This Is the End


Markets, Risk and Human Interaction

December 29, 2017

How to Burn Four Billion Dollars: The Tailspin of the UFC

December 29, 2017
How to burn 4 billion dollars Whenever I write about the UFC, I should add a standard apology to those who are reading my blog with an eye toward the area of my expertise: finance, and in particular financial risk management. But I have enjoyed mixed martial arts (MMA) since its inception in the mid-1990's, (I also love Brazilian Jiu Jitsu, which I have been active in over the same time period), and find the current missteps in UFC fascinating. Watching the UFC, by far the largest MMA organization, in its tail spin from the incredible height of its purchase by WME-IMGfor $4 billion is becoming more interesting than watching its fights.

The UFC was a failing enterprise in the 1990's, and was salvaged in 2000 by the Las Vegas Fertitta brothers for $2 million. They each cleared over half a billion from the sale. The president of the UFC, a former personal trainer, Dana White, pulled in a similar amount, plus or minus (actually, minus) a few hundred million.

Even at the time of the acquisition in 2016 the purchase price was met with skepticism. But they did have some marquise talent, most notably Ronda Rousey. Her run is over. Not a surprise, because MMA demands many fighting skills, and there are thus many ways an up-and-coming athlete can find to break through an opponent's style, which in the case of Rousey was superb grappling without a base in stand-up fighting.

So, anyway, how is it going? Ronda is gone with no other women in a position to take on anything approaching her role. Dana and crew have latched onto Connor McGregor, a brash fighter who is both flamboyant and good in the octagon as the next big draw. They went all-in with McGregor by setting up a fight with Floyd Mayweather, the undefeated boxing champion. The fight pulled in $600 million, netting a hundred million plus for each fighter. This is the point that the UFC went full-stop into entertainment business, and as I wrote in a recent post, it is the point where it jumped the shark.

Now it is not clear that McGregor will fight again in the UFC. But with the hope he will come back and defend his title, and because now entertainment trumps sports, he continues to hold the title even though he has not defended it for over a year.

The number of viewers is languishing. FOX's recent title match was the second most-watched UFC event this year, but also was the fourth-lowest on FOX to date, with two million views (though it peaked above three million during the title bout). A UFC Christmas event drew 350,000 viewers, a tenth of the draw of last year's.

Meanwhile, it looks like the entertainment complex is doubling down after the McGregor-Mayweather spectacle by suggesting Mayweather will meet McGregor in a MMA fight. If their boxing match was a joke -- Mayweather carried him for ten rounds to give the fans their money's worth before leveling him -- this would be a farce. It would be like arguing that a 41 year-old version of Lionel Messi should spend a few games as a linebacker in NFL football because in American football, among other things, they kick the ball. Mayweather is not stupid; we will never see him in the UFC, but that it would be put out there even for a second to tantalize the UFC fans is a measure of how entertainment value is dominating substance.

And, to top it all off, I hate to say that MMA is getting boring. Maybe the push toward entertainment at all costs is reducing the focus on athletic elegance. Or maybe the nature of MMA, which requires skills in a wide set of fighting styles, kickboxing while standing, jiu jitsu when on the ground, and wrestling and judo for the takedowns, leads to a jack-of-all-trades and master of none, and for those who are familiar with the best of each of these disciplines, a sport that is less than the best is inevitably going to come to seem crude.

December 25, 2017

Bitcoin Can’t Win Against Fiat Currency

December 25, 2017
I'm not going to write anything here about the huge drop in bitcoin over the last few days, so what I am writing cannot be ignored should bitcoin get back up to the 20,000 range. And I'm not going to write about the stupid articles that espouse bitcoin. Though to get a sense of the level of thoughtfulness for the arguments for bitcoin, just to pull one recent one at random, check out this from Forbes.

I'm going to point out only one simple but devastating barrier to bitcoin becoming the standard, becoming even a second-tier means of payment:

If bitcoin doesn't find its way back into the shadows of the drug trade and underground economy on its own, it will be banished by the stroke of a pen, actually, of many pens. No sovereign will give up the power of issuing and controlling its currency. The central bank and monetary authority is one the most powerful economic tools of any government. If bitcoin or other extra-governmental currencies start to take hold, they can and will be made illegal to use for payment in one country after the other.

The cryptocurrencies will still find a market in the underground economy, where people want to avoid taxes or need to remain anonymous and untracable because their activity is illegal or subversive (It is true the ledger is public so all transactions can be seen. But the identity of the user behind the address can be kept anonymous.) But it will not be useable for the bulk of transactions, like your mortgage, credit card bill, tax payments. Or purchases on Amazon. It will be good for your recreational drugs, and your under-the-radar part-time t-shirt printing business.

A few other thoughts while I'm at it:

I can't take seriously a currency, crypto or otherwise, keeping in mind that currencies are supposed to be a store of value, when its exchange rate is determined by speculative activity, untethered to anything in the real world. Where the volatility is greater than for any asset in the real world. And where the assessment by is that "it is truly difficult (and exciting) to imagine how it will play out."

To those who think there is credibility for bitcoin and other cryptocurrencies because Goldman now is considering a cryptocurrency trading operation, just remember this from Matt Taibbi:

The world's most powerful investment bank is a great vampire squid wrapped around the face of humanity, relentlessly jamming its blood funnel into anything that smells like money."

And right now, bitcoin smells like money.

Note: A fiat currency is the currency issued by a government that is declared its legal tender, accepted for payment of all debts, public and private. The word "fiat" means it is not backed by anything. No gold or silver; the government declares it as currency by fiat.

December 16, 2017

The Cry of the Pod People

December 16, 2017

Twitter was not available to the pod people in The Invasion of the Body Snatchers. They had to confront the humans directly, pointing and screeching to muster the mob to attack. But now that we have Twitter, a pod person in our day and age can efficiently and remotely signal a human to the pod-people mob with hashtag HumanToo.(This hashtag is already used in other contexts, but always by humans, so no problem.)

We don't have body snatchers right now, and, for what it is worth, we have put in legal protections should the event ever occur. Barring a dystopian state, (probably inevitable should the instance arise), no one can take someone's body without due process. No one can point and screech and have the mob take over from there.

At least that is true if body snatching is considered an assault on civil liberties that are protected by law. I suspect that is the case. Just as there are other actions that require due process. No one can be incarcerated without due process. No one's property can be seized without due process. However, there are harmful actions that can occur outside the constraints of due process, like accusations that do not rise to a threat of harm or to libel. While immune from the requirement of due process, they can destroy one's character and reputation. (Thus the term character assassination.) It can leave the victim unemployable, and set them apart from society.

The pod people had bad intentions from the start, at least from the human's perspective. But sometimes there are things going on that justify some pointing and screeching. Unfortunately, what starts off with noble motives can move into body snatcher mode. And when pointing and screeching is given free rein, that is where things inevitably arrive. With the excesses, the social winds finally turn, and any value, any noble cause, is lost in the process, even met with a backlash.

In a recent post I discussed McCarthyism. This is a good example of how a legitimate concern -- there really were spies tied to the Soviet Union infiltrating the government, intent on subverting our government -- can turn into body snatching. Accusations could be made without support. People could be targeted mistakenly or even for ulterior motives. (And, getting back to the pod people, what if a timid pod person is not body snatching, but is only body touching. Do we pile him in with the full-throttle snatchers?) All with the result that, in so charge an environment, and based on the accusation alone, they were destroyed.

December 11, 2017

Stocks to Short for Your Grandkids

December 11, 2017
As I mentioned in an earlier post, working in a pension fund makes me think toward the long term. In that post I spoke about broader long-term risks; here I will give my view about long-term risks at the more specific level -- namely, industries to short if you are looking out a generation or more. That is, how various industries will decline over the next thirty or forty years. That is a long time, like the time since Whip Inflation Now of the mid-1970's, or the LBO craze of the late 1980s, but if you are under fifty there is a good chance you will live to see it, and your grandchildren will be in the thick of it.

