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The Next Crisis

The Next Crisis: Some thoughts on shapes, paths and catalysts

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“History doesn’t repeat itself but it often rhymes” 
Twain

The 2007-08 “Great Recession” (or Global Financial Crisis as Australians prefer to call it) was a financial crisis that saw some of the largest losses and contagion effects across asset classes in at least 30 years and was coupled with one of the deepest recessions experienced in the USA in terms of job losses, since 1930. Arguably the only reason we are sitting here typing (or reading) this, is thanks to the deep and unprecedented government interventions in both fiscal and monetary policy.

Like all crisis, the recriminations began relatively swiftly after it was apparent the world was returning to some form of normal. The dominant financial narrative that has emerged is that the banks needed to be bought to heel and more highly regulated to control their reckless actions. From the investor’s perspective, money has flowed towards more “tail hedge” products that attempt to protect the downside risks of a 2008 style event and the associated catastrophic loss of capital. Further, money has flowed to those funds that performed best in 2008 and to increase due diligence of the funds used, particularly in the Hedge Fund space.

Now this neither is an exhaustive list nor is the purpose of this article to pass judgment on the narrative. Rather, it is to examine the unexpected side effects of the responses to 2008. We will focus on a few of the points raised above, then look at how these may be interacting in ways that were unanticipated.

Government Reaction: Banking Regulation

“The law of unintended consequences, often cited but rarely defined, is that actions of people—and especially of government—always have effects that are unanticipated or unintended. Economists and other social scientists have heeded its power for centuries; for just as long, politicians and popular opinion have largely ignored it.”
Norton

There have been a number of pieces of legislation introduced across the globe, with two of the most important being:

  • The Dodd-Frank Act: Introduced in the USA, this sweeping piece of legislation created a host of new governing bodies and legislation in relation to banking;
  • Basel III: Regulations on capital requirements, introduced by the Bank of International Settlements.

The sections of these pieces of regulation that are most relevant to this piece relate to the obscure area of “Repos” or Repurchase Agreements. This is where banks use collateral (in the same way when 1 someone takes a mortgage out against their house, their house is collateral) and often that collateral is US Treasury Bills which are short term loans issued by the US Government to fund themselves.

One side effect of the changes in regulation is that Banks find it much harder to issue loans or credit originating from these. There are also less of them available due to the Quantitative Easing programmes undertaken which has seen the US Federal Reserve purchase substantial amounts of these Government Bills. There has also been heightened demand from other market participants who want to use them.

Intertwined with this development in the Repo market, is that the Dodd-Frank Act has made it much more difficult for banks to use their own balance sheet to trade or hold securities, with the rationale it was the holding of Mortgage Backed Securities that got them into trouble in 2008. We will return to this point further on.

For a fuller description of this incredibly obscure and difficult to understand part of the banking system, please follow this link to an IMF paper.We won’t go much more into detail here; needless to say it is a relatively obscure and hard to understand part of the banking system but one that is what we would call “important plumbing”!

Investors Reaction: Changing the funds they use

“Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.”
Keynes

The reaction to 2008 and the QE that followed has seen all asset prices rise, but some have received more flows than other. Namely the flow into Bonds, both Government and High Yield (the so called reach for yield that has taken place) is larger than the flow into Equities.

If we focus more specifically on Hedge Funds, which account for approximately $3trn of Funds under Management (versus Mutual Funds in the USA which run $12trn), the flow has been predominately into more established and larger funds, at the expense of smaller ones. One thing to note about hedge funds is that they use leverage, i.e. they borrow money on top of their investments.

Now this in and of itself isn’t an issue, after all nearly every house purchase is funded with more debt than the deposit, with that leverage being about 100% on average, i.e. they borrow $100 for every $100 that is invested. For a house loan this more along the lines of borrowing $400 for every $100 deposit. This varies across strategy, with some long biased funds with no leverage and some specialist ones at 400-500%.

