Why Dow went haywire
Remember Deutsche bank chairman Lord Aldington and CDO squared? He was the bank boss who embarrassed himself before the Treasury Select Committee in 2008 when he couldn’t explain one of the products at the heart of the financial crisis.
Incidentally, Deutsche is among the banks which a decade on are still struggling to recover.
A reminder of this incident emerged this week as a new alphabet of financial products at the core of whip-sawing share markets came under scrutiny.
We have learned of the existence of exchange traded notes ( ETNs) and exchange traded products (ETPs) built around market turbulence. These are in addition to the exchange traded funds (ETFs) or iShares pioneered by barclays and now part of blackrock.
ETFs and ETPs were created to capture investors’ market volatility index, or the Vix. Credit Suisse rocket scientists created the Xiv – Vix spelled backwards – which moves in the opposite direction to the volatility index. The Swiss casino bank unsettled markets when it closed the fund this week after it tumbled 80pc. There were echoes from the financial crisis when, in August 2007, Paris-based BNP closed two investment funds heavily exposed to securities based on American sub-prime mortgages.
Credit Suisse was not alone in getting out of the money funds. barclays’ ‘long’ volatility fund, known as VXX, lost 99.9pc of its value, effectively wiping it out, as share markets gyrated.
No one is going to shed tears for financial whizzes making huge bets for and against volatility if they lose their shirts. They are a sophisticated version on inveterate gamblers in the betting shop having a wager on two flies climbing the wall while awaiting the 3.45pm at Newmarket. If only it were so simple. The difficulty is that the sophisticates in the trading rooms of Wall Street and the City, and the sole traders operating out of darkened rooms in miami and Hounslow, spend very little real money buying into such funds.
much of the trade is done on leverage (borrowings) and the deals are ‘insured’ by derivatives – trades in futures and options.
Such transactions are far away from the fundamentals of turnover, earnings and dividends, with an overlay of broader economic sentiment, which are the real engines of the Dow Jones, the FTSE 100 and other global equities. When sentiment shifted at the end of January, with the perception that interest rates may rise more speedily and higher than predicted, Wall Street, with justification, reacted out of fear.
WHAT wasn’t immediately recognised, and has become a huge issue for market aficionados, is that a move based on an economic trigger has managed to detonate a series of little-understood timebombs built around volatility.
The benign view is that this doesn’t matter too much since the products concerned are valued at $8bn (£5.7bn) at most. And in the context of the trillions of dollars of value created by the Dow, as it soared to a peak of 26,616 in January, the numbers are insignificant. research by the University of Southern California marshall business School indicates that across all financial markets there is far bigger $1.5 trillion (£1.1 trillion) exposure to volatility. If only a small percentage of these trades were highly leveraged and it all went very wrong there could be big credit risks for the banks.
The other potential banana skin arising from the sudden falls in stock markets, particularly if the correction turns to a rout, is that as the equity tide goes out it leaves on the seashore those companies (Carillion is a classic) carrying too much debt on their balance sheets. The IMF’s 2017 Financial Stability report calculates that, since the financial crisis, non-financial borrowing has soared to $135 trillion (£96.4 trillion) or 235pc of total output among the G20 leading economies. As interest rates rise, so will debt service costs and credit risk could take off.
So far regulators have been remarkably quiet about mounting risks of really serious disruption. Deputy bank of england governor ben broadbent noted that the rise in volatility in the past week was simply an investor response to stronger growth and greater inflation. Let us hope he is right.
but we should never underestimate the capacity of the casino banking system to create products that explode in our faces.