General propositions
The key drivers of what to short are developments in the following areas:
  • Increased reliability of products. Already, many of the things we consume are more reliable and last longer than any time in the past. Take computers and LED screens. And soon, it will be electric cars.
  • Less consumption of goods. In the sense that most of our time is spent on fewer things – like those highly reliable computer items.
  • More commodity items. Which means less demand for advertising. Compare advertisements today with those of a generation or two ago. Almost everything was driven by brands. Now we are not as focused on brands, and as far as brands go, there are so many brands that are hard to differentiate that they may as well be commodities. Meanwhile luxury goods are moving toward items that are inherently scarce, like art and real estate -- items that do not require production.
  • More efficient production. And part of that efficiency is that what we produce requires less labor.
  • Increased demand for personal space and privacy. We will circle the wagons around our personal space and privacy. We are going to draw the line when we find that companies know more about us than we know about ourselves.
Let's start with the easy ones, where there is a clear consensus, and work our way down from there:

Oil. We all know that fossil fuel is a goner. And the more obvious it becomes that oil remaining in the ground will be a stranded asset, the more oil will be pumped out in the shorter term. So between growing renewables, flowing oil, and more efficient technologies, energy will be abundant.

Will the oil jobs be replaced by renewables. Is it only a matter of retraining of those working in this sector to work with renewables? No, because even ignoring the higher economies in production, the capital plant of renewables lasts a lot longer and requires less maintenance per kilowatt-hour produced.

Saudi Arabia and the rest of the Middle East. There is a clear regional implication to this, of course. This is not good for the Middle East. And what is also bad for the Middle East is climate change. Some predictions are that the Arabian Peninsula will become so hot as to be uninhabitable. So much for the Saudi's Vision 2030. And, I really can’t understand what the thinking is with Aramco. It is a long-term bet under the clouds of oil demand dropping with increasing speed and the political vulnerability of Saudi Arabia.

Trucking. Trucking will also clearly be altered from an employment standpoint by self-driving vehicles. We got a taste of this a few weeks ago when Tesla unveiled its semi truck. Whether you like Tesla's odds or not, self-driving trucks are coming, especially for runs along the interstate.

Things will also change at the local level, for example for package delivery. A new household appliance, already in the works, will be a lockbox that can be opened for securely delivering packages, as ubiquitous as mailboxes. In the limit there will be one run per day of an autonomous vehicle to each residence and business. (How the packages get from the vehicle to the lockbox is the weak link in taking humans out of the loop in this scenario.)

Autos. Another no-brainer is that the automobile-related industries will be far smaller. Gas stations will disappear. And most mechanics. Cars will last far longer and require less maintenance, garages, which are already on the downswing, will largely disappear as well. (New tires from Costco.) Once production is scaled up with a few rounds of efficiency gains, electric cars are not complex, and are cheap to build. The cost of cars will be a fraction of what they are today. With low maintenance, low fuels costs, low purchase price, and autonomous driving, transportation will be far safer and less expensive.

People will be traveling less; fewer trips to the mall. People will have less need for a dedicated car because they will summon an autonomous car that can be running people one place or another nearly 24/7. And most people won't care as much about style because they will be treating them as what they are, transportation services -- which gets to my point about more commodity-like products.

There will still be the vestigial car, just like there are still mechanical watches. Gas-powered cars will be admired and collected for their workmanship and intricacy, and not for their performance or function. Driving a car will be a hobby, like horseback riding. And maybe not in forty years, but at some point, people-driven cars will be seen on the street about as often as horses are. They will be enjoyed on closed tracks, just as horses are today.

Casualty Insurance
It is a mixed bag; some lines will dwindle, others will grow.
Auto. Autonomous vehicles are safer than people-driven vehicles, especially when all cars are autonomous. Fewer accidents means less need for casualty insurance.
Liability. Less high-risk labor.
Property. Things will be looking up here, due to the effects of climate change.

Real Estate
Commercial. Stores will become less prominent as the efficiencies of delivery improve. And as many items last longer. This leads to issues for commercial real estate. There will be construction for warehouses and "fulfillment centers." These are cheaper to build and maintain than commercial retail space. So less construction and maintenance. With the move toward renewables, there is a drop in construction of large-scale fossil fuel plants, and the plant for renewables will not require as much construction and maintenance demand.

Residential. Demographics and lifestyle will change the demand for housing. There will be less demand for large houses with living rooms and dining rooms that are not used, and for four and five bedrooms. This means a glut for some zip codes. And it also means fewer construction jobs. Houses will have solar cells and batteries to be increasingly self-sufficient, so less energy use.

So chalk up the construction industry -- one that is more immune to technology -- as another casualty.

Basic Materials and Mining
With less demand for new cars, less construction, and key goods that are replaced less often, there will be a drop in demand for many raw materials. Though others, like those that are needed for batteries and computers, will increase in demand. Or maybe not. Who knows what raw materials will be in demand, and how great that demand will be with the changes in technology that we might see over the course of the next generations. And because these products last longer, and finally meet the needs for various functions, they will not be the same engine of production.

Advertising (and Facebook and Google)
There is a feedback loop between advertising and the information and social network companies that depends on advertising. This feedback leads to a self-destructing business model, with the information companies and advertising going down together. The information companies depend on advertising, and yet they are information engines that reduce the need for advertising.

And advertising for non-luxury and non-status goods (luxury and status goods are not the fodder of Google or Facebook) will drop for the reasons I mentioned above: less advertising because we will demand fewer goods, and many of the goods will be commodity-like. Few of us care about which chargers we buy for our phones.

There are other pressures that might build for social networks such as Facebook. We will still need search engines, but Facebook is already tiresome to some of us, and we are getting the first whiffs of the toxicity at its root. With the world veering toward an impersonal dystopia, we will guard our privacy, we will circle around our real relationships. Here are recent articles from Wired that give a flavor of where things might be going, one a truly harrowing saga of overcoming malicious cyber attack, and another one of any number you can find, appearing with increasing frequency, on privatizing Facebook. From the perspective of forty years out, Facebook and social networking in general will have been a flash in the pan.

December 9, 2017


December 09, 2017
I enjoy studying American history of the post-World War II period, and just remembered that earlier this week we passed the anniversary of a milestone for that period: On December 2, 1954, the United States Senate voted 65 to 22 to condemn McCarthy for "conduct that tends to bring the Senate into dishonor and disrepute", signaling the erosion of the crushing anti-communist excesses of the previous years. McCarthyism has been applied indiscriminately and almost invariably incorrectly to any number of perceived political and social excesses, but it is worth recalling it for what it was.

First, to criticize McCarthyism is not to diminish the real threats. We must understand that at the time there was a real, broadly recognized threat to the U.S. Through documents from Soviet archives and Soviet messages, we know that the Soviet Union engaged in substantial espionage activities in the United States during the 1940's, that the Communist Party in the U.S. was being funded by the Soviet Union, and that it was used as a base for recruiting spies. We should not have McCarthyism diminish the reality of the subversive elements of the time.

The threat was real, but the reaction to that threat was a frenzy, often described as a witch hunt, that was particularly focused on those in the entertainment industry and government. A simple accusation was sufficient for people to be attacked, lose their job and even their career, with no further prospects for employment at more than a menial level. President Truman remarked that, "A man is ruined everywhere and forever. No responsible employer would be likely to take a chance in giving him a job." Those who were accused had no recourse because the process took place through extra-judicial channels; no response could hold sway. Pleading the Fifth Amendment during the proceedings was taken as an indication of guilt.

What is more, although there were instances of serious attempts at subversion, there also were many who were attacked for activities from decades earlier that, though perhaps outside the social and political norm, had been benign. These were pulled up and judged with the now more stringent standard. It was as if a law had been enacted, and those who did not follow that law in the past were found guilty.

Yet at the time, these excessive and unlawful efforts which cast aside any notion of due process were supported by many thoughtful people. For example, William F. Buckley Jr., a prominent conservative intellectual, wrote that McCarthyism “is a movement around which men of good will and stern morality can close ranks." Certainly there were those who were opposed, but popular opinion – and no doubt the concern that those who opposed the juggernaut would be painted with the same brush – keptthem silenced.

The political climate of McCarthyism declined through the 1950’s as public opinion shifted, and a number of court rulings pushed back against the processes that supported it. Most notable is one in 1956 that pushed back on using the invocation of the Fifth Amendment to infer guilt. The Court wrote that “we must condemn the practice of imputing a sinister meaning to the exercise of a person's constitutional right under the Fifth Amendment”, and in 1957, when the Court condemned cases where “Guilt or innocence may turn on what Marx or Engels or someone else wrote or advocated as much as a hundred years or more ago.”