The issue is that most of these strategies call for capital protection. Indeed, our own fund nominates this. The most common way to protect capital is to 2 Source: McKinsey Global Institute, Haver, BIS, Deutsche Bank Figure 1 Stock of Global Financial Assets “de-risk” into a falling market, which is to reduce market exposure to reduce exposure to losses.

There is nothing inherently right or wrong with participants sharing the same strategy (a homogenous mix). The risk from a market perspective is that as the market falls, a portion of these funds will be selling into the falling market. This is worth mentioning, as the Mutual Fund industry has a much more diverse mix of strategies, as funds often promote outperformance over equities as their goal, rather than absolute returns.

As such some strategies call for “buy the dip” where they buy into a falling market, whereas others might even do nothing. This mix results in a more varied set of views and buyers and sellers. It has what we could call a heterogeneous mix of market participants.

Investors Reaction: Tail hedges and Risk Parity Investing

It has been said critically that there is a tendency in many armies to spend the peace time studying how to fight the last war.
The Military Engineer: Some Notes on the World War – Schley

Risk Parity Investing

The traditional model of balanced investing calls for 60% to be allocated to equities and 40% to be allocated to bonds in a portfolio. This is the model that large Superannuation Funds and other big pension funds outside of Australia use. There are many flaws with this approach, but one alternative to this model is to use what is called “Risk Parity” where allocations are done based on the “risk” or the volatility of an asset class.

These have grown in size since 2008 as pension funds, scarred by over 10 years of flat nominal returns on equities in the US and Europe, had insult added to injury by having these low returns endure the huge volatility of 2008. On the other hand models such as these with large weightings to bonds have had much better returns.

The issue we’d raise (and GMO in the link) is that these models encourage the selling the of assets as risk goes up, rather than the buying that the old model suggested (as equities fell in value, they became less than 60% so some more had to be bought as the market fell).

Tail hedges

Prior to 2008, the concept of a “Black Swan event” was largely the domain of the Nicholas Taleb book of the same name. That is, large unexpected events that can occur resulting in very large losses. Post 2008 the solution for most investment committees, it would seem, was to add these funds to their collection of investment products.

These can include “long volatility” strategies and “long puts” (there are more in this article and we at Morphic use the Tactical strategies in here coupled with shorting to help protect our capital, which are shown to be the lowest cost ways). The aims of these strategies are to pay out only in the event of very large losses, much in the same way insurance pays out.

But like insurance, for everyone that buys insurance, someone has to sell insurance. The firms that most often do this are large global banks (asset management firms are usually buyers of downside protection rather than sellers). The method by which they do this is what is called delta hedging, in that they have to protect themselves when the event be- 3 comes more likely, so they sell into a falling market – which is different to regular insurance. Now for the banks these have become vastly profitable products post 2008 to sell as everyone sought coverage and few had the ability or willingness to sell these. The issue only emerges when a tail event starts to occur.

Investors Reaction: Risk Models

“…The essence of this framework is that acting to reduce one type of risk would probably work to increase another, and there is sufficient uncertainty that it is better to do nothing until the picture is clearer”
Polz, Governor of Bank of Canada, Working Paper

The last area that we are looking at for changes post 2008, is that a consensus has been reached that more money needs to be invested into risk models and changes. These models take all the investments a firm has and looks how they behave together in a portfolio. Underlying the software is what is often called a “risk model” that drives the outputs. For these risk models to work, a number of assumptions are made about historical relationships and their expected future relationships.

One firm, Blackrock, has become the global standard for the aforementioned Pension Funds to use to do their risk modelling. Now this says nothing about Blackrock’s risk model – the firm has an amazing history and is one of the great success stories of finance. Rather, the issue is that everyone using the same risk model, it is suggesting that all parties run to same door if fire is yelled in a crowded room. Previously, the diversity of view may have meant people going to different doors, or not leaving at all (to torture the analogy).

