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Goodbye Bond King, we hardly knew ye

Goodbye Bond King, we hardly knew ye

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Bill Gross, the erstwhile ‘Bond King,’ has announced his retirement. Over the course of four decades, Gross made his name actively trading bonds and started doing that before those bonds were really even considered things that were actively traded. He co-founded Pimco, then moved to Janus in late 2014 in an abrupt and somewhat drama-filled chapter of market history.

While buckets of ink have been spilt on Gross’s career and legacy, I want to point out two things. The first is that, as the title suggests, there’s still a lot we don’t know about the Bond King’s strategy. While investing in bonds might seem like a straightforward activity, it’s no secret that Pimco augmented its performance with a host of derivatives and ‘overlays.’

See for instance, Zoltan Pozsar’s work on the topic in early 2015, which I wrote up in a column for the Financial Times around the same time:

Reach for returns takes funds into the shadows

… The extent to which low interest rates have driven mutual funds and other asset managers to become entwined with shadow banking is laid bare in a new research paper by Zoltan Pozsar, former senior adviser at the US Treasury.

This shadow banking system has long been described as a network of non-bank financial intermediaries, but it is perhaps better characterised as a reference to a particular set of financial activities.

Classic examples of such activities include financial institutions borrowing money by pawning their assets through ‘repo’ agreements or securities lending transactions, as well as using derivatives.

Traditional notions of shadow banking usually centre on the idea of repo being used to fund the balance sheets of broker-dealers and banks. When entities like Lehman Brothers and Bear Stearns became locked out of the repo market in 2008 they suddenly found themselves starved of financing, triggering an avalanche of stress across the financial system.

Regulators have spent the years since the financial crisis trying to clamp down on shadow banking as they attempt to improve the overall safety of the financial system. Since such activities are rarely associated with traditional mutual funds that invest in bonds and other assets on behalf of large investors such as pension funds and insurers, such funds have rarely been mentioned in conjunction with shadow banking.

Mr Pozsar’s research suggests that is a mistake. For example, a cursory look at the balance sheet of Pimco’s flagship Total Return Fund shows a bevy of derivatives including futures, forwards and swaps. Moreover, its repo borrowings at the end of the first quarter of 2014 stood at $1.12bn. The fund’s subsequent annual report shows repo borrowings for the period averaged $5.73bn — more than five times the amount reported at quarter-end.

Such window dressing is usually associated with big investment banks that cut back on their leverage ahead of quarter ends as they seek to flatter their funding profiles and impress their investors.

Its presence on Pimco’s balance sheet is symptomatic of a long-term trend that has seen mutual funds evolve from staid, largely “long-only” managers into very different beasts. In addition to accumulating billions of dollars’ worth of fixed income securities in recent years, the funds have reached for an alternative financial toolkit of derivatives, securities lending and other forms of leverage, to help boost returns.


Gross was also famously vocal when it came to espousing a short-volatility strategy in mid-2014. Doing so wasn’t necessarily wrong, as Gross noted it was “part and parcel” of an overall investment strategy that rested on sluggish U.S. growth and low interest rates, but it nevertheless raised eyebrows among his peers and competitors who viewed the new crop of buy-side volatility-sellers as tourists in a somewhat dangerous market.

The second point is that the sheer size of Gross’s creation — Pimco — has at times had massive effects on the wider market. “Big West Coast player” means just one thing for many in fixed income, and Pimco was said by plenty of observers to have frequently thrown around its gorilla-esque weight to get favourable pricing and allocation on new bond deals. Conversely, however, the sheer size of the Total Return Fund (which from memory peaked at almost $300 billion), was also said by market participants to pose challenges for its managers, the idea being the fund had grown so large it effectively struggled to beat its benchmarks.

That size could also have more deleterious effects. Few people seem to remember now, for instance, that when Gross left Pimco, it coincided with a noticeable sell-off in inflation-linked bonds and junk-rated paper. Or that the flash crash in U.S. Treasuries in October 2014 was rumoured to have been sparked by a sudden liquidation of interest rate positions favoured by Gross. There are still so many interesting open-ended questions posited by Bill Gross’s adventures in Bond Land, and from that perspective I’m somewhat sorry to see him go.

