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Monday, July 21, 2008


the flood -- dynamic hedging

on the heels of comments earlier today on deteriorating housing liquidity and deteriorating corporate liquidity, doug noland of prudent bear offers a view on how the freezing of more and more of the credit markets in the aftermath of a spectacular boom is increasing the odds of a dislocation in equities.

This week benchmark Fannie Mae MBS yields jumped 31 bps, to an 11–month high 6.15%. Spreads versus treasuries widened 18 bps to the widest level (206bps) since the height of the crisis in March. Also this week, the SEC took an extraordinary step to tighten the rules for shorting the large financial stocks. These developments are not unrelated.

In JPMorgan Chase’s and Citigroup’s earnings conference calls, both major lenders this week noted deterioration in prime mortgages. This provides additional confirmation that the mortgage crisis is now reaching the bedrock of our nation’s mortgage Credit system. And particularly with the mortgage insurers, the GSEs, and the leveraged speculating community having come under varying degrees of stress, a tightening in “conventional” mortgages will now significantly exacerbate the mortgage/housing/financial/economic crisis.

In years past, I have occasionally used my fictional “town by the river” analogy to demonstrate how the introduction of inexpensive flood insurance and a resulting speculative boom in writing this protection fostered a building boom along the river. The financial (insurance, lending and speculation) and economic (building, asset inflation, and spending) aspects of the boom were interrelated and reinforcing. In my fictional account, the booms were further spurred by a drought that both inflated the profitability of writing risk insurance (attracting throngs of speculative players) and buoyed complacency for those living, building, and spending freely near the water’s edge.

These dynamics set the stage for the inevitable dislocation in the flood insurance market. With the arrival of the first torrential rains, there was a panic as the thinly capitalized “insurers” rushed in a futile attempt to re-insure their risk of potentially catastrophic losses in the event of a flood along what had become a highly over-developed river bank. Few in the insurance market had built reserves, as most speculators simply planned on hedging flood risk in what was, at least the time of the boom/drought, a highly liquid insurance marketplace. Worse yet, over time the pricing of flood protection had become grossly inadequate with respect to the mounting (“Bubble”) risks that had developed over the life of the financial and economic booms. Any reinsurance available during the crisis was priced prohibitively.

Back in 1990, when I first began working on the short-side, there was an estimated $50bn to $60bn in the hedge fund community. The few of us actually shorting stocks were primarily focused on diligent fundamental company “micro” research and analysis. It was not until some years later that “market neutral” and “quant” strategies took the financial world by storm. And back in the early nineties the OTC (over-the-counter) derivatives industry was just starting to take hold. Today’s Wild West CDS (Credit default swap) marketplace didn’t even exist.

Nowadays, the “leveraged speculating community” is measured in the multi-Trillions; the derivatives market in the hundreds of Trillions. The scope of players and sophisticated strategies utilizing short-selling is unlike anything previously experienced in the markets. And similar to how drought magnified the boom along the river, it was the boom in leveraged speculation and derivatives that played the instrumental role in fueling self-reinforcing Credit expansion and the resulting Credit, asset price and economic Bubbles. But those Bubbles are bursting – the torrential rains are falling and there is today extraordinary and overwhelming impetus to “reinsure” – to offload - the various risks that ballooned over the life of the protracted boom.

Many writing the multitude of types of market insurance incorporate “dynamic hedging” strategies. This means that few hold little in the way of actual “reserves” to pay in the event of major losses. Instead, they rely on “shorting” various securities that, in a declining market, will provide the necessary cash-flow to satisfy any insurance obligations. This all worked wonderfully in theory, and the basic premise of modern day risk hedging capabilities was supported by the nature of highly liquid boom-time financial markets. But “torrential rains” have a way of rapidly and dramatically altering marketplace liquidity. The reality is that entire markets cannot insure themselves again declines. Any attempt by a large swath of the marketplace to hedge exposure will be problematic. Selling will either immediately overwhelm the market or the “put options” accumulated as protection will create acute market vulnerability to self-reinforcing selling pressure and market dislocation.

Today, there is little liquidity in the securitization or corporate bond markets. So, the multi-Trillions of strategies relying on shorting securities for hedging and speculating purposes have gravitated to the relative liquidity of U.S. equities. And, when it comes to hedging against or seeking profits from heightened systemic risk, one can these days see rather clearly how incredible selling pressure can come down hard on the 19 largest U.S. financial institutions. And when one considers the scope of derivative strategies that incorporate “delta hedging” trading dynamics – where the amount of selling/shorting increases as the market declines (systemic risk increases) – one recognizes the possibility of a marketplace dislocation along the lines - but significantly more systemic - than the “portfolio insurance” fiasco that fueled the 1987 stock market crash.

Importantly, this issue of acute systemic risk has taken a turn for the worst with the recent deterioration in the conventional mortgage market. The highly exposed GSEs, mortgage insurers, and leveraged speculators are positioned poorly to withstand a bust in prime mortgages. The fate of the U.S. Bubble economy today rests on the ongoing supply of low-cost "prime" mortgages. Any meaningful tightening in conventional mortgage Credit – including the lack of availability of mortgage insurance, required larger down payments, and/or tougher Credit standards – would have a major impact on Credit Availability for core housing markets throughout the country (many that have thus far held together fairly well). Such a tightening would put significant additional downward pressure on prices, exacerbating already escalating problems for the GSEs, Credit insurers, and speculators.

this amounts to an explanation of why short interest has been steadily marking all time highs. being unable to dynamically hedge in credit market underliers due to extreme liquidity constraints, operators have resorted to hedging credit exposures in the remaining liquid market of equities. as credit market conditions deteriorate, the impulse to reinsure portfolios dynamically grows -- and sets the stage for a crash in much the same manner as cascading hedging forced the events of late october 1987.

as such, credit market events must be watched very closely.

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