Jim Grant Interviews Alan Fournier: "Pension Funds Are So Desperate For Yield, They"re Systemically Selling Vol..."

In the latest installment of RealVision"s interview series featuring Jim Grant, longtime publisher of Grant"s Interest-Rate Observer, the newsletter publisher sits down with Alan Fournier, the billionaire founder of Pennant Capital, to discuss one of the most widely discussed topics across modern asset markets: Volatility - or rather, the systemic risks posed by not only the paucity of volatility in modern markets, but how risk parity and low-vol targeting strategies have created imbalances that could lead to massive dislocations should volatility spike.

In the beginning of the talk, Fournier and Grant discuss how volatility has been artificially suppressed for so long that it"s essentially become an asset class unto itself. Investors have devised all these new volatility targeting strategies - like risk parity, for example, that have generated outsize returns since the financial crisis. But many don"t recognize the underlying risks. With so much money piled into the short-volatility trade, a large enough spike could trigger extremely painful selloffs in both bond and equity markets.

JG: And one would expect that if interest rates are going to turn, it might be kind of a noisy and dramatic turn.

 

Are you plugging in the interest rate aspect to this as well the bond market side of things?

 

AF: Well the thing that concerns me the most about this sort of overall technical setup, if you will, is that the reason people own bonds is they don"t correlate with stocks. So if something bad happens in the stock markets, bonds rally, right? So risk parity, some stocks in a levered bond fund, it"s been fabulous because that"s been what we"ve seen for the last 15 or 20 years. Well if we get a turn, which is just driven by a normal business cycle and that correlation comes apart, who knows what happens? But there"s a lot of money that"s been dedicated to these kinds of strategies, whether they"re vol targeting, risk parity. We"re in sort of a spooky time.

 

JG: You use the phrase the setup, which I think is a wonderful way of expressing the notion of an overall context of things, how the forces are aligned or misaligned. And so many of those forces in this particular cyclical moment seem to be unusual if not unprecedented. Certainly the level, the nominal level and real level of interest rates is one of those forces. The positive preoccupation with the efficacy and with the certainty of outcome of passive investing must be another, right?

 

AF: Yes.

 

JG: And the peace and quiet in the markets as reflected in readings in both the MVE Index, which registers bond activity, and the VIX Index, which measures agitation in the stock market, those things are at record or near level lows. So Alan, how do you see the constellation of these forces?

 

AF: Well, we joke on a trading desk when we come in the morning if the futures are down-- like today they were down a bit this morning. But we joke about what time they"re going to go positive during the day, and usually it"s after the Europeans go to the pub or something at around 11 o"clock. By 2 o"clock they"re positive.

 

And I just mentioned this because it"s very unusual and something I"ve never seen in 30 years or so of doing this that sort of nothing rattles this market. And I think some of it is the vol being depressed.

 

JG: Now let"s explain this. So volatility now, it"s like a thing. It used to be stocks and bonds.

 

AF: It used to be observed based upon how options are priced. Now it"s actually a source of income.

 

JG: Right. It"s like an asset class.

 

AF: It"s a bond.

 

JG: But it"s movement. It"s kind of capitalized movement, right?

 

AF: Right.

Toward the beginning of the interview, Fournier shared a story with Grant about how a high-net worth broker recently asked for meeting to pitch a suite of new "short volatility" investment products. After grilling the broker about the details of how the products are managed, he asked how the funds are protected in case of a sudden spike in volatility. The broker waved his question aside and said there products are all adequately hedged.

After doing some more due diligence, Fournier discovered that the broker was wrong. And it"s not that he lied, Fournier surmised - it"s that the broker didn"t have an appropriately deep understanding of how the products work.

AF: Yeah. So I"m going to tell you a little story which is interesting, which is suggestive of the idea that we"re pretty late in this tick-tock game.

 

JG: All right, I"m ready.

 

AF: Well a friend of a friend asked to come see me who is a high net worth broker at one of the investment banks. And he said, "Look, I know I can"t help you in the stock market because you"re doing your own thing in your fund and get that, but maybe we can help here with fixed income." I said, "Sure, come on by. Let"s talk."

 

He comes in and I ask the question, "So what are people doing for income?" And he said, "We have this great product that sells vol." And I said, "Oh, how does that work?" And, well, it was a very basic explanation. Selling puts, selling calls, straddles, blah, blah, blah. And I said, "What happens if the market goes down?" And he said, "Well, there are ways they protect against that." I was like OK, and I just was very curious. So I said, "Send me the documentation." So he sends me the brochure with all the legal details and so forth, and there"s really no protection. They"re just selling vol and collecting income, which has been successful.

In the most unsettling excerpt from the interview – for mom and pop investors, that is – Fournier shared a story about a talk he gave to a group of pension-fund investment-committee members. Some investment bank trying to scrounge up brokerage business had taken the group of these investors on a tour of Washington, D.C., and Fournier was recruited to speak about his experiences in the hedge fund industry as sort of a keynote for the day’s events.

So, Fournier told a story that emphasized the risks of selling volatility.

Afterward, his audience sat there, stone-faced. As he would come to find out, many of their funds were running vol-selling strategies which – as we’ve explained time and time again – are much riskier than most investors realize.

And these are pension funds – purportedly some of the most risk-averse institutional investors.

JG: So when you sell vol, what do you do exactly? Do you sell puts on the VIX Index?

 

AF: Yes, and different tenors. And there are strategies that will sell vol at a level and buy vol further down and try to dampen potential crash risk and those kinds of things. But essentially you"re just collecting income by being a house, selling puts.

 

So a few weeks later another investment bank invites me to come and speak to some pension investors. And they were taken them to Washington to sort of hear what was going on down there. And then they brought them up  to New York and I was sort of the end of the day, talk to a hedge fund practitioner kind of thing. And I sat there and I told the story about how this guy was trying to sell me vol, expecting some kind of reaction from them.

 

JG: And they said so?

 

After doing some more due diligence, Fournier discovered that the broker was wrong. And it"s not that he lied, Fournier surmised - it"s that the broker didn"t have an appropriately deep understanding of how the products work.

 

JG: This is a group of--

 

AF: Pension funds, large European pension funds. And he said, "Yeah, but they have a strategy where, when you get a selloff, they sell more into the selloff." So if the VIX spikes from 10 to 15, you sell more. And then you continue to have this tremendous monthly pattern of income.

 

So as I was walking out of there I thought, my goodness, the central banks have succeeded in pushing people out on the risk curve. They"re taking people that are managing the pensions of state pensioners and they have them in negative earning sovereign instruments. And now they have them-- they"re so desperate for some yield, they"re systemically selling volatility, which is remarkable.

In one of the most interesting excerpts from the interview, Fournier explains how a chance breakfast meeting inspired him to switch from long subprime lenders to short a few years before the housing crisis began.

The timely switch allowed Fournier to book winning trades on both the long side – he cashed in as home prices climbed toward their pre-crisis peak – and against during the collapse. He was inspired to change his position after learning from a subprime mortgage broker how the loans the broker was selling worked.

After their discussion, it quickly became apparent to Fournier that the whole subprime lending model was reliant on home-price appreciation, and the minute housing prices peaked, there could be a very significant credit event.

JG: This is where we have different lines of work Alan, because in the years 2001, "02, "03, "04, "05, "06, Grant"s Interest Rate Observer deplored these queues of people lining up irrationally and uneconomically to buy the houses, the makers of which you were long.

 

It takes all kinds of people to make a world. I’m not throwing stones.

 

AF: We also got long subprime lenders. And we got to know them well. And early on it was clear that this was going to be a booming opportunity for subprime lenders. I mean, you were taking debt that was costing folks very high rates on credit cards and pulling equity out of homes. And so that was a natural arbitrage that created this big opportunity. And then using subprime to fund the purchase of second homes, driving up real estate prices. And I was actually at a breakfast with a company coming public that I ended up investing in where I asked them a number of questions about how these loans work. And it became very clear that the whole key to those loans was home price appreciation. And at that breakfast, I kind of logged this view, that, wow, when this turns, it"s going to be a very significant credit event.