Anyway, for those interested in mulling these questions more, here’s some previous work — much of it done with the FT’s fantastic Mike Mackenzie:

Gross exit from Pimco tests bond market – September, 2014
Pimco upheaval rattles bond market – September, 2014
Wall St sheds light on Bill Gross reign after Pimco departure – October, 2014
Bonds: Anatomy of a market meltdown – November 2014
Caught on the wrong side of the ‘vol’ trade – December, 2014
Reach for returns takes funds into the shadows – February, 2015

The year in credit (2018)

The year in credit (2018)

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So it’s been a while and I don’t write as much as I’d like to anymore, but given the amount of current interest in the credit market I thought I’d put this here.

Market Selloff Played Out in the Most Hidden Corners of Credit
If you read one thing about credit this year, please make it this. Something you hear in the market quite a bit is that ‘X’ or ‘Y’ won’t be a huge problem because we don’t have as much leverage embedded in the financial system as we did in 2008. Back then, subprime mortgages got bundled into Triple A-rated bonds that then became the subject of all sorts of derivatives bets which then helped amplify the downside across the financial system. While it’s very probable we are nowhere near that scale when it comes to corporate credit, there is an added layer of leverage that doesn’t get nearly enough attention.

How February’s market sell-off played out in corporate credit is a useful example of this concern. The selloff arguable took place not in the cash market, but in derivatives attached to it including CDX indices and options on those indices. More worryingly, there is a concern among some market participants that those options end up having an impact on the underlying indices themselves during intense bouts of market action. Dealers have to rush to hedge as those price movements cause options to expire, exacerbating the price movements and potentially causing further pain. The point to all of this is that there’s a complex ecosystem of credit exposure that, I would argue, we do not have a very good understanding of.

(As an aside, we’ve seen negative gamma-sparked bouts of market volatility a couple times this year in different asset classes, including the VIX product blow-up and — somewhat more randomly — the oil market. Unfortunately, the Oxford Dictionaries declined my nomination of gamma as word of the year.)

Some other things worth reading:

Goldman Says Riskiest Junk Bonds Are Most ‘Mispriced’ Since 2007
Do you know a special someone who likes to say that “corporate credit’s a good buy so long as defaults remain low?” This holiday season get them this note from Goldman, in which the bank lays out that its “preferred valuation measure of corporate credit, which subtracts their projected expected-loss rates from current spreads, shows U.S. high-yield obligations are now mispriced for even the most benign [default] scenarios.”

Goldman Warns of Liquidity-Fueled Sell-Off After ‘Volmageddon’
From the guys that brought you “liquidity is the new leverage,” comes this piece warning that low liquidity may not be isolated to the corporate bond market but could be a problem across the broader (equity) market. You can quibble about the meaning of liquidity in this context, but I think the point is that the market is susceptible to sudden and dramatic pullbacks as *everyone* changes direction at once. See also the two items below.

It’s Not Just Italy. Shock Moves Jolt All-Or-Nothing Markets
Another way of saying this is that in this market, everything is fine until it isn’t. Assets can be priced for perfection and many red flags ignored until everyone suddenly rushes to the exits. The catalyst isn’t necessarily a change in the fundamental outlook for the asset, but a change in investor behavior. “The binary ‘all-in/all-out’ behavior, which up until now was relegated to the fringes of the financial markets, has gone mainstream,” says Peter Atwater. (There’s a bonus Galbraith’s ‘Bezzle’ reference here too).

This Is What Happens When Markets Stop Chasing Flows
On a completely related note – this is one of the defining features of post-crisis markets in my humble opinion. Investors used to chase assets until they became ‘overvalued,’ at which point the inflows would stop. But in a market characterized by sluggish economic growth and low yields, the way to generate outperformace was not by identifying assets with the most return potential based on fundamentals, but those most likely to attract other investors. Because you’re chasing flows and not fundamentals, the market is no longer self-limiting. In other words, there’s no natural place for asset valuations to stop so long as inflows continue. This story is terminal-only but you can read a similar argument over here.

Odd Lots: What David Barse Learned From Watching A Credit Fund Blow Up
The last major hiccup in credit markets took place in late 2015, when Third Avenue Management blew up. So it’s worth listening to the thoughts of the former Third Avenue CEO on this episode, even though you may not agree with them. (Also, please subscribe to Odd Lots. I often stay up until 11pm to make these and I like to think some people are profiting from my sleeplessness!)