December 4, 2017

Assisted Dying for the Rest of Us

December 04, 2017
The baby boomers have changed our society as their demographic wave has washed over one institution and norm after another. Split sessions for public schools, a new level of competition for elite colleges, the free love generation and the rise of student protest, the housing bubble, the creation of the Millennials, (a.k.a. the echo boomers). They have the numbers and the political will to do things, and they have time and again pushed against the norm. To use the phrase of one baby boomer, they think different.

The final change will occur with the crashing of that wave: The availability of assisted dying for all. Assisted dying is already becoming the norm for those with terminal illnesses. Australia is the most recent to join the ranks of Sweden, the Netherlands, Belgium, Canada, Columbia, and Luxembourg, as well as California, Colorado, Washington, D.C., and Oregon in the U.S. (I use the term assisted dying broadly, to also involve giving the subject a lethal drug, and not literally being on hand as they take it and pass away. That is what is allowed in California.)

Currently there are restrictions, like having a terminal illness, especially one that is either painful or imminent. But once the mechanics are in place and the threshold has been passed, it is only a matter of degree to have assisted dying for those who decide that their debilitating state makes them no better off than one who is terminally ill. Once we have clear diagnosis tools for Alzheimers, for example, I can imagine voluntary assisted dying protocols along the lines of a more successful and less surreptitious Alice Howland in the film Still Alice.

The way is being paved to make this more acceptable. For example, consider the context provided by a recent full section in the New York Times devoted to the bleak world of old age and dying in Japan. We will see more articles depicting the emptiness of old age, the drain on society and our children, arguments that we should take charge of our death just as we do our lives -- this is the sort of thing that resonates with the baby boomers, also called the "me generation" -- and even arguing, as I have, that keeping someone alive can be akin to torture. I also have argued in a past post that we could help matters along by giving payments (obviously to a designated beneficiary) if someone elects to forgo expensive treatments that would only delay death by a short period.

November 18, 2017

Tesla Roadster Turns the Bugatti into a Wrist Watch

November 18, 2017

In three years Tesla will be rolling out the fastest production car in the world. And not a "production car" as in, we made ten or so of these so it can be called one. No, a production car that rolls off of an assembly line — though I hope the rate of production is controlled with DeBeers-like style — and that still outperforms any car you can buy at any price.

The Tesla Roadster that was unveiled this weekend and is slated for delivery in 2020 is not only better, it is in a different league in terms of its performance specs when compared to any car at any price. Including, for example, the 1500 hp Bugatti Chiron, which starts at $2,998,000. The Roadster does zero to sixty in under two seconds (no other car is even built with the idea it can beat two seconds), a quarter mile in under nine seconds (no other car is even close to nine seconds). Top speed of over 250 mph. (It might be ten or twenty mph shy of the record here, we will have to see. Musk has said once it gets into production, the performance might exceed what we are seeing with the prototype. For now we just know it is "over 250 mph".) Plus, it seems to be user-friendly. Obviously it is quiet. And it seats four, at least if two of the four are small.

And, its best-in-the-world performance in terms of speed and acceleration will not even be the headline item when it gets its test-drive reviews. I predict that the Tesla Roadster will take corners unlike any car built today. First of all, it has a lower center of gravity because of its batteries. Second, it can have the distribution of that weight precisely tuned because the batteries can be placed most anywhere on the underbelly. And third, with a separate motor for each of the rear tires, the Tesla can have a computer assist that keeps the car from skidding out as you take a corner. Anyone who has tried to make a Tesla S skid on wet or icy roads already knows this. Imagine what happens when you are speeding around a turn and the computer can differentially send more torque to one tire versus the other.

And, this is only the beginning. As Musk has pointed out, by the time the car is in production there will doubtlessly be further improvements. And even then, it is only Version 1.0. The bigger point is that an electric car is a better technology than the gas-powered car. Over time the gas-powered car will have to yield.

Already, two days after the announcement, I have been reading the reaction from the aficionado of high-end sports cars, supercars, and, as the Bugatti and its kin are called, hypercars. The basic argument is: "There is more to a sports car than how fast it goes. It is the workmanship. The feel of the car shifting gears. The sound of the engine growling. The melding of man and machine." It is the laudable appreciation of these finer points that is behind the market for mechanical timepieces. They cannot be as accurate, but they embody the workmanship of great craftsmen; the feel of winding the spring; the sound of the mechanism ticking; the melding of man and machine (I guess).

So it will be for the exquisitely crafted cars of today, from the Ferrari to the Bugatti. If we take performance as the objective, the best car in the world will no longer be one that is one or two or three million dollars. It will, at least for a time, be the two hundred thousand dollar Tesla. And after that, it will be another electric car. Like fine timepieces, the supercars of today will be admired and owned not for superlative performance, but for an appreciation of their workmanship and their mechanical intricacy.

November 14, 2017

Pension Actuaries: The Joke is On Us

November 14, 2017
...An Actuary is someone who wanted to be an accountant but didn't have the personality for it....An introverted actuary stares at his own feet, and extroverted one stares at the other person's feet....What is the difference between God and an actuary? God doesn't think he is an actuary...."Look at the white horses over there." Actuary: "They're white on this side, anyway."

Unfortunately, when it comes to the mess our pensions are in, actuaries are no joke. Pension funds labor under actuarial assumption for expected returns that are mainly pulled out of thin air without any regard for financial economics. Does anyone really think pensions will be able to grow at seven percent or more per annum? When they are constrained by their various constituents to hold 50% to 60% in bonds and cash? (See Figure 3 of this OECD publication.)

Those unrealistic assumptions lead to unsupportable levels of contributions, and thus pensions are underfunded as a matter of course. You know the assumption are wrong when virtually every pension is on the negative side of the ledger. But the actuaries do not seem to have been trained in the concept of making course corrections. Nor do they educate themselves in financial economics to better evaluate the mess they are creating.

Why am I going into this? Over the weekend I attended an event honoring a former colleague of mine from my days at Morgan Stanley, Jeremy Gold. He is an actuary who has spent his career trying to move the pension actuaries toward a firmer foundation in financial economics -- to have them at least avail themselves of what financial economists can provide. In the mid-1980's, Jeremy and I worked together in the Fixed Income Research Group at Morgan Stanley. He and I went on various trips to push fixed income products, and to market the fledging new strategy of portfolio insurance (flying out once to have dinner with the head of the Port Authority of Los Angeles, who we discovered, part way through the first course, had -- surprise -- thought we were selling port insurance). We co-authored a paper in 1988, In Search of the Liability Asset, that is still on various reading lists, maybe not for actuaries, but at least for those in finance.

Jeremy left Morgan Stanley in the late 1980's to get a Ph.D. from Wharton, and spent the next twenty years as a thorn in the side of the actuarial profession, pushing them to add financial and economic structure to their methods. One of the best and most widely read of his works for this is the paper Reinventing Pension Actuarial Science.

At the base of it, finance is not actuarial science. It is not predicated on repeatable, or even known, probabilities. There is no appeal to the law of large numbers for the systematic risks of the financial system.The future does not look like the past. There are no mortality tables for asset returns.

...What do actuaries and Packer fans have in common? They both think that history will repeat itself...

So if you want to be the arbiter for over 20 trillion of U.S. pension assets, a good start is to do it based upon a foundation in finance.

November 13, 2017

More on ETFs - Craziness in High Yield ETFs

November 13, 2017
Exchange Traded Fund I wrote a post a month or so ago on the risks from ETFs, in particular how ETFs on less liquid markets - with high yield bonds being my poster child - could cause problems for the market generally. Basically that there is a fundamental flaw when people think an instrument based on a illiquid market is capable of intraday liquidity. And that if the ETFs in such a market have a severe problem, ETFs generally might be considered tainted by a range of retail investors, leading to an outflow from even the more liquid ETFs.

Here is an article that points toward the potential for problems with high yield bond ETFs:

Investors Playing ETF Rout Pushed Junk Bonds to Brink of Chaos.


Trading in exchange-traded funds got a little crazy last week when it became clear that junk bonds were in for more pain. But the market was fortunate the consequences weren’t more severe, strategists warn. Though spared the worst, investors came close to creating a scenario where ETF activity drove prices....a snowball effect where a dislocation develops between the fund price and the value of its underlying assets.

November 4, 2017

Our Low Risk (Low Volatility) World

November 04, 2017
In case you haven't noticed -- and I haven't -- we apparently are in a world of exceptionally low risk. To see this you need look no further than the volatility of the major markets. The volatility of the U.S. equity market, for one, is at its lowest level in a generation. So, no worries here, right?