 

JG: Let me, if I may just interrupt to observe, how unusual it is for someone who has been long, a big theme, to turn around and successfully to change views and become short, successfully, that same theme. It"s done sometimes at a bar in recounting fabulous fabled stories, but rarely in real life. Tell me about kind of the intellectual flexibility this requires. When did you decide to kind of jettison the bullish view on subprime?

 

AF: Well, it was a matter of first developing understanding of what was going on and how this reflexive process, classic Soros reflexive process was interacting with the real world. And it was very simple. Easy credit drive up home prices. The fact that home prices was growing up was making credit easier. And so it was a matter of how long that would play out and when it would end. We had the patience to wait. And we made some money in long side of some of the subprime lenders during this period. And it was really gaining the knowledge of what these CDO and CDS securities were that was an eye-opening opportunity for me.

So Fournier switched from being long doomed mortgage lenders like American Home Mortgage to shorting the mortgage-backed security products that would eventually slide all the way to zero.

Later in the interview, Grant asks Fournier for his thoughts on bitcoin.

In a heartening display of modesty and intellect, Fournier demurred, instead of offering a barrage of chaotic, unqualified opinions like some of his peers have tended to do.

“That’s something I don’t understand well.”
 

Goldman: The Last Time This Happened Was Just Months Before The Start Of The Great Depression

Ah Goldman, never change.

One week after Goldman"s chief equity strategist David Kostin predicted a three-year bull market of "rational exuberance", lifting his 2018 S&P price target from 2,500 to 2,850 rising to 3,100 in 2020, and stating that should the exuberance turn "irrational", the S&P could rise as high as 5,300 by the end of 2020, another Goldman strategist, Christian Mueller-Glissmann, has decided it may be a good idea to play bad cop and cover all bases.

And so, in a report released on Tuesday "The Balanced Bear - Part 1: Low(er) returns and latent drawdown risk" this now bearish Goldmanite warns that in the medium-term, the two likely scenarios are either i) a "slow pain" deflation scenario of low yields and high valuations "which persist as macro is stable but there are less windfall gains from rising valuations and less carry - as a result, returns are likely to be lower across assets", or ii) a "fast pain" drawdown scenario in which there is "either a material negative growth or inflation/rate shock, or a combination of both, which drives a drawdown in 60/40 portfolios."

For those confused, don"t worry - you read it right. While on one hand Goldman is predicting nothing but blue skies for the "medium-term" of the next three years, predicting no recession and double digit equity upside, at the very same time, the very same Goldman is also forecasting either a "slow" or "fast" pain scenario, which while different, share one thing in common (as the name implies): "pain."

No surprise, Goldman talking out of both sides of its mouth, the only question being while the client-facing "research" is obviously crap and meant to get clients to do the opposite of what Goldman"s prop traders are doing, it remains debatable on what side Goldman"s prop is axed. Is the bank pulling a CDO and shorting everything it sells to its clients, or has the bank assured further S&P upside, even as valuations no "longer make sense" to quote, well, Goldman?

We don"t know the answer, nor do we care. For those who do, here is Mueller-Glissmann summary:

We think a period of low(er) returns (scenario 1) is more likely than a full-fledged bear market in 60/40 portfolios (scenario 2), at least in the near term. But there will likely be a balancing act with slowing growth and rising inflation. And at current low yield levels and with the ‘beginning of the end of QE’, bonds might be less effective hedges for equities and are likely a larger drag on balanced portfolios. And rising inflation could move the central bank put ‘more out of the money’, requiring a larger ‘growth shock’ for central banks to ease policy. Also current easing options are more limited for central banks as rates are still low and QE purchases have only just been reduced.

 

And once the balanced bear comes, it might be larger and faster. Duration risk in bond markets is much higher this cycle and vol of vol in equities has increased since the mid-80s. While we think investors should lower duration and run higher equity allocations in scenario 1, they should consider hedging at least the risk of smaller equity drawdowns in the near term. We like shorter-dated S&P 500 put spreads. In part 2, we intend to explore different strategies to enhance balanced portfolio returns while managing drawdown risk in case of a bear market.

Ultimately, like every other forecast to come out of Goldman, it"s garbage: want bullish, read Kostin; want bearish - either a little or lot - stick to Glissman. Just remember to use your friendly, Goldman salesperson who will gladly collect the trade commission whatever you do.

That said, there was one useful data point in the 26 page pdf: a chart showing that not only are we nearing the longest 60/40 bull market without a 10% return drawdown, but that the last time we were here was sometime in the late 1920s... and the Great Depression would follow in just a few months.

As Goldman observes: "we are closing in on the longest 60/40 bull market in history - there has been no 10% drawdown in real terms since 2009. A passive long-only balanced portfolio has delivered attractive risk-adjusted returns since the 90s. A favourable ‘Goldilocks’ macro backdrop, supported by the ‘Great Moderation’ and the central bank put, has boosted returns in both equities and bonds. However, after the recent ‘bull market in everything’, valuations across assets are as expensive as they have been this century, which reduces the potential for returns and diversification in balanced portfolios.

Some more statistics:

We are nearing the longest bull market for balanced equity/bond portfolios in over a century - a simple 60/40 portfolio (60% S&P 500, 40% US 10-year bonds) has not had a drawdown of more than 10% since the GFC trough (8.7 years) and has delivered a 143% return (11% p.a.) since then.

And when was the last time a balance portfolio had such a tremendous return? Goldman answers again:

"The longest run has been during  the Roaring 20s, ending with the Great Depression. The second longest run was the post-war ‘Golden age’ in the 50s - the 90s Boom has been in third place but is now fourth, after the current run.

In other words, one would have to go back to some time in early 1929 to be looking at the kind of returns that a balanced "60/40" portfolio is generating today.  In fact, the current period of staggering returns without a 10% total drawdown is now 8.7 years. How long was the comparable period in the 1928s? 9.1 years. Which means that if history is any guide, the second great depression is just around the corner.

How Much Is Equity Research Actually Worth? Probably Less Than You Thought

Over the past several months, investment banks all across Europe have scrambled to put a price tag on their equity research after years of giving it way as a "freebie" in return for trading commissions.

Of course, for wall street"s titans of finance, you know, the same guys who will look you straight in the eyes and tell you that they know with relative certainty the precise value of the synthetic CDO squared they"re selling you, we figured this would be a relatively simplistic task. Therefore, you can imagine our surprise now that the market has established a fairly wide bid-ask spread with JP Morgan on the low end at $10,000 and Barclays on the rich side at $455,000.

Luckily, since wall street"s finest don"t seem to have a clue, Bloomberg Gladfly has decided to take a look at some comps to help shed some light on the true value of equity research.

First, of course, it"s important to define what institutional clients are actually buying when they sign a research contract.  As Bloomberg points out with the chart below, and contrary to popular belief, equity research demand actually has very little to do with analyst forecasts and trade ideas but rather is dependent upon which banks provide the greatest access to those highly coveted management 1x1s.

The dirty little secret on Wall Street -- and why it"s so difficult to price research -- is that star analysts aren"t really valued for their research at all. Ask any money manager, hedge fund or research shop, and they"ll tell you it"s all about the contacts.

 

Many senior analysts spend only 10 percent of their time conducting research and writing reports. Teams of junior associates (or sometimes robots) maintain financial models and blast out notes. Some use pre-recorded voice mails to alert clients to new research.

 

Gadfly estimates that between 50 and 70 percent of a senior analyst"s time is spent on corporate access. Things like arranging lunch with a CFO or connecting a client with a lawyer, supplier or other industry expert to delve into what the data doesn"t. For this reason, analysts are often required to log the number of phone calls, meetings and events arranged each month.

 

The final 20 percent of an analyst"s time is spent on pre-IPO research, conferences and bespoke projects, such as flying a drone over a retailer"s parking lot to track how full it is; scoping the laundry outside apartment blocks; or conducting so-called channel checks to see how much oil"s being pumped through a particular pipeline.

So, what does that mean for the "value" of equity research?  Well, Bloomberg figures those actual "research" reports that flood your inbox all day long are worth basically nothing while the corporate access component of "research" (i.e. those annual trips to Miami Beach where 24-year-old hedge fund analysts get to interview CEO"s between binge drinking sessions at Story) should be valued at roughly the same price as an expert network service.

