credit bubble "portfolio insurance"

[jk]

i've taken the liberty of posting a long quote from this week's column by doug noland. i've done so because i think it points to an extraordinarily important mechanism underlying the wave of liquidity hitting all markets, including the private equity, m&a and hedge fund sectors.

anyone who went through the crash of 1987 will remember the role played by "portfolio insurance." institutional investors believed they could mitigate risk with dynamic hedging, selling stock index futures as necessary when/if the market turned down. feeling bullet proof because of the predicted effectiveness of such a strategy, they piled on risk. of course, when the market started going down, all the portfolio insurers simultaneously started selling index futures. this drove the price of the futures down, so every step of the way down arbitrageurs bought the futures and simultaneously sold the stocks. the portfolio insurers saw their equity values dropping further, and so sold more futures to hedge. repeat sufficiently to create a 25% drop in one day. get the picture?

noland's piece teases out a similar mechanism, option- instead of futures-based, underlying the tech sell-off after the peak in 2000. and he discerns the same kind of feedback loop in-the-making in the credit markets, based in credit default swaps along with similar derivatives.

i must say that, having read through this, i actually feel afraid of what's in store. thinking about the economic future, i haven't felt really afraid before.

I would like readers to recall the 1999/early-2000 environment – the terminal blow-off phase of the technology Bubble. It was common back then for the major technology companies to write put options on their own stocks. Revenues were surging throughout the industry, and most tech companies were major buyers of their own shares. Writing/selling put options on their ever-rising share prices was pretty much found money and could be rationalized as a way of reducing the cost of buybacks. Treasury departments were happy to participate, turning themselves into profit centers extraordinaire. Come the bursting, many companies were burned by these put positions – although losses generally were embedded in the cost of share repurchases rather than flowing through to (rapidly shrinking) earnings.

I hold the view that this aggressive company put option activity was likely an integral aspect of what developed into a major derivatives market distortion - playing a meaningful yet unrecognized role in the NASDAQ Melt-Up Dislocation. I am delving into this issue tonight because I believe something similar has unfolded in the corporate debt risk markets.

Importantly, throughout the technology blow-off, the huge supply of put selling by the major technology companies worked to distort both market prices and perceptions. For one, technology stock “insurance” was readily available in the marketplace at relatively inexpensive prices (considering the actual, yet at the time unappreciated, risk of collapse). This nurtured a perception within the speculator community that the best strategy was to play the market run for all it was worth, while at the same time either holding puts or planning to use the derivatives market to hedge exposure at the first indication of a bursting Bubble.

Typically, a writer of an equity put option will short a portion of the underlying stock as a hedge. This position is then adjusted (dynamic trading) to ensure that the short position generates sufficient profits as the stock declines and the put “goes into the money.” Thus, if a large number of market participants move to hedge their equities exposure (i.e. buying puts), the market would be expected to come under selling pressure as the writers of this protection short stock to establish their hedges.

But with companies selling puts options and writing other derivatives – on shares they were expecting to repurchase at some future date – the market did not bear the usual brunt of hedge-related selling pressure. Indeed, a key dynamic unfolded where the availability of inexpensive market insurance signficantly altered the market’s perception of risk - and behavior. It certainly emboldened the leveraged speculator community – in the process creating huge buying power to push the market higher, in the process ensuring that the speculators and “insurance” sellers were aptly rewarded. Additionally, those that had shorted stocks (either as bearish trades or as hedges against “insurance” written) were forced to cover – at any price. And the higher the market rose, the greater the incentive to speculate in stocks and call options, write market insurance (capture premiums) and cover shorts. Despite rapidly escalating risk, put protection remained readily available at significantly distorted prices and stocks went on a moonshot.

Importantly, the speculation and derivative-related market dislocation created a backdrop that virtually ensured a collapse. A wildly distorted derivatives “insurance” marketplace had come to create a prevailing misconception that market risk could be easily and inexpensively mitigated. And it is a very dangerous facet of contemporary derivatives markets that a large segment of a market can adopt a a seemiingly rational strategy that preordains an eventual attempt to offload market risk to “the market.” In the end, the technology Bubble became so extended that when it eventually reversed, the crowd rushed to establish hedges and liquidity almost immediately disappeared. Put sellers and derivative speculators, including tech companies, completely backed away from selling new “insurance” and the price of protection skyrocketed. Selling stock essentially became the only mechanism to “offload” risk – and the market collapsed.