Citi Warns U.S. Credit Locked in a Losing ‘Internecine’ Battle
If you think your BBB-rated bond is priced for perfection, what if it’s not really a BBB bond? There’s no denying that a huge chunk of the corporate credit market has migrated to the middle of the ratings bracket in recent years which suggests there is, by definition, some there is a lack of credit differentiation compared to previous years. In any case, it’s interesting to see different analysts pegging different ratings ‘buckets’ as the problem. Most people seem worried about BBB but there are others singling out the single As, for instance (ha). Here’s Citi: “An environment in which one single-A credit can be carted out into single-B spread territory almost overnight is perilous to ratings-constrained institutional investors, particularly in Asia, that have chased the yields of blue-chip U.S. debt into the low-A/mid-BBB territory.”

Fate of $1 Trillion in Risky U.S. Loans May Be in Japan’s Hands
Speaking of Asia, it’s usually not a good sign when the market starts looking for the bagholders but in this case you could do worse than Japanese banks, typically viewed as long-term buy-and-hold investors. Watch those FX hedging costs, that BOJ monetary policy as well as dealer activity, though. To bring everything here full-circle – It’s yet another example of complex interplay in credit markets. A bunch of these deals have been done through so-called repacks – meaning there’s typically a currency swap agreement done with another (often European) bank. So the market needs to worry about an extra layer of FX sots and dealer risk appetite/balance sheet, in addition to the underlying ‘health’ of the credit market.

Where Leverage Lives

Where Leverage Lives

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I was thinking about the recent volpocalypse and some of the action we’ve since seen in the credit market, where February’s big market ructions played out in credit derivatives as opposed to the cash corporate bond market. That’s not entirely surprising given that the cash market has long been said to be less liquid than its synthetic counterpart, but what is rather concerning is these are largely derivatives tied to credit indices and there’s the potential for a self-fulfilling feedback loop similar to what we arguably saw in VIX-related products and the Volatility Index itself. Overall, there are huge pockets of leverage in the system, from run-of-the-mill equity options used to eke out excess returns, to more esoteric credit derivatives like CDX options.

Anyway, it put me in mind of the below piece from a couple years ago.

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This Is How Leverage in the Financial System Lives On

By Tracy Alloway

(Bloomberg) — Rumors of leverage’s death have been greatly exaggerated.

In the aftermath of the 2008 financial crisis an abundance of leverage — borrowed money used to amplify returns — was blamed for exacerbating losses on subprime mortgages and contaminating the banking system with catastrophic results. Since then a host of new rules have been enacted to reduce financial leverage, including penalizing certain derivatives positions, such as the credit default swaps (CDS) villainized in the crisis, as well as outright curbing the amount of borrowing allowed at big banks.

While such efforts have made substantial steps in derisking the financial system — especially at large lenders — they’ve also encouraged the creation of new types of leverage and its migration to different players. Today, much leverage appears to sit on the balance sheets of large and small investors, often fueled by the need to generate returns amidst ultra-low interest rates and high correlations that see asset classes move together and make it more difficult to produce outperformance, known as ‘alpha.’

Leveraged strategies may include selling volatility or dabbling in derivatives tied to interest rates or corporate credit. While few are suggesting that the leverage deployed via such tactics could cause a crisis on the scale of 2008, it can create unexpected consequences ranging from a ‘flash crash’ in one of the world’s most liquid markets to constraints on the Federal Reserve’s ability to change monetary policy, as highlighted by a new paper from visiting professors at the Bank for International Settlements.

Moreover, they underscore the risks facing the market as investors continue to divide themselves between those eschewing the chance to earn a steady stream of returns by betting big — and those willing to risk the chance of outsized losses in the event of a significant change in markets.The latter group found a posterchild in the way of Bill Gross, the former co-chief investment officer of Pacific Investment Management Co. (Pimco) and erstwhile ‘Bond King’ who spoke publicly about his use of derivatives to increase returns in the “new neutral” era of ultra-low interest rates, shortly before departing the company in late 2014.

Pimco’s flagship bond fund, the Total Return Fund (TRF), sold $94 billion worth of put and call options on floating to fixed income swaps, or 41 percent of the fund’s net asset value, according to BIS data. Known as selling or shorting volatility, the strategy allowed Pimco to collect insurance-like premiums as long as interest rates stayed low.Similarly, Pimco deployed eurodollar futures, a type of derivative that locks-in interest rates for investors, with long eurodollar contracts at the Total Return Fund (TRF) jumping from 250,000 in March 2013 to almost 1.2 million as of June 2014.

