Eugene Linden
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THE PROBLEM WITH MUSK'S BID FOR TWITTER IS NOT THAT HE'S A BILLIONAIRE

Matt Taibbi, a journalist whose writing I admire, has joined the throng decrying the hypocrisy of pundits who write on the pages of the Washington Post (owned by a billionaire) that if billionaire Elon Musk buys Twitter it will be a threat to democracy. This is too glib. The problem isn’t b...

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Fire & Flood
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Winds of Change
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Afterword to the softbound edition.


The Octopus and the Orangutan
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The Future In Plain Sight
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The Parrot's Lament
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Silent Partners
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Affluence and Discontent
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The Alms Race
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Apes, Men, & Language
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Insurers: We're Not Picking Up the Tab for Climate Change


Friday June 20, 2014

[Note: A version of this musing first appeared in the Los Angeles Times]

Well, that took longer than I expected! Twenty years ago, I interviewed Frank Nutter, then and now president of the Reinsurance Assn. of America, on the threat climate change posed to the $2-trillion-plus global property and casualty insurance industry.

"It is clear," he said back then, "that global warming could bankrupt the industry."

But in the two decades since, the industry mostly limited itself to talk, sponsoring innumerable reports on the threat. Now a major insurance company has moved to protect itself, and it may be the most important milestone yet in the struggle to contend with global warming.

Illinois Farmers has filed nine class-action suits against municipal entities in and around Chicago for losses the company sustained when the sanitation system backed up, spewing geysers of sewage into hundreds of homes, after extreme storms in April 2013.

The suit explicitly says that officials in various governments were aware that climate change would bring more extreme weather and yet failed to take steps (such as draining parts of the system) that would have prevented the losses. Regardless of the outcome — courts give governments wide latitude in immunity from lawsuits — it puts an end to the charade that global warming is some scientifically uncertain threat far off in the future. [Subsequent to this writing, Illinois Farmers withdrew the suits, noting that they had served their purpose in encouraging governments to take preventive steps.]

It was predictable that a major industry player's first hardball action would be to protect itself from losses. Insurers bet their existence on being accurately able to detect, model and price changes in risk. The Farmers' suit tells the world that regardless of what politicians and pundits say about climate change, an insurer is going to try to avoid paying for losses that could have been foreseen and prevented.

Most property insurers base their pricing on historical data, which makes the industry retrospective and thus inherently conservative. This is one reason it has taken so long for insurers to react aggressively in the face of climate change — its losses only filter in slowly over many years. Even then, attributing blame is complicated by other factors, such as a vast increase in the building of ever-more expensive homes in coastal areas.

Moreover, a number of major insurers feel that the potential losses of climate change can be addressed through existing procedures for analyzing and pricing risk. For example, one thing they can do is simply leave the market in places that are highly vulnerable to foreseeable negative effects.

This was the case in Florida as insurers voted with their feet after the $26 billion in insured losses incurred by Hurricane Andrew in 1992, and after Florida regulators wouldn't let them raise prices to adjust for the increased risks created by a rapidly growing population in harm's way. In 2002, the state was forced to set up its own insurance pool to protect against losses from windstorms.

The Citizens Property Insurance Co., which charges below-market rates thanks to the voter-conscious state legislature that set it up, quickly became the biggest property and casualty insurer in the state. Noting its precarious financing, a report on the state insurance market prepared by Florida State University in 2013 asserted that "Florida could be one major storm away from the state having to take all wind risk."

Should such an event occur, Florida would cover these losses by issuing bonds, which would be paid off by a surcharge on all insurance policies. That means any insured Floridian, even those with just an auto insurance policy, would take a hit.

Thus, Florida is shifting the burden of future catastrophic losses arising from wind damage from the affluent who have built along to coast to all Floridians.

While Floridians wait for the next big storm, sea levels — the most obvious worldwide signal of global warming — continue their inexorable rise. Rising waters have already created Venice-like conditions in the Miami area.

All the nation's taxpayers have assumed this risk as insurers routinely exclude flood and storm surge damage from policies. This forces homeowners to seek coverage with the National Flood Insurance Program, a tax-dollar backed program also forced by political pressure to under-price its coverage.

Between the state program and federal flood insurance, the American middle class has been given the burden of insuring and subsidizing the affluent. Let's call it climate change socialism for the rich.

After news of the Farmers' lawsuit broke, I spoke again with Nutter. He said he too was surprised at how long it has taken for the risk of climate change to percolate through the insurance community. He also pointed out that Farmers is affiliated with the Zurich Group, which is noteworthy because European insurers, with global reach and exposure, tend to be more attentive to the risks of climate change than domestic insurers.

Is it possible that U.S. insurers are also affected by climate-change deniers? A number of recent studies by the Insurance Information Institute have singled out Florida as having the most exposure to the combined impacts of climate change, but its governor, Rick Scott, and Sen. Marco Rubio are on record dismissing the threat.

And yet everyone can see that sea levels are rising. Miami Beach Mayor Philip Levine told the New York Times last month, "We are past the point of debating climate change."

Now, as insurers begin to shift the costs of that reality through rate increases, exclusions, lawsuits and market retreat, consumers can ask such politicians, "Why, if climate change is a hoax, are we paying for it?"

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Short Take

HOW THE OPTIONS TAIL HAS COME TO WAG THE MARKET DOG: A Simple English Language Explanation of How Structural Changes in the Stock Markets Contribute to Whipsaw Movements in Prices.