I wrote a blog post in 2011 titled The Volatility Paradox which explained that when volatility is low, risk is actually rising because people are more emboldened to take on higher leverage and to move to riskier assets. If volatility is half of what it used to be, why not lever twice as much? Thus the immediate question is what happens if there is a sudden surge in volatility from our current, low level. What is the dynamic through which a volatility shock might propagate across the financial system?

A conventional stress test will assess positions that have explicit volatility exposure, such as positions in options, in the VIX and other volatility-based instruments. There is plenty of dry powder here; over the course of 2017, as the U.S. equity market volatility as measured by the VIX index dropped to one of its lowest points in history, we have seen a growing concentration in short volatility exposure by leveraged ETFs, mutual funds, and hedge funds.

But a stress test that does the simple mathematical calculation of direct portfolio exposure to volatility will underestimate the effect of a rise in volatility, because there are dynamics triggered by other strategies that do not have explicit volatility exposure but that have a link to the volatility of assets and to the assets themselves. A rise in volatility will trigger actions for these strategies, leading to selling of the underlying assets, and this in turn will lead volatility to rise even more, creating a positive feedback between the volatility of the market and the assets in the market.

What are these strategies? Well, a good place to start are volatility targeting, risk parity, and other strategies that will rebalance their portfolios when volatility rises. Volatility targeting is a strategy that targets a level of volatility to manage risk that is typically set based on the manager’s mandate. For example, the manager might follow a strategy that will seek to keep the portfolio’s volatility near 12%. If the volatility of the market is 12%, the fund can be fully invested. However, if the volatility of the market rises to 24%, the fund will sell half of its holdings in order to stay in line with its 12% target. Risk parity allocates portfolio weights to have the same total dollar volatility in each asset class. These multi-asset class strategies often use leverage to adjust holdings of underlying assets, buying more of the lower volatility assets relative to the higher volatility ones. If the volatility of one of the asset classes rises, the fund will need to sell some of that asset class in order to maintain equal dollar volatility. In both of these cases, there is a clear mechanism going from the rise in volatility to a drop in the underlying asset.

Things won't all happen at once. The agents for these strategies differ significantly in their time horizon. Those who are directly linked to volatility, those that are in short-volatility ETFs and the like, will have an immediate P L effect from a surge in volatility, and will need to reduce their positions immediately. The volatility targeters will only reduce positions as the rise in volatility is seen as having a non-transient component, and their adjustments will be in a weekly to monthly time scale. And the risk parity agents will have an even longer time horizon, because they generally make asset adjustment with a monthly or quarterly time frame, and do readjustments based on a longer-term estimate of volatility.

Oh, a little more on the relationship between low volatility and risk: If you want to see really low volatility, look back at the swaps markets in the summer of 1998. But you might recall that in August of 1998 there was a rash of defaults in Russia, which was then followed by the blow up of LTCM, the (before that) famously successful quant fund whose principals a few months earlier had graced the cover of Business Week (never a good sign). In that case, low volatility didn't spell low perceptions of risk, it was an indication that no one wanted to go into those markets because things were so uncertain. I go through my first-hand experiences with this in one of the chapters of my 2007 book, A Demon of Our Own Design.

November 2, 2017

Interview in the U.K. for the Daily Mail

November 02, 2017
I had a video interview in the U.K. on my recent book, The End of Theory, with Rachel Straus, (Big Money Questions), that just came out with the Daily Mail. You can get to it here.

October 30, 2017

The Vanishing Pavilions: Gutting Government

October 30, 2017
What will be the longest-term damage of the Trump era? A strong, principled leader will restore some semblance of decency and ethics. Foreign governments might view this period as a bad dream, or an outlier event that veered the U.S. away from a now-returning normal. The anti-scientfiic and pro-industry biases in the various departments and agencies can be rectified just as quickly as they were enacted.

There has been plenty of discussion of where the long-term damage might be on the world stage; the new path governments and businesses are taking toward China -- this might have been inevitable, and Trump has been nothing more than an accelerant; the move toward center stage of China and Germany as world leaders.

But within the U.S. the long-term damage will be more subtle. It will be the loss of the oral tradition, of institutional memory, in our government. That is, the loss of processes and interactions that are conveyed by word of mouth and by example as opposed to by written instructions.

The U.S. Treasury is a case in point. I worked there after the financial crisis, helping draft the Volcker Rule, setting up the risk management structure to get information up to the Financial Stability Oversight Council, and building an agent-based models to help assess financial instabilities. I just went back to the Treasury for the first time since the start of the year to find that is has been gutted. This is not something that is on many people's minds, but it has implications that will be felt far beyond the time that a new administration comes on the scene that wants to return the department to a more normal state.

The reason, in a nutshell, is that what the Treasury does -- and what, for that matter the State Department, a department that is in even worse shape, does -- is not in any manuals. It is set on a foundation of what might be called oral tradition. People know how things work, how to get things done, and if the keepers of the oral tradition leave, it all has to start back up from scratch.

When a new administration comes in, it is the normal course of business for all the appointees to be replaced. Generally the new appointees come from outside government, and have not had previous experience in the Treasury. They rely on the staff, which mostly stays from one administration to the next. They know the process for getting things done, for developing and administering policy.

The Treasury is not a regulator per se, but it tends to be the center of communication -- and the referee when necessary -- for the agencies that do have regulatory authority: the SEC, FDIC, CFTC, etc. There is a process that has been honed over many administrations for doing this job, for acting as the central switchboard for dealing with financial issues. What happens when the switchboard operators walk out the door, and there is no operation manual to leave behind?

October 19, 2017

The Crash of 1987 -- Happy 30th Anniversary

October 19, 2017
I was at the center of the October 19, 1987 stock market crash, when the U.S. equity market dropped 20% in a single day. The second chapter of my book, A Demon of Our Own Design recounts my experiences during the 1987 Crash, and provides an explanation of what went wrong.

The essence of the problem was a programmatic positive-feedback strategy, namely, the dynamic hedging program of portfolio insurance, coupled with the time disintermediation between the speed of the index futures market in Chicago and the more deliberate pace of those in the equity market in New York.

This is not so different structurally from what we have now with the time disintermediation between the ETFs and the underlying cash markets in the less liquid markets -- which is not observed when we have two-way flow -- coupled with various positive-feedback strategies such as volatility targeting and various flavors of what are essentially momentum strategies. Or other structural issues within the current financial system.

So, below is an edited version of Chapter 2 of A Demon of Our Own Design.

(If you have arrived here by going to my blog rather than to this post specifically, you need to click on the post to see the excerpt.)

Excerpts from A Demon of Our Own Design, Chapter 2: The Demons of ‘87
Richard Bookstaber

Portfolio insurance was commercially developed by two Berkeley finance professors, Hayne Leland and Mark Rubinstein. With John O’Brien, their marketing partner, they founded a management company, LOR, in 1981 to sell their technique. Within a few years it was programmed for action in the computers of some of the largest investment firms in the world. At the start of each day LOR sent their portfolio manager clients hedging instructions based on their runs of the Black-Scholes model. The managers did the hedging themselves.

In practice, the equity manager initiated a hedge against his equity portfolio, usually using the S&P 500 futures contract as the hedging instrument. ... As the portfolio increased in value and moved above the floor price, the hedge was reduced, allowing the portfolio to enjoy a greater fraction of the market gain. As the portfolio declined in value, the hedge was increased, so that finally, if the portfolio value fell well below the floor price, the portfolio was almost completely hedged. Thus the portfolio was hedged when it needed it, and was free to take market exposure when there was a buffer between its value and the floor value defined by the exercise price.


Since the basic option technology for portfolio insurance was well known, other firms followed LOR into the market to provide this hedging advice. I spearheaded the effort at Morgan Stanley.


This activity engulfed segments of the firm that rarely related to one another. I was in the Fixed Income Division marketing an equity product to investment banking clients and then managing the resulting programs as a fiduciary in Morgan Stanley Asset Management. I ran programs for some of the firm’s blue chip clients, including Chrysler, Ford and Gillette. This strategy was considered to be at the leading edge of market innovation; rather than buying an existing security, portfolio insurance was ushering in the brave new world of creating synthetic instruments on the fly through dynamic trading strategies.


