Cash up front please

The Telegraph reports an idea of Paul Tucker's: making the banks pay to clean up their own mess:

The banking industry could be told in advance that, if ever there was another crisis, the ultimate cost would come from banks themselves. In the midst of a crisis, that would not be possible. A government would have to pump in new equity. But when the dust had settled and the government had sold its shares, the loss (if any) could be calculated - and then collected from the industry via a levy.

This isn't a bad idea. But there is a better one. Make them pay before the crisis.

There are various ways to do this. One is to take cash from the banks, via a beefed up version of the way the FDIC works. In order to be a financial institution, you need an annually renewable license, and the license should be expensive.

A more intriguing one, though, is to make the banks hand over each year not cash, but one year call options on their stock. The regulator would then hedge these options. The bank's shareholders would only be diluted if the stock went up, sugaring the pill for them, while the hedging process would ensure the regulator made money whether the stock went up or down. Indeed, as the position is long gamma, a big fall would be particularly profitable to the hedging strategy.

Hedge this, sucker

At some point I might get around to looking at this in more detail, but just imagine for a moment that you were short downside gamma on Lloyds yesterday. Even if you were short - really short - you would almost certainly have taken a very nasty bath. So much for Black-Scholes hedging.

Tarring Taleb

I have always been a little suspicious of Nassim Taleb. He seems to take too much pleasure in discussion of crises. And his first book -- a very conventional account of hedging -- isn't actually very useful for actually running portfolios of options. Now a post on Models and Agents (an excellent blog I have only found recently) gives a more focussed critique:

the current crisis is not a black swan. Alas, the world’s economic history has offered a slew of (very consequential) credit and banking crises ... So not only aren’t credit crises highly remote; they can be a no-brainer, particularly if they involve extending huge loans to people with no income, no jobs and no assets.

Taleb also recommends that we buy insurance against good black swans—that is, investments with a tremendous (though still highly remote) upside but limited downside. For example, you could buy insurance against the (unlikely?) disappearance of Botox due to the discovery of the nectar of eternal youth. And make tons of money if it happens.

And that surely is the point. Yes, the unexpected happens with considerable frequency. But knowing which black swan is more likely than the market is charging for is the hard part. Buying protection in the wings on everything is far too expensive to be a good trading strategy. If all Taleb's observations amount to is the claim that being long gamma can sometimes be profitable, then they are hardly prophetic. What would be much more useful would be his analysis of when, exactly, black swan insurance is worth buying.

Lessons from 2001

The last time there was this big a market rout, I learnt a few lessons.

• Vol is really expensive. Sell it around the money. But the wings are dangerous. I like being short vega in this kind of environment, but to get longer on big market falls or rallies.
  
• Whipsaws happen. Live with it and plan your rehedge frequency accordingly: failing to capture the whipsaw if you are long gamma loses you a lot of potential upside. Look at your 1%, 2.5%, 5% and 10% deltas, not just the instantaneous one.
  
• Gamma holes can kill you at any strike within 30% of the money. Fill them as cheaply as you can.
  
• Correlation structures break down completely in environments like this one. Be especially careful of assumptions about cross gamma or strategies like dispersion trading that rely on stable correlations.

And if that doesn't work, pull up the drawbridge.

Amplified mortgage portfolio super seniors: a really bad idea

The UBS shareholder report on the firm's subprime losses makes fascinating reading and I will try to return to it later in the week. Meanwhile however it is worth noting that a major cause of the UBS losses were AMPs. Let the report take up the story:

[AMPs] were Super Senior positions where the risk of loss was initially hedged through the purchase of protection on a proportion of the nominal position (typically between 2% and 4% though sometimes more). This level of hedging was based on statistical analyses of historical price movements that indicated that such protection was sufficient to protect UBS from any losses on the position.

Let's try and tease this apart. The bank is long the supersenior tranche in a CMO. They 'hedged' this position by buying credit protection on the underlying mortgage portfolio in an amount calculated to minimise short term P/L volatility. I think.

Isn't this pure gaming of the VAR model? This 'hedge' dramatically reduce the VAR. But losses build up in the junior and rise through the mezz, the bank will need to short a larger and larger percentage of the underlying mortgages to remain hedged. In other words this position is massively short credit convexity even if it is credit delta neutral. And even that is assuming that you can short more of the underlying pool into a falling market, an assumption that is highly questionable.

Anyway, even if the AMPs position was not designed to game the VAR model, it certainly achieved that effect:

Once hedged, either through NegBasis or AMPS trades, the Super Senior positions were VaR and Stress Testing neutral (i.e., because they were treated as fully hedged, the Super Senior positions were netted to zero and therefore did not utilize VaR and Stress limits). The CDO desk considered a Super Senior hedged with 2% or more of AMPS protection to be fully hedged. In several MRC reports, the long and short positions were netted, and the inventory of Super Seniors was not shown, or was unclear.

(See here for a discussion of negative basis trading.) For something like this there is real danger that the system's view is seen as the only reality. If the VAR model says there is no risk, the firm might actually think that's true.

Next we come to model risk:

The AMPS model was certified by IB [UBS investment bank] Quantitative Risk Control...but with the benefit of hindsight appears not to have been subject to sufficiently robust stress testing. [...] The cost of hedging through a Negative Basis trade was approximately 11 bp, whereas the cost of hedging through an AMPS trade was approximately 5 – 6 bp.

So, a positive carry asset hedged very cheaply but leaving a large short gamma position which was not captured by the firm's risk model. They really were asking to be creamed by a big market move. And then one came along.