Access to independent research network Smartkarma starts at $7,500 a year per user for a Spotify-like subscription that opens the door to reports from more than 400 analysts. Customers can also buy additional packages of analysts" time, similar to the way lawyers or consultants get paid.

 

We reckon the closest approximation to corporate access is so-called expert networks, companies that maintain a stable of industry experts to match with fund managers and other financiers when they need quick access to esoteric information.

 

Industry leader Gerson Lehrman Group Inc. charges $100,000 a year, with the heaviest users paying millions of dollars, according to the Financial Times.

 

As for bespoke research projects, Morgan Stanley said it plans to charge $2,500 an hour for private meetings with its stock analysts, almost twice the rate of some of the best corporate lawyers. Partners at big management consulting firms such as Deloitte LLP or McKinsey & Co. charge clients anywhere from $800 to $1,300 an hour, according to career consulting guide Rocketblocks.

Then again, maybe those hedge fund managers could just ask young Trevor Worthington IV to stay home from Miami Beach and read a 10-K for free...just a thought.

Look Who Kalanick Just Appointed To The Uber Board Without Consulting Anyone

It looks like Travis Kalanick is preparing for all-out war in the Uber boardroom.

The Uber co-founder and former chief executive officer - who retains control over three board seats, including his own - has finally filled his long-vacant seats. And guess whom he picked to fill them? Former Xerox Corp. Chairwoman and CEO Ursula Burns...and former Merrill Lynch Chairman and CEO John Thain, "ratcheting up a Machiavellian battle for control of the world’s most valuable startup" as Bloomberg put it. Uber immediately challenged the appointments, calling them "a complete surprise."

“I am appointing these seats now in light of a recent board proposal to dramatically restructure the board and significantly alter the company’s voting rights,” Kalanick said in a statement emailed to Bloomberg. “It is therefore essential that the full board be in place for proper deliberation to occur, especially with such experienced board members as Ursula and John.”

As many may remember, Thain was the last CEO and chairman of Merrill Lynch before it was absorbed by Bank of American during the financial crisis. The last leader of an independent Merrill Lynch was roundly criticized for the same venal behavior as other too-big-to-fail CEOs - BOA paid a $16.7 billion fine in 2014, at the time the largest single settlement in US history, partly for Merrill"s witholding of crucial information (namely, that the products were stuffed with garbage subprime loans while being marketed as AAA) to buyers of its MBS and CDO products. There was, of course, also the whole $35,000 "commode on legs" incident as part of Thain"s $1.2 million office redecoration (which also included $17,100 traveling toilet boxes and a $15,000 dog umbrella stand).

Thain was, appropriately, singled out for criticism by former President Barack Obama, who accused him of "lining his pockets" - and those of his employees - at the taxpayers" expense by handing out massive bonuses after BofA accepted $45 billion in TARP funds.

Kalanick - who resigned as CEO on June 20 after a longrunning battle between him and the company"s largest shareholder, Benchmark Capital - is making the appointments without consulting the rest of the board, according to the Wall Street Journal, which broke the story. He was granted control of three board seats as part of $3.5 billion investment from a Saudi wealth fund in 2016.

The appointment is particularly controversial because Kalanick is presently being sued by Benchmark, who claim he mislead the company"s investors in order to gain control over an additional board seat, and as such the appointments appear to be the latest salvo in Kalanick"s war with Benchmark.

As WSJ noted, the appointments could serve to push back against Benchmark, which also holds a board seat and led other members in a coup to push Kalanick out, which has proposed a new voting structure for shareholders allowing them to vote based on the size of their stake, rather than the current system which rewards the earliest investors with greater voting power. Travis confirmed as much in a statement to WSJ, when he said he believed the "full board should be in place" before boardmembers vote on the proposal.

“I am appointing these seats now in light of a recent board proposal to dramatically restructure the board and significantly alter the company’s voting rights,” Mr. Kalanick said in the statement. “It is therefore essential that the full board be in place for proper deliberation to occur, especially with such experienced board members as Ursula and John.”

It"s also notable that the appointments come just days after Softbank, which is in talks to potentially invest as much as $10 billion in the cash-burning ride-sharing company, reportedly struck a deal with Benchmark to do everything in its power to oppose Kalanick"s efforts to be reinstated as CEO if it becomes an Uber shareholder and gains a board seat.

According to Bloomberg, Uber expressed concern at Kalanick’s announcement: "The appointments of Ms. Burns and Mr. Thain to Uber’s board of directors came as a complete surprise to Uber and its board," the company said. “That is precisely why we are working to put in place world-class governance to ensure that we are building a company every employee and shareholder can be proud of.”

Uber’s board had been scheduled to vote Tuesday on a plan to revamp the company’s corporate governance, a person familiar with the matter said.

Kalanick remains supportive of Khosrowshahi, the person said. The former CEO saw the two appointments as a way to improve the company’s board of directors ahead of the impending vote on Uber’s governance structure, the person said.

To be sure, Kalanick has reportedly told friends and family that he has no intention of returning as CEO - though he might be interested in some kind of senior-level operations position. However, his actions would suggest something entirely different. Of course, considering the astounding run of scandals that erupted under his watch - from claims of sexual harassment, a federal bribery investigation, and the revelation that Uber intentionally blocked law enforcement agents from using its app - the notion of Kalanick returning as CEO seems almost incongruous. Since leaving, his legacy has only been further tarnished by the London taxi regulator"s decision to revoke the company"s operating license, citing abuses that largely occurred during his tenure.

But regardless of whether Kalanick"s ultimate aim is to return as CEO, there"s a more pressing matter at hand: Preventing Benchmark, his primary boardroom nemisis, from asserting even more control even as skepticism continues to grow about the mega valuation of the cash-burning, regulator-flouting Silicon Valley unicorn he helped create.

Citi's Bringing Back The Synthetic CDO...But In A Way That "Insulates It From Any Losses"

Less than a decade after being forced to take a taxpayer funded bailout to avoid an embarrassing bankruptcy filing, Citibank, proving that they learned precisely nothing from the so-called "great recession," has put a 35 year old in charge of once again making the bank into a powerhouse in the Synthetic CDO market.  But please don"t worry about the risk because this time Citi says they"re building the business in a "way that insulates them from any losses."  Here"s more from Bloomberg:

It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system. But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages. Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.

This time, Citigroup says, it’s doing things differently. The deals are tailored in a way that insulates it from any losses, while giving yield-starved buyers a chance to reap returns of 20 percent or more. The market today is also just a fraction of its size before the crisis, and few see corporate defaults surging any time soon. But as years of rock-bottom interest rates have pushed investors toward riskier products, the revival of synthetic CDOs may be one of the clearest signs yet of froth in the credit markets.

Danielle Romero-Apsilos, a spokeswoman at Citigroup, said synthetic CDOs are fundamentally different than they were before the crisis and that banks today aren’t managing market risk any more. That’s because every part of a synthetic CDO deal is distributed to investors, which also helps to prevent the market from growing too fast.

“Every single client we talk to always asks the differences pre-crisis and post-crisis,” said Vikram Prasad, who oversees Chen’s team as the head of correlation and exotics credit trading. “Everyone remembers the word CDO. Our clients are thinking the same thing, they are doing the due diligence.”

Of course, at least in our experience, levering a levered product in order to juice returns by 10x is almost always incredibly safe (can you taste the sarcasm?). 

The safest portion, which would typically return 0.6 percent a year, can be levered up to 6 percent in some cases. Equity tranche returns can reach 20 percent.

Meanwhile, it"s not just Citibank looking to recreate the financial crisis...other banks, including BNP Paribas, are looking to get in on the action as well...

Other Wall Street banks, which shunned the market since the crisis or struggled to establish a foothold, are angling for a bigger slice of the action. BNP Paribas SA is also active in synthetic CDOs and others are keen to follow suit, according to people familiar with the matter, who asked not to be identified because they aren’t authorized to speak publicly.