While Pimco noted at the time that such long eurodollar futures contracts were “used to manage exposures at the short end of the yield curve and express PIMCO’s expectations for short-term rates,” they also come with the benefit of added leverage, in effect boosting returns so long as rates remained low.

Gross’s departure from the fund in September 2014 sent the TRF’s managers scrambling to liquidate the eurodollar contracts as investors redeemed their money. The liquidation may have exacerbated the flash rally in U.S. Treasuries that took place shortly after, when the yield on the benchmark 10-year note seesawed wildly in the space of a few minutes, the BIS paper said.

“The irony is that a more measured pace of liquidation would have allowed the fund to profit from the bond market ‘flash rally’ of October 15, 2014,” visiting BIS professors Lawrence Kreicher and Robert McCauley wrote in the paper. “In any case, it appears that a huge long eurodollar position could be and was liquidated in a fortnight. By contrast, [the TRF’s] liquidation of its ‘short volatility’ position may have contributed to the ‘flash rally,'” by setting off a wave of hedging amongst dealers who scrambled to absorb Pimco’s short position.

The use of eurodollar futures has not been confined to the world’s erstwhile biggest bond fund, with the BIS paper noting that while asset managers play a diminished role in day-to-day trading, they “generally hold the largest eurodollar positions among buy-side participants.” Their “dominance in positioning establishes them as gatekeepers for the Fed’s forward guidance” limiting the U.S. central bank’s ability to change monetary policy if asset managers are not positioned accordingly — as seen in the 2013 taper tantrum.

Investors seeking to boost returns at a time of abundant liquidity and unconventional mo

netary policy have also applied leverage to corporate credit, a market which has exploded in size thanks to low interest rates and yield-hungry investors who have enabled companies to sell more of their debt. While the use of single-name CDSs that offer insurance-like payouts to a single security, company, or government, has diminished in the wake of the financial crisis, trading tied to indexes comprised of multiple entities has jumped.

With corporate default rates at historic lows and with stimulus increasing correlation between asset classes, use of so-called CDS indexes has boomed as both a trading and hedging tool, allowing investors to create an “overlay” on their portfolios to protect against a systemic rise in defaults at a time when liquidity is said to have deteriorated.

Further complicating matters is the explosion in alternative derivatives or ‘derivatives of derivatives,’ with investors now served an expansive menu of exotic synthetic credit products including options on total return swaps (TRS), options on CDS indexes, and a suite of other bespoke offerings.

Such ‘swaptions,’ as they’re sometimes known, give investors the right to buy or sell the index at a particular date and for a certain price, and are said to have surged in popularity in recent years. Analysts at Citigroup Inc. estimated that about $24 billion of CDS index options traded in 2005, rising to $1.4 trillion in 2014 — a more than a 5,000 percent jump in activity in just under a decade.

Strategists at Barclays Plc have expressed concerns that the rapid rise in CDS index option volume was impacting the underlying index, while a senior credit trader at one of the biggest banks told Bloomberg earlier this year that the notional volume of credit index options traded has on some days surpassed the volume of trades in the referenced index. A more recent survey by Citigroup Inc. analysts earlier this year showed 72.6 percent of investors expressed concerned over how “investors are taking more leveraged risk using derivatives.”

In the equity market, a jump in the number and amount of products tied to the Chicago Board Options Exchange’s Volatility Index, the VIX, are sometimes said to be impacting the index itself. While the VIX, which is based on options contracts tied to the S&P 500, remains far below its financial crisis highs, volatility of the index itself last year reached an all-time record.

This is how leverage in the financial system lives on – Bloomberg, August 2016
Market selloff played out in the most hidden corners of credit – Bloomberg, February 2018

The benchmark index providers who rule the world

The benchmark index providers who rule the world

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I find the intellectual questions thrown up by benchmark indices absolutely fascinating. Talk to the providers about what it is they do exactly and most of them will say they hold a mirror up to the investable world as it exists, while simultaneously acknowledging that their decisions can end up reshaping just what that reflection looks like. What everyone can agree on: their role in a market increasingly dominated by passive investing is growing.

So here are 2,000 words or so on the index providers who rule the world … as well as the people who want to unseat them.