These days, the market distorting dislocation resides in Credit derivatives. The leveraged speculating community – having ballooned enormously since the days of the tech Bubble – has gravitated to and is making a big fortune in various endeavors (i.e. Credit default swaps, CDOs, constant proportion debt obligations/CPDOs, and myriad Credit derivatives) that are essentially writing Credit “insurance.” The proliferation of speculators seeking to sell Credit protection has profoundly reduced its price and increased its availability. This has encouraged many to speculate in risky Credits while hedging in the derivatives market. Wall Street has certainly been emboldened to fashion sophisticated structures, pooling risky loans that are "insured" against Credit loss through derivatives. Such an operation satisfies those clients wanting to borrow money, speculator clients wanting to write Credit protection, and other clients wanting to speculate on “top-quality” but higher-yielding debt instruments.

The end result is the creation of coveted top-rated “money-like” securities that today enjoy almost insatiable demand – and with it an almost unlimited potential for issuance. Finding enough loans to pool and structure has been the limiting factor, but the corporate/M&A/ leveraged loan/junk/energy/resurgent telecom booms are quickly addressing this shortage.

To be sure, this dynamic has had a profound impact on general corporate Credit Availability, the cost and availability of Credit “insurance,” Credit creation, marketplace liquidity, and asset market speculation and inflation. And the more Credit that becomes available and the greater the Credit boom, the fewer corporate defaults and the more profits for those selling Credit protection – writing flood insurance during a drought. The greater are speculative returns from writing Credit insurance, the more players and finance that clamor for a piece of the action. This, then, incites a flurry of Wall Street innovation, crafting only more sophisticated (and leveraged) structures that somehow extract greater profits from shrinking “insurance” premiums. And reminiscent of the technology blow-off, those speculating on the end of the Credit cycle – betting on widening Credit spreads – have been forced to run for cover. This has only fanned the mania.

One upshot to this incredible dynamic is an issuance explosion of securities and instruments fashioned with the attributes of “Moneyness,” though backed by increasingly risky Credits. A second is the dangerous marketplace perception of limitless inexpensive Credit insurance. A third is the perception and extrapolation of endless liquidity, “money” to fuel permanent prosperity. The Credit, insurance, and liquidity booms stoke the economy and inflate corporate revenues and earnings. They also flood the spectacular M&A boom with cheap finance, emboldening players to extrapolate both earnings growth and today’s backdrop of unlimited cheap finance. Inflating stock prices then create their own self-reinforcing speculation and liquidity Bubbles, further deflating risk premiums and distorting market perceptions – creating only more intense speculative demand for corporate securities....


Marketplace perceptions of safety and liquidity are today being grossly distorted on a scale – multi-trillions of securities from one corner of the world to another - that so overshadow the technology Bubble – that overshadow anything previously experienced in the history of finance.

Following in the footsteps of the technology derivatives Bubble, the mania in Credit “insurance” ensures a collapse. It today feeds a self-reinforcing boom, but when this cycle inevitably reverses, the scope of Credit losses will quickly overwhelm the thinly capitalized speculators that have been more than happy to book premiums directly to profits. Undoubtedly, an unfolding bust will find this “insurance” market in complete disarray. Much of the marketplace today expects that they will - when things begin to turn sour - either obtain Credit “insurance” or hedge/”reinsure” protection already written. But when much of the marketplace moves to offload Credit risk there will simply be no one to take the other side of the trade. As losses mount, the market will then face the harsh reality that minimal “insurance” reserves are actually available to make good on all the protection written. This will have a profoundly negative impact on both Credit Availability and marketplace liquidity – ruining the plans of many expecting – and requiring – that “money” always flow so freely.

[blazespinnaker]

Re: credit bubble "portfolio insurance"

Hmmm.

So, let's see, for fun:

I have a billion dollars and I buy a bunch of call options for a stock, then I buy the stock (on margin), sell the call options once I've peaked, and then buy a bunch of put options, and start to sell the the stock?

Sounds too easy, what am I missing?

[jk]

Re: credit bubble "portfolio insurance"

Hmmm.

So, let's see, for fun:

I have a billion dollars and I buy a bunch of call options for a stock, then I buy the stock (on margin), sell the call options once I've peaked, and then buy a bunch of put options, and start to sell the the stock?

