Derivatives Story 2014
by Doug Noland
October 10, 2014
At this point, I’ve seen sufficient market evidence to posit that the global financial Bubble has serious fissures. Emerging market currencies, bonds and equities are in trouble. Commodities are in trouble. The global leveraged speculating community appears close to, if not already in, trouble. Geopolitics is full of trouble. Global “risk off” liquidity issues are becoming a bigger issue – and are now being transmitted to U.S. securities markets through liquidity-challenged sectors such as small cap equities, corporate Credit and surging prices for risk protection. Corporate credit default swap (CDS) prices this week surged to multi-month highs. The VIX stock market volatility index jumped to an eight-month high. Moreover, this week’s bludgeoning in the over-loved and over-owned technology sector could have pushed some to the edge. Examining it all, the unfolding backdrop has me pondering previous vulnerable Bubbles along with the soundness of global derivatives markets.
And whenever I’m about to dive into analysis of the esoteric derivatives marketplace, I always think back to an early CBB, the fictional “Little Town on the River.” I’ll attempt a brief summary.
“It had for years been a sleepy little place. The expense and limited availability of flood insurance discouraged building and commerce along the river’s edge. There was a long history of occasional flooding that wreaked havoc. But a few years without a significant flood created greater appeal for what had evolved into an extraordinarily profitable insurance business. The newfound availability of insurance encouraged some to build along the waterfront. Others, always hoping to live and work near the river, bid up asset prices. The town’s banks began doing brisk business. And with the Little Town enjoying a simultaneous economic renaissance and drought, writing flood insurance became a booming enterprise. Additional players led to only cheaper insurance, which stimulated more building, more “wealth” creation (asset inflation) and a resulting full-fledged economic boom. And, as “luck” would have it, drought persisted. Over time, the hugely profitable insurance market attracted major speculative interest. All types of “investors” joined the fray, writing policies or taking ownership interests in the insurers, booking easy profits all along the way. Local “banks” became big players. Each year saw concerns for a bout of unexpected rain dissipate a little more. And with a thriving, highly-liquid reinsurance marketplace, players were elated to write as much insurance as they could possibly sell. Why not cash in on fabulous wealth gains, operating comfortably without traditional reserves that would protect against future damage claims. The well-crafted plan was to immediately offload risk in the reinsurance market in the low-probability event of torrential rains.”
In my unsuspecting Little Town, the availability of cheap flood insurance fueled a major boom. And Reflexivity played a major role in spurring self-reinforcing Bubble Dynamics. Cheap risk insurance fostered building and risk-taking, which stoked a generalized economic boom (replete with distortions and maladjustment), with bullish perceptions regarding the soundness of the economic and financial sectors stoking asset prices. Yet when torrential floods finally – inevitably - arrived, the crowd that had speculated on insurance contracts raced to the reinsurance marketplace. Risk players were either unwilling or unable to write more reinsurance – not with the harsh realities coming into greater focus and greed abruptly transforming to fear. Market dislocation ensured those that had been writing insurance – and had accumulated huge risk exposures – faced potential insurance claims without the financial wherewithal to cover major losses. Panic in the dislocated insurance markets then provoked fear and dislocation in the real economy. When the eventual flood arrived, it was a complete wipeout. In hindsight, the booming financial sphere (risk insurance marketplace) ensured that enormous unappreciated risk accumulated throughout the real economy.
I posted my original “A Derivative Story” back in March 2000. While it highlights some of the key concerns I had at the time with the booming derivatives marketplace, there were also some key real world differences. Importantly, no individual or group sought to control the weather.
While the prices and quantities of risk insurance had major impacts on risk-taking in both the financial and economic spheres, flood insurance market dynamics didn’t impact the amount of rainfall. In the “real world,” the scope of risk-taking and derivatives trading does have a profound impact on market behavior and the amount of accumulated underlying market risk.
In the world in which we operate, the greater the amount of financial insurance written, the greater the risk that market dynamics at some (“black swan”) point might incite market illiquidity, dislocation and panic. This had been made readily apparent in 1987 (“portfolio insurance”), 1994 (“IOs,POs” and interest-rate derivatives), 1997 (SE Asian currency derivatives), 1998 (LTCM derivatives leverage and Russian currency derivatives) and 1999/2000 (Nasdaq and tech stock derivatives).