The equity market was ripe for the promise of portfolio insurance, because there was much to insure. From 1982 to its pre-Crash peak in August 1987 the Dow Jones Industrial Average went on a bull run that nearly tripled the index. The U.S. economy cooperated providing five years of uninterrupted economic expansion. By 1987 the market was moving forward at an exponential rate; from the start of the year to late August the Dow rose more than 40 percent.

By mid-October, though, the promise of portfolio insurance began to look like a very good idea. From the close on October 16th, the market seemed like it came from a totally different world. The Dow had already fallen nearly 500 points from its August high of over 2700, washing away nearly half the year’s gains. And then decline became free fall. The week preceding the 19th, the market dropped 4% on two separate days: On Wednesday, October 14th the Dow dropped by a one-day record 95 points, and on Friday the 16th a new record was set with a drop of more than 100 points.

On the trading floors at Morgan Stanley, equity trading turned into a spectator sport. Throughout the latter part of that week fixed income traders and salesmen filtered down the stairs from the 32nd floor to the equity trading floor, standing around to watch the frenetic scene. The equity markets benefited from the built-in structure of having listed exchanges for stocks, futures, and options, and usually were much calmer than the fixed income markets, where every bond the desk purchased had to be taken out to many clients to find a new home. The crowds watching this train wreck amplified the crisis mentality. This finally led Anson Beard, the head of the Equity Division for Morgan Stanley, to post signs declaring that “Unauthorized Personnel Loitering in the Trading Area are Subject to Immediate Dismissal.” That took care of the riffraff, but the firm’s Managing Directors still found their way to the floor.

And if they were on the floor on Monday, the 19th, they got an eyeful. The open of the futures market at 9:00 a.m. that day started a cascade of selling. A half hour later, the New York Stock Exchange opened to an apparently insatiable demand to sell stocks as the NYSE tried to keep pace with the selling of S&P futures in Chicago. The imbalance of buying and selling demand was so severe that many stocks did not even open, and the rapid decline in the price of the stocks that did, coming on the heels of the previous week, left most investors frozen in their tracks. By the end of the day the market had suffered its worst one-day percentage drop in history, down over 22 percent. The S&P futures fared even worse. The program trading that normally linked the futures’ intraday prices to the S&P cash market could not keep up with the selling demand in the futures pit, so the futures dropped even further – nearly 29 percent. Overnight the panic spread around the globe to other equity markets. In the 18-hour period after the New York market open, wealth equal several years worth of global GDP was wiped from the face of the earth.

The postmortem of the 1987 Crash is filled with reams of reports that have tried to fit it into the efficient market, information-based mold of contemporary economic dogma. ... But none of the analysis stood out, either individually or in aggregate, as the source for any sort of major rethinking of the market. The 1987 Crash simply was not the result of a rational reaction to new information. What sort of information could have led the market to drop more than 20 percent on the 19th, jump 12 percent early the next morning only to fall another 10 percent in the following few hours? Nor was it a matter of herd psychology. The moon and stars did not align to lead broad segments of the market to wake up Monday morning and decide to dump their shares.
In fact, a select and concentrated set of firms generated the selling demand on the 16th and the 19th.


It didn’t take a genius to see that the source of the Crash was market illiquidity, illiquidity that was the unintended by-product of the new and wildly successful portfolio insurance strategy—and one that I had helped to popularize and implement.


If a hedge cannot be readily adjusted, then obviously all bets are off, and for a hedge to be properly executed, the hedging instrument has to be liquid: some counterparty needs to take the other side of the hedge.

If one small portfolio uses this sort of stop loss strategy, liquidity will not be an issue. If everyone in the market is trying to do it, it can become a nightmare, a little like everyone one a cruise ship trying to pile into a single lifeboat—it won’t float; neither did the market. And that, in a nutshell, is what happened. On Monday morning, October 19, 1987, everybody who was running a portfolio insurance program pulled out the computer runs from Friday’s market decline. The record drop on the previous Friday had caught some firms flatfooted, and on Monday morning they had to make hedge adjustments to the decline, pouring sell orders into the S&P futures pit by the truck full. But other such trucks had started down the road a week earlier, barreling into the option and futures markets from a distant part of the equity trading floor that was run more by rumors and personal contacts than by computers and mathematical models.


By Monday morning everyone was lined up at the gate to be the first to get orders filled. Portfolio insurance firms sold nearly half a billion dollars of S&P futures, amounting to about 30% of the public volume. The futures prices dropped precipitously, and the stock market had not even opened. About 15 minutes into the futures market decline, we started to see inexplicable activity from an unexpected quarter, cash-futures arbitrageurs. Their poorly executed attempts to capitalize on the apparent chasm between the cash and futures prices would be the red flag that triggered the stampede in the NYSE.

The futures desk on the equity floor had one junior member whose job throughout the entire trading day was to sit with a phone cradled on his shoulder. On the other end of the line was someone whose job during trading hours was to watch the pit and relay the latest trade or bid and offer to the guy on the desk. When a new level was reached, or unusual activity occurred, he would announce it in a monotonic cadence that was thankfully blended into the background noise of the trading floor. But on the morning of the 19th we were all ears.

The cash-futures spread was reaching levels that were many-fold what was generally needed to make an arbitrage worthwhile, so a host of cash-futures traders began to bring their orders to our program desk. The only problem— and in our minds it was a big problem—was that the stock market was not even open yet. The discrepancy these traders were observing was based on the current futures price versus the price of the stock market on Friday’s close. The traders were basing their actions on stale data; there could be no telling where the stock market would actually open. They put in orders to sell at the market price at the open, under the assumption that the open would be close enough to the Friday close to still make the discount in the futures contracts a profitable trade.

That was a big bet, and a far cry from the relatively low risk enterprise of the usual cash-futures trade. And in this environment, it was even more risky because when the stock market did open, it was an absolute lock to open down. The execution of the program trade would then be complicated by the downtick rule, which proscribes short selling a falling stock. The arbitrageurs wanted to buy the futures and sell the stocks short against them. If the market is in free fall, up-ticks are few and far between, and there are many short sellers trying to squeeze in their execution. It can take a long time to get a trade off. In the meantime, the long futures position is being held unhedged. If the market drops, the trader loses.

The portfolio insurance hedgers found the other side of the market in the cash-futures traders and market makers, and these traders in turn were depending on the stock market to hedge out their bets in the futures. In effect the cash-futures traders were taking the market impact from the futures pit and transmitting it back to the individual stocks on the NYSE. By buying the futures and then selling the individual stocks, the individual stocks would finally “feel” the impact that was being implied by the intense selling pressure in Chicago. In theory this arbitrage is a natural market mechanism for tying the cash and futures stock markets together, and up to Monday the 19th it worked smoothly. But on the 19th the speed and magnitude of the normal smooth waves of selling metamorphosed into a tidal wave that rushed in from Chicago. It was more than the stock market could absorb.


Program traders and arbitrageurs take positions on the S&P contracts trading in the futures pit while simultaneously taking opposite positions on the individual stocks that comprise the S&P on the NYSE. When the S&P futures contract sells for less than the price of the basket of the individual stocks in the S&P, then the cash-futures arbitrageur buys the S&P and sends in orders to sell the individual stocks. If the price difference is greater than the transaction costs of doing this trade, then they make an almost certain profit. This trade effectively transfers the stock market activities of the futures pit to the individual stocks on the NYSE. It is here where things broke down in 1987, and broke down for a simple reason: stocks are not as liquid as futures.

The problem was that the traders in the S&P pit are mostly market makers, jammed together gesticulating and shouting out orders in hopes of scalping a few ticks. They thrive because of their quick reactions to the market and their speed of execution. By contrast, equity investors of the day who frequented the NYSE were not particularly focused on speed of execution, nor were they concerned with the minute-by-minute movement of the market. As the futures traders reacted to the market and the cash-futures arbitrage traders transmitted that activity to the NYSE floor, the flow hit a wall. The specialists could not unload their inventory into the stock market as quickly as the selling was shoveled over to them from the futures pit because their clientele was not glued to their screens, ready to react in mass. The futures market was operating in broadband and the NYSE on dial up.