Sounds too easy, what am I missing?

what you're missing is the hedging operations of the options sellers. if they're selling calls, then they're buying some stock, and then more stock if they see their strike price approached. so buying calls in enough volume will itself cause the stock to rise. if you buy the stock [in volume] first, then calls at any particular strike will become more expensive for you to buy. so bottom line, if you do anything in enough volume to move the price, both options and stock will move simultaneously. if you buy in small enough volume not to move the price, then you take the risk.

the only people making money in the way you suggest are the options dealers, functioning as arbitrageurs.

[Jim Nickerson]

Re: credit bubble "portfolio insurance"

i've taken the liberty of posting a long quote from this week's column by doug noland. i've done so because i think it points to an extraordinarily important mechanism underlying the wave of liquidity hitting all markets, including the private equity, m&a and hedge fund sectors.

anyone who went through the crash of 1987 will remember the role played by "portfolio insurance." institutional investors believed they could mitigate risk with dynamic hedging, selling stock index futures as necessary when/if the market turned down. feeling bullet proof because of the predicted effectiveness of such a strategy, they piled on risk. of course, when the market started going down, all the portfolio insurers simultaneously started selling index futures. this drove the price of the futures down, so every step of the way down arbitrageurs bought the futures and simultaneously sold the stocks. the portfolio insurers saw their equity values dropping further, and so sold more futures to hedge. repeat sufficiently to create a 25% drop in one day. get the picture?

noland's piece teases out a similar mechanism, option- instead of futures-based, underlying the tech sell-off after the peak in 2000. and he discerns the same kind of feedback loop in-the-making in the credit markets, based in credit default swaps along with similar derivatives.

i must say that, having read through this, i actually feel afraid of what's in store. thinking about the economic future, i haven't felt really afraid before.

If I am the only one who reads posts on iTulip who after reading Noland's comments did not develop a sense as yours of feeling "really afraid" about the economic future, then undoubtedly it makes me the dumbest person who reads anything put up in these fora. It is a fact that I read the same piece last night sometime, and I can tell you I went to bed without it having created the least worry, thus once again supporting the dictum: ignorance is bliss.

Starting with the fact that I know zip about "Credit default swaps, CDOs, constant proportion debt obligations/CPDOs, and myriad Credit derivatives," it is readily apparent why the Noland's article had no meaning to me, woe is me!

I would never ask anyone to attempt to explain to me the essential meaning of Noland's comments; however, it seems reasonable to ask what measures might one who understands the implication of Noland's comments take in the attempt to avoid being wiped out by the unwinding of what he is warning?

[jk]

Re: credit bubble "portfolio insurance"

If I am the only one who reads posts on iTulip who after reading Noland's comments did not develop a sense as yours of feeling "really afraid" about the economic future, then undoubtedly it makes me the dumbest person who reads anything put up in these fora. It is a fact that I read the same piece last night sometime, and I can tell you I went to bed without it having created the least worry, thus once again supporting the dictum: ignorance is bliss.

Starting with the fact that I know zip about "Credit default swaps, CDOs, constant proportion debt obligations/CPDOs, and myriad Credit derivatives," it is readily apparent why the Noland's article had no meaning to me, woe is me!

I would never ask anyone to attempt to explain to me the essential meaning of Noland's comments; however, it seems reasonable to ask what measures might one who understands the implication of Noland's comments take in the attempt to avoid being wiped out by the unwinding of what he is warning?

jim, without worrying about what all those instruments are specifically, it is enough to know that it is another form of "portfolio insurance," this time in the credit markets. just like the portfolio insurance on equities in 1987, it will fail when it is most needed, and for the same reason: it is predicated on continuous and orderly markets, and on everyone not heading for the exits at the same time. saying it this way reminds me of martin mayer's piece about whispering "fire" in a darkened theater.

i think the investment conclusion is that you can't rely on being able to get out of risky investments in a timely way. when you want out, so will many others, and you'll take the hit you planned to avoid. reduce or eliminate risk now, not later. this sounds odd, given that the vix and other measures of perceived risk are so low, but that's the way it is at a peak. i remember when, the friday before the '87 crash, i called my futures broker and said i wanted to sell my remaining s&p index futures. he said his company's analysts were saying that the moderate pullback that had already occurred provided a buying, not a selling, opporunity. i shouldn't sell. i sold. on monday, during the crash, with the dow down 20%, i called again, and he sounded on the brink of hysteria. that was the consequence of portfolio insurance. now imagine it happening with all the mortgage backed and asset backed bonds out there, and the [literally] trillions of dollars worth of derivative exposures, all depending on counterparties staying solvent and living up to their obligations. when the hedges don't work, the thinly capitalized institutions, [which is pretty much all of them, i believe] will go under. that's what scares me.

i would be interested in others' thoughts about the investment implications of noland's analysis, and whether i am being hysterical myself in my interpretation of it.