Some fourteen and a half years ago I just felt there was overwhelming evidence that the Federal Reserve needed to take a more aggressive approach in overseeing what had become a dangerous proliferation of financial risk insurance. The Fed did the very opposite. Our central bank instead adopted a more heavy-handed stance with respect to market intervention. The derivatives marketplace rested upon the (specious) premise of liquid and continuous markets.
So the Fed essentially promised the marketplace it would ensure liquidity and guard against market panic and dislocation. We learned absolutely nothing, as derivatives then played an integral role in the mortgage finance Bubble and resulting 2008 financial and economic crisis.
I’m not planning on writing “Derivatives Story 2014.” But if I change my mind, my Little Town would have experienced some radical changes since 2000. Today, interest rates on local savings accounts are a goose egg. Economic activity is bustling. There may not be much building or capital investment, but consumption, services and finance are booming. Reminiscent of 2000, there’s lots of exciting new technologies. There’s certainly lots of money slushing around. Asset prices and confidence are really high. The flood insurance market is bigger and more sophisticated than ever.
Yet the biggest change from 2000 is that everyone has faith in the central authority’s capacity to control the weather. And with central control over flood risk and zero deposit rates, local savings have inundated all types of new vehicles and instruments profiting from the risk markets. You’d have to be a moron to settle for a near-zero return when central control now protects the community from flood and myriad risks. Enlightened policies from central control amount to the greatest financial innovation in the history of the community. Today, it is possible for virtually everyone in our town to participate in unprecedented wealth creation.
Switching back to the real world, I’ll excerpt from Federal Reserve Bank of Richmond’s Jeffrey Lacker and John Weinberg’s excellent and timely op-ed in Wednesday’s Wall Street Journal:
“The Fed’s Mortgage Favoritism – When the central bank buys private assets, it distorts markets and undermines its claim to independence… Some will say that central bank credit-market interventions reflect an age-old role as ‘lender of last resort.’ But this expression historically referred to policies aimed at increasing the supply of paper notes when the demand for notes surged during episodes of financial turmoil. Today, fluctuations in the demand for central bank money can easily be accommodated through open-market purchases of Treasury securities. Expansive lending powers raise credit-allocation concerns similar to those raised by the purchase of private assets. Moreover, Federal Reserve actions in the recent crisis bore little resemblance to the historical concept of a lender of last resort. While these actions were intended to preserve the stability of the financial system, they may have actually promoted greater fragility. Ambiguous boundaries around Fed credit-market intervention create expectations of intervention in future crises, dampening incentives for the private sector to monitor risk-taking and seek out stable funding arrangements.”
For “A Derivative Story 2014” purposes, I’ll focus on Lacker’s Fed “actions in the recent crisis bore little resemblance to the historical concept of a lender of last resort. While these actions were intended to preserve the stability of the financial system, they may have actually promoted greater fragility. Ambiguous boundaries around Fed credit-market intervention create expectations of intervention in future crises…”
From a macro analytical perspective, it’s such an incredibly fascinating environment. Again falling back to old favorite analytical tools, let’s ponder “economic sphere” versus “financial sphere” analysis. In the economic sphere, there has been for a while now evidence of excessive liquidity abundance. General asset inflation and a booming technology sector come first to mind. Securities and asset prices have inflated spectacularly over recent years to record levels. Accordingly, my analytical challenge has been to identify the underlying source of finance – the monetary disorder – fueling the destabilizing asset inflation and Bubbles. And this is where it gets really interesting.
Traditional “financial sphere” bank lending and Credit expansion metrics just do not equate with the type of Credit growth required to fuel systemic asset inflation and securities market booms.
Household debt expanded at a 1.6% rate in 2013 and about 3% during this year’s first half. Even with booming corporate and federal borrowings, Total Non-Financial Sector Debt expanded just 3.8% last year and about 4% during 2014’s first half. And while bank lending has picked up, the tepid expansion of this traditional source of finance in no way can explain the liquidity deluge behind Tech Bubble 2.0 and Stock Market Bubble 3.0. If I only had a dollar for every time I’ve heard a Fed official or bullish pundit say it can’t be a Bubble because there’s not the type of leverage consistent with Bubbles.
Truth be told, there is a tremendous amount of leverage. We know that the Fed’s balance sheet (“Fed Credit”) has inflated $3.6 TN, or 400%, in about six years. Fed Credit is up an incredible $1.6 TN, or 58%, in just two years. Yet this critical source of system leveraging is supposedly coming to an end soon. Which leads me to my bigger concern: leverage that we do not know – that lurks unrecognized and unappreciated. And my thoughts continually come back to my Little Town and A Derivative Story. These days I really worry about global derivatives markets – and part of the reason I worry is that the marketplace is convinced there’s no reason for worry. Global policymakers – central control – have it all under control. Market risk is not an issue.
