Eugene Linden
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Latest Musing

The Supreme Court's Own Goal on Climate Change

[This article appeared in Lawfare. It's long for a musing, but I think it's important that the public see just how shoddy was the majority reasoning in West Virginia v EPA]

In 1970, Sen. Roman Hruska of Nebraska achieved a dubious immortality when he argued that mediocrity deser...

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Fire & Flood
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Deep Past
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endangered animals
rapid climate change
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fragging

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The Ragged Edge of the World



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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GOP Scare Stories Point to the Real National Emergency


Sunday June 09, 2019

A couple of months ago, in the days before President Trump declared a national emergency to try and circumvent Congress and fund his Wall, a number of Republicans scrambled to articulate sufficiently horrifying examples of how others might misuse those powers. Florida Congressman Matt Goetz offered a nightmare scenario in which a Democratic President forcing elementary schools across the country to build transgender bathrooms. Florida senator Marco Rubio went on CNBC and asserted that the true nightmare was that, “Tomorrow, the national emergency might be, you know, climate change…” Permit me to rephrase this: for Rubio, the problem with Trump using emergency powers was not that he was using a phony emergency as a pretext, but that in the future Democrats might use those powers to try to deal with an actual emergency.

That’s what’s truly scary. Rubio’s example reveals his assumption that Congress can block action on climate change going forward, forcing a President to assume emergency powers. The Wall Street Journal editorial page also chimed in, warning that Trump invoking a national emergency might embolden a future president to use these powers to deal with rising carbon emissions, again implying that other means of dealing with rising emissions could be blocked.

OK, let’s go with this. Imagine the circumstances in which some future President thought it necessary to use a declaration of national emergency to deal with climate change. Maybe it would be a collapse in the housing market as sea level rise, super storms, and wildfires made trillions of dollars in property uninsurable, and thus ineligible for mortgages. Or perhaps it would be the banking and financial crisis attendant to these developments.

It would also imply that the public was not yet concerned enough to elect a Congress that would take action to contain the threat. It’s true that there has been a rapid uptick in concern about climate change as determined by polling, but a recent study by the Energy Policy Institute found that while 57% of those polled people thought climate change was sufficiently threatening that they would spend $1 a month to avert it, most would still balk at $10 a month. 

To put this in perspective, the amount the U.S. spent on defense and intelligence last year equates to roughly $650 a month per household and that figure does not include spending at the state and local level for police. The amount the U.S. spent last year just to fight ISIS amounted to $40 a month per household. Is ISIS, which has never successfully mounted a mass attack on U.S. soil, really 40 times the threat that climate change poses?

Part of the problem is that the threat of climate change remains something that is still treated as a matter of belief; i.e. whether one “believes” in global warming (and recent polling reported that even today, only 52% of Republicans agree that global warming is happening). Given that climate change is staring (most of) us in the face, we should be past that point, but we’re not. This cognitive dissonance will ultimately resolve itself, however, because whether you “believe” in climate change becomes irrelevant if sea level rise and storms render your house unsaleable.

Still, the Trump administration continues to fight a rear-guard action, pushing back on its own agencies that have warned about the threat.  The White House wants to convene a 12-member panel to review whether climate change is a national security threat – despite the assertions that it does threaten national security that come from intelligence agencies and defense departments around the world in the form of reports as recent as the Department of Defense report on its vulnerability to climate change this January and dating back to the 1990s. 

The real purpose of the panel becomes apparent from its membership. One of the leaders will be William Happer, who serves on the National Security Council and who has argued publicly that climate isn’t changing and that additional CO2 in the atmosphere will be beneficial rather than harmful. If this panel attaches the prestige of the White House to a report pooh-poohing global warming it could sew further confusion in the public and reduce any sense of urgency. More likely though, it will backfire as so many Trump initiatives do. Rather than undermining a sense of urgency, a clown car convention of fossil fuel apologists could undermine the prestige of the White House.

 Now, the Trump administration has also targeted the climate assessments produced by its own agencies. As assessments of the future impacts of climate change have become ever-more dire, the administration’s response is to cut off any forecasts beyond 2040. Because of the lags in the climate system, this would eliminate many of the worst scenarios as many impacts accelerate in the second half of this century. As the global scientific community will not go along with this willful blindness, this initiative will only further underscore the impression that the White House is more interested in propaganda than science.

As for the rest of us, those of us who see the changes that that climate is working in the world around us, we can only hope that some future President has the guts to declare a national emergency if things worsen and Congress continues to abnegate its responsibilities.

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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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