Benchmark indexes trace their history to the late 1800s, when Charles Dow, co-founder of Dow Jones & Co., created the first as a way to gauge the general direction of the market (and to sell newspapers). Today the number of benchmarks outnumbers that of individual stocks. “The problem is that a lot of investors assume that the benchmarks are almost God-given and that they’re ­problem-free. Most of the time they’re not,” says Mohamed ­El-Erian, chief economic adviser at Allianz SE and a Bloomberg View contributor. “It’s a crucial issue. And it’s becoming even more important as more and more people migrate to passive products.”

Index Providers Rule the World—For Now, at Least – Bloomberg Markets Magazine

Did someone say something about synthetics?

Did someone say something about synthetics?

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Two words excite me like no others.

They are synthetic securitisation (or, for the truly old-school, they are three words: regulatory capital trades). These deals usually involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches, and selling the exposure to a non-bank entity like an insurer, hedge fund, or asset manager through the use of credit derivatives.

In many respects, they hark back to the early days of securitisation, when JPMorgan first put together its BISTRO trades, otherwise known as the first synthetic CDOs. Banks may be genuinely offloading risk here, and the deals were called reg-cap trades precisely because they offered capital relief that’s so far been genuinely sanctioned by regulators. On the other hand, they seem to speak to some of the worst of the current environment: a pervasive search-for-yield that may see investors put their money in silly things at silly prices (for this reason, you will sometimes hear reg-cap specialists – usually hedge funds – gripe about the non-expertise of new entrants and the need to price the deals perfectly), as well as nagging concern that in fortifying the banking system post the financial crisis, we’ve simply offloaded a bunch of balance sheet risks onto other entities in a classic case of regulatory arbitrage.

In any case, I bring it up because in less than a week we’ve seen two stories published on the market, now said to be booming, first in the Financial Times and then in the Wall Street Journal. Both detail the rise of the market, with issuance described as having jumped by anywhere from 5.6 percent in the first quarter to at least 33 percent so far this year.

Those looking for a graphical representation of the recent rise of synthetic CDOs, could do worse than this chart from Deutsche Bank. It shows European deals only, but the direction of the trajectory is pretty obvious. The WSJ story also references some interesting figures from consultancy Coalition, pointing out that structured credit revenues at the top 12 investment banks more than doubled year-on-year to $1.5 billion the first quarter of 2017, exceeding the growth rate in more conventional trading businesses in the same period.

Growth in the business is not exactly a surprise, though.

More than five years ago I wrote in the FT about some of the bigger banks working hard to get the business going as a way of securing some new fees at a time when many of their other revenue streams were sluggish. In retrospect, that story’s now looking pretty prescient.

Big banks seek regulatory capital trades

 

Big banks are aiming to help smaller lenders cut the amount of regulatory capital they need to hold against loans in an attempt to make money from deals similar to those first created in the early days of securitisation more than a decade ago.

The big banks want to create so-called regulatory capital trades for smaller lenders as they expect demand for these kind of securitisation structures will rise ahead of regulations designed to provide more stability in the financial system.

Such trades, also known as synthetic securitisations, involve repackaging loans on a bank’s balance sheet, then slicing them up into different tranches.

The bank typically then buys protection on the riskiest or mid-level tranche from an outside investor such as a hedge fund, insurance company or private equity firm.

Doing so allows a bank to reduce the amount of regulatory capital it has to hold against the loans – a tempting prospect as banking groups are forced to hold more capital ahead of new regulation such as the forthcoming Basel III rules.

Some of the biggest global and European banks, including Barclays and Standard Chartered, are known to have recently built and used the structures to reduce the amount of capital they need to hold against corporate or trade finance loans.

But some large banks are now hoping to sell their structuring expertise and help distribute the resulting trades to buyers, investors in the trades say.

“The holy grail for some of the investment banks is to try to get some of the second and third tier banks involved, to get structuring fees,” said one investor. The trades hark back to the early days of securitisation in the late 1990s, which helped fuel the financial crisis.

“It’s almost as if you’re seeing the start of the securitisation market coming back in a very modest way,” said Walter Gontarek, chief executive of Channel Advisors, which operates Channel Capital Plc, a vehicle with $10bn in portfolio credit transactions with banks and has started a new fund dedicated to these structures.