[spunky]

Re: credit bubble "portfolio insurance"

Well, look The market, and the overall broader economy is due for a correction here. Period, no getting around it. How each individual played his/her hands and the effect on every american family is going to different. If the american economy has one thing going for it ; it is diversified.


I watched my father get caught up in all the Conseco hype, here in Indiana. Anyone remember that little gem :p ????? My father was a great saver, often times 50% of each paycheck. He went 4 yrs in his house without aircon , just to save money. During the late 90's when we had that big run up; he was brokering thru the " Pirate Ship Company " When I would go visit him,; he would rant on and on. How he made " 12,000 $ " today or " hey ma , were up 6% " and both he and his wife would giggle. " I am calling my broker, he said buy more Conseco, see son I am up 47,000$ since Jan " My brother followed suit. Me, I bought a few tools and sat on my measley little ole pile of cash.

Well, I dont have to tell you what happended. My father had to take out a mortage on his house that was paid for. He was tossed into the throngs of depression and talked like a man on the edge. He buys and resells junk at these flea markets you see on the roadside. Now dad wasnt toally stupid/greedy; he only bet 1/2 his retirement , and his SS benefits kick in July, so he will be ok.

My point is we will all survive this correction, some better than others, some will even profit, some will swim, and some will sink. Anyone remember in art class those old pen and inks of happy brits drinking ale and then you had the contrasting drawing of the throngs of despair of those brits on Gin street ?????

The higher the highs; the lower your lows will be. Greed in the end will be punished:eek:

[Jim Nickerson]

Re: credit bubble "portfolio insurance"

jim, without worrying about what all those instruments are specifically, it is enough to know that it is another form of "portfolio insurance," this time in the credit markets. just like the portfolio insurance on equities in 1987, it will fail when it is most needed, and for the same reason: it is predicated on continuous and orderly markets, and on everyone not heading for the exits at the same time. saying it this way reminds me of martin mayer's piece about whispering "fire" in a darkened theater.

i think the investment conclusion is that you can't rely on being able to get out of risky investments in a timely way. when you want out, so will many others, and you'll take the hit you planned to avoid. reduce or eliminate risk now, not later. this sounds odd, given that the vix and other measures of perceived risk are so low, but that's the way it is at a peak. i remember when, the friday before the '87 crash, i called my futures broker and said i wanted to sell my remaining s&p index futures. he said his company's analysts were saying that the moderate pullback that had already occurred provided a buying, not a selling, opporunity. i shouldn't sell. i sold. on monday, during the crash, with the dow down 20%, i called again, and he sounded on the brink of hysteria. that was the consequence of portfolio insurance. now imagine it happening with all the mortgage backed and asset backed bonds out there, and the [literally] trillions of dollars worth of derivative exposures, all depending on counterparties staying solvent and living up to their obligations. when the hedges don't work, the thinly capitalized institutions, [which is pretty much all of them, i believe] will go under. that's what scares me.

i would be interested in others' thoughts about the investment implications of noland's analysis, and whether i am being hysterical myself in my interpretation of it.

I found this article that in its first part elaborates on Doug Noland's comments of 11/10/06 that jk posted to begin this thread, and Ms. Delay sets about to describe Noland's comments in "layman's terms," which I think she did rather well. She notes 2 other aspects of how the present bubbles of "corporate profits, bond issuance, M&A activity, finance industry bonuses, and hedge fund and credit derivative frenzies" are and have been inflated.

Katy Delay, "If These Are Bubbles, Where Is All That Hot-Air Money Coming From?" November 25, 2006

http://www.prudentbear.com/archive_c...tent_idx=60572

She notes three sources of non-Fed money;

1. Mishandling of Securitization and Credit Derivatives
2. Influx of Other Countries' Excess Liquidity
3. Hot-Air Money Can Avoid the Statistics

Perhaps only the third point is new, at least to me.

