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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THE ECOLOGY OF TOXIC MORTGAGES


Saturday October 27, 2007

EUGENE LINDEN
[This musing ran in July on Huffington Post, but it's quite relevant today as the credit crisis continues to spread]
I lead two lives. Three days a week, I'm employed as chief investment strategist for a hedge fund that specializes in distressed and bankrupt situations. The rest of my time, I do what I've done for decades, which is to write about nature and the environment. There is virtually no overlap between these two worlds -- with one exception. At a metaphorical level, there are irresistible parallels between a profound flaw in early models of how to deal with pollution, and an almost exactly analogous flaw in financial models for how to deal with the financial universe's own version of toxics: risk. My role at the fund is to look at the macro situation, and to help the portfolio managers interpret how larger trends in the economy will interact to the benefit or detriment of our investments and prospective opportunities. In that capacity, I've been looking at the unfolding debacle in subprime lending, a slow motion, far-reaching toxic poisoning, whose reach and impacts have been obvious for at least eighteen months to anyone not involved in making money off the origination, sale, and securitization of these subprime loans. Unfortunately for investors, that aforementioned conflicted group includes virtually everybody in finance, including the mortgage brokers, subprime lenders, Wall Street firms that securitize the loans into mortgage-backed securities, Wall Street firms that then resecuritize slices of these bonds into collateralized debt obligations, and the rating agencies that, for a price, enable all these securitizations and re-securitizations, by blessing these teetering structures with ratings that imply far less risk than is turning out to be the case. There has been a good deal written about the ecology of finance in recent years, but reading about theoretical parallels between the worlds of nature and finance pales in comparison to the thrill of watching a toxics crisis in finance unfold before your eyes almost exactly as it does in the environment. For all our vaunted foresight, it's interesting to see that when greed and self-interest come into play, collectively we're no smarter than fruit flies. In this case, the flawed environmental model for dealing with risk might be summed up by the cute phrase, "dilution is the solution to pollution." For a number of years, we freely poured toxics into the water and skies under the assumption that pollutants would disperse and become harmless in these vast receptacles. Instead, what we discovered is that these toxics re-accumulate as creatures eat each other and are eaten, a process repeated on up the food chain until the toxics reach deadly concentrations in the top predators and big animals. I remember years ago reading that dead whales washed up in the Saint Lawrence seaway contained such high concentrations of heavy metals and other toxics that in the U.S., they would be declared superfund sites. That also could be said for some of the big investment banks, hedge funds, and Wall Street firms at the moment. The toxics in this case would be portfolios of various forms of securitization of subprime, alt-a and other loans that, amazingly enough, aren't performing according to models developed during the greatest run-up of home prices in American history. (I recall attending one conference on securitizations of home equity loans in early 2006 where the quants showed us supposedly reassuring "stress" tests of these bonds under various scenarios of home price appreciation. The most "stress" they envisioned was 3% appreciation, and not the negative price movements we are seeing just a year later). The practical logic behind packaging these risky loans was that most of them were money good, and that so long as defaults did not exceed expectations -- say 4-5% of the loans being packaged -- the great preponderance of the securitization could be treated as investment grade. And, the philosophy behind this whole process was that risk could be reduced if it was sliced up and efficiently dispersed in the investor ocean. But, in an exact analogy, to the environmental example, risk did not stay dispersed. Rather it re-aggregated in the whales (hedge funds, investment banks, and pension funds) of the investment community. And now these top dogs are discovering that risk is just as toxic if it's sliced up and reformulated as if it never was broken up in the first place. The analogy does break down ultimately, because in the investment universe version we have an accelerant to the toxicity of risk in the form of leverage. Because so many of these repackaged subprime loans were rated investment grade, the whales could gorge on the stuff using borrowed money. The embedded leverage is astonishing. While each deal is different, and this unregulated market remains opaque to non-participants, an idealized example illustrates this point: Take a billion dollars in subprime mortgages and package them into a new security. Typically, a model security would rate about 95% of the slices in this new bond as investment grade. Under these high-rated slices are what are called mezzanine tranches, the lowest piece of the investment grade slices, and the lowest of these would be rated BBB-, or just above junk status. Typically, these mezzanine tranches will amount to about 4% of the$1 billion total value. Below the mezz pieces would be the