« There is a great company called I Can’t Believe It’s Not Butter. At least they have the decency to tell you it’s not butter. They called it credit default swaps because if they called it ‘I can’t believe it’s not insurance’ maybe nobody would buy it. »
New York Democratic Rep. Gary Ackerman during congressional hearings in 2009.
In 2008, the entire financial system almost collapsed because of two products: collateralized debt obligation (CDO) and credit default swap (CDS). One the largest insurance company in the world, AIG, was just about to file for Chapter 11 the same day as Lehman Brothers, after being hit by massive losses in their CDS portfolio.
The reason was that one of their subsidiaries, AIG Financial Products, had sold many of those protections for years, considering that selling CDS on AAA tranches of RMBS or CDO was a smart way to generate yield without any risk. Said differently, a well-established insurer had sold insurance without being able to pay if something happened.
Indeed, financial derivatives like CDS or options are very similar to insurance contracts protecting against a financial risk. But the thing is: people selling those contracts are not regulated like real insurance companies. So, in the case of an extreme event, there is no guarantee that they will be able to meet their obligations.
What about now? Four days ago, London-based H2O Asset Management announced that some of their funds had lost almost 40% of their value, mainly because of short positions on volatility. Like many traders and investors, they probably had faith in the so-called ‘central banks put’ that would prevent from significant price corrections for equities or corporate bonds.
Great work has been achieved by people like Sven Henrich (founder of Northmantrader.com) or Mohamed El-Erian to explain how dangerous markets have recently become. With equity indices currently breaking key support levels, we should now bear in mind that many other people might have sold protections like that and could be exposed to severe losses. Naturally, it should lead to the following critical question: ‘can they meet their financial obligations?’.
Extreme volatility events have been a recurring problem in finance, as already explained by Nassim Nicholas Taleb in his famous book The Black Swan: The Impact of the Highly Improbable. I recently wrote a short paper to explain that daily spikes of implied volatility are distributed following a power law, like earthquakes magnitude. In other words, implied volatility can reach infinite levels.
Selling protection on capital markets can lead to significant losses and risk management is extremely difficult since standard pricing models are likely to underestimate the true level of risk of such contracts.
Warren Buffet once said that ‘derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.’ And he also said this very meaningful thing: ‘You never know who’s swimming naked until the tide goes out.’
This article was originally published on LinkedIn March 12, 2020.