For those who have forgotten how Synthetic CDOs work, below is a quick primer.  To summarize, you go out and find a bunch of suckers willing to backstop trillions of dollars worth of credit risk in return for a few bps in annual premium payments.  You then tranche out the risk being taken by the CDO investors so that those at the top can get a AAA-rating and, in return, tell their investors that they"re taking no risk at all.  Those investors then lever up their capital another 10x so they can make 8% returns on a "risk-free" investment...it"s basically as safe as having you"re own printing press from the U.S. Treasury.

Typically, these CDOs pool together about 100 different credit-default swaps tied to various companies, which are then sliced into varying levels of risk called tranches -- senior, mezzanine and equity. Over the life of a deal, which generally lasts two to three years, the swaps generate a steady stream of income for “long” investors (and are paid by “short” investors on the other side of the trade who want insurance against a potential default).

The equity tranche has the biggest risk of getting wiped out if losses from defaults exceed roughly 5 to 7 percent, and nets the highest returns.

And guess who"s buying?  If you guessed 20-something year old pension and insurance fund investors who were in middle school during the last financial crisis then you"re absolutely right...congratulations.

Yet after years of rising markets, declining corporate defaults and tighter credit spreads, the trade is finally attracting greater interest. Increasingly, pension funds and endowments have become senior tranche investors in many of Citigroup’s synthetic CDOs. And because the CDOs are derivatives, they have small upfront costs and amplify returns.

“There is a whole generation of people in finance who never knew or forgot what the problems were with synthetic CDOs,” said Janet Tavakoli, a 30-year veteran of the financial markets who runs a consulting firm and has written books on structured credit and CDOs. “Just as derivatives can lever up the upside, they can lever up the downside.”

Conclusion:  "Short everything that guy has touched."

The Secret History Of The Banking Crisis

Authored by Adam Tooze via ProspectMagazine.co.uk,

Accounts of the financial crisis leave out the story of the secretive deals between banks that kept the show on the road. How long can the system be propped up for?

It is a decade since the first tremors of what would become the Great Financial Crisis began to convulse global markets. Across the world from China and South Korea, to Ukraine, Greece, Brexit Britain and Trump’s America it has shaken our economy, our society and latterly our politics. Indeed, it has thrown into question who “we” are. It has triggered both a remarkable wave of nationalism and a deep questioning of social and economic inequalities. Politicians promise their voters that they will “take back control.” But the basic framework of globalisation remains intact, so far at least. And to keep the show on the road, networks of financial and monetary co-operation have been pulled tighter than ever before.

In Britain the beginning of the crisis was straight out of economic history’s cabinet of horrors. Early in the morning of Monday 14th September 2007, queues of panicked savers gathered outside branches of the mortgage lender Northern Rock on high streets across Britain. It was—or at least so it seemed—a classic bank run. Within the year the crisis had circled the world. Wall Street was shaking, as was the City of London. The banks of South Korea, Russia, Germany, France, Belgium, the Netherlands, Ireland and Iceland were all in trouble. We had seen nothing like it since 1929. Soon enough Ben Bernanke, then chairman of the US Federal Reserve and an expert on the Great Depression, said that this time it was worse.

But the fact that the tumult assumed such spectacular, globe-straddling dimensions had initially taken Bernanke by surprise. In May 2007 he reassured the public that he didn’t think American subprime mortgages could bring down the house. Clearly he underestimated the crisis. But was he actually wrong? For it certainly wasn’t subprime that brought down Northern Rock. The British bank didn’t have any exposure in the United States. So what was going on?

The familiar associations evoked by the Northern Rock crisis were deceptive. It wasn’t panicking pensioners all scrambling to withdraw their savings at once that killed the bank. It wasn’t even the Rock’s giant portfolio of mortgages. The narrative of Michael Lewis’s The Big Short, of securitisation, pooling and tranching, the lugubrious details of trashy mortgage dealing, the alphabet soup of securitised loans and associated derivatives (MBS, CDO, CDS, CDO-squared) tell only one part of the story. What really did for banks like Northern Rock and for all the others that would follow—Bear Stearns, Merrill Lynch, Lehman, Hypo Real State, Dexia and many more—and what made this downturn different— so sharp, so sudden and so systemic, not just a recession but the Great Recession—was the implosion of a new system not just of bank lending, but of bank funding.

It is only when we examine both sides of the balance sheet—the liabilities as well as the assets—that we can appreciate how the crisis was propagated, and then how it was ultimately contained at a global level. It is a story that the crisis-fighters have chosen not to celebrate or publicise. Ten years on, the story is worth revisiting, not only to get the history right, but because the global fix that began to be put in place in the autumn of 2007 is in many ways the most significant legacy of the crisis. It is still with us today and remains largely out of sight. The hidden rewiring of the global monetary system provides reassurance to those in the know, but it has no public or political standing, no resources with which to fight back if attacked. And this matters because it is increasingly out of kilter with the nationalist turn of politics.

In the wake of the crash and its austere aftermath, voters in many countries have pointed the finger at globalisation. The monetary authorities, however, have quietly entwined themselves more closely than ever before—and they have done so in order to provide life support to that bank funding model which caused such trouble a decade ago. Ten years on, the question of whether this fix is sustainable, or indeed wise, is a question of more than historical interest.

“To keep the show on the road, networks of financial and monetary co-operation have been pulled tighter than ever before”

In 2007 economists were expecting a crisis. Not, however, the crisis they got. The standard crisis scenario through to autumn that year involved a sudden loss of confidence in American government debt and the dollar. In the Bush era, the Republicans had cut taxes and spent heavily on the War on Terror, borrowing from China. So what would happen, it was asked anxiously, if the Chinese pulled the plug? The great fear was that the dollar would plunge, interest rates would soar and both the US economy and the Chinese export sector would crash land. It was what Larry Summers termed a balance of financial terror. America’s currency seemed so doomed that in autumn 2007, the US-based supermodel Gisele Bündchen asked to be paid in euros for a Pantene campaign, and Jay-Z dissed the dollar on MTV.

But somewhat surprisingly, like the nuclear stand-off in the Cold War, the financial balance of terror has become the basis for a precarious stability. Crucially, both Beijing and Washington understand the risks involved, or at least they seemed to until the advent of President Donald Trump. Certainly during the most worrying moments in 2008 Hank Paulson, Bush’s last Treasury Secretary, made sure that Beijing understood that its interests would be protected. Beijing reciprocated by increasing its commitment to dollar assets.

In 2007, it was not the American state that lost credibility: it was the American housing market. What unfolded was a fiasco of the American dream: 8.7m homes were lost to foreclosure. But the real estate bust wasn’t limited to the US. Ireland, Spain, the UK and the Netherlands all had huge credit booms and suffered shattering busts. As homeowners defaulted some lenders went under. This is what happened early on to predatory lenders such as New Century and Countrywide. Bankruptcy also came to the Anglo Irish Bank and Spain’s notorious regional mortgage lenders, the cajas. In the fullness of time, it was—perhaps, though not necessarily—the fate that might well have befallen Northern Rock too. But before it could suffer death by a thousand foreclosures, Northern Rock was felled by a more fast-acting kind of crisis, a crisis of “maturity mismatch.”

Banks borrow money short-term at low interest and lend long at marginally higher rates. It may sound precarious, but it is how they earn their living. In the conventional model, however, the short-term funding comes from deposits, from ordinary savers. Ordinarily, in a well-run bank, their withdrawals and deposits tend to cancel each other out. Fits of uncertainty and mass withdrawals are always possible, and perhaps even inevitable once in a while. So to prevent them turning into bank runs, governments offer guarantees up to a reasonable amount. Most of the Northern Rock depositors had little to fear. Their deposits were, like all other ordinary savers, guaranteed by then Chancellor Alistair Darling. The investors who weren’t covered by government backing were those who had provided Northern Rock with funding through a new and different channel—the wholesale money market. They had tens of billions at stake, and every reason to panic. It was the sudden withdrawal of this funding that actually killed Northern Rock.

As well as taking in money from savers, banks can also borrow from other banks and other institutional investors. The money markets offer funds overnight, or for a matter of weeks or months. It is a fiercely competitive market with financial professionals on both sides of every trade. Margins are slim, but if the volumes are large there are profits to be made. For generations this was the preserve of investment bankers—the ultimate insiders of the financial community. They didn’t bother with savers’ deposits. They borrowed in the money markets. From the 1990s commercial banks and mortgage lenders began to operate on a similar model. It was this new form of “market-based” banking combined with the famous securitisation of mortgages that enabled the huge expansion of European and US banking that began to crash in 2007.