lowest rated tranches, including the equity which absorbs the first losses if borrowers default. In this idealized securitization, the BBB- tranches might represent 1% of the total value of the bond and be buffered from losses by about 5% of equity and junk (which represents a computer model's estimate of the outer limit of realized losses). So in this case, those buying the BBB- tranche are betting that losses for the entire billion dollars in loans never rise above $50 million over the life of the bond. Fair enough, but if they do rise higher, those holding this tranche lose money in a hurry. Let's say, losses rise to 8% (some predictions are even higher). In that case, the value of the BBB- tranche would be worthless, and losses would take out all of the BBB tranche and half the BBB+ tranche as well. That's the price of leverage. But it gets worse. Given the risks of subprime loans, many lenders could not afford to make large volumes of loans if they were forced to keep the loans on their own books since they would tie up too much capital. So they finance the loans with short term borrowing and then sell the mortgages into securitizations. The buyer -- the securitizer -- then puts together his MBS. To do this, the buyer has to sell the mezzanine tranches (many securitizers keep the equity themselves). These tranches buffer the whole structure from losses, and once they have been sold, it's easy to sell the higher rated stuff. In recent years, the money funding these mezzanine tranches has come from a subset of another securitization called collateralized debt obligation or CDO. To form a CDO that invests in subprime mortgages, a securitizer will buy up mezzanine tranches from perhaps 100 different mortgage-backed securities, and then package them in different tranches similar to the way a mortgage backed security was packaged in the first place. Thus, some CDO's can consist entirely of BBB- tranches of subprime mortgage MBS, but still have 95% of their value rated investment grade. Here is where leverage is the true killer. While an increase in realized losses from 5% to 8% will wreck havoc on a $1 billion MBS, even a smaller increase from say 5% to 6% losses could utterly destroy a CDO based on BBB- tranches where the leverage is over 100 to one. That additional one percent in losses will not only wipe out the bottom tranches of the CDO, but it will eat through most of the investment-grade slices as well. Bearing in mind that many hedge funds also used leverage (meaning that they borrowed most of the funds to buy a CDO tranche), it becomes obvious that even minor variations from the expected performance of subprime loans can have a huge impact on results. This is why we are beginning to see some very sick whales, and what happens to them affects us all. Since $1 invested in a CDO ultimately funds $100 in subprime lending, this poisoning will reduce subprime lending (as much as 50% this year alone) sending further ripples through the housing market. Moreover, most Americans have exposure to this mess since pension funds accounted for 18% of purchases of the riskiest tranches of CDOs, and insurers and pension funds were investors in the investment-grade tranches as well. So, given the stakes and leverage, why haven't we seen more blow-ups such as what happened to the Bear Stearns funds? Just wait. The system has built in lags in recognizing losses since the rating agencies don't have to downgrade until losses are actually realized, and that can take 18 months or more. Moreover, markets for these bonds are highly illiquid, and without trades, holders can maintain the illusion nothing bad has happened. That's a dangerous game, however, because, investors don't have to wait for downgrades or price adjustments before pulling out of exposed hedge funds or otherwise dumping suspect investments. If a fund wants to take advantage of the illiquidity and lags in the system to maintain the illusion of good performance, it runs the risk of having to pay investors more than market value if they withdraw at the end of the quarter. That's probably why we've seen a number of funds halt withdrawals from investors in the past few weeks. This sets up an interesting dynamic for the coming months. Typically, an investor gives 90 days notice before withdrawing money from a hedge fund, and the price for the redemption will be marked to the next quarter's performance. Clearly that puts some pressure on hedge funds to come clean in their accounting of performance in the quarter that just ended, but, because alarm about this market has soared in the past month, it puts even greater pressure on funds to accurately price for the third quarter ending in September. What's likely to happen is that unlevered funds will mark down their investments in this now-toxic stuff and pay off those who want to redeem. Is there a way to avoid this day of reckoning? CDOs are actively managed, and in theory the manager can swap out badly performing investments for better stuff. The bad stuff has to be sold, however, and given the illiquidity of this market such sales could hasten the repricing of many billions of similar toxics sitting in portfolios. Also, subprime accounted for over 50% of the collateral for CDO's in 2006, and an asset class that disproportionately represented is not easy to swap out even in the best of times. More likely, this toxics crises will play out in finance just as it does in nature -- with a mass die-off.

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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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