So here’s how I see it. Fed market assurances coupled with the ballooning/leveraging of its balance sheet was instrumental in an unprecedented expansion of derivatives-related leverage. “Ambiguous boundaries around Fed credit-market intervention” did “create expectations,” in the process distorting the derivative markets like never before. The cost of financial insurance collapsed across all financial classes all over the world – U.S. and global equities, corporate Credit, European periphery debt, EM stocks and bonds, and “developed” and “developing” currencies. Importantly, global central bank backstops created “too big to fail” distortions in markets for financial institution credit risk around the world. And with central control having eradicated so-called “counter party risk,” there was at that point nothing to hold back a derivatives market speculative feeding frenzy.
I see derivatives as integral to the “global government finance Bubble,” the “Granddaddy of all Bubbles,” thesis. Central (bank) control distortions “promoted greater fragility” – absolutely no doubt about it. Indeed, fragility and inevitable instability have arrived. It appears the Global Bubble has been pierced.
The global “reflation trade” is imploding. WTI crude sank 4.4% this week to $85.82. Natural gas dropped 4.5%. Heavily leveraged balance sheets – abroad and at home – in the energy and commodities universe are increasingly suspect. The ability of EM economies to service external debt is becoming an increasing concern. Ongoing currency market instability is causing losses and de-risking/de-leveraging in various derivative “carry trades.” The global leveraged speculating community is close to some serious problems. Losses would be met with redemption notices and forced liquidations. And with lots of players all crowded into similar trades, things could quickly topple into a panic for the exits. Such a circumstance would quickly crack wide open serious shortcomings in derivatives trading, in the securities markets and for leveraged participants in these markets.
How “crowded” is the bullish technology trade? And, more importantly, how sound is the underlying finance that has been fueling Tech Bubble 2.0? Few at the time appreciated how the nineties technology boom was being financed by unstable Bubble finance – industry and Telecom debt, speculative Credit, derivative-related Credit and myriad sources of finance that would so quickly evaporate come the reversal of speculative flows and the bursting of the Bubble.
I believe the increasingly vulnerable leveraged speculator community would now like to reduce exposure to the high-flying tech space. And I would also suggest that a reversal of “hot money” from technology would mark a very important liquidity inflection point for Tech Bubble 2.0.
And if you have de-risking in tech combining with de-leveraging in currencies, de-risking/de-leveraging in commodities and EM, and de-risking in corporate Credit – wow, rather quickly you have all the necessary makings for a very problematic “risk off” market backdrop.
There is absolutely no doubt that buoyant derivatives markets have promoted epic risk-taking – in finance, in securities markets, in asset and commodities markets, in real economies globally.
Especially in our zero short-term financing rate environment, all varieties of derivative strategies have made it too easy to leverage up and chase yields and market returns. What’s your bogey? A pension fund client that requires a 9% annual return? Well, there is a bevy of derivative products easily structured to fulfill your needs. The amount of leverage is a plug variable. If spreads narrow, simply employ more leverage. And there’s no reason these days to fret leverage. The Fed promises not to raise rates much – if at all (global deflation!). Besides, if leverage or shaky markets do start to become a worry, there’s cheap derivative insurance available to calm nerves. How much of the seemingly insatiable appetite for higher-yielding securities over recent years has been due to demand from leveraged derivative strategies? Has that leverage been a key source financing a Bubble?
If I were to write a final chapter for “Derivatives Story 2014,” I’d have the local flood insurance market having expanded to communities everywhere: same players, same strategies, same bullish market perceptions and the same faith in central control. And they’d all have written boatloads of cheap flood and risk insurance – and sold lots of related “investment” products - across the universe, believing that significant losses, if they were ever to occur again, would surely be a localized problem. And in my prosperous Big Town, they’d hear about the rain and flood and losses in some distant communities. But that has nothing to do with our town, right? Actually, doesn’t it make our prosperity all the more appealing? It does, right?
Meanwhile, away from all the public exuberance, in the dark caverns of the reinsurance market things start to get a little dicey. The price of reinsurance is surging and there’s newfound fear of marketplace liquidity issues.