Run for the hills: Northern Rock depositors rush to start taking out their money. 

By the summer of 2007 only 23 per cent of Northern Rock’s funding came from regular deposits. More than three quarters of its operation was sustained by borrowing in capital and money markets.

For these funds there were no guarantees. For a run to develop in the money market, the mortgages did not need to default. All that needed to happen was for the probability of some of them defaulting to increase. That was enough for interbank lending and money market funding to come abruptly to a halt. The European money markets seized up on 9th August. Within a matter of days Northern Rock was in trouble, struggling to repay short-term loans with no new source of funding in prospect. And it was through the same funding channel that the crisis went global.

The attraction of money market funding was that it freed you from the cumbersome bricks-and-mortar branch network traditionally used to attract deposits. Using the markets, banks could source funding all over the world. South Korean banks borrowed dollars on the cheap to lend in Won. American banks operating out of London borrowed Yen in depressed Japan, flipped them into dollars and then lent them to booming Brazil. The biggest business of all was the “round tripping” of dollars between America and Europe. Funds were raised in America, which for reasons of history and the nation’s sheer scale, is the richest money market in the world. Those dollars were exported to institutions and banks in Europe, who then reinvested them in the US, very often in American mortgages. The largest inflow of funds to the US came not from the reinvestment of China’s trade surplus, but through this recycling of dollars by way of Europe’s banks. Barclays didn’t need a branch in Kansas any more than Lehman did. Both simply borrowed money in the New York money markets. From the 1990s onwards, Europe’s banks, both great and small, British, Dutch, Belgian, French, Swiss and German, made themselves into a gigantic trans-Atlantic annex of the American banking system.

All was well so long as the economy was buoyant, house and other asset prices continued to go up, money markets remained confident and the dollar moved predictably in the direction that everyone expected, that is gently downwards. If you were borrowing dollars to fund a lending business the three things that you did not want to have happen were: for your own loans to go bad; money markets to lose confidence; or for dollars to suddenly become scarce, or, what amounts to the same thing, unexpectedly expensive. While the headlines were about sub-prime, the true catastrophe of the late summer of 2007 was that all three of these assumptions were collapsing, all at once, all around the world.

“The Fed effectively established itself as a lender of last resort to the entire global financial system”

The real estate market turned down. Large losses were in the pipeline, over years to come. But as soon as Bear Stearns and Banque Nationale de Paris (BNP) shut their first real estate funds, the money markets shut down too. Given the global nature of bank funding this produced an acute shortage of dollar funding across the European and Asian banking system. It was the opposite of what the best and brightest in macroeconomics had expected: strong currencies are, after all, meant to be built on thrift and industry, not shopping splurges and speculative debts. But rather than the world being glutted with dollars, quite suddenly banks both in Europe and Asia began to suffer periodic and panic-inducing dollar shortages.

The paradigmatic case of this counterintuitive crisis would eventually be South Korea. How could South Korea, a champion exporter with huge exchange reserves be short of dollars? The answer is that in the years of the recovery from the 1997 East Asian crisis, while Korean companies Hyundai and Samsung had conquered the world, Korea’s banks had been borrowing dollars at relatively low interest rates to lend out back home in Won to the booming home economy. Not only was there an attractive interest rate margin, but thanks to South Korea’s bouyant exports, the Won was steadily appreciating. Loans taken out in dollars were easier to repay in Won. As such these loans cushioned the losses suffered by South Korean firms on their dollar export-earnings.

By the late summer of 2008 the South Korean banks operating this system owed $130bn in short-term loans. Normally this was no problem, you rolled over the loan, taking out a new short-term dollar credit to pay off the last one. But when the inter-bank market ground to a halt the South Koreans were painfully exposed. Barring emergency help, all they could do was to throw Won at the exchange markets to buy the dollars they needed, which had the effect of spectacularly devaluing their own currency and making their dollar obligations even more unpayable. South Korea, a country with a huge trade surplus and a large official dollar reserve, faced a plunging currency and a collapsing banking system.

In Europe the likes of RBS, Barclays, UBS and Deutsche had even larger dollar liabilities than their South Korean counterparts. The BIS, the central bankers’ bank, estimated that Europe’s mega-banks needed to roll over $1-1.2 trillion dollars in short-term funding. The margin that desperate European banks were willing to pay to borrow in sterling and euro and to swap into dollars surged. Huge losses threatened—and both the Bank of England and the European Central Bank (ECB) could not do much to help. Unlike their East Asian counterparts, they had totally inadequate reserves.

The one advantage that the Europeans did have over the Koreans, was that the dollars they had borrowed had largely been invested in the US, the so-called “round-tripping” again. The huge portfolios of American assets they had accumulated were of uncertain value, but they amounted to trillions of dollars and somewhere between 20 and 25 per cent of the total volume of asset- and mortgage-backed securities. In extremis the Europeans could have auctioned them off. This would have closed the dollar-funding gap, but in the resulting fire sales the European banks would have been forced to take huge write downs. And most significantly, the efforts by the Fed and the US Treasury to stabilise the American mortgage market would have been fatally undercut.

“In the 60s, swaps were about stabilising exchange rates. Now they’re all about stabilising oversized banks”

This was the catastrophic causal chain that began to emerge in August 2007.

How could the central banks address it? The answer they found was three-pronged. The most public face of crisis-fighting was the effort to boost the faltering value of the mortgage bonds on the banks’ books (typically securitised versions of other banks’ mortgage loans, which were becoming less reliable in the downturn), and to provide the banks with enough capital to absorb those losses that they would inevitably suffer. This was the saga of America’s Troubled Asset Relief Programme, which played out on Capitol Hill. In the case of Northern Rock this prong involved outright nationalisation. Others took government stakes of varying sizes. Warren Buffett made a lucrative investment in Goldman Sachs. Barclays has now been charged by the Serious Fraud Office with fraudulently organising its own bailout, by—allegedly—lending money to Qatar, which that state is then said to have reinvested in Barclays. Without the bailout, you ended up with Lehman: bewildered bankers standing on the pavements of the City and Wall Street carrying boxes of their belongings. The masters of the universe plunged to earth. It half-satisfied the public’s desire for revenge. But it did nothing for business confidence.

With enough capital a bank could absorb losses and stay afloat. But to actually operate, to make loans and thus to sustain demand and avert a downward spiral of prices and more bankruptcies, the banks needed liquidity. So, secondly, the central banks stepped in, taking over the function, which the money market had only relatively recently assumed but was now suddenly stepping back from, of being the short-term lenders. The ECB started as early as August 2007. The Bank of England came in late, but on a large scale. The Fed became the greatest liquidity pump, with all of Europe’s banks benefiting from its largesse. The New York branches of Barclays, Deutsche, BNP, UBS and Credit Suisse were all provided with short-term dollar funding on the same basis as Citi, Bank of America, JP Morgan and the rest.

But it was not enough. The Europeans needed even more dollars. So the Fed’s third, final and most radical innovation of the crisis was to devise a system to allow a select group of central banks to funnel dollars to their banks. To do so the Fed reanimated an almost-forgotten tool called the “swap lines,” agreements between central banks to trade their currencies in a given quantity for a given period of time. They had been used regularly in the 1960s, but had since gone out of use. Back then, the aim was stabilising exchange rates. This time, the aim was different: to stabilise a swollen banking system that was faltering, and yet abjectly too big to fail. At a moment when dollars were hard to come by, the new swap lines enabled the ECB to deposit euros with the Fed in exchange for the dollars that the eurozone banks were craving. The Bank of England benefited from the same privilege.

