Why February’s volatility shock was just the beginning
From Alan Gula in the Stansberry Digest:
I saw the financial crisis unfold from a Wall Street trading floor…
It was June 2008. Investment bank Barclays Capital had just hired me (Alan Gula). I spent a month in London at the company’s headquarters before returning to New York City, where I would be based.
Barclays was a familiar place. I had worked there the summer before, between my two years in graduate business school. But by the time I had returned, things had changed dramatically for the worse…
The subprime mortgage meltdown had already begun to claim casualties…
Bear Stearns was the smallest of the top-five U.S. investment banks. It was also highly leveraged and had a lot of exposure to mortgages and their derivatives.
As mortgage-related losses on Wall Street mounted, many of Bear’s counterparties and lenders grew wary of the bank. The loss of confidence drained Bear of liquidity.
To avoid a bankruptcy, the U.S. Treasury Department basically pushed Bear into the arms of JPMorgan (JPM) in March 2008.
Shortly after Bear’s failure, I joined Barclays and began a rotational program. I spent a few months on the foreign-exchange structuring desk, creating and trading complex derivatives linked to currency movements.
But it was my time on the credit desk that gave me a front-row seat to the crisis…
As far as credit trading goes, there are three main categories of corporate debt.
Investment-grade is the safest tier. These companies aren’t supposed to go bankrupt. (But it’s not impossible, as I’ll show you in a moment.)
High-yield is the tier below investment-grade. These are the bonds of highly leveraged companies… Therefore, they tend to be riskier and higher-yielding than investment-grade bonds. (We target high-yield bonds in our Stansberry’s Credit Opportunities newsletter.)
The third and lowest tier of corporate debt is distressed. This includes debt of companies that are near bankruptcy (or already in it).
I’ll never forget what happened in the fall of 2008, as I worked on Barclays’ distressed-debt desk…
The market searched for the next-weakest link…
Bear was gone, and Lehman Brothers was the fourth-largest U.S. investment bank. Lehman was also highly leveraged and carried significant mortgage risk.
Ratings agency Standard & Poor’s (S&P) still had Lehman at an “A” credit rating – investment-grade, five notches above high-yield.
On September 10, 2008, Lehman pre-announced a massive $3.9 billion loss for the third quarter. The company had significant write-downs of its mortgage-related and commercial real estate positions.
That week, S&P placed Lehman on “negative watch.” But for some reason, the ratings agency didn’t downgrade the bank right then and there. In fact, S&P was even sanguine in its note…
We continue to view Lehman’s near-term liquidity as satisfactory… Management has implemented, and continues to implement, a number of measures to ensure sound liquidity and the ability to meet funding obligations in a stressed operating environment.
Of course, nothing could have been further from the truth. We were seeing a “run on the bank” as Lehman’s counterparties distanced themselves and prime brokerage clients pulled money… similar to what had felled Bear Stearns.
On Friday, September 12, Lehman had a solid, investment-grade credit rating. By Monday, the storied investment bank had filed for bankruptcy.
We had entered the apex of the financial crisis…
Investors were panicked, and the markets were in disarray… And yet, the trading floor wasn’t especially chaotic that Monday. There was more activity than usual, but it was orderly.
Insurance companies, pension funds, and mutual funds generally can’t hold high-yield or distressed bonds because they’re considered too risky. Therefore, these institutional investors had to sell their Lehman bonds after the company filed for bankruptcy.
Most of Lehman’s senior unsecured bonds – bonds that rank above subordinated debt and that don’t have collateral – had been trading above $90 at the beginning of September. (Bonds typically have a $1,000 par value, but bonds are typically quoted as if they have a $100 par value.) The Friday before it filed, many were trading in the low $80s.
By the time Lehman filed for bankruptcy, its shares had already fallen 95% from their peak. That Monday, the share price fell to almost $0. The bonds traded down to the low $30s…
I spent the day analyzing Lehman’s corporate structure and its hundreds of subsidiaries. Meanwhile, our head trader “made a market” – providing bid and ask prices to clients wishing to sell or buy Lehman bonds.
Over the next few days, the bonds traded below $0.20 on the dollar.
At the time of its failure, Lehman had $639 billion in assets and $613 billion in liabilities. It remains the largest bankruptcy in U.S. history.
The bank run continued…
Washington Mutual was a savings bank that catered to consumers, not companies. It specialized in mortgages and other retail lending. Following the Lehman bankruptcy, savings and checking account holders panicked and pulled $16.7 billion of deposits. Regulators seized the institution’s bank and sold it to JPMorgan. It was the largest savings bank failure in U.S. history.
These and other failures were a bonanza for Barclays’ distressed-debt desk…
We saw a boom in trading volumes.
However, millions of Americans were losing their jobs and homes. Many businesses lost access to credit – the lifeblood of the modern economy. A chain reaction had started that, if not stopped, would have led to a second Great Depression.
Lehman had failed. Bank of America (BAC) was buying Merrill Lynch. The next Wall Street firm to fall would likely be Morgan Stanley (MS). In June 2007, the investment bank had had a market cap of more than $90 billion. By October 2008, it dwindled to as low as $10 billion.