The specialists tried to elicit more buyers by dropping the price, but there was a limit to how much more buying interest they could attract. No matter how quickly the price was dropped, the decision making by the equity investors took time; not all equity portfolio managers sat glued to their screens, and unlike the twitch-quick futures pit traders, they made portfolio adjustments only after reasoned consideration. With their limited capital the specialists were not willing to wait for the process to unfold, and their increasingly aggressive offers ended up backfiring. Prices dropped so violently that many potential buyers started to wonder what was happening and backed off completely. In pushing so hard, the specialists’ actions became cause for suspicion, which then fed and finally betrayed their own panic. The root dynamic was time disintermediation—the time frame for being able to do transactions was substantially different between the futures market and the equity market, yet these two markets had been linked together through market arbitrageurs.

On our trading floor we could see that the drop in price was not having the desired effect. In fact, it was scaring investors away. One of our institutional clients in Boston was bullish on IBM and had discussed strategies for adding more of the stock to his substantial portfolio. His salesman tried to grab him as IBM started to tank, but he was off his desk in a meeting. A second call could not locate him. We could imagine him heading off to grab some coffee and leaf through his morning faxes, unaware that the markets had begun to slide down around him.

Back at the NYSE, a day’s worth of activity had passed in what seemed to be 10 minutes. The specialists were starting to panic. A flood of sell orders was coming in from the other side of the cash-futures arbitrage and there were no where near enough buyers coming in to take them off of his hands. With price is his only tool, the specialist dropped IBM another point, and then two more points, to try to dredge up some buying interest.

The portfolio manager in Boston finally got back to his desk, saw the beating IBM was taking on the open and gave us a call. If IBM had been down a half point or a full point, he would have put in an order, and would have been provided the other side of the trade that the specialist needed. But with IBM and other stocks in freefall he hesitated to buy, waiting instead to get a read on what was going on with IBM and the market generally. As he spoke with us, he was interrupted and returned to announce that because the downswing was accelerating, the fund’s director of equity investments asked that no trades be executed until all the portfolio managers could meet to assess the situation.

Since this client worked for an asset management firm with a long-term investment horizon, he could put on a position just as easily tomorrow as today. He watched the market’s downward cascade with something likely approaching detached curiosity. As the markets fell further, from 5 to 10 to 20 percent, he likely felt some panic. But for the moment he and many of his counterparts were on the sidelines. Meanwhile for the specialist, more shares piled up in inventory with each passing minute. Other specialists were faced with the same onslaught and prices fell all around, so now the IBM specialist found that eliciting buyers was even more difficult, since he had to compete with the other falling stocks for attention.

It is not long before the offer price for IBM, Big Blue, the bluest of chips, was down 10 points from the open. The result was a disaster. The potential liquidity suppliers and investment buyers were being scared off by the higher volatility and wider spreads. And, more importantly, the drop in price was actually inducing more liquidity-based selling. With each point drop, the portfolio insurance programs triggered more selling, and the portfolio insurance managers threw more sell orders into the futures market. Because of the dislocation between the hair-trigger execution of the futures and the ponderous decision making on the cash equity side, compounded by the insufficient capital of the specialist to bridge the gap between the incoming supply and the timeframe of the potential buyers, the specialist dropped the price of IBM too quickly. The potential suppliers who could have taken on the selling demand – and who would have been willing to do so with modest price concessions, had the move been more gradual – got spooked, and the portfolio insurance hedgers demanded even more liquidity than they would have otherwise.

A price drop is normally the dinner bell for buyers. So precipitous drop should have had traders licking their chops. But it doesn’t work that way; if prices drop too far and too fast, it sends the wrong signal to the potential liquidity suppliers. Rather than taking the drop as an indication of liquidity demand, they viewed it as – or at least heavily weighed the possibility—that the fall was a result of some new market information. In classic “market for lemons” style, they viewed themselves at an informational disadvantage, and elected to stay out of the market.

Replay this mutual fund manager’s reaction over many times, and you basically have the fault line of the crash of 1987. Selling demand increased as prices dropped because of the pre-wired hedging rules of the portfolio insurance programs. Supply dried up because of the difference in time frames between the demanders and suppliers. By the time equity investors could have reacted to the prices and done some bargain hunting the specialists had moved prices so precipitously that these potential liquidity suppliers were scared away. The key culprit was the difference in liquidity because of the different trading time frames between the demanders and the suppliers in the two markets. If the sellers could have waited longer for the liquidity they demanded, the buyers would have had time to react and the market would have cleared at a higher price.


The problems created by portfolio insurance were compounded by a feature of the option strategy being implemented. When the portfolio is far from the floor price, the hedge is small and changes in the value of the portfolio require only a small adjustment in the hedge. This is because the position has a low likelihood of needing to be protected and because there is a lot of room between the current portfolio value and the floor value to ramp the hedge up. As the portfolio value drops and nears the floor, the size of the hedge increases and the amount of adjustment that is made for any change in the market increases as well. Another way to think about this is that the change in the value of the option being created (because that is what the hedge is doing) with a change in the underlying security (in this case the market) varies depending on how far the option is from the exercise price. In the mathematics of option theory this change in the amount of the hedge with a change in the price is called the option’s gamma. As the market declined and brought the portfolio insurance programs closer and closer to the floor, the impact the portfolio hedges, bad as they were early in the day, got worse and worse.

Nothing could change the momentum. The lack of program trading caused the discount in the price of the futures relative to the cash equity market to reappear.


In the midst of the market disconnect, the inability to get timely execution, the vanquishing of many of the liquidity providers, and the fears of a total break in liquidity through an early market close, the portfolio insurance programs continued robotically to spit out sell orders, oblivious to anything but the current market level and the mathematical requirements of the hedge. In the last 75 minutes of the trading day, the DOW dropped by 300 points, three times as much in a little over an hour as it had in any other full trading day in history.


I spent the week chained to my desk, my eyes frozen on the Quotron screen as I struggled to maintain the hedges demanded of the portfolio insurance programs I ran. Prices were moving all over the place, swinging more violently minute by minute than they usually did in an entire day, and the spread required to buy or sell the S&P futures – still the most liquid instrument in the equity market – was a dollar or more, 20 times normal. I had to weigh the implications of holding off on a hedge adjustment on the one hand with the incredible transaction costs in executing in the market on the other.

The huge volatility of the market broke down all but the most fundamental relationships between the market securities. The usual day-to-day world where investors cared about subtleties like corporate earnings or analyst forecasts dissolved as the energy of the market was turned up. All stocks moved together; if it was a stock, it was sold. The market hardly differentiated between domestic and foreign, small cap or large. It was like plasma physics: As matter becomes hotter it becomes less differentiated. The forces that bond atoms together in the form of molecules are overwhelmed, so that rather than having a myriad of different substances, we have the elemental building blocks of the atoms. Turn up the heat further and the atoms themselves are melded into plasma, positively charged ions and negatively charged free electrons; matter in its most uniform and non-differentiated state, no longer hydrogen atoms and oxygen atoms, just a seething white-hot blur of matter.

Just as high energy physics creates a state that is no more differentiable than to say that it is matter, so the high energy in the financial markets created a world where securities were no more differentiable than that they contained risk.4

This melding even extended beyond stocks. High yield bonds, which usually tracked fairly closely to Treasury Bonds, suddenly became simply high-risk bonds, and traded just like stocks. Meanwhile, Treasury Bonds, the anti-matter of the world of risk, were grabbed in the flight to quality, and traded up in price. This behavior demonstrates a characteristic I have observed and expounded repeatedly: as the market moves into crisis, the absolute value of the correlation of assets approaches one. The problem is you cannot always predict ahead of time if the correlation will be one or negative one. One asset might end up hedging another, or it might end up doubling your exposure.


The surprise for Morgan Stanley was that our biggest losses came not from equities, but from high yield bonds. The flight to quality moved investments away from equities into Treasury bonds, with the result that as equity prices declined, bond prices shot upward. In the aftermath of the 19th, the interest rate on 90-day Treasury bills dropped almost two percentage points to just over five percent and the benchmark 30-year Treasury bond shot up by over 11 points. Corporate bonds did not share in the shift to fixed income; they went south instead.


October 19th ushered in, spectacularly so, the context for a type of risk that would embrace the markets in the future. At the root of the Crash was computer-assisted liquidity in the form of rapid, programmed, cash-futures execution, and an innovative analytical products in the form of the option model’s differential equations applied to construct synthetic put options. The market was developing to allow lightning fast reactions while at the same time driving complex innovations in market instruments and strategies that required ever more time for investors to analyze and absorb. This combination of speed and complexity would be the source of many future crises.