Not that they were welcome at first. When the Fed first mooted the idea in the autumn of 2007, the ECB resisted. It did not want to be associated with a crisis that was still seen largely as American. If Gisele didn’t want to be paid her modelling fees in US dollars, why on earth should the ECB be interested? But as the European bank balance sheets unravelled, it would soon become obvious that Frankfurt needed all the dollars it could get. Initiated in December 2007, the swap lines would rapidly expand. By September all the major European central banks were included. In October 2008 the network was expanded to include Brazil, Australia, South Korea, Mexico, New Zealand and Singapore. For the inner European core, plus Japan, they were made unrestricted in volume. The sums of liquidity were huge. All told, the Fed would make swap line loans of a total of $10 trillion to the ECB, the Bank of England the National Bank of Switzerland and other major banking centres. The maximum balance outstanding was $583bn in December 2008, when they accounted for one quarter of the Fed’s balance sheet.

It was a remarkable moment: the Fed had effectively established itself as a lender of last resort to the entire global financial system. But it had done so in a decentralised fashion, issuing dollars on demand both in New York and by means of a global network of central banks. Not everyone was included. Russia wasn’t, which was hardly surprising given that it had come to blows with the west over Georgia’s Nato membership application only weeks earlier. Nor did the Fed help China or India.

And though it helped the ECB, it did not provide support to the “new Europe” in the east. The Fed probably imagined that the ECB itself would wish to help Poland, the Baltics and Hungary. But the ECB’s president Jean-Claude Trichet was not so generous. Instead, eastern Europe ended up having to rely on the International Monetary Fund (IMF).

Swapsies? As a scholar of the Great Depression, the Fed’s Ben Bernanke knew the importance of swap lines. Photo: MARK WILSON/GETTY IMAGES

The swap lines were central bank to central bank. But who did they really help? The reality, as all those involved understood, was that the Fed was providing preferential access to liquidity not to the “euro area” or “the Swiss economy” as a whole, but to Deutsche Bank and Credit Suisse. Of course, the justification was “systemic risk.” The mantra in Washington was: you have to help Wall Street to help Main Street. But the immediate beneficiaries were the banks, their staff, especially their highly-remunerated senior staff and their shareholders.

Though what the Fed was doing was stabilising the global banking system, it never acknowledged as much in so many words, certainly not on the record, where it said as little as it decently could about the swap line operation. The Fed’s actions have global effects. But it remains an American institution, answerable to Congress. Its mandate is to maintain employment and price stability in the US economy. The justification for the swap lines, therefore, was not global stability, but the need to prevent blowback from Europe’s de facto Americanised banks—to avoid a ruinous, multi-trillion dollar fire sale of American assets. Once the worst of the crisis had passed, Bernanke would assist the European banks in liquidating their American assets by way of the Fed’s three rounds of asset purchases, known as Quantitative Easing (QE).

The swaps were meticulously accounted for. Every cent was repaid. No losses were incurred—the Fed even earned a modest profit. They were not exactly covert. But given the extraordinary extension of its global influence that the swaps implied, they were never given publicity, nor even properly discussed. Bernanke’s name will be forever associated with QE, not swap lines. In his lengthy memoirs, The Courage to Act, the swaps merit no more than a few cursory pages, though Bernanke as a scholar of the 1930s knows very well just how crucial these instruments were. Is this an accident? Surely not. In the case of the swap lines, the courage to act was supplemented by an ample measure of discretion.

The Fed did everything it could to avoid disclosing the full extent and range of beneficiaries of its liquidity support operations. They did not want to name and shame the most vulnerable banks, for fear of worsening the panic. But there are politics involved too. Given the rise of the Bernanke-hating Tea Party in 2009, the likely response in Congress to news headlining the scale of the Fed’s global activity was unpredictable to say the least. When asked why no one on Capitol Hill had chosen to make an issue of the swap lines, one central banker remarked to me that it felt as though “the Fed had an angel watching over it.”

One other reason for the tight lips is that the story of the swap lines is not yet over. The network was rolled out in 2007 and 2008 as an emergency measure, but since then it has become the under-girding of a new system of global financial crisis management. In October 2013, as the Fed prepared finally to begin the process of normalisation by “tapering” its QE bond purchases, it made another decision which made plain that the new normal would not be like the old. It turned the global dollar swap line system into a standing facility: that is to say, it made its emergency treatment for the crisis into a permanent feature of the global monetary system. On demand, any of the core group of central banks can now activate a swap line with any other member of the group. Most recently the swap line system was readied for activation in the summer of 2016 in case of fallout from the Brexit referendum.

As the original crisis unfolded in 2008, radical voices like Joseph Stiglitz in the west, and central bankers in the big emerging economies called for a new Bretton Woods Conference—the meeting in 1944, which had decided on the post-war currency system and the creation of the IMF and the World Bank. The Great Financial Crisis had demonstrated that the dollar’s exorbitant privilege was a recipe for macroeconomic imbalances. The centre of gravity in the world economy was inexorably shifting. It was time for a new grand bargain.

“Central banks has staged Bretton Woods 2.0. But they had not invited the public or explained their reasons”

What these visionary suggestions failed to register was that foundation of the world’s de facto currency system were not public institutions like the IMF, but the private, dollar-based global banking system. The introduction of the swap lines gave that system unprecedented state support. The Fed had ensured that the crisis in global banking did not become a crisis of the dollar. It had signalled that global banks could rely on access to dollar liquidity in virtually unlimited amounts, even in the most extreme circumstances. The central banks had, in other words, staged their Bretton Woods 2.0. But they had omitted to invite the cameras or the public, or indeed to explain what they were doing.

The new central bank network created since 2008 is of a piece with the new networks for stress testing and regulating the world’s systemically important banks. The international economy they regulate is not one made up of a jigsaw puzzle of national economies, each with its gross national product and national trade flows. Instead they oversee, regulate and act on the interlocking, transnational matrix of bank balance sheets.

This system was put in place without fanfare. It was essential to containing the crisis, and so far it has operated effectively. But to make this technical financial network into the foundation for a new global order is a gamble.

It worked on the well-established trans-Atlantic axis. But will it work as effectively if it is asked to contain the fallout from an East Asian financial crisis? Can it continue to operate below the political radar, and is it acceptable for it to do so? With the Fed in the lead it places the resources, expertise and authority of the world’s central banks behind a market-based system of banking that has shown its capacity for over-expansion and catastrophic collapse. For all the talk of “macroprudential” regulation, Basel III and Basel IV, rather than disarming, down-sizing and constraining the global banking system, we have—through the swap lines—embarked on, if you like, a regulatory race to the top, where the authorities intervene heavily to allow the big banks in some countries to continue what they were doing before the unsustainable ceased to be sustained. And without even the political legitimacy conferred by G20 approval. Not everyone in the G20 is part of the swap line system.

The Fed’s safety net for global banking was born at the fag-end of the “great moderation,” the era when economies behaved nicely and predictably, and when a “permissive consensus” enabled globalisation. Though a child of crisis, it bore the technocratic, “evidence-based” hall marks of that earlier era. It bears them still.

Can it survive in an age when the United States is being convulsed by a new wave of economic nationalism? Is there still a guardian angel watching over the Fed on Capitol Hill? And with Trump in the White House, how loudly should we even ask the question?

Matt King: "We Are More Reliant On Central Banks Holding Markets Together Than Ever Before"

Two weeks ago we summarized the stunning impact that ECB Predit Mario Draghi"s "whatever it takes" efforts have had on European capital markets in one simple chart...

... which as Wolf Richter showed on Friday meant that European junk bond yields are now on top, if not lower than 10Y US Treasurys, indicative of a market that has "gone nuts" largely thanks to the ECB"s daily intervention, which as reported moments ago, now holds €103.39BN in Europe"s corporate bonds, or nearly 13% of the total outstanding.

Today, perhaps troubled by the ongoing distortions in the European bond market, Citi"s global credit strategist Matt King also looks at the European bond market and in a note titled "Partying like it"s 2007", he looks at recent development in the Investment Grade bond market and writes that "after the rally in recent weeks, the 53bp z spread on € iBoxx Corp is 20bp wide to the 33bp it reached in June 2007. However, he noted that a straight comparison of the index spread level now with then is misleading."

King points out that a huge decline in index rating quality means that, on a like-for-like basis, spreads would only be 41bp: just 8bp shy of the tightest € IG spreads ever.

This means that the upside is very limited: "Even if we do rally back to the all-time tights, that would equate to less than 0.5% of excess returns from here."

