There are a number of striking similarities between financial markets before the 2008 financial crisis and today. The most obvious is the low level of volatility. While everyone’s favorite indicator of risk taking is the VIX, other metrics of risk and uncertainty are even lower today than they were in 2007. For instance, the metrics of interest rate volatility today are much lower than in 2007, and could probably be the lowest ever on record.
But there are many other parallels. In 2007, the prevalence of “Structured Investment Vehicles,” or SIVs, are ascribed some degree of blame for the ultimate unwinding of credit leverage. In quite simple terms, an SIV is a shadow bank, which borrowed short and lent long, not unlike what a bank does, or borrowed at lower-risk interest rates and lent out at higher rates. By doing so, SIVs operated under the radar of bank regulators, and captured both the “term” spread and the “credit spread”. Since this maturity and credit transformation was so attractive for the initial participants, it attracted others looking for the same “free” money, until the size of the market became so large that it eventually imploded from within. Of course as we now know the underlying assumption that drove this excess was that the collateral, i.e. the housing market, would never go down too much. Given the financial engineering of the times, one could operate a levered vehicle, such as a shadow bank, out of the proverbial “garage” as long as there was a provider of funds that could be loaned out or invested.
Today, regulators have essentially put a stop to such shadow banks. But shadow banks have been replaced with what I will loosely call “shadow financial insurance companies”. When an investor sells an option, whether it is through the explicit sale of put options or call options, or through products that pre-package such insurance, the investor is essentially selling insurance against large market moves. The underlying assumption is that over time, the seller of insurance always gets to keep a risk premium over the true value of the insurance. And in a world where one cannot see volatility rising, just as one could not see housing prices ever going down, it is perfectly rational to operate such an insurance selling operation since it is a positive expected return strategy over time.
As a matter of fact, it makes sense to diversify the business by operating like a multi-line insurer, selling insurance across all asset classes and maturities. Just as an investor can use the derivatives markets to operate a virtual refinery out of his bedroom (for example, by selling gasoline futures and buying crude oil futures), an investor is now able to operate a virtual insurance company by buying an inverse volatility ETF like XIV or SVXY. Indeed, an investor who buys one of these products listed on the exchanges, is getting into a contract whereby the provider of the security goes out as an agent and sells VIX futures in an amount exactly matched to produce the payoff pattern from selling volatility. Just as the SIV was a sophisticated bit of financial engineering to bring credit and term structure arbitrage to the masses, volatility ETFs and ETNs bring volatility selling, until now an institutional activity, to the masses.
In the case of the SIV, there are multiple layers of financial engineering which are worth dissecting. In the first step, there is a loan that finances the home purchase. In the second step, the loans are pooled together into a security. In the third step, derivatives (i.e. credit default swaps) are built on the pooled loan security. Finally the derivatives are sliced, or “tranched”, and put into the SIVs that finance the purchase through borrowing. In the four-step process, the risks of the ultimate underlying asset, the price of the house, is levered multiple times and each rung on the ladder becomes increasingly sensitive to housing price fluctuations. As housing prices rose, the mathematical expectation of the tranches not being able to pay off diminished, thereby creating more interest and demand. On the other hand, as housing prices fell, the inverse happened, and the tranches fell, in many cases to zero, thereby wiping out demand.
Now let us track the financial engineering steps involved with an inverse volatility ETF, which in many ways is similar (including the uncanny similarity in name). First, there is an underlying security, which is the stock of a large cap company. In the second step, many such stocks are pooled together into an index, e.g. the S&P 500 index. In the third step, derivatives are designed and traded on the index, i.e. call and put options on the index. In the fourth step, an index of all the put and call options is constructed, e.g. the VIX index, based on a theoretical formula. Since the VIX itself is not tradable, in the fifth step a new derivative is constructed on the VIX index, i.e. the VIX futures contract, which is tradable. In the final step, a security is constructed on the VIX futures contract itself, i.e. the VXX, XIV, SVXY, etc. which all trade on the stock exchanges and can be bought and sold as a stocks.
As should be clear at this stage, financial engineering technology has taken a plain vanilla security, and by slicing, dicing and re-packaging it multiple times, created another security that is a levered version of the first generation security, which also trades on the exchanges under the same rules, even though it is an extremely levered version of the initial security. There is actually a further round of financial engineering, i.e. call and put options on the ETF or ETN itself, but we will ignore that for now. Like the CDOs of CDOs of yesteryear, there is really no natural stopping point for how far financial engineering can go. Only the lack of demand limits the supply.