She concludes, "The push-the-string Keynesian policies of the Fed could indeed be causing the bubbles without their knowledge, because their interpretation of the statistics on which they judge their policy's performance understates the reality of the money they and the global system have created."

[Finster]

Re: credit bubble "portfolio insurance"

i would be interested in others' thoughts about the investment implications of noland's analysis, and whether i am being hysterical myself in my interpretation of it.

Something's Always Going Up, JK. Just make sure you have a proper asset allocation and don't worry about it.

[jk]

Re: credit bubble "portfolio insurance"

Something's Always Going Up, JK. Just make sure you have a proper asset allocation and don't worry about it.

one issue which i mostly ignore is whether the financial institutions holding my assets will be both solvent and functioning normally.

[Finster]

Re: credit bubble "portfolio insurance"

one issue which i mostly ignore is whether the financial institutions holding my assets will be both solvent and functioning normally.

I try not to think about it too much. But this is one area where you can get that extra margin of comfort holding assets that represent no one else's obligation, like physical gold in your personal possession.

[Spartacus]

Nasser Saber and Peter Warburton have something to say about this

Saber says that left to its own devices, speculative capital's leverage always grows and never shrinks.

As speculators make money, others see the profits and pile on the trade, reducing margins. The only way to recapture the original margins is ... MORE LEVERAGE !!!!!!!

[Jim Nickerson]

Re: credit bubble "portfolio insurance"

I try not to think about it too much. But this is one area where you can get that extra margin of comfort holding assets that represent no one else's obligation, like physical gold in your personal possession.

An article I found at Fiendbear's site 11/24/06
Gold ETF Impact 2
Adam Hamilton
http://www.zealllc.com/2006/gldetf2.htm

I found this rather interesting regarding at least this author's insight about GLD. The author said he or his company never owned or recommended and likely never would own or recommend GLD, choosing rather the metal and mining stocks. But he did not see GLD in a poor light. I found it worth reading, though sort of long.

One thing he pointed out is the physical hassle of owning gold coins or bars is the costs of transactions with them, average about 6% in and out transaction costs, and another is the tax implications--28% capital gains.

If one had a million bonars, how much wealth can one protect by owning physical gold. If I had a million bonars and felt owning physical gold was important, then even at 10% of that wealth, to own $100k of gold coins or bars is to me an unimagineable hassle to store and to transact physically.

If things financially in this country ever get so bad that the only wealth of which one is "assured" to have to live on is what one has in physical gold, then for most people anything like life as we now know will be over. If everyone else has nothing and one has some or a lot of gold, I expect the odds are that he with the gold will get killed or robbed.

[spunky]

Re: credit bubble "portfolio insurance"

An article I found at Fiendbear's site 11/24/06
Gold ETF Impact 2
Adam Hamilton
http://www.zealllc.com/2006/gldetf2.htm

I found this rather interesting regarding at least this author's insight about GLD. The author said he or his company never owned or recommended and likely never would own or recommend GLD, choosing rather the metal and mining stocks. But he did not see GLD in a poor light. I found it worth reading, though sort of long.

One thing he pointed out is the physical hassle of owning gold coins or bars is the costs of transactions with them, average about 6% in and out transaction costs, and another is the tax implications--28% capital gains.

If one had a million bonars, how much wealth can one protect by owning physical gold. If I had a million bonars and felt owning physical gold was important, then even at 10% of that wealth, to own $100k of gold coins or bars is to me an unimagineable hassle to store and to transact physically.

If things financially in this country ever get so bad that the only wealth of which one is "assured" to have to live on is what one has in physical gold, then for most people anything like life as we now know will be over. If everyone else has nothing and one has some or a lot of gold, I expect the odds are that he with the gold will get killed or robbed.

Not necessarily Jim. It is all how you work the system, and just like rock and roll ; it is about sticking to the man. Your looking at an extreme reaction . I would be thinking in those times you would be selling down, ( trading for new bonars ) in small increments ( just like you buy into postions ) and then using the new currency to purchase goods and services. It doesnt always come down to trading your exact store of wealth for goods and services.

And again if the bonar is sooo friggin great, why is the US Gov , still the worlds largest holder of gold stockpiles ?????