We won"t go into the details of the breakdown of the adjusted credit spread, but we will highlight a key thing in King"s observations, namely what is the true level of European leverage, and what is prompting this market distortion (spoiler alert: central banks).

Sceptics may argue that the system is much less levered now than in 2007, and (insofar as it goes) this is true. Back then, the response to tight spreads on what was believed to be low-risk assets was to lever up – by taking exposure through a hedge fund buying on margin and benefiting from European banks’ lack of constraint on leverage ratios, or by buying a structured product which leveraged the underlying assets.

Still, even if the growing back then leverage may have been a source of risk, King is not so sure that it all led in the direction of spread tightening, and as he adds "we are doubtful that today’s one-way reach-for-yield, in which many investors have almost despaired of relative value as a concept, is as much safer as regulators like to think."

To the extent that higher gross CDS notionals (Figure 14) are a crude reflection of this increased leverage, much of the trading being done involved relative value relationships – shorts as well as longs – in a way that simply doesn’t happen today. Indeed, it feels to us as though markets were much more two-way back then than they are now. In some sense the additional leverage clearly did add to systemic risk – it is impossible to look at the 2008 liquidity squeeze and argue otherwise – but we are doubtful that today’s one-way reach-for-yield, in which many investors have almost despaired of relative value as a concept, is as much safer as regulators like to think.

Another difference between 2017 and 2007 is CDO issuance, a product which remains largelly dormant in the current market:

Probably the biggest source of “artificial tightening through leverage” back in 2007 was the volume of synthetic CDO issuance. Synthetic CDOs (CSOs) effectively created negative net supply, as net protection selling by investors forced dealers to buy bonds to hedge their books, dragging both CDS and cash spreads tighter in the process. From 2003-2006, global delta-adjusted CSO issuance ran around $300bn/year; in 2007, this increased over $600bn.

As for today...

But the comparable number today is the buying from global central banks. This too produces an “irresistible force” driving spreads tighter, which investors feel powerless to resist. And the volumes are much larger still, averaging around $1.2tn/year (Figure 15) relative to CSOs’ $3-600bn. Admittedly this is spread across asset classes, with the CSPP in isolation amounting to only €80bn – but to take the latter number would to our minds grossly understate the additional demand created in credit. While it’s essentially impossible to isolate an undistorted credit spread in either case, the fact that the increasingly finite demand of central banks is what has facilitated such tight spreads in the first place is hardly reassuring.

In other words, the same thing verbalized as the chart shown up top shows in very simple terms: it"s all frontrunning the ECB"s corporate purchases/

What does this mean for returns?

The post-adjustment 8.5bp of additional spread on the current index relative to the 2007 tights equates to less than 0.5% of index return – from the point where spreads are back to the tightest level on record. And that was a level that with hindsight was driven by leverage and unrealistic assumptions about credit quality – of banks, of corporates and of sovereigns. The aftermath was not a pretty sight.

The conclusion for both the economy, and market, is troubling especially at a time when central banks are preparing to reduce their balance sheets:

With asset prices displaying a high degree of correlation with central bank liquidity additions in recent years, that feedback loop makes the economy, upon which both corporate profitability and bank net interest margins depend, more reliant on central banks holding markets together than almost ever before. That delicate balance may well be sustained for the time being. But with central banks beginning to move, however gingerly, towards an exit, is it really worth chasing the last few bp of spread from here?

Between record high valuations, FOMO, and confidence that central banks will come to the rescue once again, not to mention the MSCI World Index and the DJIA both hitting yet another all time high, the answer appears to be a resounding yes.

Goldman Issues First Warning On Q3 Results

Remember what Goldman said when it reported atrocious earnings two weeks ago, when it revealed that FICC revenues plunged by 40%? Here is a reminder:

"During the quarter, Fixed Income, Currency and Commodities Client Execution operated in a challenging environment characterized by low levels of volatility, low client activity and generally difficult market-making conditions... During the quarter, Equities operated in an environment characterized by generally higher global equity prices, while volatility levels remained low."

Spot the common theme? Yup: lack of volatility.

Fast forward to today when Goldman became the first bank to warn that Q3 is shaping up to be a continuation of Q2. This is what its CFO Chavez said moments ago, via Reuters:

• GS CFO CHAVEZ: FICC TRADING MARKET BACKDROP, LOW VOLATILITY WE SAW IN SECOND QUARTER HAS CONTINUED INTO THIRD QUARTER

However, Chavez declines to provide specifics on trading revenue so far this quarter during the company"s fixed-income call with investors.

Some other highlights from the ongoing Fixed Income presentation currently taking place, according to which Goldman is increasingly hoping to become a commercial bank. Maybe it can be the next Wells Fargo? It certainly shares the ethics...

• TREASURER ROBIN VINCE: WE HAVE PLANS TO EXPAND ONLINE DEPOSIT PLATFORM

It sure does: judging by this the once feared Goldman, is happy to be seen as a boring, old deposit gatherer:

Some other comments:

• Filling out the gap in client coverage in trading business is first priority, he says


• Excluding treasuries from Goldman’s supplementary leverage ratio would boost it by 70 basis points, Treasurer Robin Vince says on call


• “We are believers in risk-based” capital requirements, Vince says

• GOLDMAN CFO MARTY CHAVEZ: WE ARE TRYING TO CLOSE COVERAGE GAPS TO IMPROVE OUR FIXED INCOME BUSINESS


• GS CFO CHAVEZ: WE"RE ASKING OUR FIXED INCOME CLIENTS HOW WE"RE DOING AND WHAT WE CAN DO BETTER


• GS CFO CHAVEZ: WE SEE OPPORTUNITY IN BUILDING OUT CASH SERVICES, MORE CROSS-SELLING WITH INVESTMENT BANK AND TRADING

And if the revenues don"t materialize soon, taking a page out of the Wells Fargo playbook, Goldman will be just as happy to "cross-sell" you into a long CDO position the next time you deposit $500 with the bank.

Full presentation below:

Russell 2000 Flash-Crashes

"Probably nothing..."

Small-cap stocks briefly erased gains, with the Russell 2000 plunging 0.4 percent in less than a minute as volume exploded...

As Bloomberg notes, about 3.84 million shares traded in the benchmark index at 11:51 a.m., more than 10 times the volume in the previous minute.

Trading also surged in futures, with more than 10,000 contracts changing hands between 11:50 and 11:53, 58 times the volume in the previous three minutes.

Mini futures on the Russell 2000 Index fell about 9 points 1,375.9 in a few seconds, while the iShares Russell 2000 ETF slid more than half a percentage point to $137.

Small Caps were not the only thing act strangely today - VIX dumped and pumped around 1030ET...

S&P and Dow are glued to unchanged from the Trump Dump ahead of FOMC Minutes...

*  *  *

How long before faith in the ETF "CDO" fails?

S&P Confirms That NJ Plan To Pay 50% Of Required Pension Contributions Is Bad; Maintains Negative Outlook

Standard and Poor"s credit rating analysts for the state of New Jersey, David Hitchcock and John Sugden, apparently think that funding only half of your state"s annual actuarially determined contributions is a bad thing...who knew?  So, just to make sure we achieve crystal clarity here, S&P believes that adding to NJ"s $66 billion pension underfunded liability, which would be much higher but for a ridiculous assumption the state makes in setting its return on assets at an artificially high rate of 7.65%, each and every year by contributing less to the fund than what is paid out in benefits, is a bad thing?

Of course, as S&P notes, NJ"s pension problems won"t bankrupt the state until sometime "down the road" so an "A-" rating is still reasonable for now.

Short term, the proposed budget leaves the state in similar financial condition to where it started 2017, with slim, but adequate reserves, and some vulnerability to potential revenue shortfalls. However, down the road, because New Jersey plans to only partially fund its actuarially determined contributions (ADC), the picture looks much worse, as reflected in our current "A-" general obligation rating and a negative outlook on the state.