The risk to this house of cards of course is that one of the links in the financial engineering turns out to be a weak one. The most obvious culprit, one would think, is a severe down move in the stock market as a whole. I think the situation is a bit more complicated than that.
Again, while it is true that even a small move in the price of housing could have brought the SIV and indeed the credit markets to a crash in 2008, the real risk was not a sustained housing market downturn, but indeed the forced selling of the securities built at the top of the financial engineering pyramid. As these top level securities were sold at fire sale prices (e.g. during the liquidation of the Bear Stearns hedge funds), each rung in the ladder weakened, and one could argue that as the spigot of easy credit was turned off, the housing market suffocated and prices started to fall. Whether the housing market crash created the financial crisis or the failure of levered securities created the housing market crisis is largely a technical detail, since either one fluctuating would eventually have resulted in the events that happened.
In my view, the real risk today is not a sharp fall in the equity markets, though it very well could be. The real risk is that for some unforecastable reason, volatility and fear rises and creates a set of cascading shocks that ultimately results in the equity markets falling as they readjust. Let us trace out the links on how this might happen.
Let us say we come in one day and there is an event that creates a large amount of uncertainty. This could be on either side of the market. On the negative side, we have geopolitical and political uncertainty which continues to rise. On the positive side, we have a potential large tax deal, or perhaps a new, positive regulatory change. As we walk in one day, an unexpected negative or positive event could result in a large shock to, say, the VIX, or to the volatility of interest rates. This results in some of the systematic volatility selling strategies (“shadow insurance companies”), to back off from selling insurance, or maybe even buying back their insurance contracts at a higher price for safety. Tracing the financial engineering described above backwards, the provider of the packaged insurance security then buys back the VIX futures or the short volatility derivatives. As the expectation of VIX rises, arbitrageurs bid up the prices of the options, i.e. the actual value of the VIX goes up.
At this stage, a number of mechanical strategies that use the VIX as a major input parameter, such as volatility targeting, trend following, risk-parity and others that are in many institutional portfolios, are triggered to reduce their exposure as per their design specification. The way many of these strategies work is that they sell equity futures, as volatility rises. If many of these strategies trigger selling at the same time, or even in a sequential manner, this puts pressure on the equity index futures markets, which then by the mechanism of arbitrage forces actual selling of index stocks. As the stocks sell off, other markets, such as high yield, corporate credit etc. start to feel the impact, with their spreads widening, and force liquidations from holders of credit. As credit becomes less available, further liquidation happens. In the worst case scenario, this shock cascades across markets and regions, and the rising liquidation and risk aversion spreads like it did in the last crisis. In the best case scenario, a lender of last resort steps in and stops the liquidation as soon as it threatens systemic instability.
This is a scary event, and clearly a very low probability event. But can it happen? Of course history suggests that it can, only it won’t be obvious whether it has already commenced until it is too late. Two questions remain unanswered, however: What causes the uncertainty to rise in the first place, and what can one do to manage the risks? While the list of events that could cause uncertainty to rise is too long to list here, it could be as simple as interest rates rising or a major geopolitical event, or as opaque as the unwinding of leverage by a large market participant as a precautionary measure. Knowing that the system is increasingly susceptible to events is cause enough for any market observer or market participant to exercise caution today.
On the topic of managing the risks, the answer is much simpler. One can become a little more careful in allocation to risk assets, especially those that smack of selling volatility, keep lots of cash, or if able and willing, intelligently accumulate protection strategies by being a buyer of insurance rather than by operating as a “shadow insurance company”.
Vineer Bhansali, Ph.D. is the Founder and Chief Investment Officer of LongTail Alpha, LLC, a California-registered investment adviser and a CFTC-registered CTA and CPO. Any opinions or views expressed by Dr. Bhansali are solely those of Dr. Bhansali and do not necessarily reflect the opinions or views of LongTail Alpha, LLC or any of its affiliates (collectively, “LongTail Alpha”), or any other associated persons of LongTail Alpha. You should not treat any opinion expressed by Dr. Bhansali as investment advice or as a recommendation to make an investment in any particular investment strategy or investment product. Dr. Bhansali’s opinions and commentaries are based upon information he considers credible, but which may not constitute research by LongTail Alpha. Dr. Bhansali does not warrant the completeness or accuracy of the information upon which his opinions or commentaries are based.