October 15, 2017

Can We have an ETF Meltdown?

October 15, 2017
What is the magic that allows us to have intraday liquidity through an ETF on a market that itself trades more or less by appointment? Case in point: the high yield bond market. Or emerging markets. Or just about any bond market short of sovereigns and maybe agencies.

Suppose there is a sudden rush for the exits in the high yield bond market. Those in the cash bonds know the drill. They will put in orders with the bank/dealer market makers. For a while those high yield bond trading desks will buy the bonds and hold them in inventory. But it won't take long for the trading desks to reach their capacity. After that point, they won't be buyers. They will act as agent -- also knows as riskless principal -- and look for someone on the other side of the trade. In the meantime the seller has to bide its time. The point is that on the cash bond side, it is not an intraday sort of a transaction. It can take days to find the other side for the trade. And anyone who is active in the high yield bond market knows that, so they structure their leverage and liquidity accordingly.

However, those in the ETFs by and large have no inkling that this is the way the market for high yield bonds works. As far as they can tell, the ETFs trade like an S&P 500 stock. You put in an order to sell, and you are done in minutes.

The reason there is typically high liquidity in the ETFs is that there is typically good two-way flow. And beyond the buyers and sellers are what are called authorized participants. The authorized participants keep the ETFs linked to the underlying cash bonds. They can create ETFs by buying up and bundling the underlying bonds, and they can take in the ETFs and unbundle them and sell the underlying bonds. In a functioning, two-way market, this all works the way arbitrage does for equities indexes. If the ETFs are at too high a price relative to the cash bonds, they grab the cash bonds to create and sell ETFs. If the ETFs are at too low a price relative to the cash bonds, they buy the ETFs and take the bonds to sell in the bank/dealer market.

It sounds simple, but it can't really be foolproof. You know there must be something that can go wrong when you have an instrument -- the high yield bond ETF -- that is as liquid as water even though the bonds it contains are almost the definition of an illiquid security. There is something akin to trying to cheat the law of conservation of momentum. And we all know that anytime something depends on some notion of arbitrage, things can go off the rails. I was in the middle of the portfolio insurance problems that led to the market crash in October, 1987. I knew all about option theory, but when the market was in free fall and the bid-offer spread for the S&P 500 futures was over a dollar, no one was in the mood to try to keep prices in line by doing delta hedging. Options traded in their own world. Implied volatilities were 80% and higher. The option market went into rotation -- trading one stock at a time throughout the day.

For the ETFs, things can go off the rails if the authorized participants can't do their job. If there is not a two-way market, and if the authorized participants' inventory is filled up with ETFs, and if they see that it will take days to get the bonds off of their hands, at the very time that prices are going crazy, they will be stepping away. At that point there is nothing tethering the ETFs to the cash market. The ETF market and the high yield bond market will each trade as their own thing, based on who needs to sell and who is there to buy. At that point it might as well be one market for Martian gravel and another for Enceladian ice cones.

Sure, that is taking it a little too far. There will be some real money investors who will finally step in and keep things from moving into a totally imaginary world. But for the time being the ETF market will, for all practical purposes, shut down. And, getting to the next chapter in this story, it is the "for all practical purposes" that matters.

A clear-thinking, experienced investor in, say, an ETF on an equity market index or gold or currency will not be bothered much by the failure of the high yield bond ETFs. They will get the point that the high yield ETF was creating a fiction of liquidity when there wasn't any, whereas in these equity and currency and commodity markets the underlying markets trade with pretty much the same liquidity as the ETF. But for many investors, all they will hear is that ETFs are in trouble. In the face of the major market dislocation in which the high yield bond problems are likely to be embroiled, people are already going to be in risk-off mode, and if they smell some sort of structural risk with these "newfangled ETFs" they will sell them, period. And there will be plenty of sources out there ready to spread the view that something is amiss.

And, getting to Soros's theory of reflexivity, the changing expectations that come from people in the market buying into this view means that those clear-thinking experienced investors will get out of these more liquid ETFs themselves. And if the authorized participants are still up for doing their job in those markets, that selling will feed back to drop the underlying markets in equities, currencies, and commodities.

October 1, 2017

Out-there Scenarios: ISIS and Asset Management

October 01, 2017
I break risk management into three levels, Versions 1.0, 2.0, and 3.0.

Risk Management 1.0 is the standard risk management of VaR and the like, where history is used as a guide, and thus where things work if the future is drawn from the same distribution as the past. Any approach that is looking at risks historically, whether using past prices or variance-covariance relationships or leverage numbers or credit ratings; whether using a normal distribution or a t distribution or a gamma distribution or a part of a distribution like semi-variance, is part of this. If the future looks like the past in some specific ways, it works; if the futures deviates from the past it might not work.

Risk Management 2.0 is a reaction to the fact that the 1.0 methods failed during the 2008 crisis. This failure is not surprising or unexpected by most of those working in risk management, because we understand the assumptions behind Version 1.0. But sometimes this was not articulated well when the numbers were passed up the chain. In any case, after 2008 risk management started to depend more visibly on stress testing. I say "more visibly" because anyone doing risk management over the past decades has done stress testing in one form or another. Certainly when there are non-linear risk-return tradeoffs, like with option exposures, it is a standard method. But after 2008 it became de rigor in the analysis of bank risk, for example using CCAR.

And there is Risk Management 3.0, which I won't get into here. It recognizes that a static stress will miss important dynamics that lead to feedback, contagion, and cascades. And it is not something that can be readily addressed with the standard economics. You can check out my book, The End of Theory, or some of my papers while I was at the Office of Financial Research to get more on this.

Here I am focused on what we need to do before we can get to these dynamics: We need to know what is triggering a market dislocation. And we are particularly interested in triggers that are large in either magnitude or in the number of agents that are affected. So even before worrying about the methods for dealing with crisis dynamics, the question to ask is: What can go wrong in a really big way.

I sometimes get at this by starting with something really extreme, and then dialing it back until it can be considered as a reasonable scenario. Reasonable does not mean it is likely to happen, but it also is not "what if an asteroid hits New York" either. Anyway, I want to run through some of the extreme scenarios that I have been thinking about. I'll put one out here and see if anyone responds, either with comments on it in particular, or with others that they are cooking up in a similar vein.

So, Out-there Scenario I: A large asset manager is rumored to be funding ISIS.

Suppose a rumor goes viral that a very large asset management firm is actually owned by, or at least is funding ISIS. This hits all the usual fake news outlets, and is then, of course, bounces into the real news if only as a "there is a rumor, unsubstantiated, making the rounds that...." The result will be large scale redemptions in that asset manager. This will start a downdraft in the markets. It will also lead to questions about other asset managers, and redemptions there as well. The resulting cascade could spread across the markets, erode confidence, and become a major market event.

Now, of course (at least I hope it is obvious) I am not saying specifically that this rumor is likely. But start with this and, as I suggested above, dial it down a bit. The point is, we can come up with scenarios where there can be massive redemptions in some particular major asset manager, and they can be exogenous to anything in the market, and on the face of it might be unreasonable.

One argument against this path to major redemptions hitting the market is that people can redeem by moving their holdings to another asset manager. If they do that there will be no actual selling of assets, and no market impact. This is the way investors will redeem if they continue to want to hold the assets and if they operate with professional aplomb. But the sort of people who would buy into a rumor like this are also likely to simply say, "give me my money", and then figure out what to do after that.

A little footnote: A few years ago the Office of Financial Research did a research study of the asset management community, with the key question being whether the largest asset should be SIFIs (systemically important financial institutions). The report was castigated, especially by the SEC, mostly, I think, because the SEC was honed for inter-agency rivalry. But in any case, no one threw the ISIS scenario into the report.

September 19, 2017

Risk Management in the Long Term

September 19, 2017
I work in a pension fund. And pension funds, as well as sovereign wealth funds -- which are like pension funds for an entire country -- need to take the long view. The liabilities can stretch out for twenty or thirty years. And a lot can happen in between. But some of this is not too hard to divine. In fact, ironically, the issues that extend to the long term are in some ways more predictable than those of the shorter term. Things like demographics, changes in demand due to the adoption of new technology, fixed income of retirement, and, unfortunately, climate change.