The governor"s budget proposal follows his multi-year plan to gradually ramp up to full funding of the state pension ADC over 10 years. New Jersey would fund only 50% of the ADC in fiscal 2018, after funding 40% in fiscal 2017. Underfunding in any year ratchets up future state liabilities, in effect pushing back the tide, as New Jersey comes closer to the day when it will be left with no choice but to confront its very significant retirement obligations. The term-limited governor"s successor will face tough funding decisions as early as fiscal 2019. The planned 50% ADC contribution in fiscal 2018 in itself represents a record payment of $2.5 billion, boosted in part by the state"s decision to lower the assumed rate of return to a somewhat less aggressive 7.65% from 7.90%. We calculate the budget proposal, if enacted, would leave New Jersey with a sizable structural budget gap of about 9% of proposed 2018 appropriations--2% attributable to various one-time budget items in fiscal 2018, and 7% representing pension funding below ADC--a similar structural budget gap to last year, despite the increased pension contribution in 2018.

That said, we"re happy to note that S&P was encouraged by Chris Christie"s recommendation, even though it wasn"t a part of his official budget and would likely face stiff opposition, to set aside revenues from his state"s lottery enterprise system to fund New Jersey"s pension ponzi for a period of 30 years. Per NJ.com:

Christie"s biggest surprise was his plan to use proceeds from state lottery ticket sales to pay for public worker pensions" ever-increasing tab.

The lottery, which is expected to bring in $965 million this year, helps fund education programs, psychiatric hospitals, centers for people with developmental disabilities and homes for disabled soldiers.

Under the state Constitution, lottery proceeds must be spent on state institutions and state aid for education. The state pays a number of costs on behalf of local school districts that can be categorized as aid, including the employer share of the Teachers" Pension and Annuity Fund.

The governor estimated this quick injection of cash would reduce the pension fund"s unfunded liability -- $66.2 billion -- immediately by $13 billion and each year reduce the amount actuaries recommend the state chip in.

"If implemented correctly this action would increase the value and stability of our pension funds immediately and would please bond investors and credit rating agencies, also giving greater confidence to New Jersey"s public employees," he said.

State Senate President Stephen Sweeney (D-Gloucester) said if Christie"s lottery plan "makes sense" to help fix the pension system, state lawmakers "will be happy to do it."

Of course, as we pointed out previously, Christie"s plan to send lottery dollars to his own pension just might have something to do with his state"s latest ponzi that envisions issuing debt, intended to cover state budget deficits, to it"s own insolvent pension fund.

After struggling to raise debt from third parties to repair crumbling
infrastructure, the state of New Jersey has come up with a "clever" approach to fundraising that entails selling debt to their own insolvent pension funds...something we"ve dubbed the "Pension Ponzi Squared."  Of course, because when everybody else shuns your debt for being too risky who better to sell it to than yourself?

With $3.4 billion in annual benefits payments versus only $1.9 billion in contributions, funds like the New Jersey Public Employees" Retirement System already qualified as a plain vanilla ponzi scheme.  But, using what little pension assets they have left (38% net funded) to buy debt in the entity that ultimately backstops their liabilities is a whole new level of madness.  As we recall, the mortgage CDO^2 didn"t work out so well back in 2008.

For those who haven"t followed the pension debacle in NJ, here is a decent recap of how decades of bad leadership in the governor"s office created the mess that will inevitably bankrupt the state.

Trump Concerned There Are Too Many "Goldman Guys" On His Team

Two days after democratic senators Elizabeth Warren and Tammy Baldwin sent a letter to Goldman CEO Lloyd Blankfein, asking if Goldman effectively runs the country through its extensive alumni links at the Trump administration, and requesting details on "lobbying" activities in the bank related to review of the Dodd-Frank Act and the Obama-era fiduciary rule on financial advice, as well as asking for any communication between the bank"s employees and Cohn, Mnuchin, nominee for the SEC chair Jay Clayton and chief strategist Steve Bannon, Bloomberg reported overnight that yet another Goldman banker, Jim Donovan, was under consideration for the No. 2 job at the Treasury Department, however it appears he has "got one big thing working against him."

That "thing" is the overdue realization by the new president that his cabinet openly appears to have been created and staffed by populism arch nemesis #1, Goldman Sachs.  Besides Steven Mnuchin, Trump’s pick for Treasury Secretary, former Goldman officials working for the new administration include former president Gary Cohn, now director of the National Economic Council; Stephen Bannon, the chief White House strategist; and Dina Powell, formerly the bank’s head of philanthropic investment, who’s an assistant to the president and senior counselor for economic initiatives.

So just like Goldman would staff every central bank"s core positions prior to Trump, after the US election, the world"s most influential investment bank has shifted all of its attention on just one person, and he is finally starting to realize that that may not be a good thing.

Too many “Goldman guys” already have high-up positions in the Trump administration, the person said, and that could knock Donovan down to one of the undersecretary positions -- possibly undersecretary of the Treasury for domestic finance.

The presence of several former Goldman officials at the highest reaches of the administration runs counter to the president’s regular attacks on Wall Street firms during the campaign. “Donald Trump’s Argument for America,” a two-minute advertisement that ran in prime-time days before the election, featured Goldman Chief Executive Officer Lloyd Blankfein in an segment about corporate chieftains pocketing the wealth of American workers.

Having reneged on this core populist angle of his campaign, and opening himself up to democratic attacks over the extensive presence of Goldman bankers in his team, "now the White House seems sensitive to the issue and is taking it into consideration as it attempts to fill remaining top posts."

Donovan, whose time at Goldman overlapped with Mnuchin, most recently was a managing director at the bank’s private wealth management division and has been at Goldman since 1993. He would be subject to Senate confirmation. At Treasury, Donovan "would join the effort to execute the extensive economic policy agenda that the new administration has promised. Trump has vowed to cut regulations and taxes with the goal of unlocking economic growth. The Treasury Department will also be responsible for navigating economic diplomacy for a White House not shy about jawboning currencies."

Donovan’s name emerged in January as a front-runner for undersecretary of domestic finance, a key Treasury position that helps oversee the $13.8 trillion market for Treasuries.

Meanwhile, underscoring the coverage Trump"s Goldman ties are getting in the press, on Saturday Gary Cohn, the former Goldman Sachs President and COO who runs economic policy inside the White House and who is now in charge of drafting Trump"s "phenomenal" tax plan, got the star treatment when both the Wall Street Journal and New York Times published two very similar, laudatory pieces detailing Cohn"s rise. Some of the highlights via Axios::

• WSJ: "At Donald Trump"s first meeting with Gary Cohn in late November, he appeared so impressed with the then-president of Goldman Sachs Group Inc. that he joked about offering him the post of Treasury secretary, said a person who recalled the moment. Sitting nearby was the odds-on favorite for the job, Steven Mnuchin, who got the nod."


• NYT: "People with knowledge of his new role said that Mr. Cohn, a Democrat, is summoned to the Oval Office for impromptu meetings with the president up to five times a day — and that he reaches out to the president on other occasions. Mr. Trump, said one of these people, is oriented toward the bottom line when it comes to shaping policy, often asking Mr. Cohn, "What do you want to do?"


• NYT: "Mr. Cohn collaborates frequently with Mr. Kushner, who is now a senior adviser to Mr. Trump. Along with Mr. Kushner and his wife, Ivanka Trump, Mr. Cohn recently helped persuade the president not to pursue an executive order that would have rolled back rights for gay, lesbian, bisexual and transgender people."

Goldman Sachs CEO Lloyd Blankfein, left, with COO Gary Cohn, in April 2010
awaiting a speech on financial regulation by then-President Barack Obama

The best part: Goldman"s response to Elizabeth Warren:

On Friday, Sens. Elizabeth Warren (D., Mass.) and Tammy Baldwin (D., Wis.) sent a letter to Mr. Blankfein asking whether Goldman officials have been in contact with Mr. Cohn or other Goldman alumni in the White House and whether the firm expects to benefit from changes to financial regulation Mr. Cohn is pushing through executive orders.

A spokesman for Goldman said it had no involvement in drafting executive orders. In an interview before the executive orders were signed, Mr. Cohn said the administration’s goal of deregulating financial markets “has nothing to do with Goldman Sachs” but was focused on maintaining the nation’s dominant position in global banking.

And if you believe that, the Trump adminstration, pardon, Goldman Sachs has a nice, refurbished, 10-year-old CDO squared in pristine shape to sell you.