Investors such as Channel Advisors say the yields on the deals are attractive compared with other debt securities on offer, and they are able to gain exposure to a specific portion of a bank’s balance sheet rather than invest in the entire thing. The insurers, hedge funds or private equity firms are not bound by the same, relatively onerous capital regulations as the banks. That makes it easier for them to write protection on the underlying loans in a classic case of regulatory arbitrage.”

…MORE… 

Some more early coverage below, for those interested.

Synthetic tranches anyone? – FT Alphaville
Anti-Abacus, anti-BISTRO and anti-balance sheet synthetic securitisation – FT Alphaville
Big banks seek regulatory capital trades – FT, April 2012
Banks share risk with investors – FT, September 2011
Balance sheet optimisation – BOOM! – FT Alphaville, 2010

Safe assets, revisited

Safe assets, revisited

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The idea of a shortage of ‘safe’ assets is a favorite of mine, dating back from 2011 when I first wrote about a crunch in triple-A rated assets for FT Alphaville to more recent things such as this piece for Bloomberg, and sometimes even on this blog. So it was a pleasure to discover, courtesy of Simon Hinrichsen (a former Odd Lots guest whom you should definitely follow on Twitter), a new paper on exactly this topic from Ricardo Caballero, Emmanuel Farhi and Pierre-Olivier Gourinchas. Read it for rather glorious sentences such as this one: “What is relatively new, relative to post–World War II history, is that the global economy is going through a complex structural period where the standard valuation adjustment for safe assets— via interest rate changes—have run out their course.”

Here’s a summary I wrote as part of our morning ‘Five Things’ newsletter, which you can sign-up for here.

“Want a stylized prism through which to understand almost everything that’s happened in the global financial system over the past two decades? Then take a look at this paper on “The Safe Assets Shortage Conundrum.” In it, the authors argue that savers’ desire to put their money in a reliable instrument has created a need for ‘safe’ assets that the financial system has had various degrees of success in fulfilling. In the early 2000s, the private sector tried to fill that need by creating triple A-rated bonds out of subprime mortgages. We know what happened next. After that, safe financial assets became largely the purview of governments via the bonds they sell – first the eurozone (which then experienced its own ratings problems) and then the U.S. Supply has ultimately failed to keep up with demand, however, mostly because slower growth has meant ‘safe’ governments in the developed world have been unable to generate assets at a fast enough pace to satisfy savings from emerging markets. It’s a state of affairs that will probably stick around for a long time, and one that helps explain why bond yields continue to plumb new lows, seemingly without rhyme or reason. But seriously, go read the whole thing.”

A side note: I do wonder what might constitute safe in the current environment. Yes, government debt is the clear winner here but corporate debt issued by cash-heavy, investment grade, national champion corporates – think Apple – can’t be far behind…

It’s not just about the VIX

It’s not just about the VIX

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There’s so much talk about volatility right now — and specifically the stubbornly low behaviour of the VIX  — that I thought I’d do a round-up of some of my previous pieces on it.

Please note, I’m in an anti-paragraph, anti-proofreading kind of mood today. So typos and big blocks of text are ahead.

1. On the VIX 

Let’s start with this one, from September 2013, about a new index trying to challenge the VIX, the index that most people associate with ‘volatility.’ For more than two decades, the VIX index run by the Chicago Board Options Exchange has been the financial industry’s go-to method for measuring expectations of volatility in the wider marketplace, with the CBOE turning the index into something of a cash cow thanks to the launch of futures tied to the gauge. VIX-related futures have in turn allowed a plethora of VIX-based exchange-traded products (ETPs) to also launch. With all that money benchmarked to the VIX, it’s no surprise that we have occasionally seen upstarts attempt to challenge it.

2. Selling volatility

Now let’s go here to this story from December 2014. About six years on from the financial crisis and deep in the era of monetary stimulus, investors are struggling to make returns and seize upon the realisation that selling volatility — whether that be through shorting the VIX or some other derivative-based method — can be a lucrative (if risky) strategy. This was the big shift in the volatility market. Instead of having a bunch of banks or hedge funds (or de facto, GSEs) sell volatility, you suddenly have a bunch of buy-side funds and retail investors who are interested and able to do so, the latter largely thanks to the explosion in VIX-related products. The big question, per the piece, is whether these new sellers of volatility are more likely to behave differently than traditional vol-sellers. Are they more or less likely to react to abrupt shifts in volatility?

