging cost, multiplied by reflexivity. At least last time, it took over 18 months to fully play out, wonder how it will evolve this time.

skippy said...


One of the most concise and brief summaries I ever read. Kudos.

Skippy... instant classic and a keeper. Be shoving this under more than a few noses.

Mercury said...

“But going back fifteen years to LTCM, what one saw "under the hood" was that the entire Street generally acted as a counter-trend buffer with vast liquidity-providing positions contra the flow.”
The entire street except Bear Stearns. Unfortunately for them the shoe was on the other foot in 2007.

Ultimately the Fed has acquired the largest amount of negative gamma as they have effectively or implicitly written puts on everything. Their “portfolio” is increasingly characterized by a higher probability of decelerating gains and accelerating losses.

My current nomination for “doing too much of precisely that thing which we shouldn't” is systemic and prolonged risk price suppression.

RichL said...

I agree with everything.

To amplify a bit, the problem always has been some variant of the prudent man rule. Bankers liked real estate loans in the 2000’s because they made money in the loans and wouldn’t be criticized before whatever hit the fan.

Hedge funds all talk to each other and think alike, so the hedge fund hotel stocks are what get hit most in selloffs like this. Finance is a social game, and the need for reaffirmation from smart peers guarantees selling squalls. Remember, the hedge fund PMs feign being brave and fearless, but the institutional money that funds them are scared rabbits that can and will pull funds at a moment’s notice. The same applies to broker loans and margin clerks. That is the incongruity that causes enormous volatility what are seen as the best positions.

As far as Bear and LTCM goes, Bear cleared LTCM and had visibility as to the enormity of the positions they carried. Bear arb also had the same positions on their books, because they recommended the positions to LTCM. LTCM people actually thought that Bear was their FRIEND!
When the run started, Bear saw the potential for markdowns in its own portfolio caused by the forced liquidation of LTCM, and sold ahead of them.
The risk that I’m scared of is that the bond market is right, and that slow economic activity for a long time causes a step-function repricing of all equities at a time when it’s most inconvenient for everyone.

vlade said...

"The paradoxical result, in a world with more risk-managers than ever, using better measurement and technology, with more position limitations, thresholds, and more-than-abundant capital is a market that is likely to prove more brittle than ever before"

This is pretty much what you'd expect I say in the "controlled ecology" situation. Regulators, investors AND CBs are creating fragile monocultures. That's why I found interesting some comments from regulators (BoE) some time back in regards of the capital calculation - that the intention was for it to be vague and ambiguous so that a number of different internal models (that could/would compete) could come up.

Unfortunately, on a number of items we've got either formal (VaR) or informal (index-as-a-performance-benchmark) settings that further stoke the monoculture. The latest one is the "transparency" by CBs. I do wonder whether they realise that transparency by CBs means that while everyone knows what CB intends, no-one really knows what CB will do. As a result, you again get low volatility punctuated by crashes - or worse yet, CB that is unwilling to act since all the market is sitting on a position in-line with CBs guidance before - and unable to exit when CB needs to change what it does because world has changed.