The thing about demographics is that you get plenty of warning. If the driving issue for risk is what twenty year-olds are up to, you get to know how many twenty year-olds you will be dealing with twenty years ahead of time. (Excluding immigration.) And, similarly, you have a pretty good head start in knowing what lies ahead as people retire, like, that they will live longer, and that there is a sizable group that does not have enough between savings (which is close to zero) and social security and pensions (which averages under $20K a year) to make a go of it.

Demographics is a slow motion tidal wave that washes over society. Look at how our institutions have changed as the baby boomers moved into school age (remember split sessions as elementary schools became overcrowded ) and then college age, and then became home buyers. And now they are moving into retirement, an age of dissaving, of heading off to Florida, and of consuming more and more health care resources. Will we soon see in reverse the housing boom that occurred when the baby boomers reached house-buying age. Will the cash strapped Millennials be able to pick up the inventory? In a time when dining rooms and living rooms are the housing equivalent of an appendix, will there be demand for what will be coming onto the market?

We don't know what lies ahead for technological innovation, but we do know the longer-term trend as the technology that we already have is improved and adopted. Jobs in transportation will shrink. Jobs generally will shrink. The oil, insurance, and auto industries will face huge disruption. The wonders of innovation will meet the realities of political will. The winner-takes-all business models, Amazon being the dominant case, will find increasing headwinds from the regulators and lawmakers.

What is true for the path of demographics is also true for climate change. We have a pretty good read on the direction, if not the magnitude, of climate change. There has been so much energy expended in fighting the pushback on whether climate change is real that we haven't had the energy to contemplate the full implications of its course. If you want to get a scary version of what can happen, read the New York Magazine article The Uninhabitable Earth. The author spoke to climate scientists about their views of the future, views that they generally do not share publicly because it is hard enough to put the simple, non-dire view out there without dodging tomatoes. The dire-view list includes, section by section in the article: heat death, the end of food, climate plagues, unbreathable air, perpetual war, permanent economic collapse, and poisoned oceans.

Where does all this lead? To something that is more concerning (well, not as concerning as heat death, the end of food, and the rest) than the trends themselves: social revolt. The ushering in of the industrial age had its Karl Marx and its hundred years of revolution rolling across the globe. What will we see rolling across the globe when the broadly predictable demographic, retirement, employment, and climate trends take their course during the next decades? (And I haven't even discussed the implications of all of this for rising inequality and marginalization.) When we have a younger generation trying to support an older one that outnumbers it by some multiple; when it is doing so without being able to find meaningful (or just about any) jobs; where the retirees do not have the wherewithal for self support; all with the backdrop of a climate that is making the earth uninhabitable in multiple ways?

Has the UFC Jumped the Shark?

September 19, 2017
Now, in the middle of hurricanes, Trump, and a (possibly) overheated stock market, here's a blog about something different and somewhat inconsequential: The mixed martial arts world, which pretty much means the UFC.

I have been interested in martial arts for a long time -- I have been training in Brazilian Jiu Jitsu for over twenty years -- and have enjoyed the increasing interest in mixed martial arts. But about a year ago the dominant organization for mixed martial arts was purchased by a consortium of WME and IMG for a staggering $4 billion. These are organizations that are not focused on sports, but on entertainment, and the UFC has followed the lead to increasingly become an entertainment enterprise.

In its first incarnation, the UFC was a little better than a refereed bar fight. Such as it was, these fights are what got me interested in Brazilian Jiu Jitsu, because Royce Gracie, a member of the famous Gracie clan that brought BJJ to the U.S., defeated opponent after opponent regardless of the size differential using these ground-based techniques. I train at his nephew Renzo Gracie's academy in New York (In the photo I'm at the bottom right, Renzo is two to the left of me).

Then in 2001 the UFC was bought by the Fertittas brothers, and it was rebuilt as a serious sports enterprise. Over time it attracted top athletes, first men, and then women, most famously Ronda Rousey, that fought in weight classes built on a professional structure.

But if you want to recoup that sort of investment, you have to reach for a broader audience. You have to create buzz and spectacle. The poster child for this, of course, is the fight between Floyd Mayweather and Connor McGregor. This fight pitted two men who were undefeated in the boxing ring. One with a 49-0 record, the other undefeated for the same reason that I remain undefeated as a professional boxer. He had never been in the ring.

This fight looked more interesting than it fundamentally was. Mayweather promised to give the spectators a show, and the match lasted for ten rounds of boxing action. In part because Mayweather didn't bother to throw punches for the first rounds, and then let the exhausted Connor gamely trudge on until he leveled him with a barrage. The slow start could be chalked up to caution on Mayweather's part, making sure he understood an opponent that he had never seen in the ring before. Or it could be that he didn't want fans who spent hundreds of million of dollars to watch the fight head home after a few minutes.

This fight will mark the turning point, when the sport, at least in its most popular venue, will have jumped the shark. Former UFC champion Benson Henderson put it succinctly, "It's a very slippery slope when you have a world champion boxer fighting an MMA guy for the sake of money, and he can't knock him out in the first round," Henderson said. "He has to make sure he carries him a little bit. For me, that's too close to skirting the edge [of a fixed fight].

Now Paulie Malignaggi, a sparring partner for McGregor and world champion in two weight divisions before retiring earlier this year, has been trying to get into the circus by fueling demand for a grudge match with McGregor based on a falling out after a video appe ared that showed Malignaggi hitting the canvas during a sparring session. He argued it was a push, McGregor's camp called it a knock down.

In any case, there is more showmanship where this is coming from. With Mayweather versus McGregor we had boxer versus MMA fighter. But before that, we had the WWE star CM Punk come into the UFC octagon to get destroyed (surprise) by a UFC professional of no particular note. We are having a fight of 38 year-old Michael Bisping, who last fought a year ago, versus 36 year-old George St-Pierre, who retired five years ago. And we have another MMA versus pro wrestling bout being bandied about between Jon Jones and Brock Lesner. There is a huge weight discrepancy between them, so maybe it will be billed as David versus Goliath. It also could be billed along some lines related to the fact that both fighters have been banned from legitimate fights for failing drug tests.

August 30, 2017


August 30, 2017
Many of us wonder what drives President Trump. Or more uncharitably, what is the nature of his mental instability. The natural place to turn is the psychiatric community, but they have walled themselves off from the discussion because of the American Psychiatric Associations's Goldwater Rule, which prohibits them from diagnosing anyone they have not personally examined. Now a few people are peeking out from that wall.

In an Op-Ed piece yesterday in the New York Times, under the cover of a broad discussion of how decisions should be made on whether someone, say Trump, is unfit to govern, the authors, two psychiatrists, (one by the way a Democrat and the other a Republican), wrote this:

"Today, diagnosis is often linked to observable traits, making evaluation at a distance plausible. Even if Mr. Trump refused to cooperate, diagnosis might be the easy part — perhaps too easy. Whether or not they can say so, many experts believe that Mr. Trump has a narcissistic personality disorder."

Starting with this opening, we have a comment from a reader, a professor emeritus of psychology, featured as one of the NYT picks, who wrote that "Donald Trump, in words and behavior, has every single symptom needed for an unequivocal diagnosis of Narcissistic Personality Disorder according to the latest diagnostic manual (DSM-V) of the American Psychiatric Association."

I have heard people casually being described as narcissists, so I checked out what Narcissistic Personality Disorder really is. In the Wikipedia entry, the first thing I saw is a synonym: Megalomania. This does not bode well -- it is one thing call someone a narcissist, or to go further and have a serious clinical discussion a personality disorder. It is another to be saying, in different words, that your country is run by a megalomaniac.

Then I skipped down to the symptoms:
  1. Grandiosity with expectations of superior treatment from others
  2. Fixated on fantasies of power, success, intelligence, attractiveness, etc.
  3. Self-perception of being unique, superior and associated with high-status people and institutions
  4. Needing constant admiration from others
  5. Sense of entitlement to special treatment and to obedience from others
  6. Exploitative of others to achieve personal gain
  7. Unwilling to empathize with others' feelings, wishes, or needs
  8. Intensely envious of others and the belief that others are equally envious of them
  9. Pompous and arrogant demeanor

Reflecting on these symptoms, I would submit that there is more clarity for a diagnosis of President Trump based on his observed behavior over the course of his presidency than there would be by having a personal examination by a psychiatrist. Trump is mentally ill, the diagnosis is clear, and it is time for those in the psychiatric community to come forward. Literally, our country is being run by a megalomaniac.