3. Self-reflexive VIX

By September 2015, the VIX is again in the headlines after the unexpected devaluation of the Chinese yuan spooked markets. While the VIX did jump on this news, it was the VVIX (in effect, volatility of volatility) that reached an all-time record. Here’s my article about that: “When there’s a sudden spike in volatility, as occurred last month, the price of near-term VIX futures rises. Meanwhile, volatility players — notably hedge funds and CTAs — scramble to buy protection as they seek either to hedge or cover short positions, causing a feedback loop that encourages near-term futures to rise even further.” CFTC positioning data at the time did suggest a classic short squeeze as investors closed out their short vol positions post the spike. In effect there were said to be two major forces impacting the VIX, systematic volatility sellers as well as VIX-related ETPs that have to buy or sell futures to rebalance. This rebalancing act makes the VIX curve important, a point picked up on by Chris Cole of Artemis Capital in a story I wrote about a month later: “VIX term structure inverted at the greatest degree in history in August, so much so and so fast that many structured products that use simple historical relationships to gauge term structure switching and hedging ratios just couldn’t handle it,” he said. The concern is that the explosion in volatility-trading means more demand to buy or sell futures to rebalance, which could impact the shape of the curve itself.

4. VIX and beyond!

The proliferation of ETPs tied to the VIX is a concern insofar as it affects the volatility landscape, but it’s not the whole story. To explain, let’s go to Bill Gross, who became the poster child for volatility-sellers after publicly saying in June 2014 — while still at Pimco — that the company was selling “insurance, basically, against price movements” to juice returns in an era of low interest rates. Not once did he mention the VIX. It wasn’t until October 2014, after Gross’s abrupt departure from Pimco, that we got a better sense of what that insurance-selling strategy might mean when the U.S. Treasury market experienced a sudden melt-up, of sorts. At the time, there was plenty of talk that Pimco was liquidating some derivatives positions, which ended up having an outsized effect on the underlying cash market. The U.S. government’s report on the episode later mentioned that: “In particular, anecdotal commentary suggested that some dealers had absorbed a portion of the sizable ‘short volatility’ position believed to have been previously maintained by large asset managers. As volatility spiked on October 15, those positions would have prompted some dealers to dynamically hedge this exposure, exacerbating the downward move in yields.” Then, in August of last year, the BIS published a paper on asset managers dabbling in eurodollars including the example of Pimco in 2014, which I wrote up in a piece called “This is where leverage lives in the system.” That article contained a laundry list of potentially risky strategies across rates (viz eurodollars, futures, forwards), credit (using swaptions and swaps) as well as equities (options, VIX ETPs, etc.). What’s my point? I don’t mean to underplay what’s happening with the VIX, but my concern is that if we’re looking for potential flash points in the financial system then we may want to broaden our horizons.

The End

The End

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Is this the end? Are you my friend?
It seems to me, you ought to be free.
You used to be mine when the chips were down.
You used to be mine when I weren’t around…
– The Doors.

Those immortal lyrics spring to mind courtesy of this Citi survey of investors:

I’ve been surprised by the suddenness with which markets appear to have shifted gears from an apparent six-year reliance on easy monetary policy to pinning their hopes on the expectation of fiscal stimulus that is still far from materializing. We’ve touched on it in our various coverage at Bloomberg but it seems this will be the theme to watch in 2017. How rapid is the tightening? How pervasive? And, crucially, can the market remain relatively resilient in the face of rising rates and investors who still have a massive long position on credit?

Speaking of which, as is becoming tradition around here, here’s this year’s list of credit coverage. You’ll notice it peters out as the year goes by. That’s because I got busy with a new home and some new work. See you in the new year and here’s hoping your 2017 be filled with all the right kind of surprises.

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The AAA bubble, deflated

The AAA bubble, deflated

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Half a decade ago, I wrote a post with a rather eye-catching lede. “This, we think, could well be the most important chart in the world right now,” it said.

AAAratings
It went on to discuss the disappearance of triple-A rated securities in the aftermath of the U.S. housing bubble and trillions of dollars worth of downgraded mortgage-backed securities. The disappearance was short-lived, however. By 2009, highly-rated government debt had more than filled the hole left by increasingly scarce AAA-rated securitizations.