See Wile E. run

From the Telegraph:

The Saigon Times said this morning that the State Bank of Vietnam was abandoning the attempt to hold down the Vietnamese currency through heavy purchases of dollars.

Separately, the gas-rich Gulf state of Qatar announced that it had cut the dollar holdings of its $50bn sovereign wealth fund from 99pc to 40pc, switching into investments in China, Japan, and emerging Asia.

This action is certainly adding pressure to the dollar and further falls seem likely. But will we see a rout (aka a Wile E. Coyote moment)? Put on your gamma, take a seat, watch the action.

The Dollar and the fans of Wile E. Coyote

Paul Krugman uses the term 'Wile E. Coyote' moment for when traders find a currency level is unsupported by fundamentals and it drops precipitously. Certainly some currencies display very fat tails: they tend to have long periods of stability, followed by one or more greater than five s.d. moves. (The interested reader may at this point wish to fit the Generalised Pareto Distribution to twenty or more years worth of dollar/yen returns, and compare the GPD VAR with the normal one at 99.99%: typically it's very roughly four times higher.)

Krugman further suggests that a Wile E. Coyote moment may be approaching for the dollar. This is more than just suggesting that the dollar will fall: the fall has to be steep to qualify. Tanta over on Calculated Risk has some supporting evidence (which is a little glib but bear with me):

Bear in mind that the principal channel through which Fed policy affects domestic demand is via housing. If a burst housing bubble is part of the economic problem, the Fed’s leverage over the economy will be greatly reduced, and even a zero Fed funds rate might have only modest stimulative effect.

The problem is too many people are talking about this possibility: many currency strategists expect dollar weakening, so existing dollar shorts will tend to make large falls much less likely. The macroeconomic picture is not encouraging for the dollar, it's true. As Long or Short Capital put it, albeit amusingly bluntly:

I challenge you to find one measure of wealth OTHER THAN THE DOLLAR which shows the US economy as worth more now than in 2001. If I wanted to buy our country it would cost me 30% fewer euros today than it did in 2001, it would cost me less bars of gold, less barrels of oil, less ounces of copper, less btu’s of natural gas, less cubic feet of lumber, less of almost anything that has intrinsic value. Yet you keep reporting GDP growth, why? Because your quick fix is to effectively print more money so that in dollar units everything is getting more “valuable”. But guess what, to the 95% of the world that doesn’t use dollars the true value of the US economy has been shrinking, rapidly.

Moreover, central banks, notably asian central banks, are not buying enough dollars to provide a floor. As Brad Setser says:

The world’s key central banks have concluded that they have more reserves than they need, and are rapidly losing interest in adding to their dollar reserves. China’s central bank has made it known that it thinks it has enough reserves. Some in China think the PBoC already has far more reserves than it needs. Korea’s central bank has indicated -- at various points in time -- that it has more than enough salted away. The ADB agrees.

Still, currencies are often a long way from macro-economic equilibrium, and the U.S. has historically shown an astonishing ability to grow out of difficulties. Despite the fundamentals then instinct suggests that while one might not want to be short dollars yet. That just leaves buying the potential to benefit from a Wile E. moment via the options market. Perhaps selling short term downside gamma (in the belief that Wile E. will take a while to arrive at the cliff) generating cash to pay for a longer-dated further from the money position might be interesting.

I'm sure a salesperson will soon christen this 'the Coyote trade': look for a range of North American mammal structured notes at your friendly investment bank shortly.

Servicer-related convexity in RMBS

An aban- doned shoe and a banana skin on Old Street to begin a post on the willingness of ABS servicers to abandon their trades if things go badly. Specifically, Tanta on Calculated Risk makes a good point about rising defaults in RMBS:

Foreclosure waves create additional losses just by being foreclosure waves. You can try to rush for the exits all you want; it takes too long to get out of this door if there are too many people in line [...] when declining home values [...] get to a certain point, the foreclosure volume gets to a point such that the operational risk explodes, which drives those loss severities even deeper.

So when house prices go down not only do you have rising losses in RMBS, these losses increase costs dramatically at the servicer. Therefore you also have massive pressure on servicing fees because if you don't agree to let the servicer raise them to cover these costs, they default, and the back up servicer will demand higher fees anyway. There is not sufficient liquidity for all holders to be able to get out at anything like the marked price once this starts happening. As Tanta puts it:

"Look, bondholders, you'll either approve some modifications or your servicer will fold beneath you and any substitute servicer will be able to name its price because you need them waaay more than they need you,"

In most ABS the holder is short a (real) option for the servicer to demand a change in fees, and this option is really worth something. Moreover its moneyness is highly correlated with default levels. If you hold, say, non Agency AAA, are you getting paid for being short this option?

The short gamma of short gamma

Very roughly, a short gamma trading strategy is one that profits from not much happening and loses a lot of money if there are big moves, whereas a long gamma strategy loses a little money every day there isn't a big more, but makes a lot if there is.

Short gamma traders (in the widest sense) are trend followers or people who believe things will be normal. Long gamma traders want something unusual to happen.

Now here's the thing. At the moment there is a lot of talk about a market crash being imminent. For instance, Calculated Risk is doing a good job of recording the woes of the US housing market, Nassim Taleb's new book on long gamma has been getting a lot of publicity, and Anthony Bolton is predicting a crash. But if everyone is expecting a crash, surely this is the orthodoxy. And true long gamma traders pay to get a position that will profit if the orthodoxy does not prevail. So shouldn't they go short gamma? And vice versa of course.