Monday, October 30, 2017

The Vanishing Pavilions: The Gutting of the Government and the Loss of Oral Tradition

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?


Thursday, October 26, 2017

On WealthTrack for the 30th Anniversary of the 1987 Crash

I was the guest for the PBS show WealthTrack for the 30th anniversary of the 1987 stock market crash.  Here is a link to it.


Thursday, October 19, 2017

The Crash of 1987 -- Happy 30th Anniversary

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.)

Sunday, October 15, 2017

Can We have an ETF Meltdown?

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.




Sunday, October 1, 2017

Out-there Scenarios I: ISIS is Funded by a Major Asset Management Firm

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.