“The AAA bubble re-inflates and suddenly sovereign debt becomes the major force driving the world’s triple-A supply,” said the 2011 post, written when worries over the eurozone debt crisis were in full swing. “It’s one reason why the sovereign crisis is well and truly painful.”

Frances Coppola has a much more recent post that reminded me of this.

It features a chart from the rating agency Standard & Poor’s, which forecasts that triple-A rated sovereign debt will essentially become an endangered species by 2050 thanks to a rise in government borrowing.

sandp

Coppola makes a good point here. “It’s a great chart. But what it is really telling us is that S&P’s way of assessing the creditworthiness of sovereigns belongs to a bygone age. In the new world, junk is safe, debt is an asset and investors fear governments. So ratings will be meaningless in future, and ratings agencies, redundant,” she concludes.

That said, I do wonder about the need and ability of the financial industry to re-engineer ‘safe’ securities with top-tier credit ratings, given the degree to which such ratings are still (incredibly!) embedded in our financial system – from liquidity buffers to central bank asset purchase programmes. For this reason, I would dearly love to see an updated chart encompassing all fixed income.

Update: A few days after this post, Gary Gorton and Tyler Muir published a related BIS paper on collateral shortages. Check out the write-up here.

Peer-to-Fear

Peer-to-Fear

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In January of this year I resurfaced some of my older reporting on the peer-to-peer, or marketplace, lending industry and wrote this line in the first article about Lending Club raising interest rates for the riskiest borrowers on its platform:

It’s worth recalling the words of some investors at the time who criticized LendingClub’s lofty $8.9 billion valuation—reached partly because of overwhelming enthusiasm for all things tech-related.  “These companies are really specialty finance companies, but look at where specialty finance companies trade in the public markets,” said one major marketplace lending investor at the time [of LendingClub’s late 2014 IPO].

It’s a point that, like much of my coverage, has been oft-repeated since – especially in the wake of recent news that Renaud Laplanche, LendingClub’s CEO, resigned following allegations of internal control issues and a rather sloppy ABS deal with Jefferies. My interest in marketplace lending has always been its overlap with traditional finance and the degree to which – as I’ve often written – the disruptive sector has been  co-opted by the very thing it sought to disrupt. In fact, one of the earliest enterprise pieces I wrote on the nascent industry, from January 2013, included the following gems:

“The one thing about peer-to-peer lending is it’s still a relatively manual process. This business needs a lot of scale to be profitable,” said a P2P analyst.

“In order to grow this business one must really have made relationships on the institutional side,” said a P2P CEO.

“On the surface it really almost comes across as too good to be true,” said a P2P institutional investor.

More than three years later and the pressures of scaling a ‘technology’ business that still relies on direct mail for advertising, and which derives much of its value from avoiding the legacy costs (including regulation) of traditional banks, seems to have come to a head viz LendingClub’s apparently lax internal controls, funding and securitization processes.

For those interested, here’s my more recent coverage of the industry’s travails.

When credit market concerns arrive at the marketplace lenders, January 2016 – Recall that the bear case for marketplace lenders was always a turning of the credit cycle that would either produce a rise in borrower defaults or result in a dearth of funding as skittish investors cut their lending on the platform. At the beginning of this year, credit markets spasmed,and LendingClub raised rates on lower-quality loans on its platform by about 67bps as it sought to better compensate nervous investors.

More trouble in bonds backed by peer-to-peer loans, March 2016 – A rating agency slapping a credit rating on a securitization only to downgrade it eight weeks later because of faster-than-expected-delinquencies seems … reminiscent of something.

A new class action suit wants to treat peer-to-peer lenders like mobsters, April 2016 – A scoop about a class action suit that strikes at the heart of the marketplace lending model and came on top of the already troublesome Madden vs Midland Funding decision, completed the ‘doomsday duo’ of funding concerns and regulatory scrutiny for the industry.

LendingClub is turning out to be anything but a direct lender, May 2016 – The resignation of Laplanche sent LendingClub shares plunging and, more significantly, exposed one of the biggest oddities at the center of the company’s business model. While promising to democratize finance by using new technology to directly match borrowers with lenders, LendingClub has turned to a complicated network of middlemen and professional investors to fund its rapid expansion and disintermediate traditional banks.

And the latest edition of our Odd Lots podcast, which sums up some of my thoughts on the matter:

https://soundcloud.com/bloomberg-business/28-how-finances-hot-new-thing-ended-up-in-an-old-school-scandal