Lately a string of violent price movements and reversals in the equity markets make it look like the markets are having a nervous breakdown. The last day of trading in April 2022 saw a 939 point drop in the Dow. The day before that, the Dow rose about 625 points, and two days before that it fell over 800 points. The very next week, after two quiet days, the Dow rose over 900 points after the Fed announced its biggest rate hike in 22 years (ordinarily a big negative for the markets), and then, the next day, fell over 1000 points (more on this later).  There have been plenty of headlines – about the Ukraine Invasion, inflation, the threat of a Fed caused recession, supply chain disruptions – to justify increased uncertainty, but the amplitude of the moves (and the sudden reversals) suggest something more may be at work. Here follows an effort to explain in simple language the significant changes in the market that have contributed to this volatility.

 

“This time it’s different” is perhaps the most dangerous phrase in finance as usually it’s uttered by market cheerleaders just before a bubble bursts. That said, markets do change, and those changes have their impacts. One change in the markets has been the shift from intermediaries (such as brokers) to direct electronic trading, a shift that has made the markets somewhat frictionless, and allowed computer driven funds to do high speed trading. This shift began a couple of decades ago. Today’s markets can move faster than a human can react.

 

Another shift has been the degree to which passive investing through index funds and algorithmic trading through various quant funds have come to eclipse retail investing and dominate trading. A consequence of this is that to some degree it has mooted individual stock picking because when investors move in or out of index funds, the managers have to buy or sell the stocks held on a pro rata basis and not on individual merit. This change too has been developing over recent decades.

 

A more recent and consequential shift, however, has been the explosion in the sale of derivatives, particularly options (the right to buy or sell a stock or index at a specified price on or before a specific date). Between 2019 and the end of 2021, the volume of call options (the right to buy a stock at a specified price on or before a particular date) has roughly doubled. During times of volatility, more and more retail and institutional investors now buy calls or puts rather than the stocks. 

 

Today, trading in options has reached a scale that it affects market moves. A critical factor is the role of the dealers who write options and account for a significant percentage of the options issued. Dealers have been happy to accommodate the growth in option trading by selling calls or puts. This however, makes them essentially short what they have just sold. Normally, this doesn't matter as most options expire out of the money and worthless, leaving the happy dealer to book the premium. Being short options, however, does begin to matter more and more as an option both moves closer to being in the money and closer to expiration. 

 

This situation is more likely to occur when markets make large and fast moves, situations such as we have today given the pile of major uncertainties. Such moves force dealers to hedge their exposure. 

 

Here’s how it works. If, for instance, a dealer has sold puts on an index or a stock, as a put comes closer to being in the money (and closer to expiration), the dealer will hedge his short (writing the put) by selling the underlying stock. This has the combined effect of protecting the dealer -- he's hedged his potential losses – while accelerating the downward pressure on the price. In other words, this hedging is pro-cyclical, meaning that the hedging will accelerate a price move in a particular direction.

 

Traders look at crucial second derivatives of stock prices, referred to by the Greek letters delta and gamma to determine exposure to such squeezes. As an option moves closer to in the money it's delta -- it's price movement relative to the price movement of the underlying, and its gamma -- the rate of change of the delta relative to a one point move in the underlying, both rise. The closer to both the strike price and expiration date, the more the dealer is forced to hedge. The result is what’s called a gamma squeeze. Once the overhang of gamma exposure has been cleared, however, the selling or buying pressure abates, and gamma may flip, with new positioning and hedging done in the opposite direction. The result can be a whipsaw in the larger markets. This same phenomenon can happen with indexes and futures.

 

How do we know that the hedging of option positioning are contributing to violent price changes and reversals in the market? While not conclusive, perhaps the strongest evidence is that large lopsided agglomerations of options at or near the money have been coincident with surprising market moves as expiration dates approach. In fact, some market players use this data to reposition investments, in effect shifting investment strategy from individual companies to the technical structure of the markets. This is what Warren Buffett was referring to when, at his recent annual meeting, he decried the explosion of options and other Wall Street fads as reducing companies to “poker chips” in a casino.

 

The week of the May Fed meeting gave us a real-time example of how a market move that looks insane on the surface reflects the underlying positioning in various derivatives. To set the stage: ordinarily, given debt burdens and the threat of recession, the markets would be expected to react badly to a Fed tightening cycle that is accelerated by the biggest rate hike in 22 years. On Wednesday, however, market indices began to soar on Wednesday when Fed Chairman Powell, one half hour after the Fed announced it 50 basis point raise, suggested that the Fed was not considering larger 75 basis point hikes during this tightening cycle. Traders interpreted this as taking the most hawkish scenario off the table. Up to that point, institutions were extremely bearish in their positioning, heavily weighted to puts on indexes and stocks, and also positioned for future rises in volatility in the markets. Right after Powell made his comments, investors started hedging and unwinding this positioning, and all the pro-cyclical elements entailed in this repositioning kicked in. By the end of the day, the technical pressures producing the squeeze had largely abated, setting the stage for a renewed, procyclical push downward the next day, as the negative aspects of the tightening cycle (and other economic headwinds) came to the fore. 

 

What these violent moves in the market are telling us is that while in the broader sense, this time is not different --the overall sine wave of the market is still that bubbles build and burst -- how the present bubble is bursting may be following a different dynamic than previous episodes. The changes since the great financial crisis-- the rise to dominance of passive trading through indexes and algorithmic trading through various quant strategies – reduced the friction in the markets as well as the value of picking individual companies. Now, the more recent explosion of option issuance, further accelerates market moves, and leads to unpredictable reversals that have to do with option positioning rather than fundamentals such as earnings, politics, or the state of the economy. 

 

The tail (the options and other derivatives markets) now wags the dog (the equities markets).

 

 



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