October 2014: A Real time Experiment

“This accident is an outstanding example of something we’ve seen time and time again in airplane crashes: multiple errors, none of them necessarily fatal on their own accord, combining and compounding at the worst possible moment to precipitate a catastrophe. Rarely is the cause of disaster something simple and unambiguous.”
The Untold Story of the Concorde Disaster

The prior sections have outlined some of the factors that have all may come into play in the next crisis. As the quote above on the Concorde crash of 2000 outlines, no single factor ever accounts for an event and in normal circumstances is innocuous. It is when they combine into a cocktail that exacerbates an issue is when they become deadly. All the above changes were introduced with good intentions, but we believe there is a not insignificant risk that they could combine to come into play and exacerbate the next crisis.

The one certainty of operating with humans and uncertainty about future events is that crises occur regularly as the future doesn’t evolve to the expectations of the majority. These financial crises are usually bought to the fore by an increase in interest rates, this being the catalyst to unmask flaws within the system.

2015 is likely to see the start of interest rates increasing in the USA for the first time since 2006 so we are approaching the point where issues could emerge again, though it should be noted that historically the first rate increase is usually not the catalyst. Like the proverbial straw on the camels back, it often occurs a number of rate increases into the cycle when parts of the system are unable to cope.

October of 2014 to most non-market participants is an otherwise unremarkable month. Looking at the below returns table for the months of 2014, it’s not clear why we should use this as an example with the market ending the month higher than September. 

But if we look at the intra-month move (Figure 3), one can see the incredible volatility that came into the market. The market fell 7.5% that month (or over 9% from its peak in September) to then rally 10%. To give some idea of how large this is, the equity market on average should move 3% a month up or down to be within the range of what is ‘normal’.

If we zoom in further into the market, particularly the trading days of the 14th and 15th October, an even more unnerving picture begins to unfold. The story for the 15th begins in the bond markets. Here liquidity dried up (Figure 4). Participants then sought to trade through the Futures market on the CME, using Bond futures and Eurodollar futures) as participants sought to hedge their risks out.

These then drove prices to extremes as the markets set off what was probably a “stop fest” where funds tried to pull their exposures back to reduce losses.

Clearly by this point, with risks rising, some players started selling in the equity markets as a proxy for their risk exposure (if you are stuck in a trade and can’t get liquidity, it is common to sell a proxy to provide some coverage until you get out. A relevant example was the Australian dollar in the Asian Crisis of 1997 when it was used as a proxy for other Asian currencies).

The clue as to who was selling the equity and why it was a proxy was that Futures were leading the market down. This was forcing the cash market for large stocks to equalise (defined here as the S&P 500 Index), but a lot of “real money” (the phrase given to long only mutual funds and directly held shares) stocks (defined as the Russell 2000) wasn’t falling as much despite the fact that it is generally considered higher risk in smaller stocks than large stocks.

This would suggest to us that selling was being driven by funds or investors liquidating at the “macro” level – i.e. asset allocation level or quantitatively driven processes, rather than individual/ bottom up stock processes.

By 2pm on the 15th, the market had found a floor and rallied into the close. As such it is mere speculation as to what may or may not have happened if the market had kept falling into the close of trading that day. The point here is that a lot of the risk factors we have discussed in this article seemed to be at play that day.

Conclusion

“The secret of change is to focus all of your energy, not on fighting the old, but on building the new.”
Socrates

To us, October was a “warning shot across the bow” of how a number of new factors (new in the sense they didn’t play a role in the 2008 crisis) could come into play in the next crisis. Namely:

  • We saw liquidity dry up in the bond market;
  • Which forced rapid price movements; that 6 Source: Nanex Figure 6 Intra-day movements in US Interest Rates Source: Bloomberg Figure 7 Comparing intra-day price movements between the Russell 2000 and S&P 500
  • Forced hedging and reduction of risk appetite from some participants;
  • That then infected other markets. 

But missing from October (as the market found a floor and recovered) was the follow through into further tail risk hedging or margin calls that may have come through the next day. If we are right, then the risk of this occurring in the future is higher than most participants believe. We think we will see some of these factors come to the fore again. Or as Warren Buffett famously put it: "It’s not until the tide goes out that you see who was swimming naked".