Our policymakers knew something had to be done… So Congress passed the $700 billion Troubled Asset Relief Program (“TARP”) in October 2008.
The following month, the Federal Reserve unveiled its quantitative-easing (“QE”) program.
Regular Digest readers are familiar with QE – often referred to as “money printing.” Basically, the central bank buys securities from the market, typically in the form of government bonds. This increases the base money supply and is intended to stimulate the economy.
In December, the Fed cut short-term interest rates to near zero.
These actions ultimately instilled confidence in our financial system and helped “unfreeze” the credit markets. The situation was dire. And clearly, more firms would have failed.
But there was little need for the ’emergency stimulus’ to continue… and continue…
The Fed’s first QE program ended in March 2010. Later that year, another round of bond-buying began, which ran through mid-2011. Inexplicably, the Fed carried out a third round of QE from 2012 to 2014.
Before Lehman’s bankruptcy, the Fed had about $900 million worth of assets on its balance sheet. By the end of 2014, it had $4.5 trillion.
The Fed halted its bond-buying in 2014. But the other central banks around the world more than picked up the slack. The chart below shows the total assets of four major central banks: the Fed, the European Central Bank (ECB), the Bank of Japan (BOJ), and the Swiss National Bank (SNB)…
These central banks now have a total of about $15.4 trillion in assets. As you can see, their combined asset buying even accelerated in recent years.
Each central bank went about QE in a unique way…
The Fed bought Treasury securities and mortgage-backed securities. The ECB has been buying government debt of eurozone countries, and began to buy investment-grade corporate bonds of European companies in 2016. The BOJ has focused on Japanese government bonds and exchange-traded funds. And the SNB has built a portfolio of foreign equities, including about $80 billion worth of U.S. stocks, including Apple (AAPL), Alphabet (GOOGL), Microsoft (MSFT), and Facebook (FB).
What started out as a drastic maneuver by the Fed in 2008 has become the norm around the world. Plus, the stimulus has a global impact. For example, capital has fled Europe and Japan – due to negative interest rates and QE – and has come to the U.S. in search of yield.
With all of this stimulus, is it any wonder why stocks and corporate bonds have done so well over the last nine years? And is anyone surprised that volatility has – until recently –remained historically low?
But that’s all set to change…
Last September, the Fed announced its intention to let its assets “roll off.” It isn’t selling… It just isn’t buying more bonds once they mature. This will shrink its balance sheet.
In the fourth quarter of 2017, the roll-off was capped at $10 billion per month. Every quarter, that Fed will raise that threshold by $10 billion until it reaches $50 billion. At the end of this month, the Fed will allow as much as $40 billion to roll off its balance sheet per month.
The Fed isn’t alone, either… The ECB is planning to end its QE program by the end of this year.
The “great unwind” that my colleague Justin Brill has written about extensively here in the Digest has begun.
The major central banks likely won’t ever sell anything… But this global monetary experiment is ending (at least, temporarily).
Global stimulus has continued almost unabated since Lehman went bankrupt…
And that has suppressed volatility in the financial markets.
Last year was the calmest year in decades for the U.S. stock market. I personally became worried that investors had grown too complacent. Many traders were even speculating that volatility would decline even further.
It was a dangerous bet. So last November, I issued a warning to readers of my Stansberry Alpha trading service…
Shorting volatility has become too popular… Right now, we’re seeing a once-in-a-decade calm market. And more and more investors are betting that the calm will continue…
I even highlighted the massive growth in assets of two products that let traders bet on declining volatility. One of them was the VelocityShares Daily Inverse VIX Short-Term ETN (XIV).
Less than three months later, the market experienced a volatility shock. From late January to early February, the benchmark S&P 500 Index fell more than 10% in just 10 trading sessions… sending volatility to its highest level in more than two years.
The shock blew up XIV. In just three trading days, XIV shares lost more than 90% of their value. The decline was so bad that its sponsor – investment bank Credit Suisse – pulled the plug on the product.
As stimulus around the world ebbs, we’re going to experience more volatility shocks like the one in early 2018… and they will become more frequent.
I urge you to take our advice seriously…
Higher volatility will become the norm. This will frighten most investors… But you don’t have to get scared out of the market.
Follow your trailing stops, raise cash, and be prepared to buy the shares of high-quality companies as they go on sale.
But if you’re looking to make higher volatility work in your favor, I have an even better solution…
As some of you may know, Stansberry Alpha is an options-trading service that takes advantage of high volatility.
To be honest, it had been difficult to find opportunities last year with volatility at historic lows. But even during periods of low volatility, we had success.
In fact, we recently booked one of the biggest gains in Stansberry Alpha history trading on apparel maker Ralph Lauren (RL). We opened the trade last September, during a historic calm in the markets… and earlier this month, we closed it for a 176% gain (relative to the margin requirement).
If we can do that well during one of the calmest periods in market history, imagine how well we’ll do in periods of market turmoil… like the ones we expect as the global stimulus wanes.
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